Susquehanna Bancshares 10-K 2006
Documents found in this filing:
on Form 10-K/A
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
Amendment No. 1
ANNUAL REPORT PURSUANT TO SECTIONS 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2005
For the transition period from to
Commission file number 0-10674
Susquehanna Bancshares, Inc.
(Exact Name of Registrant as Specified in Its Charter)
Registrants telephone number, including area code (717) 626-4721
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
common stock, par value $2.00 per share
Indicate by check mark if the registrant is a well-seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes ¨ No x
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of 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. x
Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b2). Yes x No ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The aggregate market value of voting stock held by non-affiliates of the registrant was approximately $1,119,278,792 as of June 30, 2005, based upon the closing price quoted on the Nasdaq National Market for such date. Shares of common stock held by each executive officer and director and by each person who beneficially owns more than 5% of the outstanding common stock have been excluded in that such persons may under certain circumstances be deemed to be affiliates. This determination of executive officer or affiliate status is not necessarily a conclusive determination for other purposes. The number of shares issued and outstanding of the registrants common stock as of February 28, 2006, was 46,882,478.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of Susquehannas definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held May 3, 2006 are incorporated by reference into Part III of this Annual Report.
Explanatory Note: This Amendment No. 1 on Form 10-K/A amends our Form 10-K for the year ended December 31, 2005, initially filed with the Securities and Exchange Commission (the SEC) on March 14, 2006 (the original 2005 Form 10-K).
This Form 10-K/A includes our restated consolidated financial statements for the years ended December 31, 2005, 2004 and 2003, including the notes thereto. Our financial statements have been restated principally to restate our consolidated statements of cash flows in order to reclassify items related to origination, repayment and disposition of our portfolio of vehicle leases from operating activities to investing activities. In addition, we have restated our unaudited consolidated financial statements as of and for the quarters ended March 31, 2005, June 30, 2005 and September 30, 2005 that were included in the periodic reports on Form 10-Q that we filed in 2005 (the 2005 Forms 10-Q). Refer to Note 2, Restatement, in this Form 10-K/A for further information on the restatement impact for the years ended December 31, 2005, 2004 and 2003.
This Form 10-K/A only amends and restates Items 8 and 9A of Part II of the original 2005 Form 10-K and no other items in the original 2005 Form 10-K are amended hereby. The foregoing items have not been updated to reflect other events occurring after the filing of the original 2005 Form 10-K or to modify or update those disclosures affected by subsequent events. In addition, pursuant to the rules of the SEC, Item 15 of Part IV of the original 2005 Form 10-K has been amended to contain currently-dated consents from our independent auditors and certifications from our Chief Executive Officer and Chief Financial Officer, as required by Sections 302 and 906 of the Sarbanes Oxley Act of 2002.
TABLE OF CONTENTS
Unless the context otherwise requires, the terms Susquehanna, we, us, and our refer to Susquehanna Bancshares, Inc. and its subsidiaries.
Item 1. Business
Susquehanna Bancshares, Inc. is a financial holding company that provides a wide range of retail and commercial banking and financial services through our subsidiaries in the mid-Atlantic region. In addition to three commercial banks, we operate a trust and investment company, an asset management company (which provides investment advisory, asset management, brokerage and retirement planning services), a property and casualty insurance brokerage company, a commercial leasing company and a vehicle leasing company. As of December 31, 2005, we had total assets of $7.5 billion, consolidated net loans and leases of $5.2 billion, deposits of $5.3 billion and shareholders equity of $780.5 million.
Susquehanna was incorporated in Pennsylvania in 1982. Our executive offices are located at 26 North Cedar Street, Lititz, Pennsylvania 17543. Our telephone number is (717) 626-4721, and our web-site address is www.susquehanna.net. Our stock is traded on the Nasdaq National Market under the symbol SUSQ. We make available free of charge, through the Investor Relations section of our web site, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission. We include our web-site address in this Annual Report on Form 10-K only as an inactive textual reference and do not intend it to be an active link to our web site.
As a financial holding company with operations in multiple states, we manage our subsidiaries on a geographic market basis, which allows each subsidiary operating in different markets to retain its autonomy with regard to loan approvals and product pricing. We believe that this approach differentiates us from other large competitors because it gives our subsidiaries greater flexibility to better serve their markets and increase responsiveness to the needs of local customers. We continue, however, to implement consolidations in selected lines of business, operations and support functions in order to achieve economies of scale and cost savings. We also provide our banking subsidiaries guidance in the areas of credit policy and administration, risk assessment, investment advisory administration, strategic planning, investment portfolio management, asset liability management, liquidity management and other financial, administrative, and control services.
Our Bank Subsidiaries
The following table sets forth information, for the year ended December 31, 2005, regarding our bank subsidiaries and our non-bank subsidiaries that had annual revenues in excess of $5.0 million:
As of December 31, 2005, non-interest income represented 34.1% of our total revenue. Bank subsidiaries contributed 52.5% of total non-interest income, and non-bank affiliates 47.5% of total non-interest income.
We are managed from a long-term perspective with financial objectives that emphasize loan quality, balance sheet liquidity and earnings stability. Consistent with this approach, we emphasize a low-risk loan portfolio derived from our local markets. In addition, we focus on not having any portion of our business dependent upon a single customer or limited group of customers or a substantial portion of our loans or investments concentrated within a single industry or a group of related industries. Our net charge-offs over the past five years have averaged 0.20% of total average loans and leases.
As of December 31, 2005, our total loans and leases (net of unearned income) in dollars and by percentage were as follows:
As of December 31, 2005, core deposits funded 71.2% of our lending and investing activities. The following chart reflects the total loans and deposits of our banks and their subsidiaries as of December 31, 2005:
Our Non-bank Subsidiaries. Susquehanna Trust & Investment Company and Valley Forge Asset Management Corp. operate primarily in the same market areas as our bank subsidiaries. The Addis Group, LLC operates primarily in southeastern Pennsylvania, southern New Jersey and northern Delaware. Boston Service Company, Inc. (t/a Hann Financial Service Corp.) operates primarily in New Jersey, eastern Pennsylvania and southeastern New York. Susquehanna Patriot Commercial Leasing Company, Inc. operates throughout the continental United States.
While conditions in our market area are presently stable, a variety of factors (e.g., any substantial rise in inflation or unemployment rates, decrease in consumer confidence, natural disasters, war, or political instability) may affect such stability, both in our markets as well as national markets. We will continue our emphasis on managing our funding costs and lending rates to effectively maintain profitability. In addition, we will seek relationships that can generate fee income that is not directly tied to lending relationships. We anticipate that this approach will help mitigate profit fluctuations that are caused by movements in interest rates, business and consumer loan cycles, and local economic factors.
Products and Services
Our Bank Subsidiaries. Our commercial bank subsidiaries operate as an extensive branch network and maintain a strong market presence in our primary markets. They provide a wide-range of retail banking services, including checking, savings and club accounts, check cards, debit cards, money market accounts, certificates of deposit, individual retirement accounts, home equity lines of credit, residential mortgage loans, home improvement loans, student loans, automobile loans, personal loans and internet banking services. They also provide a wide-range of commercial banking services, including business checking accounts, cash management services, money market accounts, land acquisition and development loans, commercial loans, floor plan, equipment and working capital lines of credit, small business loans and internet banking services.
Our Non-bank Subsidiaries. Our non-bank subsidiaries offer a variety of financial services to complement our core banking operations, broaden our customer base, and diversify our revenue sources. The Addis Group, LLC provides commercial, personal property and casualty insurance, and risk management programs for medium and large size companies. Susquehanna Trust & Investment Company, a subsidiary of Susquehanna Bank PA, provides traditional trust and custodial services, and acts as administrator, executor, guardian and managing agent for individuals, businesses and non-profit entities. Valley Forge Asset Management Corp. offers investment advisory, asset management and brokerage services for institutional and high net worth individual clients, and through a subsidiary, retirement planning services. Boston Service Company, Inc. (t/a Hann Financial Service Corp.) provides comprehensive consumer vehicle financing services. Susquehanna Patriot Commercial Leasing Company, Inc., a subsidiary of Susquehanna Patriot Bank, provides comprehensive commercial leasing services.
Our Long-Term Strategy
We manage our business for sustained long-term growth and profitability. Our primary strategies are internal growth through expansion of our customer base in existing markets and external growth through
acquisitions in selected markets. We focus on leveraging customer relationships by cross-selling a comprehensive range of financial services and products by a highly trained and motivated employee sales force. Our long-term strategic plan to enhance shareholder value has three main components: growing our business profitably through the specific methods mentioned above; developing our sales culture; and focusing on risk management. Integrated into our strategic plan under these components are various company-wide initiatives we believe are important to achieving our plan, including technology, rewards, teamwork, training, communications and organizational structure.
Mergers and Acquisitions
Bank Charter Consolidations. On January 21, 2005, our former wholly owned subsidiaries, WNB Bank and First Susquehanna Bank & Trust, were merged into Susquehanna Bank PA. On April 15, 2005, our former wholly owned subsidiaries, Susquehanna Bank; Citizens Bank of Southern Pennsylvania; and First American Bank of Pennsylvania, were merged into Farmers & Merchants Bank and Trust, who subsequently changed its name to Susquehanna Bank.
Brandywine. On February 1, 2005, we acquired Brandywine Benefit Corporation, Rockford Pensions, LLC and JFP Strategies (collectively, Brandywine), Wilmington, Delaware, a financial planning, consulting and administration firm specializing in retirement benefit plans for small to medium-sized businesses. JFP Strategies was acquired through an asset-only acquisition; Brandywine Benefit Corporation and Rockford Pensions, LLC were merged into Valley Forge Asset Management Enterprises, LLC (subsequently changing its name to Brandywine Benefits Company, LLC), a wholly owned subsidiary of our wealth management subsidiary, Valley Forge Asset Management Corp.
Minotola. On November 14, 2005, we announced the signing of a definitive merger agreement pursuant to which we will acquire Minotola National Bank (Minotola) of Vineland, New Jersey. Under the terms of the Agreement and Plan of Merger among Susquehanna Bancshares, Inc., Susquehanna Patriot Bank and Minotola, for each share of Minotola held, a Minotola shareholder may elect to receive either $3,226 in cash, 134 Susquehanna common shares, or a combination thereof such that 30% of the Minotola shares would be exchanged for cash, and 70% would be exchanged for Susquehanna common stock. It is anticipated that the transaction will be completed by April 30, 2006, pending regulatory approvals.
Future Acquisitions. We routinely evaluate possible future acquisitions of other banks, and may also seek to enter businesses closely related to banking or that are financial in nature, or to acquire existing companies already engaged in such activities, including investment advisory services and insurance brokerage services. Any acquisition by us may require notice to or approval of the Board of Governors of the Federal Reserve System, the Pennsylvania Department of Banking, other regulatory agencies and, in some instances, our shareholders. While any such acquisition may occur in any market area, the four major growth corridors that we are currently focused on are as follows:
Other than the Minotola transaction discussed above, we currently have no other formal commitments with respect to the acquisition of any entities, although discussions with prospects occur on a regular and continuing basis.
As of December 31, 2005, we had 1,991 full-time and 220 part-time employees.
Financial holding companies and their subsidiaries compete with many institutions for deposits, loans, trust services and other banking-related and financial services. We are subject to competition from less heavily regulated entities such as brokerage firms, money market funds, credit unions, consumer finance and credit card companies and other financial services companies.
The Gramm-Leach-Bliley Act has liberalized many of the regulatory restrictions previously imposed on us, including our subsidiaries. Further legislative proposals are pending or may be introduced which could further affect the financial services industry. It is not possible to assess whether any of such proposals will be enacted, and if enacted, what effect such a proposal would have on our competitive positions in our marketplace.
As a result of state and federal legislation enacted over the past 20 years, consolidation in the industry has continued at a rapid pace. Further, as a result of the relaxation of laws and regulations pertaining to branch banking in the state, and the opportunity to engage in interstate banking, consolidation within the banking industry has had a significant effect on us and our markets. At present, our bank subsidiaries and we compete with numerous super-regional institutions, with significantly greater resources and assets, that conduct banking business throughout the region.
Supervision and Regulation
General. We are a financial holding company registered with the Board of Governors of the Federal Reserve System (the Federal Reserve Board) and are subject to regulation under the Bank Holding Company Act of 1956, as amended. The Bank Holding Company Act requires prior approval of an acquisition of all or substantially all of the assets of a bank or of ownership or control of voting shares of any bank if the share acquisition would give us more than 5% of the voting shares of any bank or bank holding company. It also imposes restrictions, summarized below, on the assets or voting shares of non-banking companies that we may acquire.
Our bank subsidiaries are also subject to regulation and supervision. Susquehanna Bank PA is a Pennsylvania state bank subject to regulation and periodic examination by the Pennsylvania Department of Banking and the Federal Reserve Board. Susquehanna Patriot Bank is a New Jersey state member bank subject to regulation and periodic examination by the New Jersey Department of Banking and Insurance and the Federal Reserve Board. Susquehanna Bank is a Maryland state bank subject to regulation and periodic examination by the Division of Financial Regulation of the Maryland Department of Labor, Licensing and Regulation and the Federal Reserve Board. Susquehanna Trust & Investment Company is a Pennsylvania non-depository trust company subject to regulation and periodic examination by the Pennsylvania Department of Banking. All of our subsidiaries are subject to examination by the Federal Reserve Board even if not otherwise regulated by the Federal Reserve Board, subject to certain conditions in the case of functionally regulated subsidiaries, such as broker/dealers and registered investment advisers.
Consistent with the requirements of the Bank Holding Company Act, our only lines of business in 2005 consisted of providing our customers with banking, trust and other financial products and services. These services include commercial banking through our subsidiary banks, trust and related services through Susquehanna Trust & Investment Company, consumer vehicle financing through Boston Service Company, Inc. (t/a Hann Financial Service Corp.), commercial leasing through Susquehanna Patriot Commercial Leasing Company, Inc., investment advisory, asset management, retirement plan consulting and brokerage services through Valley Forge Asset Management Corp. and property and casualty insurance brokerage services through The Addis Group, LLC. Of these activities, banking activities accounted for 88% of our gross revenues in 2005 and 84% of our gross revenues in 2004.
Regulations governing our bank subsidiaries restrict extensions of credit by such institutions to Susquehanna and, with some exceptions, the other Susquehanna affiliates. For these purposes, extensions of credit include loans and advances to and guarantees and letters of credit on behalf of Susquehanna and such affiliates. These regulations also restrict investments by our bank subsidiaries in the stock or other securities of Susquehanna and the covered affiliates, as well as the acceptance of such stock or other securities as collateral for loans to any borrower, whether or not related to Susquehanna.
Our bank subsidiaries are subject to comprehensive federal and state regulations dealing with a wide variety of subjects, including reserve requirements, loan limitations, restrictions as to interest rates on loans and deposits, restrictions as to dividend payments, requirements governing the establishment of branches and numerous other aspects of their operations. These regulations generally have been adopted to protect depositors and creditors rather than shareholders.
Additional Activities. Susquehanna is a financial holding company (an FHC) under the Gramm-Leach-Bliley Act (the GLB Act). As an FHC, we are permitted to engage, directly or through subsidiaries, in a wide variety of activities which are financial in nature or are incidental or complementary to a financial activity, in addition to all of the activities otherwise allowed to us. The additional activities permitted to us as an FHC (if we so determine to conduct them) include, among others, insurance and securities underwriting, merchant banking activities, issuing and selling annuities and securitized interests in financial assets and engaging domestically in activities that bank holding companies previously have been permitted to engage in only overseas. It is expected that in the future other activities will be added to the permitted list. All of these listed activities can be conducted, through an acquisition or on a start-up basis, without prior Federal Reserve Board approval and with only notice to the Federal Reserve Board afterward.
The GLB Act also generally permits well-capitalized national banks and, if state law permits, well-capitalized state chartered banks as well, to form or acquire financial subsidiaries to engage in most of these same activities, with the exception of certain specified activities (insurance underwriting, for example) which must be conducted only at the level of the holding company or a non-bank subsidiary. State chartered banks in Pennsylvania, New Jersey and Maryland are generally allowed to engage (with proper regulatory authority) in activities that are permitted to national banks.
As an FHC, Susquehanna is generally subject to the same regulation as other bank holding companies, including the reporting, examination, supervision and consolidated capital requirements of the Federal Reserve Board. However, in some respects the regulation is modified as a result of FHC status. For example, Susquehanna must continue to satisfy certain conditions (discussed below) to preserve our full flexibility as an FHC. However, as an FHC, Susquehanna (unlike traditional bank holding companies) is permitted to undertake several new types of activities, and to acquire companies engaged in several additional kinds of activities, without prior Federal Reserve Board approval and with only notice afterward. To preserve our FHC status, we must ensure that all of our insured depository institution subsidiaries remain well-capitalized and well-managed for regulatory purposes and earn satisfactory or better ratings on their periodic Community Reinvestment Act (CRA) examinations.
An FHC ceasing to meet these standards is subject to a variety of restrictions, depending on the circumstances. If the Federal Reserve Board determines that any of the FHCs subsidiary depository institutions are either not well-capitalized or not well-managed, it must notify the FHC. Until compliance is restored, the Federal Reserve Board has broad discretion to impose appropriate limitations on the FHCs activities. If compliance is not restored within 180 days, the Board may ultimately require the FHC to divest its depository institutions or in the alternative, to discontinue or divest any activities that are permitted only to FHC bank holding companies.
The potential restrictions are different if the lapse pertains to the CRA requirement. In that case, until all the subsidiary institutions are restored to at least satisfactory CRA rating status, the FHC may not engage, directly
or through a subsidiary, in any of the additional activities permissible under the GLB Act nor make additional acquisitions of companies engaged in the additional activities. However, completed acquisitions and additional activities and affiliations previously begun are left undisturbed, as the GLB Act does not require divestiture for this type of situation.
Capital Adequacy. Under the risk-based capital requirements applicable to them, bank holding companies must maintain a ratio of total capital to risk-weighted assets (including the asset equivalent of certain off-balance sheet activities such as acceptances and letters of credit) of not less than 8% (10% in order to be considered well-capitalized). At least 4% out of the total capital (6% to be well capitalized) must be composed of common stock, related surplus, retained earnings, qualifying perpetual preferred stock and minority interests in the equity accounts of certain consolidated subsidiaries, after deducting goodwill and certain other intangibles (tier 1 capital). The remainder of total capital (tier 2 capital) may consist of certain perpetual debt securities, mandatory convertible debt securities, hybrid capital instruments and limited amounts of subordinated debt, qualifying preferred stock, allowance for loan and lease losses, and unrealized gains on equity securities.
At December 31, 2005, our tier 1 capital and total capital (i.e., tier 1 plus tier 2) ratios were 8.53% and 11.61%, respectively.
The Federal Reserve Board has also established minimum leverage ratio guidelines for bank holding companies. These guidelines mandate a minimum leverage ratio of tier 1 capital to adjusted quarterly average total assets less certain amounts (leverage amounts) equal to 3% for bank holding companies meeting certain criteria (including those having the highest regulatory rating). All other banking organizations are generally required to maintain a leverage ratio of at least 3% plus an additional cushion of at least 100 basis points and in some cases more. The Federal Reserve Boards guidelines also provide that bank holding companies experiencing internal growth or making acquisitions are expected to maintain capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Furthermore, the guidelines indicate that the Federal Reserve Board will continue to consider a tangible tier 1 leverage ratio (i.e., after deducting all intangibles) in evaluating proposals for expansion or new activities. The Federal Reserve Board has not advised us of any specific minimum leverage ratio applicable to us. At December 31, 2005, our leverage ratio was 7.77%.
Our subsidiary depository institutions are all subject to similar capital standards promulgated by their respective federal regulatory agencies. No such agency has advised any of our subsidiary institutions of any specific minimum leverage ratios applicable to it.
The federal regulatory authorities risk-based capital guidelines are presently based upon the 1988 capital accord (Basel I) of the Basel Committee on Banking Supervision (the BCS). The BCS is a committee of central bankers and bank supervisors from the major industrialized countries. It develops broad policy guidelines for use by each countrys supervisors in determining the supervisory policies they apply. In 2004, the BCS proposed a new capital adequacy framework (Basel II) for large, internationally active banking organizations to replace Basel I. Basel II is designed to produce a more risk sensitive result than its predecessor. However, Basel II will entail complexities and costs that are expected to effectively limit its practical application to the largest and most internationally active banking organizations, those which can take advantage of economies of scale necessary to absorb the associated expenses. Accordingly, Basel I is expected to continue to apply to most depository institutions in the United States even after full implementation of Basel II.
Community and regional banking organizations responded to the proposed adoption of Basel II in the United States with expressed concern that the new framework would result in regulatory capital charges that differ for similar bank products offered by both large and small banking organizations, to the competitive disadvantage of the community and regional organizations.
In response to these concerns, the federal bank and thrift regulatory agencies (including the Federal Reserve Board) postponed further implementation of Basel II while they undertook additional analytical work and, in
the fall of 2005, published for preliminary comment a proposal to make substantial revisions to Basel I. The proposed revisions to the existing framework are intended to enhance the risk-sensitivity of the capital charges assigned to various assets under Basel I, to reflect changes in accounting standards and financial markets and to address the questions of competitive equity raised by the proposed Basel II.
The agencies fall 2005 proposal with respect to Basel I would, among other things, increase the number of risk-weight categories to which various credit exposures may be assigned, would expand the use of external credit ratings (such as those given by Moodys, Standard & Poors and Fitch) as credit risk indicators, would expand the range of collateral and guarantors that may justify a lower risk weight, would use loan to value ratios, credit assessments and other broad measures of credit risk in the case of commercial mortgages, would increase the risk weights of certain delinquent or non-accrual assets and would assess a risk-based capital charge to reflect the risks in securitizations backed by revolving retail exposures with early amortization provisions.
If implemented, the new capital rules, including both a new Basel II and a broadly revised Basel I, could affect the minimum capital requirements applicable to us and could otherwise have a competitive impact on us.
Prompt Corrective Action. The Federal Deposit Insurance Corporation Improvement Act of 1991, or FDICIA, requires the federal regulators to take prompt corrective action against any undercapitalized institution. FDICIA establishes five capital categories: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. Well-capitalized institutions significantly exceed the required minimum level for each relevant capital measure. Adequately capitalized institutions include depository institutions that meet but do not significantly exceed the required minimum level for each relevant capital measure. Undercapitalized institutions consist of those that fail to meet the required minimum level for one or more relevant capital measures. Significantly undercapitalized characterizes depository institutions with capital levels significantly below the minimum requirements for any relevant capital measure. Critically undercapitalized refers to depository institutions with minimal capital and at serious risk for government seizure.
Under certain circumstances, a well-capitalized, adequately capitalized or undercapitalized institution may be treated as if the institution were in the next lower capital category. A depository institution is generally prohibited from making capital distributions, including paying dividends, or paying management fees to a holding company if the institution would thereafter be undercapitalized. Institutions that are adequately but not well-capitalized cannot accept, renew or roll over brokered deposits except with a waiver from the Federal Deposit Insurance Corporation (FDIC) and are subject to restrictions on the interest rates that can be paid on such deposits. Undercapitalized institutions may not accept, renew or roll over brokered deposits.
The banking regulatory agencies are permitted or, in certain cases, required to take certain actions with respect to institutions falling within one of the three undercapitalized categories. Depending on the level of an institutions capital, the agencys corrective powers include, among other things:
A banking institution that is undercapitalized is required to submit a capital restoration plan, and such a plan will not be accepted unless, among other things, the banking institutions holding company guarantees the plan
up to a certain specified amount. Any such guarantee from a depository institutions holding company is entitled to a priority of payment in bankruptcy. As of December 31, 2005, all of our depository institution subsidiaries exceeded the required capital ratios for classification as well capitalized.
Cross Guarantees. Our insured depository institution subsidiaries are also subject to cross-guaranty liability under federal law. This means that if one FDIC-insured depository institution subsidiary of a multi-institution bank holding company fails or requires FDIC assistance, the FDIC may assess commonly controlled depository institutions for the estimated losses suffered by the FDIC. Such liability could have a material adverse effect on the financial condition of any assessed subsidiary institution and on Susquehanna as the common parent. While the FDICs cross-guaranty claim is generally junior to the claims of depositors, holders of secured liabilities, general creditors and subordinated creditors, it is generally superior to the claims of shareholders and affiliates.
Source of Strength Doctrine. Under Federal Reserve Board policy and regulation, a bank holding company must serve as a source of financial and managerial strength to each of its subsidiary banks and is expected to stand prepared to commit resources to support each of them. Consistent with this, the Federal Reserve Board has stated that, as a matter of prudent banking, a bank holding company should generally not maintain a given rate of cash dividends unless its net income available to common shareholders has been sufficient to fully fund the dividends and the prospective rate of earnings retention appears to be consistent with the organizations capital needs, asset quality and overall financial condition.
Interstate Banking and Branching. Under the Pennsylvania Banking Code of 1965, there is no limit on the number of banks that may be owned or controlled by a Pennsylvania-based bank holding company and the Pennsylvania bank subsidiaries may branch freely throughout the Commonwealth and, with Department of Banking approval, elsewhere in the United States and abroad. The banking laws of New Jersey and Maryland also extend to banks organized under their laws broad powers to operate out-of-state branch offices.
Substantially all state law barriers to the acquisition of banks by out-of-state bank holding companies have been eliminated. In addition, the federal banking agencies are generally permitted to approve merger transactions resulting in the creation of branches by banks outside their home states if the host state into which they propose to branch has enacted authorizing legislation. Of the middle-Atlantic states, Pennsylvania and West Virginia have enacted legislation authorizing de novo branching by banks located in states offering reciprocal treatment to their institutions. Maryland and Ohio have as well, but without the reciprocity requirement. Delaware, New Jersey and New York do not allow entry through full de novo branching by sister-state banks and require that they enter the state through mergers of established institutions. Liberalizing the branching laws in recent years has had the effect of increasing competition within the markets in which we now operate.
USA Patriot Act of 2001. A major focus of governmental policy applicable to financial institutions in recent years has been the effort to combat money laundering and terrorism financing. The USA Patriot Act of 2001 was enacted to strengthen the ability of the U.S. law enforcement and intelligence communities to achieve this goal. The Act requires financial institutions, including our banking and broker-dealer subsidiaries, to assist in the prevention, detection and prosecution of money laundering and the financing of terrorism. The Act established standards to be followed by institutions in verifying client identification when accounts are opened and provides rules to promote cooperation among financial institutions, regulators and law enforcement organizations in identifying parties that may be involved in terrorism or money laundering.
Regulation of Non-bank Subsidiaries. In addition to Susquehanna Trust & Investment Company, we have other primary non-bank subsidiaries whose activities subject them to licensing and regulation. Boston Service Company, Inc. (t/a Hann Financial Service Corp.) is organized under the laws of New Jersey. It is regulated by Connecticut as a motor vehicle leasing company, by Delaware as a finance or small loan agency, and by New Jersey and Pennsylvania as a sales finance company. Valley Forge Asset Management Corp. is organized under the laws of Pennsylvania. It is registered with the Securities and Exchange Commission (the SEC) as an
investment adviser under the Investment Advisers Act of 1940. It is also a registered broker-dealer and is a member of the National Association of Securities Dealers. It is also licensed with the securities commissions of various states. The Addis Group, LLC is organized under the laws of Pennsylvania. It is licensed with the Pennsylvania Insurance Commissioner and the insurance commissioners of 47 other states.
Privacy. Title V of the GLB Act is intended to increase the level of privacy protection afforded to customers of financial institutions, including customers of the securities and insurance affiliates of such institutions, partly in recognition of the increased cross-marketing opportunities created by the Acts elimination of many of the boundaries previously separating various segments of the financial services industry. Among other things, these provisions require institutions to have in place administrative, technical and physical safeguards to ensure the security and confidentiality of customer records and information, to protect against anticipated threats or hazards to the security or integrity of such records and to protect against unauthorized access to or use of such records that could result in substantial harm or inconvenience to a customer. The Act also requires institutions to furnish consumers at the outset of the relationship and annually thereafter written disclosures concerning the institutions privacy policies.
Future Legislation. From time to time, various legislation is introduced in Congress and state legislatures with respect to the regulation of financial institutions. Such legislation may change banking statutes and our operating environment or that of our subsidiaries in substantial and unpredictable ways. We cannot determine the ultimate effect that potential legislation, if enacted, or any regulations issued to implement it, would have upon our financial condition or results of operations.
National Monetary Policy. In addition to being affected by general economic conditions, the earnings and growth of Susquehanna and our subsidiaries are affected by the policies of the Federal Reserve Board. An important function of the Federal Reserve Board is to regulate the money supply and credit conditions. Among the instruments used by the Federal Reserve Board to implement these objectives are open market operations in U.S. Government securities, adjustments of the discount rate and changes in reserve requirements against bank deposits. These instruments are used in varying combinations to influence overall economic growth and the distribution of credit, bank loans, investments and deposits. Their use also affects interest rates charged on loans or paid on deposits.
The monetary policies and regulations of the Federal Reserve Board have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. The effects of such policies upon our future business, earnings and growth cannot be predicted.
As of December 31, 2005, the executive officers of Susquehanna, their ages and their positions with Susquehanna, are set forth in the following table:
William J. Reuter has been a Director of Susquehanna since 1999 and became Chairman of the Board in May 2002. He has been Chief Executive Officer since May 2001 and President since January 2000. From January 1998 until he was named President, he was Senior Vice President. He has also been Chairman of the Board of Susquehanna Bank PA (including its predecessor, Farmers First Bank) since March 2001, and a Director of Susquehanna Bank since 1985 (including its predecessor, Farmers & Merchants Bank and Trust), Boston Service Company, Inc. (t/a Hann Financial Service Corp.) since February 2000, Valley Forge Asset Management Corp. since March 2000, and The Addis Group, LLC. since September 2002.
Gregory A. Duncan was appointed Chief Operating Officer in May 2001 and Executive Vice President in January 2000. From January 1998 until his appointment as Executive Vice President, he was Senior Vice PresidentAdministration. He was appointed President and Chief Executive Officer of Susquehanna Bank PA in October 2005.
Drew K. Hostetter was appointed Executive Vice President in May 2001 and has been Treasurer and Chief Financial Officer since 1998. From January 2000 until his appointment as Executive Vice President, he was Senior Vice President. He was also appointed as Chairman of Hann Financial Service Corp. in February 2004.
Edward Balderston, Jr. was appointed Executive Vice President and Chief Administrative Officer in June 2004. From May 2001 until his appointment as Executive Vice President and Chief Administrative Officer, he was Senior Vice President and Group Executive. From May 1998 until his appointment as Senior Vice President and Group Executive, he was Vice President in Charge of Marketing and Human Resources.
Michael M. Quick was appointed Executive Vice President and Group Executive in May 2005. From June 2004 until his appointment as Executive Vice President and Group Executive, he was Senior Vice President and Group Executive. From May 2001 until his appointment as Senior Vice President and Group Executive, he was Vice President and Group Executive of Susquehanna. He was appointed Chairman and Chief Executive Officer of Susquehanna Patriot Bank in November 2005. From June 2004 until his appointment as Chairman and Chief Executive Officer of the bank, he was Chairman of Susquehanna Patriot Bank. From March 1998 until his appointment as Chairman, he was President and Chief Executive Officer of Equity Bank.
David D. Keim was appointed Senior Vice President and Chief Risk and Credit Officer in April 2002. From May 2001 until his appointment as Senior Vice President and Chief Risk and Credit Officer, he was Senior Vice President and Group Executive. From April 1998 until his appointment as Senior Vice President and Group Executive, he was Vice President.
James G. Pierné was appointed as Senior Vice President and Group Executive in June 2004. From May 2001 until his appointment as Senior Vice President and Group Executive, he was Vice President and Group Executive. He has been Chairman, President and Chief Executive Officer of Susquehanna Bank (including its predecessor, Farmers & Merchants Bank and Trust) since March 2002. He also served as President and Chief Executive Officer of Farmers & Merchants Bank and Trust from March 2000 to March 2002. From March 1999 until his appointment as President and Chief Executive Officer, he was Executive Vice President of Farmers & Merchants Bank and Trust. From 1993 until his appointment as Executive Vice President, he was Senior Vice President of Farmers & Merchants Bank and Trust.
Peter J. Sahd was appointed Senior Vice President and Group Executive in June 2004. From May 2001 until his appointment as Senior Vice President and Group Executive, he was Vice President and Group Executive. From April 1999 until his appointment as Vice President and Group Executive, he was Director Alternative Delivery Services. Prior to joining Susquehanna, Mr. Sahd served as Senior Vice President, Operations, of Fulton Bank from August 1994 until April 1999.
Rodney A. Lefever was appointed Senior Vice President and Chief Technology Officer in June 2004. From May 2002 until his appointment as Senior Vice President and Chief Technology Officer, he was Vice President
and Chief Technology Officer. From April 2001 until his appointment as Vice President and Chief Technology Officer, he was Chief Technology Officer. Prior to joining Susquehanna, he served as Director, Earthlink Everywhere, Earthlink, Inc. from September 2000 until April 2001, as the President of New Business Development, OneMain.com Inc. from December 1999 until September 2000 and the President of D&E Supernet (and its predecessors) from March 1995 until December 1999.
Bernard A. Francis, Jr. was appointed Senior Vice President and Group Executive in May, 2005. From June 2004 until his appointment as Senior Vice President and Group Executive, he was Vice President. From March 2000, he has been President and Chief Executive Officer of Valley Forge Asset Management Corp.
Lisa M. Cavage was appointed Senior Vice President in May 2005. From May 2001 until her appointment as Senior Vice President, she was Vice President. She has been Counsel to Susquehanna since March 1998.
There are no family relationships among the executive officers of Susquehanna. The executive officers are elected or appointed by the Board of Directors of Susquehanna and serve until the appointment or election and qualification of their successor or their earlier death, resignation or removal. There are no arrangements or understandings between any of them and any other person pursuant to which any of them was selected an officer of Susquehanna.
Item 1A. Risk Factors
We may not be able to continue to grow our business, which may adversely impact our results of operations.
Our total assets have grown from approximately $3.5 billion at December 31, 1997, prior to restatements for pooling of interests, to $7.5 billion at December 31, 2005. Our business strategy calls for continued expansion. Our ability to continue to grow depends, in part, upon our ability to open new branch locations, successfully attract deposits, identify favorable loan and investment opportunities and acquire other bank and non-bank entities. In the event that we do not continue to grow, our results of operations could be adversely impacted.
Our ability to grow successfully will depend on whether we can continue to fund this growth while maintaining cost controls and asset quality, as well as on factors beyond our control, such as national and regional economic conditions and interest rate trends. If we are not able to control costs and maintain asset quality, such growth could adversely impact our earnings and financial condition.
If we are unable to complete our pending merger with Minotola, or we are unable to successfully integrate operations or achieve the anticipated cost savings relating to the integration of our operations, we may experience significant charges to earnings that may adversely affect our stock price, operating results and financial condition.
In November 2005, we entered into a definitive agreement to acquire by merger all of the outstanding shares of Minotola National Bank. Minotola received approval of the merger from its shareholders; regulatory approval is still pending. Under the terms of the merger agreement, in addition to various termination rights granted to each of us and Minotola for breach of representations, warranties and covenants, Minotola may unilaterally terminate the merger if our stock price falls below certain levels as described in the merger agreement, and if we do not elect to increase the amount of merger consideration to be paid to Minotola shareholders to appropriately adjust for such a decline in our stock price.
If the transaction does not close for any reason, we will not realize the anticipated benefits of the Minotola transaction.
We must consolidate and integrate the operations of Minotola with our business. Integration efforts often take a significant amount of time, place a significant strain on our managerial, operational and financial resources and could prove to be more difficult and expensive than we predicted. If we fail to realize the expected benefits from this acquisition, or from acquisitions we may consummate in the future, whether as a result of unidentified risks, integration difficulties, regulatory setbacks or otherwise, our business, results of operations and financial condition could be adversely affected.
In addition, if we are unable to complete the merger with Minotola, we will experience charges for merger and merger related expenses that may include transactions costs, such as fees for attorneys and accountants. The incurrence of these charges could adversely affect our results of operations for particular quarterly or annual periods.
Geographic concentration in one market may unfavorably impact our operations.
Our operations are heavily concentrated in the Mid-Atlantic region. As a result of this geographic concentration, our results depend largely on economic conditions in these and surrounding areas. Deterioration in economic conditions in this market could:
Loss of certain of our key officers would adversely affect our business.
Our future operating results are substantially dependent on the continued service of William J. Reuter, our Chairman, President and Chief Executive Officer; Gregory A. Duncan, our Executive Vice President and Chief Operating Officer; Drew K. Hostetter, our Executive Vice President and Chief Financial Officer; Michael M. Quick, our Executive Vice President and Group Executive; James G. Pierné, our Senior Vice President and Group Executive; and Bernard A. Francis, Jr., our Senior Vice President and Group Executive. The loss of the services of Messrs. Reuter, Duncan, Hostetter, Quick, Pierné, and Francis would have a negative impact on our business because of their expertise and years of industry experience. In addition, the loss of the services of Mr. Reuter would have a negative impact on our business because of his leadership, business development skills and community involvement. We do not maintain key man life insurance on Messrs. Reuter, Duncan, Hostetter, Quick, Pierné, or Francis.
Our exposure to credit risk, because we focus on commercial lending, could adversely affect our earnings and financial condition.
There are certain risks inherent in making loans. These risks include interest rate changes over the time period in which loans may be repaid, risks resulting from changes in the economy, risks inherent in dealing with borrowers and, in the case of a loan backed by collateral, risks resulting from uncertainties about the future value of the collateral.
Commercial loans, including commercial real estate, are generally viewed as having a higher credit risk than residential real estate or consumer loans because they usually involve larger loan balances to a single borrower and are more susceptible to a risk of default during an economic downturn. Our consolidated commercial lending operations include commercial, financial and agricultural lending, real estate construction lending and commercial mortgage lending, which comprised 16.0%, 17.9% and 24.1% of our total loan portfolio, respectively, as of December 31, 2005. Construction financing typically involves a higher degree of credit risk than commercial mortgage lending. Risk of loss on a construction loan depends largely on the accuracy of the initial estimate of the propertys value at completion of construction compared to the estimated cost (including interest) of construction. If the estimated property value proves to be inaccurate, the loan may be inadequately collateralized.
Because our loan portfolio contains a significant number of commercial real estate, commercial and industrial loans and construction loans, the deterioration of these loans may cause a significant increase in nonperforming loans. An increase in nonperforming loans could cause an increase in loan charge-offs and a corresponding increase in the provision for loan losses, which could adversely impact our financial condition and results of operations.
If our allowance for loan and lease losses is not sufficient to cover actual loan and lease losses, our earnings would decrease.
In an attempt to mitigate any loan and lease losses that we may incur, we maintain an allowance for loan and lease losses based on, among other things, national and regional economic conditions, historical loss experience and delinquency trends. However, we cannot predict loan and lease losses with certainty, and we cannot assure you that charge-offs in future periods will not exceed the allowance for loan and lease losses. If charge-offs exceed our allowance, our earnings would decrease. In addition, regulatory agencies, as an integral part of their examination process, review our allowance for loan and lease losses and may require additions to the allowance based on their judgment about information available to them at the time of their examination. Factors that require an increase in our allowance for loan and lease losses could reduce our earnings.
Changes in interest rates may adversely affect our earnings and financial condition.
Our net income depends primarily upon our net interest income. Net interest income is income that remains after deducting, from total income generated by earning assets, the interest expense attributable to the acquisition of the funds required to support earning assets. Income from earning assets includes income from loans, investment securities and short-term investments. The amount of interest income is dependent on many factors including the volume of earning assets, the general level of interest rates, the dynamics of the change in interest rates and the levels of nonperforming loans. The cost of funds varies with the amount of funds necessary to support earning assets, the rates paid to attract and hold deposits, rates paid on borrowed funds and the levels of non-interest-bearing demand deposits and equity capital.
Different types of assets and liabilities may react differently, and at different times, to changes in market interest rates. We expect that we will periodically experience gaps in the interest rate sensitivities of our assets and liabilities. That means either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest-earning assets, or vice versa. When interest-bearing liabilities mature or reprice more quickly than interest-earning assets, an increase in market rates of interest could reduce our net interest income. Likewise, when interest-earning assets mature or reprice more quickly than interest-bearing liabilities, falling interest rates could reduce our net interest income. We are unable to predict changes in market interest rates, which are affected by many factors beyond our control, including inflation, recession, unemployment, money supply, domestic and international events and changes in the United States and other financial markets.
We attempt to manage risk from changes in market interest rates, in part, by controlling the mix of interest-rate-sensitive assets and interest-rate-sensitive liabilities. However, interest-rate risk management techniques are not exact. A rapid increase or decrease in interest rates could adversely affect our results of operations and financial performance.
Adverse economic and business conditions in our market area may have an adverse effect on our earnings.
Substantially all of our business is with customers located within Pennsylvania, Maryland and New Jersey. Generally, we make loans to small to mid-sized businesses whose success depends on the regional economy. These businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities. Adverse economic and business conditions in our market area could reduce our growth rate, affect our borrowers ability to repay their loans and, consequently, adversely affect our financial condition and performance. For example, a loss of market confidence in vehicle leasing paper and related residual values could have a negative effect on our vehicle leasing subsidiarys ability to fund future vehicle lease originations. If this should occur, our vehicle leasing subsidiarys revenues and earnings would be adversely affected. Further, we place substantial reliance on real estate as collateral for our loan portfolio. A sharp downturn in real estate values in our market area could leave many of our loans inadequately collateralized. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings could be adversely affected.
If we are not able to securitize assets, it could negatively affect our liquidity and capital ratios.
We use the securitization of financial assets as a source of funding and a means to manage capital. It is part of our core business. If we were not able to securitize these assets for any reasons, including without limitation, market conditions, a failure to maintain our investment-grade senior unsecured long-term debt ratings, or regulatory changes, it could negatively affect our capital ratios and require us to rely more heavily on other sources of funding such as repos, brokered deposits and the Federal Home Loan Bank (FHLB).
Adverse business conditions in our vehicle leasing subsidiary could adversely affect our financial performance.
Through our subsidiary, Boston Service Company, Inc. (t/a Hann Financial Service Corp.), we are involved in the vehicle leasing business. In 2005, Hann suffered a decrease in its vehicle origination, servicing, and
securitization fees, due to a combination of decreased lease origination volumes and decreased fees from securitization transactions due to the current interest rate environment. We believe that this reduction in volume principally resulted from special financing offers provided by the major automobile manufacturers with whom Hann competes. If these special financing offers continue, our financial performance could be negatively impacted. Additionally, in 2005, vehicle residual value expense at Hann increased significantly based upon service agreements with Auto Lenders Liquidation Center, Inc., a third party residual value guarantor. Under the terms of these servicing agreements, vehicle residual value expense will be substantially less in 2006, 2007, and 2008. Beyond 2008, vehicle residual value expense could once again increase depending upon the used vehicle market conditions. If this were to happen, it could have a negative impact on our financial performance after 2008.
Competition from other financial institutions in originating loans, attracting deposits and providing various financial services may adversely affect our profitability.
Our banking subsidiaries face substantial competition in originating loans, both commercial and consumer. This competition comes principally from other banks, savings institutions, mortgage banking companies and other lenders. Many of our competitors enjoy advantages, including greater financial resources and higher lending limits, a wider geographic presence, more accessible branch office locations, the ability to offer a wider array of services or more favorable pricing alternatives, as well as lower origination and operating costs. This competition could reduce our net income by decreasing the number and size of loans that our banking subsidiaries originate and the interest rates they may charge on these loans.
In attracting business and consumer deposits, our banking subsidiaries face substantial competition from other insured depository institutions such as banks, savings institutions and credit unions, as well as institutions offering uninsured investment alternatives, including money market funds. Many of our competitors enjoy advantages, including greater financial resources, more aggressive marketing campaigns and better brand recognition and more branch locations. These competitors may offer higher interest rates than we do, which could decrease the deposits that we attract or require us to increase our rates to retain existing deposits or attract new deposits. Increased deposit competition could adversely affect our ability to generate the funds necessary for lending operations. As a result, we may need to seek other sources of funds that may be more expensive to obtain and could increase our cost of funds.
Our banking and non-banking subsidiaries also compete with non-bank providers of financial services, such as brokerage firms, consumer finance companies, credit unions, insurance companies and governmental organizations which may offer more favorable terms. Some of our non-bank competitors are not subject to the same extensive regulations that govern our banking operations. As a result, such non-bank competitors may have advantages over our banking and non-banking subsidiaries in providing certain products and services. This competition may reduce or limit our margins on banking and non-banking services, reduce our market share and adversely affect our earnings and financial condition.
We continually encounter technological change, and we may have fewer resources than many of our competitors to continue to invest in technological improvements, which could reduce our ability to effectively compete.
The financial services industry is undergoing rapid technological changes with frequent introduction of new technology-driven products and services. In addition to better serving customers, the effective use of technology increases efficiency and enables financial service institutions to reduce costs. Our future success will depend, in part, upon our ability to address the needs of our customers by using technology to provide products and services to enhance customer convenience, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. There can be no assurance that we will be able to effectively implement new technology-driven products and services, which could reduce our ability to effectively compete.
Government regulation significantly affects our business.
The banking industry is heavily regulated, and such regulations are intended primarily for the protection of depositors and the federal deposit insurance funds, not shareholders. As a financial holding company, we are subject to regulation by the Federal Reserve Board. Our three bank subsidiaries, as of December 31, 2005, are also regulated by the Federal Reserve Board and are subject to regulation by the state banking departments of the state in which they are chartered. These regulations affect lending practices, capital structure, investment practices, dividend policy and growth. In addition, we have non-bank operating subsidiaries from which we derive income. Several of these non-bank subsidiaries engage in providing investment management and insurance brokerage services, which industries are also heavily regulated on both a state and federal level. In addition, changes in laws, regulations and regulatory practices affecting the financial service industry may limit the manner in which we may conduct our business. Such changes may adversely affect us, including our ability to offer new products and services, obtain financing, attract deposits, make loans and leases and achieve satisfactory spreads, and may also result in the imposition of additional costs on us. As a public company, we are also subject to the corporate governance standards set forth in the Sarbanes-Oxley Act of 2002, as well as any applicable rules or regulations promulgated by the SEC or The NASDAQ Stock Market, Inc. Complying with these standards, rules and regulations may impose administrative costs and burdens on us.
The Pennsylvania business corporation law and various anti-takeover provisions under our articles of incorporation could impede the takeover of the company.
Various Pennsylvania laws affecting business corporations may have the effect of discouraging offers to acquire Susquehanna, even if the acquisition would be advantageous to shareholders. In addition, we have various anti-takeover measures in please under our articles of incorporation. Any one or more of these measures may impede the takeover of Susquehanna without the approval of our board of directors and may prevent our shareholders from taking part in a transaction in which they could realize a premium over the current market price of our common stock.
Item 2. Properties
We reimburse our subsidiaries for space and services utilized. In 2005, we also leased office space located at 13511 Label Lane, Hagerstown, Maryland, for our loan servicing center.
Our bank subsidiaries operate 153 branches and 17 free-standing automated teller machines. They own 72 of the branches and lease the remaining 81. Five additional locations are owned or leased by our bank subsidiaries to facilitate operations and expansion. We believe that the properties currently owned and leased by our subsidiaries are adequate for present levels of operation.
As of December 31, 2005, the offices (including executive offices) of our bank subsidiaries were as follows:
As of December 31, 2005, the offices (including executive offices) of our non-bank subsidiaries were as follows:
Item 3. Legal Proceedings.
There are no material proceedings to which Susquehanna or any of our subsidiaries are a party or by which, to Susquehannas knowledge, we, or any of our subsidiaries, are threatened. All legal proceedings presently pending or threatened against Susquehanna or our subsidiaries involve routine litigation incidental to our business or that of the subsidiary involved and are not material in respect to the amount in controversy.
Item 4. Submission of Matters to a Vote of Security Holders.
There were no matters submitted to a vote of security holders during the fourth quarter of 2005.
Item 5. Market for Susquehannas Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities
Market Information. Susquehanna common stock is listed for quotation on the Nasdaq National Market System. Set forth below are the quarterly high and low sales prices of Susquehannas common stock as reported on the Nasdaq National Market System for the years 2005 and 2004, and cash dividends paid. The table represents prices between dealers and does not include retail markups, markdowns or commissions and does not necessarily represent actual transactions.
As of February 28, 2006, there were 6,831 record holders of Susquehanna common stock.
Dividend Policy. Dividends paid by Susquehanna are provided from dividends paid to us by our subsidiaries. Our ability to pay dividends is largely dependent upon the receipt of dividends from our bank subsidiaries. Both federal and state laws impose restrictions on the ability of these subsidiaries to pay dividends. These include the Pennsylvania Banking Code of 1965 in the case of Susquehanna Bank PA, the Financial Institutions Article of the Annotated Code of Maryland in the case of Susquehanna Bank, the New Jersey Banking Act of 1948 in the case of Susquehanna Patriot Bank, the Federal Reserve Act in the case of all three banks, and the applicable regulations under such laws. The net capital rules of the SEC under the Securities Exchange Act of 1934 also limit the ability of Valley Forge Asset Management Corp. to pay dividends to us. In addition to the specific restrictions, summarized below, the banking and securities regulatory agencies also have broad authority to prohibit otherwise permitted dividends proposed to be made by an institution regulated by them if the agency determines that their distribution would constitute an unsafe or unsound practice.
The Federal Reserve Board has issued policy statements which provide that, as a general matter, insured banks and bank holding companies should pay dividends only out of current operating earnings.
For state-chartered banks which are members of the Federal Reserve System, the approval of the Federal Reserve Board is required for the payment of dividends by the bank subsidiary in any calendar year if the total of all dividends declared by the bank in that calendar year, including the proposed dividend, exceeds the current years net income combined with the retained net income for the two preceding calendar years. Retained net income for any period means the net income for that period less any common or preferred stock dividends declared in that period. Moreover, no dividends may be paid by such bank in excess of its undivided profits account.
Dividends by a Pennsylvania state-chartered bank may be paid only out of accumulated net earnings and are restricted by the requirement that the bank set aside to a surplus fund each year at least 10% of its net earnings until the banks surplus equals the amount of its capital (a requirement presently satisfied in the case of Susquehanna Bank PA). Furthermore, a Pennsylvania bank may not pay a dividend if the payment would result in a reduction of the surplus account of the bank.
A Maryland state-chartered bank may pay dividends out of undivided profits or, with the approval of the Maryland Commissioner of Financial Regulation, from surplus in excess of 100% of required capital stock. If, however, the surplus of a Maryland bank is less than 100% of its capital stock, cash dividends may not be paid in excess of 90% of net earnings.
A New Jersey state-chartered bank may pay dividends on its capital stock unless the capital stock of the bank would be impaired after the payment. In addition, the bank must have a capital surplus after payment of the dividend of at least 50% of its capital stock or, if not, the payment would not reduce the surplus of the bank.
Within the regulatory restrictions described above, each of our bank subsidiaries presently has the ability to pay dividends. At December 31, 2005, $44.0 million in the aggregate was available for dividend distributions during calendar 2006 to us from our bank subsidiaries without regulatory approval and with their remaining well-capitalized. Also, our non-bank subsidiaries at December 31, 2005 had approximately $85.0 million which they could dividend to us without regulatory approval. We presently expect that cash dividends will continue to be paid by our subsidiaries in the future at levels comparable with those of prior years.
Item 6. Selected Financial Data.
Susquehanna Bancshares, Inc. & Subsidiaries
Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
The following pages of this report present managements discussion and analysis of the consolidated financial condition and results of operations of Susquehanna Bancshares, Inc. and its subsidiaries. Unless the context requires otherwise, the terms Susquehanna, we, us, and our refer to Susquehanna Bancshares, Inc. and its subsidiaries.
Certain statements in this document may be considered to be forward-looking statements as that term is defined in the U.S. Private Securities Litigation Reform Act of 1995, such as statements that include the words expect, estimate, project, anticipate, should, intend, probability, risk, target, objective and similar expressions or variations on such expressions. In particular, this document includes forward-looking statements relating, but not limited to, Susquehannas potential exposures to various types of market risks, such as interest rate risk; credit risk; whether Susquehannas allowance for loan and lease losses is adequate to meet probable loan and lease losses; the impact of a breach by Auto Lenders on residual loss exposure; the likelihood of an occurrence of an Early Amortization Event (as defined in this report); the anticipated conclusion of our sale leaseback transaction at the end of 2006; expectations regarding our branding strategy and internal realignment plans and their potential impact on our efficiency ratios and earnings; expectations regarding the timing of the Minotola transaction; and expectations regarding the future performance of Hann. Such statements are subject to certain risks and uncertainties. For example, certain of the market risk disclosures are dependent on choices about essential model characteristics and assumptions and are subject to various limitations. By their nature, certain of the market risk disclosures are only estimates and could be materially different from what actually occurs in the future. As a result, actual income gains and losses could materially differ from those that have been estimated. Other factors that could cause actual results to differ materially from those estimated by the forward-looking statements contained in this document include, but are not limited to:
We encourage readers of this report to understand forward-looking statements to be strategic objectives rather than absolute targets of future performance. Forward-looking statements speak only as of the date they are made. We do not intend to update publicly any forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events except as required by law.
The following discussion and analysis, the purpose of which is to provide investors and others with information that we believe to be necessary for an understanding of Susquehannas financial condition, changes in financial condition, and results of operations, should be read in conjunction with the financial statements, notes, and other information contained in this document.
The following information refers to the parent company and its wholly owned subsidiaries: Boston Service Company, Inc. (t/a Hann Financial Service Corporation) (Hann), Conestoga Management Company, Susquehanna Bank PA and subsidiaries, Susquehanna Patriot Bank and subsidiaries (Susquehanna Patriot), Susquehanna Bank and subsidiaries, Susque-Bancshares Life Insurance Co. (dissolved in December 2005), Valley Forge Asset Management Corp. and subsidiaries (VFAM), and The Addis Group, LLC (Addis).
Critical Accounting Estimates
Susquehannas consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. Application of these principles involves significant judgments and assumptions by management that have a material impact on the carrying value of certain assets and liabilities. The judgments and assumptions that we used are based on historical experiences and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions that we have made, actual results could differ from these judgments and estimates, which could have a material impact on the carrying values of assets and liabilities and the results of our operations.
Our most critical accounting estimates are presented in Note 1 to the consolidated financial statements. Furthermore, we believe that the determination of the allowance for loan and lease losses and the valuation of recorded interests in securitized assets to be the accounting areas that require the most subjective and complex judgments. The treatment of securitizations and off-balance sheet financing is discussed in detail in the section titled Securitizations and Off-Balance Sheet Financings.
The allowance for loan and lease losses represents managements estimate of probable credit losses inherent in the loan and lease portfolio. Determining the amount of the allowance for loan and lease losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan and lease portfolio also represents the largest asset type on the consolidated balance sheet. Note 1 to the consolidated financial statements describes the methodology used to determine the allowance for loan and lease losses.
Recorded interests in securitized assets are established and accounted for based on discounted cash flow modeling techniques which require management to make estimates regarding the amount and timing of expected future cash flows, including assumptions about lease repayment rates, credit loss experience, and discount rates that consider the risk involved. Since the values of these assets are sensitive to changes in assumptions, the valuation of recorded interests in securitized assets is considered a critical accounting estimate. Note 1 and the section titled Securitizations and Off-Balance Sheet Financings provide additional information regarding recorded interests.
Any material effect on the consolidated financial statements related to these critical accounting areas is also discussed within the body of this document.
2005 was a year of significant progress in many areas. We completed the consolidation of our eight community banks into three banks, launched an advertising campaign to promote our brand, and announced plans to acquire Minotola National Bank in New Jersey.
The following table compares our 2005 financial goals to actual results:
In 2005, we continued to face challenges with our auto leasing subsidiary, Hann. As a result, throughout most of the year, we worked with a major investment banking firm to explore strategic alternatives with respect to it. In the end, we decided that for now, it would be in the best interest of shareholders to continue to hold and operate the business, instead of selling the business at a significant discount. We will, however, continue to monitor and actively manage the business while keeping all of our strategic options open. Because of an expected return to normal lease origination volumes; a reduction in residual value guarantee premiums under contract for the next 3 years; an expected reduction in costs due to a new state-of-the-art reconditioning center by our third party residual value guarantor; recently enacted changes in federal vicarious liability laws that will reduce insurance costs; and the anticipated conclusion of our sale leaseback transaction at the end of 2006, we expect significant improvement at Hann in 2006 and a return to profitability in 2007.
At the end of 2005, we also announced that due to the growing trend in the financial services industry not to provide earnings guidance, we were discontinuing the practice going forward. Because of this, in 2006, we do not
include fully diluted earnings per share, return on average tangible equity, nor efficiency ratio excluding Hann in our published financial goals. Our financial goals for 2006 are as follows:
These financial goals include $16.0 million of securitization gains. The timing and amount of these associated securitizations, which we use as a funding source and a means to manage capital, are difficult to predict. Consequently, quarterly earnings will fluctuate.
Minotola National Bank
On November 14, 2005, we announced the signing of a definitive merger agreement pursuant to which we will acquire Minotola National Bank in a stock and cash transaction valued at approximately $165 million. The acquisition of Minotola, with total assets of $623 million and fourteen branch locations provides us with an opportunity to expand our franchise into high-growth markets in southern New Jersey.
Under the terms of the merger agreement, for each share of Minotola stock held, a Minotola shareholder may elect to receive either $3,226 in cash, 134 common shares of Susquehanna, or a combination thereof such that 30% of the Minotola shares would be exchanged for cash, and 70% would be exchanged for Susquehanna common stock. We anticipate that the transaction will be completed by April 30, 2006, pending regulatory approvals.
Brandywine Benefits Corporation and Rockford Pensions, LLC
On February 1, 2005, we acquired Brandywine Benefits Corporation and Rockford Pensions, LLC (collectively Brandywine) located in Wilmington, Delaware. Brandywine is a financial planning, consulting and administration firm specializing in retirement benefit plans for small-to-medium-sized businesses and is a wholly owned subsidiary of Brandywine Benefits Corp., LLC, which in turn is a wholly owned subsidiary of VFAM. The acquisition was accounted for under the purchase method, and all transactions since that date are included in our consolidated financial statements
Patriot Bank Corp.
On June 10, 2004, we completed our acquisition of Patriot Bank Corp (Patriot). The acquisition was accounted for under the purchase method, and all transactions since that date are included in our consolidated financial statements.
Other Notable Events
On January 21, 2005, we merged two of our subsidiary banks, First Susquehanna Bank and Trust and WNB Bank, into our Susquehanna Bank PA subsidiary. On April 15, 2005, we merged three of our subsidiary banks, Susquehanna Bank; Citizens Bank of Southern Pennsylvania; and First American Bank of Pennsylvania, into our Farmers & Merchants Bank subsidiary, which subsequently changed its name to Susquehanna Bank. These actions were taken as part of the consolidation plan we first announced in October 2004.
Results of Operations
Summary of 2005 Compared to 2004
Net income for the year ended December 31, 2005 was $79.6 million, an increase of $9.4 million, or 13.4%, over net income of $70.2 million in 2004. Net interest income increased 13.2%, to $242.2 million for 2005, from $214.0 million in 2004. Non-interest income increased 9.2%, to $125.1 million for 2005, from $114.6 million in 2004, and non-interest expenses increased 10.7%, to $242.6 million for 2005, from $219.0 million for 2004.
Additional information is as follows:
The following discussion details the factors that contributed to these results.
(1) Supplemental Reporting of Non-GAAP-based Financial Measures
Return on average tangible equity is a non-GAAP-based financial measure calculated using non-GAAP amounts. The most directly comparable GAAP-based measure is return on average equity. We calculate return on average tangible equity by excluding the balance of intangible assets and their related amortization expense from our calculation of return on average equity. Management uses the return on average tangible equity in order to review our core operating results. Management believes that this is a better measure of our performance. In addition, this is consistent with the treatment by bank regulatory agencies, which excludes goodwill and other intangible assets from the calculation of risk-based capital ratios. A reconciliation of return on average equity to return on average tangible equity is set forth below.
Efficiency ratio excluding Hann is a non-GAAP-based financial measure calculated using non-GAAP amounts. The most directly comparable GAAP-based measure is the efficiency ratio. We measure our efficiency ratio by dividing noninterest expenses by the sum of net interest income, on an FTE basis, and noninterest income. The presentation of an efficiency ratio excluding Hann is computed as the efficiency ratio excluding the effect of our auto leasing subsidiary, Hann Financial. Management believes this to be a preferred measure because it excludes the volatility of vehicle residual values and vehicle delivery and preparation expense of Hann and provides better visibility into our core business activities. A reconciliation of efficiency ratio to efficiency ratio excluding Hann is set forth below.
Net Interest Income Taxable Equivalent Basis
Our major source of operating revenues is net interest income, which increased to $242.2 million in 2005, as compared to $214.0 million in 2004. Net interest income as a percentage of net interest income plus other income
was 66% for the twelve months ended December 31, 2005, 65% for the twelve months ended December 31, 2004, and 65% for the twelve months ended December 31, 2003.
Net interest income is the income that remains after deducting, from total income generated by earning assets, the interest expense attributable to the acquisition of the funds required to support earning assets. Income from earning assets includes income from loans, investment securities, and short-term investments. The amount of interest income is dependent upon many factors including the volume of earning assets, the general level of interest rates, the dynamics of the change in interest rates, and the levels of non-performing loans. The cost of funds varies with the amount of funds necessary to support earning assets, the rates paid to attract and hold deposits, the rates paid on borrowed funds, and the levels of noninterest-bearing demand deposits and equity capital.
TABLE 1 - Distribution of Assets, Liabilities and Shareholders Equity
Interest Rates and Interest Differential - Tax Equivalent Basis
Average loan balances include non accrual loans.
Tax-exempt income has been adjusted to a tax-equivalent basis using a marginal rate of 35%.
For presentation in this table, average balances and the corresponding average rates for investment securities are based upon historical cost, adjusted for amortization of premiums and accretion of discounts.
Table 1 presents average balances, taxable equivalent interest income and expense and yields earned or paid on these assets and liabilities. For purposes of calculating taxable equivalent interest income, tax-exempt interest has been adjusted using a marginal tax rate of 35% in order to equate the yield to that of taxable interest rates. Table 2 illustrates the changes in net interest income caused by changes in average volume, rates, and yields.
The $28.2 million increase in our net interest income in 2005, as compared to 2004, was primarily the result of the net contribution from interest-earning assets and interest-bearing liabilities acquired from Patriot in June 2004. In addition, since we are an asset-sensitive institution, where assets reprice more quickly than liabilities, we experienced improvement in our net interest margin, from 3.60% for 2004, to 3.76% for 2005, due to recent increases in interest rates. We have, however, reduced our asset-sensitivity by offering premium rates on interest-bearing deposits, primarily indexed money market accounts, since June 1, 2005. These promotional deposit programs were instituted so that we would continue to be competitive in our marketplace.
Variances do occur in the net interest margin, as an exact repricing of assets and liabilities is not possible. A further explanation of the impact of asset and liability repricing is found in the section titled Market Risks.
TABLE 2 - Changes in Net Interest Income - Tax Equivalent Basis
Changes which are due in part to volume and in part to rate are allocated in proportion to their relationship to the amounts of changes attributed directly to volume and rate.
Provision and Allowance for Loan and Lease Losses
The provision for loan and lease losses is the expense necessary to maintain the allowance for loan and lease losses at a level adequate to absorb managements estimate of probable losses in the loan and lease portfolio. Our provision for loan and lease losses is based upon managements quarterly review of the loan portfolio. The purpose of the review is to assess loan quality, identify impaired loans and leases, analyze delinquencies, ascertain loan and lease growth, evaluate potential charge-offs and recoveries, and assess general economic conditions in the markets we serve.
Commercial and commercial real estate loans are internally risk rated, using a standard rating system, by our loan officers and periodically reviewed by loan quality personnel. Consumer loans, residential real estate loans, and leases are generally analyzed in the aggregate as they are of relatively small dollar size and homogeneous in nature.
Under our methodology for calculating the allowance for loan and lease losses, loss rates for the last three years on a rolling quarter-to-quarter basis are determined for: (a) commercial credits (including agriculture, commercial, commercial real estate, land acquisition, development and construction) and (b) consumer credits (including residential real estate, consumer direct, consumer indirect, consumer revolving, and leases). The loss rates are calculated for each affiliate bank, and they are applied to loan balances of the portfolio segments described above.
In addition to using loss rates, non-accrual loans of $0.25 million or greater are reviewed for impairment as required under FAS No. 114. Those loans that have specific loss allocations are identified and included in the reserve allocation. Risk-rated loans that are not reviewed for impairment are segregated into homogeneous pools with loss allocation rates that reflect the severity of risk. Loss rates are adjusted by applying other factors to the calculations. These factors include adjustment for current economic trends, delinquency and risk trends, credit concentrations, credit administration and other special allocations for unusual events or changes in products.
This methodology provides an in-depth analysis of the portfolios of our banks and reflects the estimated losses within the various portfolios. Reserve allocations are then reviewed and consolidated. This process is performed on a quarterly basis, including a risk-rated review of commercial credit relationships at the banking affiliates.
Prior to 2002, we did not have a standard risk rating system for affiliate banks. The banks used their own methodology for calculating the allowance, and loss data was not broken out in as many categories, particularly real estate loans, because the data was not available. Table 10, Allocation of Allowance for Loan and Lease Losses, reflects comparative data for 2005, 2004, 2003, and 2002 using the revised methodology. If data were available, and we could retroactively apply our current methodology to 2001, we believe the allocation between the categories of real estate construction and real estate mortgage would be consistent with 2005, 2004, 2003, and 2002 allocations.
Determining the level of the allowance for possible loan and lease losses at any given point in time is difficult, particularly during uncertain economic periods. We must make estimates using assumptions and information that is often subjective and changing rapidly. The review of the loan and lease portfolios is a continuing event in light of a changing economy and the dynamics of the banking and regulatory environment. In our opinion, the allowance for loan and lease losses is adequate to meet probable loan and lease losses at December 31, 2005. There can be no assurance, however, that we will not sustain losses in future periods that could be greater than the size of the allowance at December 31, 2005.
The provision for loan and lease losses was $12.3 million for 2005, and $10.0 million in 2004. This $2.3 million increase in the provision was the result of a $5.0 million increase in net charge-offs in 2005, as compared to 2004. The increase in net charge-offs was caused by a $3.6 million net charge-off related to one customer in the telecommunications industry.
The allowance for loan and lease losses at December 31, 2005 was 1.03% of period-end loans and leases, or $53.7 million, and 1.03%, or $54.1 million, at December 31, 2004.
Should the economic climate deteriorate, borrowers may experience increasing difficulty in meeting their payment obligations, and the level of non-performing loans and assets, charge-offs, and delinquencies could rise and require further increases in the provision. In addition, regulatory authorities, as an integral part of their examinations, periodically review the level of the allowance for loan and lease losses. They may require additions to allowances based upon their judgments about information available to them at the time of examination.
It is our policy not to renegotiate the terms of a commercial loan simply because of a delinquency status. Rather, a commercial loan is typically transferred to non-accrual status if it is not well secured and in the process of collection, and is considered delinquent in payment if either principal or interest is past due 90 days or more. Interest income received on impaired commercial loans in 2005 and 2004 was $0.16 million and $0.10 million, respectively. Interest income that would have been recorded on these loans under the original terms was $0.3 million and $1.1 million for 2005 and 2004, respectively. At December 31, 2005, we had no outstanding commitments to advance additional funds with respect to these impaired loans.
Consumer loans are typically charged-off when they are 120 days past due unless they are secured by real estate. Loans secured by real estate are evaluated on the basis of collateral value. Loans that are well-secured may continue to accrue interest, while other loans are charged down to net realizable value or placed on non-accrual depending upon their loan to value ratio.
Table 3 is an analysis of the provision levels as well as the activity in the allowance for loan and lease losses for the past five years. Table 4 reflects the five-year history of non-performing assets and loans and leases contractually past due 90 days and not placed on non-accrual. At December 31, 2005, non-performing assets totaled $20.0 million and included $2.6 million in other real estate acquired through foreclosure. At December 31, 2004, non-performing assets totaled $21.7 million, and included $1.3 million in other real estate acquired through foreclosure.
TABLE 3 - Provision and Allowance for Loan and Lease Losses
TABLE 4 - Non-Performing Assets
Real estate acquired through foreclosure is carried at its fair value, which is calculated as the lower of the recorded amount of the loan for which the foreclosed property served as collateral, or the fair market value of the property as determined by a current appraisal less estimated costs to sell. Prior to foreclosure, the recorded amount of the loan is written-down, if necessary, to fair value by charging the allowance for loan and lease losses. Subsequent to foreclosure, gains or losses on the sale of real estate acquired through foreclosure are recorded in operating income, and any losses determined as a result of periodic valuations are charged to other operating expense.
Loans with principal and/or interest delinquent 90 days or more and still accruing interest totaled $9.0 million at December 31, 2005, a decrease from $10.2 million at December 31, 2004. A softening of certain segments of the economy may adversely affect certain borrowers and may cause additional loans to become past due beyond 90 days or be placed on non-accrual status because of the uncertainty of receiving full payment of either principal or interest on these loans.
Potential problem loans consist of loans that are performing under contract but for which potential credit problems have caused us to place them on our internally monitored loan list. These loans, which are not included in Table 4, totaled $29.8 million at December 31, 2005, and $30.1 million at December 31, 2004. Depending upon the state of the economy and its impact on these borrowers, as well as future events, such as regulatory examination assessments, these loans and others not currently so identified could be classified as non-performing assets in the future.
Noninterest income, as a percentage of net interest income plus noninterest income, was 34%, 35%, and 35% for 2005, 2004, and 2003, respectively.
Noninterest income increased $10.5 million, or 9.2%, in 2005, over 2004. This net increase primarily is composed of the following:
Asset management fees and commissions on brokerage, life insurance, and annuity sales. As part of our strategy to increase other fee-based income, we continued to focus on enhancing the wealth management aspect of our business. As a result, asset management fees increased 24.1%, as assets under administration at VFAM increased 4.8%, to $3.8 billion at December 31, 2005, from $3.6 billion at December 31, 2004. This increase is also due, in part, to our strategic acquisitions.
Commissions on property and casualty insurance sales. The 21.2% increase in commissions on property and casualty insurance sales is attributed to new business, growth in existing business, and better than expected contingency fee income in the first quarter of 2005.
Gains on sales of loans and leases. The 55.2% increase in gains on sales of loans and leases can be attributed to the sale and subsequent securitization of $239.8 million in home equity line of credit loans (HELOCs) in the fourth quarter of 2005. The net gain relating to this transaction was $6.7 million.
Net gains on the sales of bank branches. During 2005, we sold six bank branches and realized an aggregate net pre-tax gain of $5.2 million. During 2004, we sold four bank branches and realized an aggregate net pre-tax gain of $3.2 million. These sales were part of our effort to enhance the efficiency of our branch network through our previously announced plans to consolidate and/or sell several locations.
Other income. The 22.4% increase in other income for 2005, is directly related to the inclusion of Patriot operations for the entire year.
Vehicle origination, securitization, and servicing fees. The 21.1% decrease in vehicle origination, servicing, and securitization fees was primarily due to a combination of decreased lease origination volumes and decreased fees from securitization transactions at Hann. The decrease in securitization fees is due to the current interest rate environment.
Noninterest expenses increased $23.5 million, or 10.7%, in 2005, over 2004. This net increase primarily is composed of the following:
Salaries and employee benefits. The largest component of noninterest expense is salaries and employee benefits, which increased 7.6% in 2005. This increase is primarily the result of the Patriot acquisition, normal annual salary increases, new revenue producing positions, and higher benefit costs. Offsetting this increase was a decline in related expenses due to our charter consolidations.
On December 14, 2005, our Board of Directors approved the accelerated vesting, effective as of December 15, 2005, of all unvested stock options granted to employees and directors in 2002 and 2004. The
decision to accelerate the vesting of these options primarily was made to reduce non-cash compensation expense that would have been recorded in our income statement in future periods as a result of the adoption of FAS No. 123(R), Share-Based Payment, in January 2006. We estimate that, as a result of this action, approximately $0.4 million of compensation expense will have been eliminated in 2006, approximately $0.3 million of compensation expense will have been eliminated in 2007, and approximately $0.2 million of compensation expense will have been eliminated in 2008. As a result of the accelerated vesting of these options, compensation expense totaling $0.1 million was included in our results of operations for 2005.
Occupancy and furniture and equipment. Charges for occupancy and furniture and equipment increased 16.9% in 2005. The increase can be attributed to the Patriot acquisition and general increases in the costs of doing business, predominantly in the categories of rent expense and maintenance expense.
Vehicle residual value. As we had anticipated, vehicle residual value expense increased for 2005, based upon servicing agreements with Auto Lenders, our third-party residual value guarantor. However, due to improving market conditions, residual value guarantee premiums are contractually committed to decrease by $5.5 million in 2006, and by another $2.7 million in 2007. For further information, refer to the discussion concerning Vehicle Leasing Residual Value Risk on page 50 of this Form 10-K.
Vehicle delivery and preparation. The 23.2% decrease in these expenses is due to efficiencies recognized through the operation of the new reconditioning center at Auto Lenders. In addition, fewer vehicle leases matured in 2005.
Other expense. All other expenses increased $9.9 million, net (see Table 5). The inclusion of Patriot operations since June 10, 2004, contributed to a general increase in all expense categories. In addition, we incurred increased advertising and marketing expenses relating to our branding initiative in 2005.
TABLE 5 - Analysis of Other Expenses
Our effective tax rates for 2005 and 2004 were 29.2% and 29.5%, respectively.
During 2005, Susquehanna instituted a request under a particular states voluntary compliance process to establish the right to loss carryforwards. This process was completed with the state in October, 2005. Due to the establishment of loss carryforwards in an additional state, as well as other initiatives undertaken during the fourth quarter of 2005, Susquehanna has assessed that all of the remaining state net operating losses are realizable at December 31, 2005, and the valuation allowance was released.
Offsetting the impact of the release of the valuation allowance was a reduced level of tax-advantaged income.
Summary of 2005 Compared to 2004
Total assets at December 31, 2005 and 2004 were $7.5 billion. Loans and leases, as a result of two securitization transactions completed by our banking subsidiaries in 2005, experienced a slight decrease, to $5.2 billion at December 31, 2005, from $5.3 billion at December 31, 2004. Deposits increased to $5.3 billion, from $5.1 billion during the same time period. Equity capital was $780.5 million at December 31, 2005, or $16.66 per share, compared to $751.7 million, or $16.13 per share, at December 31, 2004.
We follow FAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. This accounting pronouncement requires the segregation of investment securities into three categories, each having a distinct accounting treatment:
Securities identified as held-to-maturity continue to be carried at their amortized cost and, except for limited circumstances, may not be sold prior to maturity. Securities identified as available-for-sale must be reported at their market or fair value, and the difference between that value and their amortized cost is recorded in the equity section, net of taxes, as a component of other comprehensive income. Consequently, our total equity was negatively impacted by $15.2 million, as the unrealized losses, net of taxes, on available-for-sale securities increased from a loss of $2.3 million at December 31, 2004, to a loss of $17.5 million at December 31, 2005. We do not believe any individual unrealized loss represents a material other-than-temporary impairment. Unrealized losses recorded for U.S. Government agencies and mortgage-backed securities are attributable to changes in interest rates. We have both the intent and the ability to hold the securities for a time necessary to recover the amortized cost.
Investment securities available for sale decreased $93.1 million, from December 31, 2004, to December 31, 2005. This decrease occurred because we chose to use some of the cash inflows from sales, maturities, and repayments of securities to fund loan growth rather than reinvest in additional securities. In addition, the $23.5 million increase in unrealized losses in the portfolio also contributed to the decrease.
Securities identified as trading account securities are marked-to-market with the change recorded in the income statement. Presently, we do not engage in trading activity, but we do engage in active portfolio management, that requires the majority of our security portfolios to be identified as available-for-sale. While FAS 115 requires segregation into held-to-maturity and available-for-sale categories (see Table 6), it does not change our policy concerning the purchase of only high quality securities. Strategies employed address liquidity, capital adequacy, and net interest margin considerations, which then determine the assignment of purchases into these two categories. Table 7 illustrates the maturities of these security portfolios and the weighted-average yields based upon amortized costs. Yields are shown on a tax equivalent basis assuming a 35% federal income tax rate.
At December 31, 2005, we held no securities of any one issuer where the aggregate book value exceeded ten percent of shareholders equity. Furthermore, there were no investment securities whose ratings were less than investment grade at December 31, 2005 and 2004.
TABLE 6 - Carrying Value of Investment Securities
TABLE 7 - Maturities of Investment Securities
Weighted-average yields are based on amortized cost. For presentation in this table, yields on tax-exempt securities have been calculated on a tax-equivalent basis.
Information included in this table regarding mortgage-backed securities is based on final maturities.
Loans and Leases
In March 2005, our banking subsidiaries entered into a term securitization transaction in which we collectively sold and contributed beneficial interests in a portfolio of automobile leases and related vehicles with an aggregate balance of $366.8 million. In December 2005, we entered into a term securitization transaction in which we sold a portfolio of HELOCs with an aggregate balance of $239.8 million. Internal growth within the loan and lease portfolio was approximately $575.8 million. As a result, loans and leases decreased $30.8 million, net, from December 31, 2004, to December 31, 2005.
In general, we believe that the internal growth that occurred in our loan portfolio in 2005 was accomplished through our sales and marketing efforts. We remain committed, however, to maintaining credit quality and doing business in our market area with customers we know.
Table 8 presents loans outstanding, by type of loan, in our portfolio for the past five years. In general, the composition of our loan portfolio, by percentage of total loans, has remained relatively unchanged from December 31, 2004, to December 31, 2005. The greatest percentage changes were between real estate construction loans, which increased by 3.8% of total loans and leases, and residential real estate loans, which decreased by 4.7% of total loans and leases as a result of the HELOC securitization.
TABLE 8 - Loan and Lease Portfolio
Our bank subsidiaries have historically reported a significant amount of loans secured by real estate, as depicted in Table 8. Many of these loans have real estate collateral taken as additional security not related to the acquisition of the real estate pledged. Open-end home equity loans totaled $150.7 million at December 31, 2005, and an additional $138.7 million was lent against junior liens on residential properties at December 31, 2005. Senior liens on 1 - 4 family residential properties totaled $945.9 million at December 31, 2005, and much of the $1.3 billion in loans secured by non-farm, non-residential properties represented collateralization of operating lines of credit, or term loans that finance equipment, inventory, or receivables. Loans secured by farmland totaled $45.1 million, while loans secured by multi-family residential properties totaled $120.3 million at December 31, 2005.
Table 9 represents the maturity of commercial, financial, and agricultural loans, as well as real estate construction loans. Table 10 presents the allocation of the allowance for loan and lease losses by type of loan.
Substantially all of our loans and leases are to enterprises and individuals in our market area. As shown in Table 11, there is no concentration of loans to borrowers in any one industry, or related industries, which exceeds 10% of total loans.
TABLE 9 - Loan Maturity and Interest Sensitivity
TABLE 10 - Allocation of Allowance for Loan and Lease Losses
TABLE 11 - Loan Concentrations
At December 31, 2005, Susquehannas portfolio included the following industry concentrations:
Goodwill and Other Identifiable Intangible Assets
As a result of the Brandywine acquisition in February 2005, we recognized goodwill of $1.9 million and a customer list intangible of $1.3 million. Furthermore, in the second quarter of 2005, we recorded additional goodwill of $0.2 million as a result of a contingent earn-out agreement related to a previous Patriot acquisition.
Investment in and Receivables from Unconsolidated Entities
Concurrent with the lease-securitization transaction in March 2005, our banking subsidiaries recorded investments in and receivables from unconsolidated entities of $48.5 million. This amount represents receivables from the unconsolidated qualified special purpose entities that were established to transact the securitization, which resulted in a $2.9 million gain on sale of leases.
Our deposit base is consumer-oriented, consisting of time deposits, primarily certificates of deposit with various terms, interest-bearing demand accounts, savings accounts, and demand deposits. Average deposit balances by type and the associated average rate paid are summarized in Table 12.
TABLE 12 - Average Deposit Balances
Total deposits increased $178.5 million, or 3.5%, from December 31, 2004 to December 31, 2005. During 2005, we sold five branch locations and associated deposits totaling $60.1 million. Also, in 2004, we sold branch deposits totaling approximately $44.2 million. These sales were part of our realignment and consolidation project.
Of the net increase in total deposits, $51.4 million was in brokered certificates of deposit, which are being utilized as an alternative funding source to support the increase in our loan portfolio. In addition, we redesigned the money-management products offered to some of our municipal customers and consequently transferred approximately $71.1 million in funds that had been invested in securities sold under repurchase agreements into certificates of deposit greater than $0.1 million.
We do not rely upon time deposits of $0.1 million or more as a principal source of funds, as they represent only 14.6% of total deposits. Table 13 presents a breakdown by maturity of time deposits of $0.1 million or more as of December 31, 2005.
TABLE 13 - Deposit Maturity
The maturities of time deposits of $0.1 million or more at December 31, 2005 were as follows:
Short-term borrowings, which include securities sold under repurchase agreements, federal funds purchased, and Treasury tax and loan notes, decreased by $113.3 million, or 26.9%, from December 31, 2004, to December 31, 2005. The greatest decrease within this category occurred in securities sold under repurchase agreements (as discussed above), which decreased $101.3 million, from $307.8 million at December 31, 2004, to $206.5 million at December 31, 2005.
Federal Home Loan Bank Borrowings and Long-term Debt
Federal Home Loan Bank borrowings decreased $82.6 million, and long-term debt decreased $50.5 million, from December 31, 2004, to December 31, 2005. The decrease in FHLB borrowings was accomplished through the utilization of proceeds from the HELOC securitization. Prior to the securitization in December 2005, FHLB borrowings were used to support the increase in our loan portfolio. The decrease in long-term debt was the result of our repayment, at maturity on February 1, 2005, of $50.0 million aggregate principal amount of 9.0% subordinated notes.
Contractual Obligations and Commercial Commitments
Table 14 presents certain of our contractual obligations and commercial commitments, including Susquehannas guarantees on behalf of its subsidiaries, and their expected year of payment or expiration.
TABLE 14 - Contractual Obligations and Commercial Commitments
Risk-based capital ratios, based upon guidelines adopted by bank regulators in 1989, focus upon credit risk. Assets and certain off-balance sheet items are segmented into one of four broad risk categories and weighted according to the relative percentage of credit risk assigned by the regulatory authorities. Off-balance sheet instruments are converted into a balance sheet credit equivalent before being assigned to one of the four risk-weighted categories. To supplement the risk-based capital ratios, the regulators issued a minimum leverage ratio guideline (Tier 1 capital as a percentage of average assets less excludable intangibles).
Capital elements are segmented into two tiers. Tier 1 capital represents shareholders equity plus junior subordinated debentures reduced by excludable intangibles. Tier 2 capital represents certain allowable long-term debt, the portion of the allowance for loan and lease losses equal to 1.25% of risk-adjusted assets, and 45% of the unrealized gain on equity securities. The sum of Tier 1 capital and Tier 2 capital is total risk-based capital.
The maintenance of a strong capital base at both the parent company level as well as at each bank affiliate is an important aspect of our philosophy. We, and each of our bank subsidiaries, have leverage and risk-weighted ratios well in excess of regulatory minimums, and each entity is considered well capitalized under regulatory guidelines.
The types of market risk exposures generally faced by banking entities include:
Due to the nature of our operations, foreign currency and commodity price risk are not significant to us. However, in addition to general banking risks, we have other risks that are related to vehicle leasing, asset securitizations, and off-balance sheet financing that are also discussed below.
Equity Market Price Risk
Equity market price risk is the risk related to market fluctuations of equity prices in the securities markets. While we do not have significant risk in our investment portfolio, market price fluctuations may affect fee income generated through our asset management operations. Generally, our fee structure is based on the market value of assets being managed at specific time frames. If market values decline, our fee income may also decline.
The maintenance of adequate liquidity the ability to meet the cash requirements of our customers and other financial commitments is a fundamental aspect of our asset/liability management strategy. Our policy of diversifying our funding sources purchased funds, repurchase agreements, and deposit accounts allows us to avoid undue concentration in any single financial market and also to avoid heavy funding requirements within short periods of time. At December 31, 2005, our bank subsidiaries had approximately $656.6 million available to them under collateralized lines of credit with various FHLBs; and $409.6 million more was available provided that additional collateral had been pledged.
Liquidity is not entirely dependent on increasing our liability balances. Liquidity is also evaluated by taking into consideration maturing or readily marketable assets. Unrestricted short-term investments amounted to $69.9 million for the year ended December 31, 2005 and represented additional sources of liquidity.
As an additional source of liquidity, we periodically enter into securitization transactions in which we sell the beneficial interests in leases and related vehicles to qualified special purpose entities. Most recently, we entered into a term securitization transaction of HELOCs. The purchase of these assets is financed through the issuance of asset-backed notes to third-party investors. During 2005, net proceeds from these transactions totaled $584.8 million.
Interest Rate Risk
The management of interest rate risk focuses on controlling the risk to net interest income and the associated net interest margin as the result of changing market rates and spreads. Interest rate sensitivity is the matching or mismatching of the repricing and rate structure of the interest-bearing assets and liabilities. Our goal is to control risk exposure to changing rates within managements accepted guidelines to maintain an acceptable level of risk exposure in support of consistent earnings.
We employ a variety of methods to monitor interest rate risk. These methods include basic gap analysis, which points to directional exposure; routine rate shocks simulation; and evaluation of the change in economic value of equity. Board directed guidelines have been adopted for both the rate shock simulations and economic value of equity exposure limits. By dividing the assets and liabilities into three groups, fixed rate, floating rate and those which reprice only at our discretion, strategies are developed to control the exposure to interest rate fluctuations.
Our interest rate risk using the static gap analysis is presented in Table 15. This method reports the difference between interest-rate sensitive assets and liabilities at a specific point in time. Management uses the static gap methodology to identify our directional interest-rate risk. Table 15 also illustrates our estimated interest rate sensitivity (periodic and cumulative) gap positions as calculated as of December 31, 2005 and 2004. These estimates include anticipated prepayments on commercial and residential loans, mortgage-backed securities, in addition to certain repricing assumptions relative to our core deposits. Traditionally, an institution with more assets repricing than liabilities over a given time frame is considered asset sensitive, and one with more liabilities repricing than assets is considered liability sensitive. An asset sensitive institution will generally benefit from rising rates, and a liability sensitive institution will generally benefit from declining rates. Static gap analysis is widely accepted because of its simplicity in identifying interest rate risk exposure; but it ignores market spread adjustments, the changing mix of the balance sheet, planned balance sheet management strategies, and the change in prepayment assumptions.
TABLE 15 - Balance Sheet Gap Analysis