Valley National Bancorp 10-K 2008
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended December 31, 2007
For the transition period from to
Commission File Number 1-11277
VALLEY NATIONAL BANCORP
(Exact name of registrant as specified in its charter)
(Registrants telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes þ No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes ¨ No þ
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes þ No ¨
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. þ
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act (check one):
Large accelerated filer þ Accelerated filer ¨
Non-accelerated filer ¨ (Do not check if a smaller reporting company) Smaller reporting company ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)
Yes ¨ No þ
The aggregate market value of the voting stock held by non-affiliates of the registrant was approximately $2.5 billion on June 30, 2007.
There were 119,933,384 shares of Common Stock outstanding at February 25, 2008.
Documents incorporated by reference:
Certain portions of the registrants Definitive Proxy Statement (the 2008 Proxy Statement) for the 2008 Annual Meeting of Shareholders to be held April 7, 2008 will be incorporated by reference in Part III.
TABLE OF CONTENTS
Item 1. Business
The disclosures set forth in this item are qualified by Item 1ARisk Factors and the section captioned Cautionary Statement Concerning Forward-Looking Statements in Item 7Managements Discussion and Analysis of Financial Condition and Results of Operations of this report and other cautionary statements set forth elsewhere in this report.
Valley National Bancorp is a New Jersey corporation registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (Holding Company Act), and is headquartered in Wayne, New Jersey. The words Valley, the Company, we, our and us refer to Valley National Bancorp and its wholly owned subsidiaries, unless we indicate otherwise. At December 31, 2007, Valley had consolidated total assets of $12.7 billion, total loans of $8.5 billion, total deposits of $8.1 billion and total shareholders equity of $949.1 million. In addition to its principal subsidiary, Valley National Bank (VNB or the Bank), Valley owns 100 percent of the voting shares of VNB Capital Trust I, through which it issued trust preferred securities. VNB Capital Trust I is not a consolidated subsidiary. See Note 12 of the consolidated financial statements.
VNB is a national banking association chartered in 1927 under the laws of the United States. Currently, VNB has 176 full-service banking offices located throughout northern and central New Jersey and New York City. The Bank provides a full range of commercial and retail banking services. These services include the following: the acceptance of demand, savings and time deposits; extension of consumer, real estate, Small Business Administration (SBA) loans and other commercial credits; equipment leasing; personal and corporate trust, and pension and fiduciary services.
VNBs wholly-owned subsidiaries are all included in the consolidated financial statements of Valley (See Exhibit 21 at Part IV, Item 15 for a complete list of subsidiaries). These subsidiaries include a mortgage servicing company; a title insurance agency; asset management advisors which are Securities and Exchange Commission (SEC) registered investment advisors; an all-line insurance agency offering property and casualty, life and health insurance; subsidiaries which hold, maintain and manage investment assets for VNB; a subsidiary which owns and services auto loans; a subsidiary which specializes in asset-based lending; a subsidiary which offers both commercial equipment leases and financing for general aviation aircraft; and a subsidiary which is a registered broker-dealer (see Recent Developments below for further information on our broker-dealer subsidiary). VNBs subsidiaries also include real estate investment trust subsidiaries (the REIT subsidiaries) which own real estate related investments and a REIT subsidiary which owns some of the real estate utilized by VNB and related real estate investments. Except for Valleys REIT subsidiaries, all subsidiaries mentioned above are directly or indirectly wholly-owned by VNB. Because each REIT must have 100 or more shareholders to qualify as a REIT, each REIT has issued less than 20 percent of their outstanding non-voting preferred stock to individuals, most of whom are non-senior management VNB employees. VNB owns the remaining preferred stock and all the common stock of the REITs.
VNB has four business segments it monitors and reports on to manage its business operations. These segments are consumer lending, commercial lending, investment management, and corporate and other adjustments. Valleys Wealth Management Division comprised of trust, broker-dealer, asset management and insurance services, is included in the consumer lending segment. For financial data on the four business segments see Note 19 of the consolidated financial statements.
On January 31, 2008, Valley entered an agreement to sell its broker-dealer subsidiary, Glen Rauch Securities, Inc., for a total of approximately $1.9 million, consisting of cash and a note payable. Glen Rauch Securities, Inc. had total assets of approximately $4.0 million as of December 31, 2007. The transaction, subject to regulatory approval, is expected to close in the first quarter of 2008. This pending divesture was not accounted for in the audited consolidated financial statements included elsewhere in this report as discontinued operations due to the immaterial nature of this subsidiarys financial position and results of operations for the periods presented.
SEC Reports and Corporate Governance
Valley makes its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K and amendments thereto available on its website at www.valleynationalbank.com without charge as soon as reasonably practicable after filing or furnishing them to the SEC. Also available on the website are Valleys Code of Conduct and Ethics that applies to all of Valleys employees including principal officers and directors, Valleys Audit and Risk Committee Charter, Valleys Compensation and Human Resources Committee Charter, Valleys Nominating and Corporate Governance Committee Charter as well as Valleys Corporate Governance Guidelines.
Valley filed the certifications of the Chief Executive Officer and Chief Financial Officer required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 with respect to Valleys Annual Report on Form 10-K as exhibits to this Report. Valleys CEO submitted the required annual CEOs Certification regarding the New York Stock Exchanges corporate governance listing standards within the required timeframe after the 2007 annual shareholders meeting.
Additionally, Valley will provide without charge, a copy of its Annual Report on Form 10-K or the Code of Conduct and Ethics to any shareholder by mail. Requests should be sent to Valley National Bancorp, Attention: Shareholder Relations, 1455 Valley Road, Wayne, NJ 07470.
The market for banking and bank-related services is highly competitive and we face substantial competition in all phases of our operations. Valley competes with other providers of financial services such as other bank holding companies, commercial banks, savings institutions, credit unions, mutual funds, mortgage companies, title agencies, asset managers, insurance companies and a growing list of other local, regional and national institutions which offer financial services. De novo branching by several national financial institutions and mergers between financial institutions within New Jersey and New York, as well as other neighboring states have heightened the competitive pressure in our primary markets. We compete by offering quality products and convenient services at competitive prices (including interest rates paid on deposits, interest rates charged on loans and fees charged for other non-interest related services). Valley regularly reviews its products, locations, alternative delivery channels and various acquisition prospects and periodically engages in discussions regarding possible acquisitions to maintain and enhance its competitive position.
At December 31, 2007, VNB and its subsidiaries employed 2,562 full-time equivalent persons. Management considers relations with its employees to be satisfactory.
All officers serve at the pleasure of the Board of Directors.
SUPERVISION AND REGULATION
The banking industry is highly regulated. Statutory and regulatory controls increase a bank holding companys cost of doing business and limit the options of its management to deploy assets and maximize income. The following discussion is not intended to be a complete list of all the activities regulated by the banking laws or of the impact of such laws and regulations on Valley or VNB. It is intended only to briefly summarize some material provisions.
Bank Holding Company Regulation
Valley is a bank holding company within the meaning of the Holding Company Act. As a bank holding company, Valley is supervised by the Board of Governors of the Federal Reserve System (FRB) and is required to file reports with the FRB and provide such additional information as the FRB may require.
The Holding Company Act prohibits Valley, with certain exceptions, from acquiring direct or indirect ownership or control of more than five percent of the voting shares of any company which is not a bank and from engaging in any business other than that of banking, managing and controlling banks or furnishing services to subsidiary banks, except that it may, upon application, engage in, and may own shares of companies engaged in, certain businesses found by the FRB to be so closely related to banking as to be a proper incident thereto. The Holding Company Act requires prior approval by the FRB of the acquisition by Valley of more than five percent of the voting stock of any other bank. Satisfactory capital ratios and Community Reinvestment Act ratings and anti-money laundering policies are generally prerequisites to obtaining federal regulatory approval to make acquisitions. The policy of the FRB provides that a bank holding company is expected to act as a source of financial strength to its subsidiary bank and to commit resources to support the subsidiary bank in circumstances in which it might not do so absent that policy. Acquisitions through VNB require approval of the Office of the Comptroller of the Currency of the United States (OCC). The Holding Company Act does not place territorial restrictions on the activities of non-bank subsidiaries of bank holding companies. The Gramm-Leach-Bliley Act, discussed below, allows Valley to expand into insurance, securities, merchant banking activities, and other activities that are financial in nature.
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (Interstate Banking and Branching Act) enables bank holding companies to acquire banks in states other than its home state, regardless of applicable state law. The Interstate Banking and Branching Act also authorizes banks to merge across state lines, thereby creating interstate banks with branches in more than one state. Under the legislation, each state had the opportunity to opt-out of this provision. Furthermore, a state may opt-in with respect to de novo branching, thereby permitting a bank to open new branches in a state in which the bank does not already have a branch. Without de novo branching, an out-of-state commercial bank can enter the state only by acquiring an existing bank or branch. The vast majority of states have allowed interstate banking by merger but have not authorized de novo branching.
New Jersey enacted legislation to authorize interstate banking and branching and the entry into New Jersey of foreign country banks. New Jersey did not authorize de novo branching into the state. However, under federal law, federal savings banks which meet certain conditions may branch de novo into a state, regardless of state law.
Regulation of Bank Subsidiary
VNB is subject to the supervision of, and to regular examination by, the OCC. Various laws and the regulations thereunder applicable to Valley and its bank subsidiary impose restrictions and requirements in many areas, including capital requirements, the maintenance of reserves, establishment of new offices, the making of loans and investments, consumer protection, employment practices, bank acquisitions and entry into new types of business. There are various legal limitations, including Sections 23A and 23B of the Federal Reserve Act, which govern the extent to which a bank subsidiary may finance or otherwise supply funds to its holding company or its holding companys non-bank subsidiaries. Under federal law, no bank subsidiary may, subject to certain limited exceptions, make loans or extensions of credit to, or investments in the securities of, its parent or the non-bank subsidiaries of its parent (other than direct subsidiaries of such bank which are not financial subsidiaries) or take their securities as collateral for loans to any borrower. Each bank subsidiary is also subject to collateral security requirements for any loans or extensions of credit permitted by such exceptions.
Valley is a legal entity separate and distinct from its subsidiaries. Valleys revenues (on a parent company only basis) result in substantial part from dividends paid by VNB. VNB dividend payments, without prior regulatory approval, are subject to regulatory limitations. Under the National Bank Act, dividends may be declared only if, after payment thereof, capital would be unimpaired and remaining surplus would equal 100 percent of capital. Moreover, a national bank may declare, in any one year, dividends only in an amount aggregating not more than the sum of its net profits for such year and its retained net profits for the preceding two years. In addition, the bank regulatory agencies have the authority to prohibit VNB from paying dividends or otherwise supplying funds to Valley if the supervising agency determines that such payment would constitute an unsafe or unsound banking practice.
Loans to Related Parties
VNBs authority to extend credit to its directors, executive officers and 10 percent stockholders, as well as to entities controlled by such persons, is currently governed by the requirements of the National Bank Act, Sarbanes-Oxley Act and Regulation O of the FRB thereunder. Among other things, these provisions require that extensions of credit to insiders (i) be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with unaffiliated persons and that do not involve more than the normal risk of repayment or present other unfavorable features and (ii) not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of VNBs capital. In addition, extensions of credit in excess of certain limits must be approved by VNBs Board of Directors. Under the Sarbanes-Oxley Act, Valley and its subsidiaries, other than VNB, may not extend or arrange for any personal loans to its directors and executive officers.
Under the Community Reinvestment Act (CRA), as implemented by OCC regulations, a national bank has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate-income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institutions discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires the OCC, in connection with its examination of a national bank, to assess the associations record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by such association. The CRA also requires all institutions to make public disclosure of their CRA ratings. VNB received a satisfactory CRA rating in its most recent examination.
Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 added new legal requirements for public companies affecting corporate governance, accounting and corporate reporting.
The Sarbanes-Oxley Act of 2002 provides for, among other things:
Each of the national stock exchanges, including the New York Stock Exchange (NYSE) where Valleys securities are listed, have implemented corporate governance listing standards, including rules strengthening director independence requirements for boards, and requiring the adoption of charters for the nominating, corporate governance and audit committees. These rules require Valley to certify to the NYSE that there are no violations of any corporate listing standards. Valley has provided the NYSE with the certification required by the NYSE Rule.
USA PATRIOT Act
As part of the USA PATRIOT Act, Congress adopted the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (the Anti Money Laundering Act). The Anti Money Laundering Act authorizes the Secretary of the Treasury, in consultation with the heads of other government agencies, to adopt special measures applicable to financial institutions such as banks, bank holding companies, broker-dealers and insurance companies. Among its other provisions, the Anti Money Laundering Act requires each financial institution: (i) to establish an anti-money laundering program; (ii) to establish due diligence policies, procedures and controls that are reasonably designed to detect and report instances of money laundering in United States private banking accounts and correspondent accounts maintained for non-United States persons or their representatives; and (iii) to avoid establishing, maintaining, administering, or managing correspondent accounts in the United States for, or on behalf of, a foreign shell bank that does not have a physical presence in any country. In addition, the Anti Money Laundering Act expands the circumstances under which funds in a bank account may be forfeited and requires covered financial institutions to respond under certain circumstances to requests for information from federal banking agencies within 120 hours.
Regulations implementing the due diligence requirements, require minimum standards to verify customer identity and maintain accurate records, encourage cooperation among financial institutions, federal banking agencies, and law enforcement authorities regarding possible money laundering or terrorist activities, prohibit the anonymous use of concentration accounts, and requires all covered financial institutions to have in place an anti-money laundering compliance program. The OCC, along with other banking agencies, have strictly enforced various anti-money laundering and suspicious activity reporting requirements using formal and informal enforcement tools to cause banks to comply with these provisions.
The Anti Money Laundering Act amended the Bank Holding Company Act and the Bank Merger Act to require the federal banking agencies to consider the effectiveness of any financial institution involved in a proposed merger transaction in combating money laundering activities when reviewing an application under these acts.
Regulatory Relief Law
In late 2000, the American Home Ownership and Economic Act of 2000 instituted a number of regulatory relief provisions applicable to national banks, such as permitting national banks to have classified directors and to merge their business subsidiaries into the bank.
The Gramm-Leach-Bliley Financial Modernization Act of 1999 (Gramm-Leach-Bliley Act) became effective in early 2000. The Gramm-Leach-Bliley Act provides for the following:
If a bank holding company elects to become a financial holding company, it files a certification, effective in 30 days, and thereafter may engage in certain financial activities without further approvals. Valley has not elected to become a financial holding company.
The OCC adopted rules to allow national banks to form subsidiaries to engage in financial activities allowed for financial holding companies. Electing national banks must meet the same management and capital standards as financial holding companies but may not engage in insurance underwriting, real estate development or merchant banking. Sections 23A and 23B of the Federal Reserve Act apply to financial subsidiaries and the capital invested by a bank in its financial subsidiaries will be eliminated from the banks capital in measuring all capital ratios. VNB wholly owns one financial subsidiaryGlen Rauch Securities, Inc.
The Gramm-Leach-Bliley Act modified other financial laws, including laws related to financial privacy and community reinvestment.
Additional proposals to change the laws and regulations governing the banking and financial services industry are frequently introduced in Congress, in the state legislatures and before the various bank regulatory agencies. The likelihood and timing of any such changes and the impact such changes might have on Valley cannot be determined at this time.
Under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), a depository institution insured by the Federal Deposit Insurance Corp (FDIC) can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default. These provisions have commonly been referred to as FIRREAs cross guarantee provisions. Further, under FIRREA, the failure to meet capital guidelines could subject a bank to a variety of enforcement remedies available to federal regulatory authorities.
FIRREA also imposes certain independent appraisal requirements upon a banks real estate lending activities and further imposes certain loan-to-value restrictions on a banks real estate lending activities. The bank regulators have promulgated regulations in these areas.
Pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), each federal banking agency has promulgated regulations, specifying the levels at which a financial institution would be considered well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, or critically undercapitalized, and to take certain mandatory and discretionary supervisory actions based on the capital level of the institution. To qualify to engage in financial activities under the Gramm-Leach-Bliley Act, all depository institutions must be well capitalized. The financial holding company of a national bank will be put under directives to raise its capital levels or divest its activities if the depository institution falls from that level.
The OCCs regulations implementing these provisions of FDICIA provide that an institution will be classified as well capitalized if it (i) has a total risk-based capital ratio of at least 10.0 percent, (ii) has a Tier 1 risk-based capital ratio of at least 6.0 percent, (iii) has a Tier 1 leverage ratio of at least 5.0 percent, and (iv) meets certain other requirements. An institution will be classified as adequately capitalized if it (i) has a total risk-based capital ratio of at least 8.0 percent, (ii) has a Tier 1 risk-based capital ratio of at least 4.0 percent, (iii) has a Tier 1 leverage ratio of (a) at least 4.0 percent or (b) at least 3.0 percent if the institution was rated 1 in its most recent examination, and (iv) does not meet the definition of well capitalized. An institution will be classified as undercapitalized if it (i) has a total risk-based capital ratio of less than 8.0 percent, (ii) has a Tier 1 risk-based capital ratio of less than 4.0 percent, or (iii) has a Tier 1 leverage ratio of (a) less than 4.0 percent or (b) less than 3.0 percent if the institution was rated 1 in its most recent examination. An institution will be classified as significantly undercapitalized if it (i) has a total risk-based capital ratio of less than 6.0 percent, (ii) has a Tier 1 risk-based capital ratio of less than 3.0 percent, or (iii) has a Tier 1 leverage ratio of less than 3.0 percent. An institution will be classified as critically undercapitalized if it has a tangible equity to total assets ratio that is equal to or less than 2.0 percent. An insured depository institution may be deemed to be in a lower capitalization category if it receives an unsatisfactory examination rating. Similar categories apply to bank holding companies.
In addition, significant provisions of FDICIA required federal banking regulators to impose standards in a number of other important areas to assure bank safety and soundness, including internal controls, information systems and internal audit systems, credit underwriting, asset growth, compensation, loan documentation and interest rate exposure.
Item 1A. Risk Factors
An investment in Valleys common stock is subject to risks inherent to Valleys business. The material risks and uncertainties that management believes affect Valley are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing Valley. Additional risks and uncertainties that management is not aware of or that management currently believes are immaterial may also impair Valleys business operations. This report is qualified in its entirety by these risk factors.
If any of the following risks actually occur, Valleys financial condition and results of operations could be materially and adversely affected.
Changes in Interest Rates Can Have an Adverse Effect on Profitability
Valleys earnings and cash flows are largely dependent upon its net interest income. Net interest income is the difference between interest income earned on interest earning assets, such as loans and investment securities, and interest expense paid on interest bearing liabilities, such as deposits and borrowed funds. Interest rates are sensitive to many factors that are beyond Valleys control, including general economic conditions, competition, and policies of various governmental and regulatory agencies and, in particular, the policies of the FRB. Changes in monetary policy, including changes in interest rates, could influence not only the interest Valley receives on loans and investment securities and the amount of interest it pays on deposits and borrowings, but such changes could also affect (i) Valleys ability to originate loans and obtain deposits, (ii) the fair value of Valleys financial assets and liabilities, including the held to maturity, available for sale, and trading securities portfolios, and (iii) the average duration of Valleys interest earning assets. This also includes the risk that interest earning assets may be more responsive to changes in interest rates than interest bearing liabilities, or vice versa (repricing risk), the risk that the individual interest rates or rate indices underlying various interest earning assets and interest bearing liabilities may not change in the same degree over a given time period (basis risk), and the risk of changing interest rate relationships across the spectrum of interest earning asset and interest bearing liability maturities (yield curve risk), including a prolonged flat or inverted yield curve environment.
Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on Valleys results of operations, any substantial, unexpected, prolonged change in market interest rates could have a material adverse effect on Valleys financial condition and results of operations. See Net Interest Income and Interest Rate Sensitivity sections in Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations located elsewhere in this report for further discussion related to Valleys management of interest rate risk.
Competition in the Financial Services Industry
Valley faces substantial competition in all areas of its operations from a variety of different competitors, many of which are larger and may have more financial resources than Valley. Valley competes with other providers of financial services such as commercial and savings banks, savings and loan associations, credit unions, money market and mutual funds, mortgage companies, title agencies, asset managers, insurance companies and a growing list of other local, regional and national institutions which offer financial services. Mergers between financial institutions within New Jersey and in neighboring states have added competitive pressure. If Valley is unable to compete effectively, it will lose market share and income generated from loans, deposits, and other financial products will decline.
Liquidity risk is the potential that Valley will be unable to meet its obligations as they come due, capitalize on growth opportunities as they arise, or pay regular dividends because of an inability to liquidate assets or obtain adequate funding in a timely basis, at a reasonable cost and within acceptable risk tolerances.
Liquidity is required to fund various obligations, including credit obligations to borrowers, mortgage originations, withdrawals by depositors, repayment of debt, dividends to shareholders, operating expenses and capital expenditures.
Liquidity is derived primarily from retail deposit growth and retention; principal and interest payments on loans; principal and interest payments, sale, maturity and prepayment of investment securities; net cash provided from operations and access to other funding sources.
Valleys liquidity can be affected by a variety of factors, including general economic conditions, market disruption, operational problems affecting third parties or Valley, unfavorable pricing, competition, Valleys credit rating and regulatory restrictions.
Loss of Lower Cost Funding Sources
Checking and savings, NOW, and money market deposit account balances and other forms of customer deposits can decrease when customers perceive alternative investments, such as the stock market, as providing a better risk/return tradeoff. If customers move money out of bank deposits and into other investments, Valley could lose a relatively low cost source of funds, increasing its funding costs and reducing Valleys net interest income and net income.
Changes in Primary Market Areas Could Adversely Impact Results of Operations and Financial Condition
Much of Valleys lending is in northern and central New Jersey and New York City. As a result of this geographic concentration, a significant broad based deterioration in economic conditions in New Jersey and the New York City metropolitan area could have a material adverse impact on the quality of Valleys loan portfolio, and accordingly, Valleys results of operations. Such a decline in economic conditions could restrict borrowers ability to pay outstanding principal and interest on loans when due, and, consequently, adversely affect the cash flows of Valleys business.
Valleys loan portfolio is largely secured by real estate collateral. A substantial portion of the real and personal property securing the loans in Valleys portfolio is located in New Jersey and New York City. Conditions in the real estate markets in which the collateral for Valleys loans are located strongly influence the level of Valleys non-performing loans and results of operations. A decline in the New Jersey and New York City metropolitan area real estate markets, as well as the other external factors, could adversely affect Valleys loan portfolio.
Allowance For Loan Losses May Be Insufficient
Valley maintains an allowance for loan losses based on, among other things, national and regional economic conditions, historical loss experience and delinquency trends. However, Valley cannot predict loan losses with certainty, and Valley cannot provide assurance that charge-offs in future periods will not exceed the allowance for loan losses. If net charge-offs exceed Valleys allowance, its earnings would decrease. In addition, regulatory agencies review Valleys allowance for loan losses and may require additions to the allowance based on their judgment about information available to them at the time of their examination. Valley management could also decide that the allowance for loan losses should be increased. An increase in Valleys allowance for loan losses could reduce its earnings.
Potential Acquisitions May Disrupt Valleys Business and Dilute Stockholder Value
Valley regularly evaluates merger and acquisition opportunities and conducts due diligence activities related to possible transactions with other financial institutions and financial services companies. As a result, merger or
acquisition discussions and, in some cases, negotiations may take place and future mergers or acquisitions involving cash, debt or equity securities may occur at any time. Acquisitions typically involve the payment of a premium over book and market values, and, therefore, some dilution of Valleys tangible book value and net income per common share may occur in connection with any future transaction. Furthermore, failure to realize the expected revenue increases, cost savings, increases in geographic or product presence, and/or other projected benefits from an acquisition could have a material adverse effect on Valleys financial condition and results of operations.
Valley seeks merger or acquisition partners that are culturally similar, have experienced management and possess either a market presence or have potential for improved profitability through financial management, economies of scale or expanded services. Acquiring other banks, businesses, or branches involves various risks commonly associated with acquisitions, including, among other things:
Implementation of Growth Strategies
Valley has a strategic branch expansion initiative to expand its physical presence in New York City, including entry into new market areas located in Kings and Queens counties, New York, and fill in its markets within New Jersey. Additionally in 2007, Valley expanded the geographic presence of its auto loan dealer network into Connecticut, which network already includes Pennsylvania, Florida, New York, and New Jersey. Valley can provide no assurances that it will successfully implement these initiatives.
Valleys ability to successfully execute these initiatives depends upon a variety of factors, including its ability to attract and retain experienced personnel, the continued availability of desirable business opportunities and locations, the competitive responses from other financial institutions in Valleys new market areas, and the ability to manage growth. These initiatives could cause Valleys expenses to increase faster than revenues.
There are considerable initial and on-going costs involved in opening branches, growing loans in new markets, and attracting new deposit relationships. These expenses could negatively impact future earnings. For example, it takes time for new branches and relationships to achieve profitability. Expenses could be further increased if there are delays in the opening of new branches or if attraction strategies are more costly than expected. Delays in opening new branches can be caused by a number of factors such as the inability to find suitable locations, zoning and construction delays, and success in attracting qualified personnel to staff the new branch. In addition, there is no assurance that a new branch will be successful even after it has been established.
From time to time, Valley may implement new lines of business or offer new products and services within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. Valley may invest significant time and resources to develop and market new lines of business and/or products and services. Initial timetables for the introduction and development of new lines of business and/or new products or services many not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives, and shifting customer preferences, may also impact the successful implementation of a new line of business or a new product or service. Additionally, any new line of business and/or new product or service could have a significant impact on the effectiveness of Valleys system of internal controls. Failure to successfully manage these risks could have a material adverse effect on Valleys business, results of operations and financial condition.
Changes in Accounting Policies or Accounting Standards
Valleys accounting policies are fundamental to understanding its financial results and condition. Some of these policies require use of estimates and assumptions that may affect the value of Valleys assets or liabilities and financial results. Valley identified its accounting policies regarding the allowance for loan losses, goodwill and other intangible assets, and income taxes to be critical because they require management to make difficult, subjective and complex judgments about matters that are inherently uncertain. Under each of these policies, it is possible that materially different amounts would be reported under different conditions, using different assumptions, or as new information becomes available. For a description of Valleys critical accounting policies, refer to Critical Accounting Policies and Estimates at Item 7 of this Report.
From time to time the Financial Accounting Standards Board (FASB) and the SEC change the financial accounting and reporting standards that govern the form and content of Valleys external financial statements. In addition, accounting standard setters and those who interpret the accounting standards (such as the FASB, SEC, banking regulators and Valleys outside auditors) may change or even reverse their previous interpretations or positions on how these standards should be applied. Changes in financial accounting and reporting standards and changes in current interpretations may be beyond Valleys control, can be hard to predict and could materially impact how Valley reports its financial results and condition. In certain cases, Valley could be required to apply a new or revised standard retroactively or apply an existing standard differently (also retroactively) which may result in Valley restating prior period financial statements in material amounts.
Extensive Regulation and Supervision
Valley, primarily through its principal subsidiary, VNB, and certain non-bank subsidiaries, is subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors funds, federal deposit insurance funds and the banking system as a whole. Such laws are not designed to protect Valley shareholders. These regulations affect Valleys lending practices, capital structure, investment practices, dividend policy and growth, among other things. Valley is also subject to a number of federal laws, which, among other things, require it to lend to various sectors of the economy and population, and establish and maintain comprehensive programs relating to anti-money laundering and customer identification. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect Valley in substantial and unpredictable ways. Such changes could subject Valley to additional costs, limit the types of financial services and products it may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on Valleys business, financial condition and results of operations. Valleys compliance with certain of these laws will be considered by banking regulators when reviewing bank merger and bank holding company acquisitions. While Valley has policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur. See the Supervision and Regulation section in Item 1, Business and Note 16 to consolidated financial statements included in Item 8, Financial Statements and Supplementary Data, which are located elsewhere in this report.
Encountering Continuous Technological Change
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Valleys future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in Valleys operations. Many of Valleys competitors have substantially greater resources to invest in technological improvements. Valley may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on Valleys business and, in turn, Valleys financial condition and results of operations.
Valley faces the risk that the design of its controls and procedures, including those to mitigate the risk of fraud by employees or outsiders, may prove to be inadequate or are circumvented, thereby causing delays in detection of errors or inaccuracies in data and information. Management regularly reviews and updates Valleys internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of Valleys controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on Valleys business, results of operations and financial condition.
Valley may also be subject to disruptions of its systems, arising from events that are wholly or partially beyond its control (including, for example, computer viruses or electrical or telecommunications outages), which may give rise to losses in service to customers and to financial loss or liability. Valley is further exposed to the risk that its external vendors may be unable to fulfill their contractual obligations (or will be subject to the same risk of fraud or operational errors by their respective employees as is Valley) and to the risk that Valleys (or its vendors) business continuity and data security systems prove to be inadequate.
Valleys performance is largely dependent on the talents and efforts of highly skilled individuals. There is intense competition in the financial services industry for qualified employees. In addition, Valley faces increasing competition with businesses outside the financial services industry for the most highly skilled individuals. Valleys business operations could be adversely affected if it were unable to attract new employees and retain and motivate its existing employees.
Claims and Litigation Pertaining to Fiduciary Responsibility
From time to time as part of Valleys normal course of business, customers make claims and take legal action against Valley based on actions or inactions of Valley employees (see Item 3 that follows below for further information). If such claims and legal actions are not resolved in a manner favorable to Valley, they may result in financial liability and/or adversely affect the market perception of Valley and its products and services. This may also impact customer demand for Valleys products and services. Any financial liability or reputation damage could have a material adverse effect on Valleys business, which, in turn, could have a material adverse effect on its financial condition and results of operations.
Item 2. Properties
VNBs corporate headquarters consist of three office buildings located adjacent to each other in Wayne, New Jersey. These headquarters encompass commercial, commercial mortgage, and consumer lending; deposit and computer operations; and the executive offices of both Valley and VNB. Two of the three buildings are owned by a subsidiary of VNB and leased to VNB, the other building is leased by VNB from an independent third party.
VNB owns two other office buildings located in Wayne, New Jersey, one of which is occupied by VNB departments and subsidiaries providing trust and investment management services; the other office building is utilized primarily for VNBs mortgage lending and operations, as well as commercial lending operations. In addition, a subsidiary of VNB owns a building in Chestnut Ridge, New York, primarily occupied by Masters Coverage Corp. and VNB Loan Services, Inc., also subsidiaries of VNB.
VNB provides banking services at 176 locations of which 84 locations are owned by VNB or a subsidiary of VNB and leased to VNB, and 92 locations are leased from independent third parties. Additionally, VNB has 12 other properties located in New Jersey and New York City that were either owned or under contract to purchase or lease as of December 31, 2007. VNB intends to develop these other properties into new branch locations during 2008 and 2009.
Item 3. Legal Proceedings
In the normal course of business, Valley may be a party to various outstanding legal proceedings and claims. In the opinion of management, except for the lawsuits noted below, the consolidated statements of financial condition or results of operations of Valley should not be materially affected by the outcome of such legal proceedings and claims.
Three companies, Synovus Bank of Tampa Bay (Synovus) (formerly known as United Bank and Trust Company), American Express Travel Related Services Company (American Express), and Discover Financial Services (Discover) filed lawsuits against Valley in the United States District Court, Southern District of New York. Each plaintiff alleges or alleged, among other claims, that Valley breached its contractual and fiduciary duties to it in connection with Valleys activities as a depository for Southeast Airlines, a now defunct charter airline carrier. Valley obtained summary judgment against Synovus in February 2007 and Synovus filed an appeal. Synovus dismissed its appeal against Valley on November 16, 2007 concluding that case. During the third quarter of 2007, American Express withdrew its lawsuit, without prejudice, against Valley. The Discover lawsuit remains active as of December 31, 2007 with both Valley and Discover having filed motions for summary judgment. Valley believes it has meritorious defenses to the Discover action as well as the American Express action, if reinstated, but Valley cannot ensure that it will prevail in such litigation or be able to settle such litigations for an immaterial amount.
The anti-money laundering (AML) and bank secrecy (BSA) laws have imposed far-reaching and substantial requirements on financial institutions. The enforcement policy of the OCC with respect to AML/BSA compliance has been vigorously applied throughout the industry, with regulatory action taking various forms. Valley believes that its policies and procedures with respect to combating money laundering are effective and that Valleys AML/BSA policies and procedures are reasonably designed to comply with applicable standards. Valley cannot provide assurance that in the future it will not face a regulatory action, adversely affecting its ability to acquire banks and thrifts, or open new branches. However, Valley is not prohibited from acquiring banks, thrifts or opening branches based upon the results of its most recently completed regulatory examination.
Item 4. Submission of Matters to a Vote of Security Holders
Valleys common stock is traded on the NYSE under the ticker symbol VLY. The following table sets forth for each quarter period indicated the high and low sales prices for the common stock of Valley, as reported by the NYSE, and the cash dividends declared per common share for each quarter. The amounts shown in the table below have been adjusted for all stock dividends and stock splits.
Federal laws and regulations contain restrictions on the ability of Valley and VNB to pay dividends. For information regarding restrictions on dividends, see Part I, Item 1, BusinessDividend Limitations and Part II, Item 8, Financial Statements and Supplementary DataDividend Restrictions, Note 16 of the consolidated financial statements. In addition, under the terms of the trust preferred securities issued by VNB Capital Trust I, Valley could not pay dividends on its common stock if Valley deferred payments on the junior subordinated debentures which provide the cash flow for the payments on the trust preferred securities.
There were 8,793 shareholders of record as of December 31, 2007.
The following graph compares the cumulative total return on a hypothetical $100 investment made on December 31, 2002 in: (a) Valleys common stock; (b) the Standard and Poors (S&P) 500 Stock Index; and (c) the Keefe, Bruyette & Woods KBW50 Bank Index. The graph is calculated assuming that all dividends are reinvested during the relevant periods. The graph shows how a $100 investment would increase or decrease in value over time based on dividends (stock or cash) and increases or decreases in the market price of the stock.
Issuer Repurchase of Equity Securities
The following table sets forth information for the three months ended December 31, 2007 with respect to repurchases of Valleys outstanding common shares:
The following selected financial data should be read in conjunction with Valleys consolidated financial statements and the accompanying notes thereto presented herein in response to Item 8.
See Notes to the Selected Financial Data that follows.
Notes to Selected Financial Data
Tangible book value per common share, which is a non-GAAP measure, is computed by dividing shareholders equity less goodwill and other intangible assets by common shares outstanding, as follows:
The purpose of this analysis is to provide the reader with information relevant to understanding and assessing Valleys results of operations for each of the past three years and financial condition for each of the past two years. In order to fully appreciate this analysis the reader is encouraged to review the consolidated financial statements and accompanying notes thereto appearing under Item 8 of this report, and statistical data presented in this document.
Cautionary Statement Concerning Forward-Looking Statements
This Annual Report on Form 10-K, both in the MD&A and elsewhere, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are not historical facts and include expressions about managements confidence and strategies and managements expectations about new and existing programs and products, acquisitions, relationships, opportunities, taxation, technology, market conditions and economic expectations. These statements may be identified by such forward-looking terminology as expect, anticipate, look, view, opportunities, allow, continues, reflects, believe, may, should, will, estimates or similar statements or variations of such terms. Such forward-looking statements involve certain risks and uncertainties. Actual results may differ materially from such forward-looking statements. Valley assumes no obligation for updating any such forward-looking statement at any time. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, but are not limited to:
Any public statements or disclosures by Valley following this report that modify or impact any of the forward-looking statements contained in or accompanying this report will be deemed to modify or supercede such forward-looking statements in or accompanying this report.
Critical Accounting Policies and Estimates
The accounting and reporting policies followed by Valley conform, in all material respects, to accounting principles generally accepted in the United States of America. In preparing the consolidated financial statements, management has made estimates, judgments and assumptions that affect the reported amounts of assets and liabilities as of the date of the consolidated statements of condition and results of operations for the periods indicated. Actual results could differ significantly from those estimates.
Valleys accounting policies are fundamental to understanding managements discussion and analysis of its financial condition and results of operations. The most significant accounting policies followed by Valley are presented in Note 1 to the consolidated financial statements. Valley has identified its policies on the allowance for loan losses, goodwill and other intangible assets, and income taxes to be critical because management has to make subjective and/or complex judgments about matters that are inherently uncertain and could be most subject to revision as new information becomes available. Management has reviewed the application of these policies with the Audit and Risk Committee of Valleys Board of Directors.
Allowance for Loan Losses. The allowance for loan losses represents managements estimate of probable loan losses inherent in the loan portfolio. Determining the amount of the allowance for loan 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 portfolio also represents the largest asset type on the consolidated statements of financial condition. Note 1 of the consolidated financial statements describes the methodology used to determine the allowance for loan losses and a discussion of the factors driving changes in the amount of the allowance for loan losses is included in this MD&A.
The allowance for loan losses consists of four elements: (1) specific reserves for individually impaired credits, (2) reserves for classified, or higher risk rated, loans, (3) reserves for non-classified loans based on historical loss factors, and (4) reserves based on general economic conditions and other qualitative risk factors both internal and external to Valley, including changes in loan portfolio volume, the composition and concentrations of credit, new market initiatives, and the impact of competition on loan structuring and pricing.
Valley considers it difficult to quantify the impact of changes in forecast on its allowance for loan losses. However, management believes the following discussion may enable investors to better understand the variables that drive the allowance for loan losses.
For impaired credits, if the fair value of the loans were ten percent higher or lower, the allowance would have increased or decreased by approximately $257 thousand, respectively, at December 31, 2007.
If classified loan balances were ten percent higher or lower, the allowance would have increased or decreased by approximately $1.3 million, respectively, at December 31, 2007.
The credit rating assigned to each non-classified credit is a significant variable in determining the allowance. If each non-classified credit were rated one grade worse, the allowance would have increased by $4.5 million, while if each non-classified credit were rated one grade better there would be no change in the level of the allowance as of December 31, 2007. Additionally, if the historical loss factors used to calculate the reserve for non-classified loans were ten percent higher or lower, the allowance would have increased or decreased by $4.8 million, respectively, at December 31, 2007.
A key variable in determining the allowance is managements judgment in determining the size of the reserves based on general economic conditions and other qualitative risk factors. At December 31, 2007, these reserves were 11.8 percent of the total allowance. If the reserves were ten percent higher or lower, the allowance would have increased or decreased by $882 thousand, respectively, at December 31, 2007.
Goodwill and Other Intangible Assets. Valley records all assets and liabilities acquired in purchase acquisitions, including goodwill and other intangible assets, at fair value as required by Statement of Financial Accounting Standards (SFAS) No. 141. Goodwill totaling $179.8 million at December 31, 2007 is not amortized but is subject to annual tests for impairment or more often if events or circumstances indicate it may be impaired. Other intangible assets are amortized over their estimated useful lives and are subject to impairment tests if events or circumstances indicate a possible inability to realize the carrying amount. The initial recording and subsequent impairment testing of goodwill and other intangible assets requires subjective judgments concerning estimates of the fair value of the acquired assets. These fair value measurements are subject to the provisions of SFAS No. 157 which Valley adopted as of January 1, 2007. See Recent Accounting Pronouncements at Note 1 to the consolidated financial statements.
The goodwill impairment test is performed in two phases. The first step compares the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired; however, if the carrying amount of the reporting unit exceeds its fair value, an additional procedure must be performed. That additional procedure compares the implied fair value of the reporting units goodwill with the carrying amount of that goodwill. An impairment loss is recorded to the extent that the carrying amount of goodwill exceeds its implied fair value.
Other intangible assets totaling $24.7 million at December 31, 2007 are evaluated for impairment if events and circumstances indicate a possible impairment. Such evaluation of other intangible assets is based on undiscounted cash flow projections.
Fair value may be determined using: market prices, comparison to similar assets, market multiples, discounted cash flow analysis and other determinants. Estimated cash flows may extend far into the future and, by their nature, are difficult to determine over an extended timeframe. Factors that may significantly affect the estimates include, among others, competitive forces, customer behaviors and attrition, changes in revenue growth trends, cost structures and technology, and changes in discount rates and specific industry or market sector conditions.
Other key judgments in accounting for intangibles include useful life and classification between goodwill and other intangible assets which require amortization. See Note 9 to consolidated financial statements for additional information regarding goodwill and other intangible assets.
To assist in assessing the impact of a goodwill or other intangible asset impairment charge, at December 31, 2007, the Company had $204.5 million of goodwill and other intangible assets. The impact of a five percent impairment charge would result in a reduction in pre-tax income of approximately $10.2 million. During the fourth quarter of 2007, Valley recognized a $2.3 million goodwill impairment charge due to its decision to sell its unprofitable broker-dealer subsidiary. See Note 3 to the consolidated financial statements for details regarding the fair value measurement of goodwill at December 31, 2007.
Income Taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entitys financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in Valleys consolidated financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences could impact Valleys consolidated financial condition or results of operations.
In connection with determining its income tax provision under SFAS No. 109 and FASB Interpretation No. 48 (FIN 48), Valley maintains a reserve related to certain tax positions and strategies that management believes contain an element of uncertainty. Periodically, Valley evaluates each of its tax positions and strategies to determine whether the reserve continues to be appropriate. Notes 1 and 14 to the consolidated financial statements and the Income Taxes section below include additional discussion on the accounting for income taxes.
Recent Accounting Pronouncements. See Note 1 of the consolidated financial statements for a description of recent accounting pronouncements including the dates of adoption and the effect on the results of operations and financial condition.
Net income for the year ended December 31, 2007 was $153.2 million compared to $163.7 million for the year ended December 31, 2006. Fully diluted earnings per common share was $1.27 for the year ended December 31, 2007 compared to $1.33 per common share for the year ended December 31, 2006. All common share data is adjusted to reflect a five percent stock dividend issued on May 25, 2007.
In 2007, the interest rate environment remained a challenging one for Valley, as the yield curve was partially inverted or flat for the most of the first half of the year before its shape began to normalize in the third quarter. Additionally, Valleys primary markets continue to be highly competitive for loans and deposits. The competitive market for certificates of deposit combined with the maturity of many lower cost time deposits was one of the primary reasons that Valleys cost of funds increased by 30 basis points from one year ago. In an effort to more successfully manage the interest and market risks of Valleys balance sheet, effective January 1, 2007, management elected to early adopt the provisions of SFAS Nos. 159 and 157 for $1.8 billion of certain financial assets and liabilities. See further analysis under the Fair Value Measurement section below, as well as Note 3 to the consolidated financial statements.
The yield on loans increased by 19 basis points during the year ended December 31, 2007, partially offsetting the increased cost of funds during the same period. Total loans grew by $164.5 million or 2.0 percent from December 31, 2006 primarily due to a $209.7 million or 16.9 percent increase in Valleys automobile loan portfolio. Valley has continued to focus its efforts to expand the geographic presence of its indirect auto loan origination franchise beyond northern and central New Jersey. During 2007, Valley expanded its dealer network into Connecticut adding to the markets it already serves in New Jersey, New York, Pennsylvania, and Florida. Partially offsetting the increase in total loans, construction, home equity, and other consumer loans declined during the year ended December 31, 2007 mainly due to fallout from the housing market slump. Residential mortgages also declined from the prior year mainly due to managements election under SFAS No. 159 to transfer 1,940 existing residential mortgage loans with a net carrying value of $254.4 million to loans held for sale as of January 1, 2007.
In addition to net interest income and net interest margin compression, 2007 earnings were negatively impacted by a higher provision for credit losses mainly due to loan growth and higher net charge-offs; increased operating expenses due to new branch openings; a $17.9 million other-than-temporary impairment on certain available for sale securities; a $2.3 million goodwill impairment charge recognized due to Valleys decision to sell its unprofitable broker-dealer subsidiary; partially offset by an immediate gain of $16.4 million on the sale of a Manhattan branch location; higher service charges on deposit accounts due to improved collection efforts; an increase in bank owned life insurance income; and an increase in unrealized gains on certain the assets and liabilities elected to be held at fair value.
Net Interest Income
Net interest income consists of interest income and dividends earned on interest earning assets less interest expense paid on interest bearing liabilities and represents the main source of income for Valley. The net interest margin is calculated by dividing tax equivalent net interest income by average interest earning assets and is a key measurement used in the banking industry to measure income from earning assets. The net interest margin declined for the year ended December 31, 2007, and each of the preceding five years, but somewhat stabilized in the fourth quarter of 2007 partly due to managements efforts to contain Valleys cost of funds. The year over year declining trend may continue in 2008 due to the Federal Reserves abrupt 125 basis point reduction in the targeted federal funds rate in January 2008, the asset sensitivity of Valleys balance sheet, as well as intense pricing competition for loans and deposits in Valleys primary markets. During the fourth quarter, Valley chose to remain less competitive on its pricing for new time deposit and increased its positions in lower cost long-term
borrowings, which positively impacted the net interest margin. However, management cannot guarantee that this action and other asset/liability management strategies will prevent future declines in the net interest margin or net interest income.
Net interest income on a tax equivalent basis decreased to $387.9 million for 2007 compared with $397.7 million for 2006. During 2007, the yield on average interest earning assets increased 25 basis points over 2006, but was more than offset by a 30 basis point increase in the interest rates paid on average interest bearing liabilities and higher average balances in time deposits and long-term borrowings. Market interest rates on interest bearing deposits were slightly higher in 2007 as the average federal funds rate increased 9 basis points as compared to 2006. The maturity of lower costing time deposits as well as a shift in customer funds to higher priced new certificates of deposits accounted for the majority of the increased cost of funds during 2007 and the decline in the net interest income.
Valleys earning asset portfolio is comprised of both fixed rate and adjustable rate loans and investments. Many of Valleys earning assets are priced based on the prevailing treasury rates and prime rate. As noted above, the average federal funds rate increased 9 basis points in 2007; however, in January 2008 the Federal Reserve decreased the target federal funds rate by 125 basis points due to the weakened economy and fall out from the subprime lending market. As a result, Valleys prime rate has moved from 7.25 percent at December 31, 2007 to 6.00 percent in January 2008. On average, the 10-year treasury rate decreased from 4.79 percent in 2006 to 4.63 percent in 2007 and continued to decline in the first quarter of 2008, averaging 3.73 percent in January 2008, with the recent Federal Reserve action. The decrease in the federal funds rate and the downward movement in the treasury rates will have a negative effect of the yield on Valleys average earning assets in 2008.
Average loans totaling $8.3 billion for the year ended December 31, 2007, remained relatively flat as compared to the same period for 2006. Average investment securities declined $304.8 million, or 9.7 percent in 2007 as compared to the year ended December 31, 2006. Despite the flat loan volumes, interest income on a tax equivalent basis for loans increased $15.6 million for the year ended December 31, 2007 compared with the same period in 2006 due to a 19 basis point increase in the yield on average loans. Interest income on a tax equivalent basis for investment securities decreased $4.9 million or 2.9 percent mainly due to the decrease in average investment securities for the twelve months in 2007 compared to the same period in 2006. The decrease in average investment securities was mainly due to investment cash flows reallocation to federal funds sold, held through most of the third quarter of 2007, as well as $75.0 million allocated to an additional investment in bank owned life insurance during the second quarter of 2007. The higher average balances within the federal funds sold category resulted in an increase of $6.5 million in interest income on such investments in 2007 compared to the same period twelve month period in 2006.
Average interest bearing liabilities totaling $9.4 billion for the year ended December 31, 2007 remained relatively unchanged from the same period in 2006. Average time deposits increased $190.2 million, or 6.9 percent due to some movement of lower yielding deposit accounts to time deposits as the yield on average time deposits increased 49 basis points from 2006, as well as new time deposit accounts from the six de novo branches opened in 2007 and other existing branches. Average long-term borrowings increased $58.5 million from 2006 as Valley increased its long-term positions in lower cost Federal Home Loan Bank advances during the fourth quarter of 2007. Average savings, NOW, and money market deposits decreased $284.5 million, or 7.6 percent for 2007 as compared to 2006 mainly due to aggressive pricing by our competitors in the marketplace, as well as customer movement from lower yielding deposit accounts to higher yielding alternatives, such as certificates of deposit. The Federal Reserves decision to lower the target federal funds rate by 25 basis points in December 2007 and again by an additional 125 basis points in January 2008 should positively impact our cost of deposits in 2008. However, continued competitive pricing of deposits and the lack of industry deposit growth may cause our short-term and long-term borrowings to further escalate in 2008.
The net interest margin on a tax equivalent basis was 3.43 percent for the year ended December 31, 2007 compared with 3.46 percent for the year ended December 31, 2006. The change was mainly attributable to the increase in interest rates paid on time deposits and long-term borrowings and an increase in the average balance of such interest bearing liabilities, partially offset by a higher yield on average loans and investments. Average
interest rates earned on interest earning assets increased 25 basis points while average interest rates paid on interest bearing liabilities increased 30 basis points causing compression in the net interest margin for Valley as compared to the year ended December 31, 2006.
During the fourth quarter of 2007, net interest income on a tax equivalent basis increased $866 thousand and the net interest margin increased 1 basis point when compared with the third quarter of 2007. The increases in net interest margin resulted primarily from a decrease in the cost of funds as Valley increased its position in lower cost long-term Federal Home Loan Bank advances, and remained less competitive for new time deposits and experienced normal run-off of maturing older, higher cost time deposits. However, as previously noted the Federal Reserve lowered the target federal funds rate in by 150 basis points since December 11, 2007. Due to this abrupt change in market interest rates, management anticipates continued pressure on the net interest margin due to the asset sensitivity of Valleys balance sheet, as well as the potential continuation of artificially high deposit rates caused by competition within its primary markets. Valley continues to actively manage the interest earning assets and liabilities to maximize net interest margin and create shareholder value. Managements move from higher cost time deposits may help reduce further declines in the margin, however, competitive pricing of deposits and the current decline in market rates for loans and investments are expected to negatively impact net interest income during the first half of 2008.
The following table reflects the components of net interest income for each of the three years ended December 31, 2007, 2006 and 2005:
ANALYSIS OF AVERAGE ASSETS, LIABILITIES AND SHAREHOLDERS EQUITY AND
NET INTEREST INCOME ON A TAX EQUIVALENT BASIS
The following table demonstrates the relative impact on net interest income of changes in the volume of interest earning assets and interest bearing liabilities and changes in rates earned and paid by Valley on such assets and liabilities. Variances resulting from a combination of changes in volume and rates are allocated to the categories in proportion to the absolute dollar amounts of the change in each category.
CHANGE IN NET INTEREST INCOME ON A TAX EQUIVALENT BASIS
The following table presents the components of non-interest income for the years ended December 31, 2007, 2006 and 2005:
Non-interest income represented 10.6 percent and 9.2 percent of total interest income plus non-interest income for 2007 and 2006, respectively. For the year ended December 31, 2007, non-interest income increased $14.2 million or 19.7 percent, compared with the same period in 2006, due to increases in most categories included in the table above, partially offset by an increase in net losses on securities transactions.
Service charges on deposit accounts increased $3.6 million, or 15.3 percent in 2007 compared with 2006 mainly due to stronger overdraft fee collection initiatives implemented by management throughout Valleys branch network operations during 2007.
Losses on securities transactions, net, increased $10.3 million to a net loss of $15.8 million for the year ended December 31, 2007. The increase was mainly due to an other-than-temporary impairment charge totaling $17.9 million ($10.4 million after-taxes) with regard to Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) and Federal National Mortgage Association (FNMA or Fannie Mae) government sponsored investment grade perpetual callable preferred securities during the fourth quarter of 2007. The other-than-temporary impairment charge was recorded on 8 perpetual preferred stock issues classified as available for sale investment securities with a total book value (prior to the recognition of the impairment charge) of $81.7 million. The securities were deemed other-than-temporary impaired due to a recent significant decline in the market value of these securities and because it is unlikely that these securities will recover to their original book value in the next six to nine months. During 2006, Valley recognized a net loss of $5.5 million mainly due to a $4.7 million impairment charge recognized on certain mortgage-backed and equity securities classified as available for sale and a $2.1 million loss on trust preferred securities called for redemption prior to their scheduled maturity date, partially offset by various gains on securities transactions throughout 2006.
Net gains on trading securities increased $3.4 million for the year ended December 31, 2007 compared with the same period in 2006 mainly due to increased trading activity in 2007 resulting from Valleys early adoption of SFAS Nos. 157 and 159. Valley elected to fair value investment securities with a total carrying amount of approximately $1.3 billion at January 1, 2007. During the second quarter of 2007, Valley executed a series of interest rate derivative transactions designed to hedge the market risk inherent in the trading securities. The derivative transactions did not offset the volatility in the trading securities to the extent expected and as a result Valley sold approximately $1.0 billion of these securities and simultaneously terminated the derivative transactions. The majority of these securities sold during the second quarter were replaced with shorter duration investments held in trading securities as of December 31, 2007. See Notes 3 and 4 to the consolidated financial statements for additional information.
Gains on sales of loans, net, increased $3.3 million to $4.8 million for the year ended December 31, 2007 compared to $1.5 million for the prior year. This increase was primarily due to the gains realized on the sale of approximately $240 million of residential mortgage loans held for sale during 2007 that Valley elected to carry at fair value effective as of January 1, 2007.
Gains on sales of assets, net increased $12.2 million, to $16.1 million for the year-ended December 31, 2007 compared to $3.8 million for the same period in 2006 mainly due to a $16.4 million immediate gain recognized on the sale of a Manhattan office building in the first quarter of 2007. Valley sold the nine-story building for approximately $37.5 million while simultaneously entering into a long-term lease for its branch office located on the first floor of the same building. The transaction resulted in a $32.3 million pre-tax gain, of which $16.4 million was immediately recognized in earnings in 2007 and $15.9 million was deferred and amortized into earnings over the 20 year term of the lease pursuant to the sale-leaseback accounting rules. Approximately $594 thousand of the initial deferred gain was amortized to net gains on sales of assets during 2007. During 2006, Valley sold an office building located in Manhattan that was originally intended for construction of a new branch, however, Valley ultimately decided to sell the property and not pursue the project. The transaction resulted in $3.8 million gain recognized in the fourth quarter of 2006.
BOLI income increased $3.4 million, or 41.3 percent for year-ended December 31, 2007 compared with the same period of 2006 due to income generated from an additional BOLI investment of $75.0 million during the second quarter of 2007 which was invested to offset rising employee benefit costs. BOLI income is exempt from
federal and state income taxes. The BOLI is invested primarily in mortgage-backed securities, U.S. Treasuries and high grade corporate securities, and the underlying portfolio is managed by two independent investment firms.
The following table presents the components of non-interest expense for the years ended December 31, 2007, 2006 and 2005:
Non-interest expense increased $824 thousand to $251.2 million for the year-ended December 31, 2007 from $250.3 million for the same period in 2006. Increases in salary expense, employee benefit expense, goodwill impairment, and net occupancy and equipment expense were partially offset with decreases in amortization of other intangible assets, professional and legal fees, and advertising. Valley incurred additional expenses due to de novo expansion efforts in 2007 and 2006 in its target expansion areas of northern and central New Jersey, New York City, Brooklyn and Queens. These expansion efforts will negatively impact non-interest expense until these new branches become profitable or breakeven, typically over a period of three years. The largest component of non-interest expense is salary and employee benefit expense which totaled $145.7 million in 2007 compared with $138.4 million in 2006.
The efficiency ratio measures a banks total non-interest expense as a percentage of net interest income plus non-interest income. Valleys efficiency ratio for the year ended December 31, 2007 was 53.7 percent compared to 54.0 percent for the same period of 2006. Valley strives to control its efficiency ratio and expenses as a means of producing increased earnings for its shareholders. The efficiency ratio has decreased as a result of higher non-interest income partially attributable to a $16.4 million immediate gain recognized on the sale of a Manhattan office building in the first quarter of 2007, as well as, an initiative to raise non-interest income throughout Valley and its subsidiaries.
Salary and employee benefit expense increased $7.3 million, or 5.3 percent for the year ended December 31, 2007 compared with the same period in 2006. The increase from 2006 was mainly due additional expenses incurred to support the expanded branch operations resulting from the de novo branches opened during 2007 and the latter half of 2006, as well as rising health insurance costs. At December 31, 2007, full-time equivalent staff was 2,562 compared to 2,489 at December 31, 2006.
Net occupancy and equipment expense increased $3.5 million, or 7.6 percent during 2007 in comparison to 2006. This increase was also largely due to Valleys de novo branch expansion efforts, which includes, among other things, additional rents, utilities, real estate taxes, and maintenance charges in connection with investments in technology and facilities. Rent expense increased $2.0 million, or 15.7 percent in 2007 compared with the prior year. Equipment maintenance increased by approximately $566 thousand, or 22.0 percent during 2007 compared with the prior year.
Amortization of other intangible assets, consisting primarily of amortization of loan servicing rights, core deposits, customer lists, and covenants not to compete decreased $1.2 million, or 13.8 percent, to $7.5 million for the year ended December 31, 2007 compared with the same period in 2006. The decrease is primarily due to a decline of $744 thousand in amortization of loan servicing rights. Valleys loan servicing portfolio continued to decline in 2007 as Valley did not purchase loan servicing portfolios from third parties in the secondary markets. The remaining decrease was due to various other intangibles from previous acquisitions which were fully amortized into earnings during 2007.
Goodwill impairment of $2.3 million ($1.5 million after-taxes) was recorded during the fourth quarter of 2007 due to Valleys decision to sell its wholly owned broker-dealer subsidiary, Glen Rauch Securities, Inc. See Notes 2, 3 and 9 to the consolidated financial statements for further discussion.
Professional and legal fees declined $3.8 million, or 42.4 percent for the year ended December 31, 2007 compared to the same period one year ago. The decrease was primarily due to a $1.7 million reduction in legal contingencies during the fourth quarter of 2007 and a reduction in fees related to tax planning as compared to the 2006 period.
Advertising expense decreased $5.6 million, or 65.6 percent in 2007 compared to 2006 mainly due to fewer Valley name branding promotions run during 2007.
Other non-interest expense decreased $1.7 million, or 4.4 percent for the year ended December 31, 2007 compared with the same period in 2006 mainly due to $2.7 million in net unrealized gains on Valleys junior subordinated debentures issued to capital trust and one Federal Home Loan Bank advance held at fair value. Exclusive of the $2.7 million net unrealized gain, other non-interest expense increased $1.0 million from 2006 due to a normal rise in operating expenses resulting from inflation and the expansion of Valleys branch network. Significant components of other non-interest expense include data processing, telephone, service fees, debit card fees, postage, stationery, insurance, and title search fees.
Income tax expense was $51.7 million for the year ended December 31, 2007, reflecting an effective tax rate of 25.2 percent, compared with $39.9 million for the year ended December 31, 2006, reflecting an effective tax rate of 19.6 percent. The increase in 2007 income tax expense reflects a $13.5 million tax benefit recognized during the comparable 2006 period due to managements reassessment of required tax accruals.
Management expects that Valleys adherence to FIN 48 will continue to result in increased volatility in Valleys future quarterly and annual effective income tax rates because FIN 48 requires that any change in judgment or change in measurement of a tax position taken in a prior annual period be recognized as a discrete event in the period in which it occurs. Factors that could impact managements judgment include changes in income, tax laws and regulations, and tax planning strategies. For 2008, Valley anticipates an effective tax rate of 28.0 percent, compared to 25.2 percent for 2007.
Valley has four business segments it monitors and reports on to manage its business operations. These segments are consumer lending, commercial lending, investment management, and corporate and other adjustments. Lines of business and actual structure of operations determine each segment. Each is reviewed routinely for its asset growth, contribution to income before income taxes and return on average interest earning assets. Expenses related to the branch network, all other components of retail banking, along with the back office departments of the bank are allocated from the corporate and other adjustments segment to each of the other three business segments. Valleys Wealth Management Division, comprised of trust, broker-dealer, asset management and insurance services, is included in the consumer lending segment. The financial reporting for each segment contains allocations and reporting in line with Valleys operations, which may not necessarily be comparable to any other financial institution. The accounting for each segment includes internal accounting policies designed to
measure consistent and reasonable financial reporting, and may not necessarily conform to GAAP. For financial data on the four business segments see Note 19 to the consolidated financial statements.
Consumer lending. The consumer lending portfolio is mainly comprised of residential mortgages, home equity loans and automobile loans. The duration of the loan portfolio is subject to movements in the market level of interest rates and forecasted residential mortgage prepayment speeds. The automobile loans within the portfolio have an average weighted life ranging from 24 to 30 months, relatively irrespective of movements in the market level of interest rates.
The consumer lending portfolio had a return on average interest earning assets before income taxes of 1.53 percent for the year ended December 31, 2007 compared with 1.57 percent for the year ended December 31, 2006, while income before taxes decreased $1.6 million for the 2007 period as compared to 2006. The decrease was primarily due to higher provision for loan losses, partly offset by a decrease in internal transfer expense. Average interest earning assets increased $4.5 million. Net interest income remained unchanged, resulting from the increase in interest rates on loans, offset by higher cost of funds. Average interest rates on loans increased 29 basis points to 6.11 percent, while the interest expense associated with funding sources increased 29 basis points to 2.86 percent.
Commercial lending. The commercial lending portfolio is mainly comprised of floating rate and adjustable rate commercial loans, as well as fixed rate owner occupied and commercial mortgage loans. Due to the portfolios interest rate characteristics, commercial lending is Valleys most sensitive business segment to movements in market interest rates.
Since December 11, 2007, the Federal Reserve has incrementally decreased short-term interest rates by a total of 150 basis points. Although the decreases in interest rates had little impact on the 2007 results, Valleys prime rate moved downward in conjunction with each cut in the target federal funds rate. The decline in Valleys prime rate will likely lower interest income in future periods depending on Valleys ability to grow the commercial lending portfolio, or other loan portfolios and its ability to mitigate such decreases in interest rates.
The return on average interest earning assets before income taxes for the commercial lending portfolio decreased to 2.39 percent in 2007 compared with 2.75 percent for the year ended December 31, 2006, and income before income taxes decreased $16.3 million for 2007 as compared to 2006. The decrease in income before income taxes was primarily the result of the decrease in net interest income, an increase in non-interest expense and a decrease in non-interest income, partially offset by a decrease in internal transfer expense. Average interest earning assets decreased $6.1 million attributed to new loan originations and draw downs on new and existing commercial lines of credit. Interest rates on commercial lending increased by 3 basis points to 7.18 percent, while the expenses associated with funding sources increased by 29 basis points to 2.86 percent.
Investment management. The investment management portfolio is mainly comprised of fixed rate investments, trading securities and federal funds sold. The fixed rate investments held within this portfolio are one of Valleys least sensitive assets to changes in market interest rates. The trading securities are relatively short-term securities and are highly susceptible to changes in interest rates. Due to the daily repricing nature of federal funds sold, management considers the balance to be carried at fair value as of each reporting date. Net gains and losses on the change in fair value of trading securities and other-than-temporary impairment of investment securities classified as available for sale are reflected in the corporate and other adjustments segment.
The investment management portfolio had a return on average interest earning assets before income taxes of 2.04 percent for the year ended December 31, 2007 compared with 1.59 percent for the year ended December 31, 2006, and income before income taxes increased $10.9 million in 2007 as compared to the same period in 2006. The increase was primarily due to the increase in non-interest income and lower internal transfer expense, partly offset by a decline in net interest income. The increase in non-interest income was due to increases in BOLI income and net gains on securities transactions, exclusive of other-than-temporary impairment charges included in the corporate segment, during 2007. The increase in BOLI income was primarily due to income generated from an additional BOLI investment of $75.0 million purchased in the second quarter of 2007. The return on
average interest earning assets before income taxes increased to 2.04 percent compared with 1.59 percent for the prior year period. The average yield on investments, which includes federal funds sold, increased 38 basis points to 5.88 percent and the rate associated with funding sources increased 29 basis points to 2.86 percent. Average interest earning assets decreased by $178.9 million mainly due to trust preferred securities called for early redemption and normal principal paydowns on investments. A majority of the investment proceeds were reallocated to higher yielding assets in other business segments.
Corporate segment. The corporate and other adjustments segment represents income and expense items not directly attributable to a specific segment, including trading and securities gains (losses) not reported in the investment management segment above, interest expense related to the junior subordinated debentures issued to capital trust, interest expense related to $100 million in subordinated notes issued in July 2005, as well as income and expense from derivative financial instruments. The loss before income taxes in the corporate segment decreased by $8.3 million for the year ended December 31, 2007 compared with December 31, 2006 primarily due to increases in net interest income and non-interest income, offset by decreases in non-interest expense and internal transfer income. The decrease in non-interest expense was mainly attributable to an unrealized gain on the change in fair value of the junior subordinated debentures issued to capital trust recorded in other non-interest expense. Net gains on the change in fair value of loans held for sale are reflected in the corporate and other adjustments segment.
Interest Rate Sensitivity
Valleys success is largely dependent upon its ability to manage interest rate risk. Interest rate risk can be defined as the exposure of Valleys interest rate sensitive assets and liabilities to the movement in interest rates. Valleys Asset/Liability Management Committee is responsible for managing such risks and establishing policies that monitor and coordinate Valleys sources, uses and pricing of funds. Asset/Liability management is a continuous process due to the constant change in interest rate risk factors. In assessing the appropriate interest rate risk levels for Valley, management weighs the potential benefit of each risk management activity within the desired parameters of liquidity, capital levels and managements tolerance for exposure to income fluctuations. Many of the actions undertaken by management utilize fair value analysis and attempt to achieve consistent accounting and economic benefits for financial assets and their related funding sources. Valley has predominately focused on managing its interest rate risk by attempting to match the inherent risk of financial assets and liabilities. Specifically, management employs multiple risk management activities such as divestures, change in product pricing levels, change in desired maturity levels for new originations, change in balance sheet composition levels as well as several other risk management activities. With the early adoption of SFAS No. 159, management has the fair value measurement option available for new financial assets, financial liabilities, and derivative transactions potentially entered into as part of its on-going interest rate risk management activities.
Valley uses a simulation model to analyze net interest income sensitivity to movements in interest rates. The simulation model projects net interest income based on various interest rate scenarios over a twelve and twenty-four month period. The model is based on the actual maturity and re-pricing characteristics of rate sensitive assets and liabilities. The model incorporates certain assumptions which management believes to be reasonable regarding the impact of changing interest rates and the prepayment assumptions of certain assets and liabilities as of December 31, 2007. The model assumes changes in interest rates without any proactive change in the balance sheet by management. In the model, the forecasted shape of the yield curve remains static as of December 31, 2007.
Valleys simulation model is based on market interest rates and prepayment speeds prevalent in the market as of December 31, 2007. Reinvestments of projected principal payments and prepayments as well as rate spreads are estimated utilizing Valleys actual originations during the fourth quarter of 2007. The model utilizes an immediate parallel shift in the market interest rates at December 31, 2007.
The following table reflects managements expectations of the change in Valleys net interest income over a one-year period in light of the aforementioned assumptions:
As a result of balance sheet management strategies implemented during the year ended December 31, 2007, Valleys asset sensitivity position increased as compared to one year ago. The increase is mainly attributable to a decrease in the duration of certain interest earning assets. In part due to its asset/liability mix and market competition driving the level of short-term interest rates on deposits, Valley is more susceptible to a decrease in interest rates under a scenario with an immediate parallel change in the level of market interest rates than an increase in interest rates under the same assumptions. Other factors, including, but not limited to, slope of the yield curve and projected cash flows will impact Valleys net interest income results and may increase or decrease the level of asset sensitivity of Valleys balance sheet.
Valleys net interest income is affected by changes in interest rates and cash flows from its loan and investment portfolios. Valley actively manages these cash flows in conjunction with its liability mix, duration and rates to optimize the net interest income, while prudently structuring the balance sheet to manage changes in interest rates. Additionally, Valleys net interest income is impacted by the level of competition within its marketplace. Competition can increase the cost of deposits and impact the level of interest rates attainable on loans, which may result in downward pressure on Valleys net interest margin in future periods.
Convexity is a measure of how the duration of a bond changes as the market interest rate changes. Potential movements in the convexity of bonds held in Valleys investment portfolio, as well as the duration of the loan portfolio may have a positive or negative impact to Valleys net interest income in varying interest rate environments. As a result, the increase or decrease in forecasted net interest income may not have a linear relationship to the results reflected in the table above. Management cannot provide any assurance about the actual effect of changes in interest rates on Valleys net interest income.
The following table shows the financial instruments that are sensitive to changes in interest rates, categorized by expected maturity and the instruments fair value at December 31, 2007. Forecasted maturities and prepayments for rate sensitive assets and liabilities were calculated using actual interest rates in conjunction with market interest rates and prepayment assumptions as of December 31, 2007.
INTEREST RATE SENSITIVITY ANALYSIS
Expected maturities are contractual maturities adjusted for all projected payments of principal. For investment securities, loans, long-term borrowings and junior subordinated debentures, expected maturities are based upon contractual maturity or call dates, projected repayments and prepayments of principal. The prepayment experience reflected herein is based on historical experience combined with market consensus expectations derived from independent external sources. The actual maturities of these instruments could vary substantially if future prepayments differ from historical experience. For non-maturity deposit liabilities, in accordance with standard industry practice and Valleys own historical experience, decay factors were used to estimate deposit runoff. Valley uses various assumptions to estimate fair values. See Note 3 of the consolidated financial statements for further discussion of fair values.
The total gap re-pricing within one year as of December 31, 2007 was negative $231.4 million, representing a ratio of interest sensitive assets to interest sensitive liabilities of 0.95:1, as compared to a negative gap of $581.2 million for the same period as of December 31, 2006, representing a ratio of interest sensitive assets to interest sensitive liabilities of 0.87:1. The primary reason for the change in Valleys gap position over the last twelve months is the short-term duration of most investment securities held in the trading securities portfolio,
partially offset by an increase in short-term borrowings at December 31, 2007. Management does not view the negative one year gap position as of December 31, 2007 as presenting an unusually high risk potential, although no assurances can be given that Valley is not at risk from interest rate increases or decreases.
Fair Value Measurement
Effective January 1, 2007, Valley elected early adoption of SFAS Nos. 159 and 157. SFAS No. 159 issued on February 15, 2007, generally permits the measurement of selected eligible financial instruments at fair value at specified election dates. Upon adoption, Valley elected to record the following pre-existing financial assets and financial liabilities at fair value:
The adoption of SFAS No. 159 for these assets and liabilities did not significantly impact Valleys net interest margin for the year ended December 31, 2007. Valleys non-interest income increased $7.8 million and non-interest expense declined $2.7 million for the year ended December 31, 2007 due to net unrealized gains recognized for the changes in the market value of financial assets and liabilities held at fair value under SFAS No. 159. The financial statement impact resulting from the adoption of SFAS No. 159 was considered by our Compensation and Human Resources Committee when determining executive compensation which is based upon, among other things, improved financial performance.
Managements Reasons for Electing Fair Value Option
Management believes Valleys adoption of SFAS No. 159 for certain financial instruments will provide the users of its financial statements with transparent and relevant financial information that provides better insight into Valleys risk management activities. Traditionally, risk management activities conducted by management, including divesture of certain financial instruments and application of hedging strategies, have been viewed and judged by the users of Valleys financial statements based on historical cost data, although managements actions are based on the same data at fair value. Application of SFAS No. 159 and its disclosure requirements for financial instruments elected to be carried at fair value will expand the transparency of risk management activities and eliminate or reduce the obstacles presented by complex accounting standards related to hedging investment securities and other financial instruments.
At adoption, some of Valleys specific asset/liability management goals included shortening the duration of the investment portfolio, limiting the risk that the duration for certain assets would extend beyond expected levels, increasing the asset sensitivity of the balance sheet, increasing the stability of returns on certain financial instruments and modifying some of its interest bearing liabilities with the expectation of a future steepening of the yield curve. As early as April, but worsening significantly in the second half of 2007, many changes occurred within the economy and financial markets, which directly impacted these strategies employed by Valley, specifically, widening credit spreads and limited liquidity for mortgage related products. Additionally, as a result of the market volatility, many of the variables relied upon within Valleys initial rationale outlined below for adopting fair value on an instrument level basis witnessed dramatic changes. While Valley did not invest in subprime mortgages, CDOs, SIVs and other forms of exotic high risk financial instruments, the industry wide turmoil, caused by such instruments, directly impacted the pricing and availability of various financial
instruments, including those which Valley holds and may effect trades in. Specifically, Valleys purchase decisions for investment securities, as well as the balance sheet classification election for each security purchased, were greatly impacted by these changes in the financial markets. Additionally, these conditions severely impacted Valleys loan origination volume. As a result of the changes in market variables during the second half of 2007, including a steepening of the yield curve, Valley engaged in a leverage strategy involving the purchase of certain mortgage-backed securities classified as available for sale matched with additional fixed rate Federal Home Loan Bank advances during the fourth quarter of 2007 which effected the composition of the investment portfolio as well as the interest bearing liabilities as of December 31, 2007.
In March 2007, Valleys management team set in motion its initial evaluation of all the potential impacts of the provisions of SFAS Nos. 159 and 157 on Valleys balance sheet and its risk management strategies. After a thorough analysis and discussions with Valleys Board of Directors, management elected to early adopt the standards in March, with the Boards final approval, on April 2, 2007. Valleys adoption of SFAS No. 159 reflects managements desire to mitigate the impact of changing interest rate and other market risks related to certain financial instruments that may have a greater propensity to those changes than other financial instruments on Valleys balance sheet. Managements efforts to reduce price and market risk of financial instruments with the highest potential future earnings volatility (the dispersion of net income under various market conditions and levels of interest rates, which may include the potential fluctuation in the yield and expected total return of each financial instrument) and prepayment risk are consistent with Valleys risk management activities. Management believes that the fair value option for select financial assets and liabilities will enable it to achieve this objective by providing enhanced flexibility, including the ability to utilize derivative transactions without applying the complex hedge accounting provisions of SFAS No. 133.
SFAS No. 159 prohibits the election of the fair value option for deposit liabilities which are withdrawable on demand. These types of deposits are a material component of Valleys balance sheet and risk management activities and accordingly, set certain limitations on the number and amount of financial instruments management ultimately selected for fair value measurement at January 1, 2007. Below are additional details on managements selection of certain eligible items for fair value measurement.
Investment securities. Management identified and elected to fair value 62 existing held to maturity securities and 95 available for sale securities with a total carrying value of $1.3 billion immediately prior to adoption of SFAS No. 159 due to their significant earnings volatility, prepayment, extension, and market value risk as compared to the remaining investment portfolio. In order to potentially mitigate these risks, management elected to fair value these securities with the intent to hedge or possibly sell such securities, in which case the securities may be replaced by securities or other asset classifications, carried at fair value, with acceptable risk characteristics. SFAS No. 159 provided Valley with enhanced flexibility to manage these assets in manners previously unavailable due to complex hedge accounting rules and the implication on classification of investments that results from transfers between investment categories. Upon managements fair value election, these securities were immediately transferred to trading securities effective January 1, 2007.
During the first quarter of 2007, management worked closely with its advisor in the derivatives market, at a considerable cost, to construct a hedging strategy for the trading securities portfolio. As a result of this evaluation process, Valley executed a series of interest rate derivative transactions with notional amounts totaling approximately $1.0 billion in April 2007. The purpose of the derivative transactions was to offset volatility in the market value of over $800 million in trading securities consisting primarily of mortgage-backed securities transferred from the available for sale portfolio at January 1, 2007 by transforming these fixed rate assets into floating rates in anticipation of a steepening yield curve. However, the derivative transactions did not offset the volatility in the trading securities to the extent expected due to several factors, including the financial markets forward expectations of interest rate movements and the unanticipated expansion of credit spreads in the marketplace. To that end, Valley terminated the derivatives entire notional amounts and sold the corresponding trading securities through several transactions over a number of weeks during the second quarter of 2007. The ineffectiveness and ultimately, the termination of the derivatives and hedged securities sold resulted in a $2.0 million net loss recorded in losses on trading securities, net during the second quarter of 2007. The hedged securities were part of approximately $1.0 billion in mortgage-backed securities issued by FNMA, FHLMC and
private institutions that were sold during the second quarter of 2007. The investment proceeds were primarily reinvested in short-term U.S. treasury securities, short-term other government agencies and short-term corporate debt classified as trading securities under SFAS No. 115, with the remainder of the proceeds used to fund loan growth and to offset a reduction in funding due to the redemption of the $20.6 million in junior subordinated debentures issued to capital trust during the second quarter of 2007.
As of December 31, 2007, the trading securities portfolio totaled $722.6 million (see the trading securities table in the Investment Securities section below and at Note 4 of the consolidated financial statements). Management continued to maintain a trading securities portfolio, in addition to the trading securities portfolio used to fund customer transactions at Valleys broker-dealer subsidiary, as part of its on-going asset/liability management strategies. This was evidenced by the fact that during the period ended December 31, 2007, Valley purchased approximately $3 billion of trading securities, significantly expanding its use of the fair value option on its balance sheet. However, management could elect to invest future sale proceeds in other asset classifications not carried at fair value based on changes or perceived changes in the financial markets, in whole or partially due to one or more of the risk factors inherent to Valleys business disclosed in Part I, Item 1A of this report. Since our adoption of SFAS No. 159, investment securities classified as held to maturity have declined $47.8 million to $556.1 million at December 31, 2007. During this same period, investment securities classified as available for sale increased $550.7 million to $1.6 billion at December 31, 2007 mainly due to managements decision (subject to the changes in market related credit and liquidity variables) in the fourth quarter of 2007 to purchase certain mortgage-backed securities matched with the addition of fixed rate Federal Home Loan Bank advances.
On January 1, 2007, the $498.9 million in investment securities held to maturity transferred to trading securities included $214.5 million in trust preferred securities issued by other financial institutions that were callable or contain call option provisions that occur during the first six months of 2007. Valley reported in its Annual Report on Form 10-K for the year ended December 31, 2006 that it could incur losses of $4.4 million, net of tax, should these securities be called during the six months ended June 30, 2007. Due to the fair value election, Valley recorded a $5.5 million, net of tax, adjustment to retained earnings for these securities as of January 1, 2007. As of December 31, 2007, $145.5 million of the original $214.5 million in trust preferred securities transferred to trading securities had been called for early redemption, which resulted in trading losses of $228 thousand for the year ended December 31, 2007. None of the remaining trust preferred securities transferred to trading securities on January 1, 2007 were sold during the year ended December 31, 2007.
Residential mortgage loans. Management identified and elected to fair value 1,940 existing 15 year fixed rate conforming residential mortgage loans held for investment with a net carrying value of $254.4 million immediately prior to adoption of SFAS No. 159. These loans are highly dependent on the movement of interest rates and prepayment speeds and as a result have significant earnings volatility, extension, and market value risk as compared to the remaining mortgage portfolio. At the time of adoption, management intended to hedge these fixed rate loans in order to increase the asset sensitivity of the portfolio and, at a minimum, to neutralize the impact of these instruments on yields. Management also concluded at that time that it would fair value the majority of new loan originations with similar characteristics to these loans, subject to asset liability management objectives at the time of such originations in order to reflect the impact of changing market conditions currently as opposed to at the time of sale. Additionally, management elected to account for all loans held for sale at fair value which results in the financial impact of changing market conditions being reflected currently in earnings as opposed to being dependent upon the timing of sales.
Upon managements fair value election for these assets, management evaluated several hedging strategies in conjunction with a third party advisor in the derivatives market (who also helped construct a hedging strategy for the trading securities portfolio) to assess the opportunity to hedge the market value risk of these mortgages. Changing market conditions and the challenges of hedging these instruments effectively were determined to be a significant obstacle in executing managements strategy. As a result, management elected to transfer these assets to loans held for sale with the intent to sell them and originate similar or different classes of loans with tolerable performance and risk characteristics. Managements decision to sell the loans at that time was based on the unexpected earnings volatility from the expansion of credit spreads in the mortgage loan market driven by
sub-prime and Alt-A loan activity. During the second quarter of 2007, Valley sold the majority of these mortgage loans to Fannie Mae while retaining the servicing of such loans. Had management executed the same strategy without the benefit of the fair value option, it would have resulted in a decrease in earnings of less than $3 million.
Subsequent to March 31, 2007, Valley elected the fair value measurement option for all newly originated mortgage loans held for sale as part of its current asset/liability management strategies. From April 1, 2007 to December 31, 2007, Valley originated, exclusive of loan purchases, 15 year fixed rate conforming residential mortgage loans totaling $11.5 million. Valley elected to fair value $4.9 million, or 42.4 percent of the $11.5 million mortgages during the year ended December 31, 2007 primarily based upon its acceptable risk tolerance levels for the loan portfolio at the time of each loan origination. Valley also performed an instrument by instrument analysis of the other residential mortgage originations during this period and, as a result, elected to fair value an additional $25.2 million of the mortgages originations during the nine months ended December 31, 2007.
Valleys fair value election for loans held for sale may significantly simplify any future hedge accounting decisions by management and potentially reduce future earnings volatility due to non-economic factors associated with Valleys mortgage pipeline. At adoption, Valley had anticipated originating and accounting for at fair value a substantially higher volume of residential mortgage loans. As a result of the disruption in the mortgage market impacting both origination volume and pricing, Valleys new loan production was severely limited and therefore so was its ability to expand the use of fair value in this asset class. Should market conditions recover, Valley would anticipate its expanded use of fair value, dependent upon asset/liability management objectives.
Federal Home Loan Bank advances. Management identified and elected to fair value two existing Federal Home Loan Bank advances with a total carrying value of $40.0 million immediately prior to adoption of SFAS No. 159 due to their significant earnings, price and market value risk as compared to the other long-term borrowings.
Valley prepaid the two Federal Home Loan Bank advances and recognized prepayment gains totaling $276 thousand as a reduction to interest on long-term borrowings during the first quarter of 2007. Valley immediately replaced the advances sold with the issuance of a $40.0 million Federal Home Loan Bank advance, elected to be held at fair value, with a fixed rate of 5.09 percent and an estimated duration of 5 years. At December 31, 2007, the Federal Home Loan Bank Advance had a fair value of approximately $41.4 million. Had management executed the same strategy without the benefit of the fair value option, it would have resulted in a decrease in earnings of approximately $1.1 million.
Junior subordinated debentures issued to capital trust. Management elected to fair value the junior subordinated debentures issued to VNB Capital Trust I with a total carrying value of $206.2 million immediately prior to the adoption of SFAS No. 159 due to significant earnings volatility, price and market value risk. These risks relate, in part, to the call feature associated with these instruments. In order to potentially mitigate these risks, management elected to fair value these obligations with the intent to potentially hedge or call them for early extinguishment. Management believes that fair value measurement of instruments with such call features provides the users of Valleys financial statements with a clearer view of the impact of current market conditions on the value of the debt. Such information is used by management in its asset/liability management process to evaluate actions with respect to these instruments. As a result of changing market conditions, on June 25, 2007 and October 29, 2007, Valley redeemed a total of $41.2 million of the original principal face amount of the junior subordinated debentures issued to capital trust. The decision to partially redeem the outstanding debentures was done, in part, by management to maintain Valleys overall cost of capital at acceptable levels, while partially offsetting some of the changes in earnings volatility risk associated with financial assets held at fair value. See Note 12 to the consolidated financial statements for additional information on the junior subordinated debentures issued to capital trust.
See additional discussion and analysis of the adoption of SFAS Nos. 159 and 157 at Notes 1, 3, 4 and 12 to the consolidated financial statements.
Bank Liquidity. Liquidity measures the ability to satisfy current and future cash flow needs as they become due. A banks liquidity reflects its ability to meet loan demand, to accommodate possible outflows in deposits and to take advantage of interest rate opportunities in the marketplace. Liquidity management is monitored by an Asset/Liability Management Committee, consisting of members of management and the board of directors of VNB, which review historical funding requirements, current liquidity position, sources and stability of funding, marketability of assets, options for attracting additional funds, and anticipated future funding needs, including the level of unfunded commitments.
Our bank subsidiary has no required regulatory liquidity ratios to maintain; however, it adheres to an internal policy which dictates the level of available liquidity, a ratio of loans to deposits and the total amount of non-core funding, which generally includes certificates of deposits $100 thousand and over, federal funds purchased, repurchase agreements and Federal Home Loan Bank advances. The level of available liquidity is measured as the projected cash inflows and outflows of our major asset and liability categories over the next three month period. The projected available liquidity must be greater than 75 percent of total shareholders equity. Our current policy also maintains that we may not have a ratio of loans to deposits in excess of 110 percent and non-core funding greater than 40 percent of total assets. At December 31, 2007, we were in compliance with the foregoing policies.
On the asset side of the balance sheet, Valley has numerous sources of liquid funds in the form of cash and due from banks, interest bearing deposits with banks, federal funds sold, investment securities held to maturity maturing within one year, investment securities available for sale, trading securities and loans held for sale. These liquid assets totaled approximately $2.6 billion and $2.2 billion at December 31, 2007 and 2006, respectively, representing 23.0 percent and 19.5 percent of earning assets, and 20.6 percent and 18.0 percent of total assets at December 31, 2007 and 2006, respectively. Of the $2.6 billion of liquid assets, approximately $1.4 billion of various investment securities were pledged to counter parties to support Valleys earning asset funding strategies.
Additional liquidity is derived from scheduled loan payments of principal and interest, as well as prepayments received. Loan principal payments are projected to be approximately $3.2 billion over the next twelve months. As a contingency plan for significant funding needs, liquidity could also be derived from the sale of residential mortgages, commercial mortgages, auto and home equity loans, as these are all marketable portfolios, or from the temporary curtailment of lending activities.
On the liability side of the balance sheet, Valley also utilizes multiple sources of funds to meet liquidity needs. Valleys core deposit base, which generally excludes certificates of deposit over $100 thousand as well as brokered certificates of deposit, represents the largest of these sources. Core deposits averaged approximately $7.1 billion and $7.3 billion for the years ended December 31, 2007 and 2006, representing 62.9 percent and 63.5 percent of average earning assets at December 31, 2007 and 2006, respectively. The level of interest bearing deposits is affected by interest rates offered, which is often influenced by Valleys need for funds and the need to match the maturities of assets and liabilities. Brokered certificates of deposit totaled $2.9 million at December 31, 2007 and $117.9 million at December 31, 2006.
In the event that additional short-term liquidity is needed, VNB has established relationships with several correspondent banks to provide short-term borrowings in the form of federal funds purchases. While, at December 31, 2007, there were no firm lending commitments in place, management believes that VNB could borrow approximately $1.2 billion for a short time from these banks on a collective basis. Additionally, VNB is a member of the Federal Home Loan Bank of New York and has the ability to borrow from them in the form of FHLB advances secured by pledges of mortgage-backed securities and a blanket assignment of qualifying residential mortgage loans.
The following table lists, by maturity, all certificates of deposit of $100 thousand and over at December 31, 2007:
Valley has access to a variety of borrowing sources and uses both short-term and long-term borrowings to support its asset base. Short-term borrowings include federal funds purchased, securities sold under agreements to repurchase (repos), treasury tax and loan accounts, and FHLB advances. Short-term borrowings increased by $242.6 million to $605.2 million at December 31, 2007 compared to $362.6 million at December 31, 2006 primarily due to increases in FHLB advances and federal funds purchased (see Note 11 to the consolidated financial statements). At December 31, 2007, all short-term repos represent customer deposit balances being swept into this vehicle overnight.
The following table sets forth information regarding Valleys short-term repos at the dates and for the periods indicated:
Corporation Liquidity. Valleys recurring cash requirements primarily consist of dividends to shareholders and interest expense on junior subordinated debentures issued to VNB Capital Trust I. These cash needs are routinely satisfied by dividends collected from its subsidiary bank, along with cash flows from investment securities held at the holding company. See Note 16 Shareholders Equity in the accompanying notes to the consolidated financial statements included elsewhere in this report regarding restrictions to such subsidiary bank dividends. Projected cash flows from these sources are expected to be adequate to pay dividends and interest expense payable to VNB Capital Trust I, given the current capital levels and current profitable operations of its subsidiary. In addition, Valley may repurchase shares of its outstanding common stock under its share repurchase program or call for early redemption all, or part, of its junior subordinated debentures. The cash required for the repurchase of Valleys common stock or redemption of its junior subordinated debentures can be met by using its own funds, dividends received from its subsidiary bank, VNB, as well as borrowed funds.
Securities are classified as held to maturity and carried at amortized cost when Valley has the positive intent and ability to hold them to maturity. Securities are classified as available for sale when they might be sold before maturity, and are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income, net of tax. Securities classified as trading are held primarily for sale in the short term and are carried at fair value, with unrealized gains and losses included immediately in other income. Valley determines the appropriate classification of securities at the time of purchase. Securities with limited marketability and/or restrictions, such as Federal Home Loan Bank and Federal Reserve Bank stocks, are carried at cost in other assets.
Investment securities at December 31, 2007, 2006 and 2005 were as follows:
* See discussion at Notes 3 and 4 of the consolidated financial statements of Valleys early adoption of SFAS Nos. 159 and 157.
The following table presents the maturity distribution schedule with its corresponding weighted-average yields of held to maturity and available for sale securities at December 31, 2007:
Valleys investment portfolio is comprised of U.S. government and federal agency securities, tax-exempt issues of states and political subdivisions, mortgage-backed securities, corporate bonds, equity and other securities. There were no securities in the name of any one issuer exceeding 10 percent of shareholders equity, except for securities issued by United States government agencies, which includes the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. The decision to purchase or sell securities is based upon the current assessment of long and short-term economic and financial conditions, including the interest rate environment and other statement of financial condition components.
At December 31, 2007, Valley had $52.1 million, $1.0 billion, and $29.0 million of mortgage-backed securities classified as held to maturity, available for sale, and trading securities, respectively. Substantially all the mortgage-backed securities held by Valley are issued or backed by federal agencies. The mortgage-backed securities portfolio is a source of significant liquidity to Valley through the monthly cash flow of principal and interest. Mortgage-backed securities, like all securities, are sensitive to change in the interest rate environment, increasing and decreasing in value as interest rates fall and rise. As interest rates fall, the increase in prepayments can reduce the yield on the mortgage-backed securities portfolio, and reinvestment of the proceeds will be at lower yields. Conversely, rising interest rates will reduce cash flows from prepayments and extend anticipated duration of these assets. Valley monitors the changes in interest rates, cash flows and duration, in accordance with its investment policies. Management seeks out investment securities with an attractive spread over Valleys cost of funds.
As of December 31, 2007, Valley had $1.6 billion of securities available for sale, a decrease of $163.6 million from December 31, 2006. As of December 31, 2007, the investment securities available for sale had a net unrealized loss of $778 thousand, net of deferred taxes, compared to a net unrealized loss of $19.0 million, net of deferred taxes, at December 31, 2006. Available for sale securities are not considered trading account securities, but rather are securities which may be sold on a non-routine basis.
As of December 31, 2007 and 2006, Valley had a total of $722.6 million and $4.7 million, respectively, in trading account securities. The increase partially reflects the transfer of $820.5 million investment securities classified as available for sale and $498.9 million investment securities classified as held to maturity to trading securities on January 1, 2007. The $498.9 million in investment securities held to maturity transferred to trading securities on January 1, 2007 included $214.5 million in trust preferred securities issued by other financial institutions that were callable or contain call option provisions that occur by June 30, 2007. As of December 31, 2007, $145.5 million of the original $214.5 million in trust preferred securities transferred to trading securities had been called for early redemption, which resulted in trading losses of $228 thousand for the year ended December 31, 2007. See further discussion and analysis of Valleys adoption of SFAS No. 159 at Notes 1 and 3 to the consolidated financial statements.
As part of managements regular quarterly review for impairment of marketable securities, Valley recognized an other-than-temporary impairment charge of $17.9 million ($10.4 million after-taxes) during the fourth quarter of 2007 on FHLMC and FNMA government sponsored, investment grade perpetual callable preferred securities. The other-than-temporary-impairment charge was recorded on 8 perpetual preferred stock issues classified as available for sale investment securities with a total book value (prior to recognition of the impairment charge) of $81.7 million. Valley decided to reclassify the unrealized mark-to-market loss on these investment grade securities to an other-than-temporary impairment charge because of the recent significant decline in the market value of these securities and because it is unlikely that these securities will recover their original book value in the next six to nine months. Both FHLMC and FNMA securities were investment grade at the time of purchase and remain investment grade with ratings of AA- by S&P and Aa3 by Moodys. The securities continue to perform according to their contractual terms and all dividend payments are current. Historically, market value fluctuations were recorded as an unrealized mark-to-market loss on securities available for sale and reflected as a reduction to shareholders equity through other comprehensive income. Accordingly, the reclassification of the unrealized after tax loss to an other-than-temporary impairment non-cash charge did not affect Valleys shareholders equity or tangible shareholders equity.
As of December 31, 2007, total loans were $8.5 billion compared to $8.3 billion at December 31, 2006, an increase of $164.5 million or 2.0 percent. The following table reflects the composition of the loan portfolio for the five years ended December 31, 2007:
Commercial loans increased $96.3 million or 6.6 percent in 2007 primarily due to increased drawdowns on existing commercial lines of credit and new commercial loans, net of large payoff activity during the year.
Mortgage loans, comprised of construction, residential and commercial mortgage loans, decreased $105.4 million in 2007, due to the decline in construction and residential mortgage lending. Construction loans decreased $123.5 million, or 23.5 percent in 2007 over last year due to normal paydown activity and a lack of new loan volume, as the slowdown in the home building market continues to negatively impact growth in this portfolio. Residential mortgage loans decreased $43.1 million in 2007 over last year partially due to lower demand in a competitive marketplace and managements election under SFAS No. 159 to transfer mortgage loans with a net carrying value of $254.4 million to loans held for sale as of January 1, 2007. Valley continued its non-participation in the subprime residential and negative amortization loan markets, helping Valley avoid much of the negative credit quality issues resulting from the currently stressed real estate market. Commercial mortgage loans increased $61.1 million, or 2.6 percent during 2007 mainly due to an increase in loans through new and existing business development, net of a large amount of payoffs.
The largest increase in loans for 2007 was from automobile loans which increased by $209.7 million or 16.9 percent as compared to December 31, 2006. Valley has continued to focus its efforts to expand the geographic presence of its indirect auto loan origination franchise, as nearly 42 percent of the dealer auto originations were made outside of New Jersey during the year. During 2007, Valley added Connecticut to its auto dealer network which also includes New Jersey, New York, Pennsylvania, and Florida.
Much of Valleys lending is in northern and central New Jersey and New York City, with the exception of the out-of-state auto loan portfolio, SBA loans and a small amount of out-of-state residential mortgage loans. However, efforts are made to maintain a diversified portfolio as to type of borrower and loan to guard against a potential downward turn in any one economic sector. As a result of Valleys lending, this could present a geographic and credit risk if there was a significant broad based downturn of the economy within the region.
The following table reflects the contractual maturity distribution of the commercial and construction loan portfolios as of December 31, 2007:
Prior to maturity of each loan with a balloon payment and if the borrower requests an extension, Valley generally conducts a review which normally includes an analysis of the borrowers financial condition and, if applicable, a review of the adequacy of collateral. A rollover of the loan at maturity may require a principal paydown.
VNB is a preferred SBA lender with authority to make loans without the prior approval of the SBA. VNB currently has approval to make SBA loans nationwide, however, management focuses primarily on lending in New Jersey, New York and Pennsylvania. Generally, between 75 percent and 85 percent of each loan is guaranteed by the SBA and is typically sold into the secondary market, with the balance retained in VNBs portfolio. VNB is committed to this area of lending because it provides a good source of fee income and loans with floating interest rates tied to the prime lending rate. This program can expand or contract based upon guidelines and availability of lending established by the SBA.
During 2007 and 2006, VNB originated approximately $13.4 million and $14.9 million of SBA loans, respectively, and sold $3.1 million and $10.0 million, respectively. At December 31, 2007 and 2006, $50.1 million and $52.0 million, respectively, of SBA loans were held in VNBs portfolio and VNB serviced for others approximately $52.6 million and $75.0 million, respectively, of SBA loans.
Non-performing assets include non-accrual loans, other real estate owned (OREO), and other repossessed assets which mainly represent automobiles. Loans are generally placed on a non-accrual status when they become past due in excess of 90 days as to payment of principal or interest. Exceptions to the non-accrual policy may be permitted if the loan is sufficiently collateralized and in the process of collection. OREO is acquired through foreclosure on loans secured by land or real estate. OREO and other repossessed assets are reported at the lower of cost or fair value at the time of acquisition and at the lower of fair value, less estimated costs to sell, or cost thereafter. The level of non-performing assets remained relatively low as a percentage of the total loan portfolio as shown in the table below.
The following table sets forth non-performing assets and accruing loans, which were 90 days or more past due as to principal or interest payments on the dates indicated in conjunction with asset quality ratios for Valley:
Non-accrual loans have ranged from a low of $22.3 million to $30.6 million over the last five years. Valleys non-accrual experience as a percentage of total loans indicates that the amount of non-accrual loans is historically low and there is no guarantee that this low level will continue. If interest on non-accrual loans had been accrued in accordance with the original contractual terms, such interest income would have amounted to approximately $2.8 million, $2.1 million and $1.9 million for the years ended December 31, 2007, 2006, and 2005, respectively; none of these amounts were included in interest income during these periods. Interest income recognized on loans once classified as non-accrual loans totaled $45 thousand, $498 thousand and $21 thousand for the years ended December 31, 2007, 2006, and 2005, respectively. No mortgage loans classified as loans held for sale and carried at fair value were on non-accrual status at December 31, 2007.
Loans 90 days or more past due and still accruing, which were not included in the non-performing category, are presented in the above table. These loans ranged from 0.04 percent to 0.10 percent of total loans for the last five years. Valley cannot predict that this current low level of past due loans as compared to the total loan portfolio will continue. These loans represent most loan types and are generally well secured and in the process of collection. At December 31, 2007, no mortgage loans classified loans held for sale were 90 days or more past due and still accruing interest.
Troubled debt restructured loans, in compliance with modified terms and not reported as past due or non-accrual, are presented in the table above. These loans increased $7.7 million to $8.4 million at December 31, 2007 from December 31, 2006. Restructured loans consist of seven commercial loan relationships at December 31, 2007.
Total loans past due in excess of 30 days were 1.00 percent of all loans at December 31, 2007 compared with 0.84 percent at December 31, 2006 and include matured loans in the normal process of renewal totaling approximately $7.5 million and $8.5 million at December 31, 2007 and 2006, respectively. Valley strives to keep the loans past due in excess of 30 days at these current low levels, however, there is no guarantee that these low levels will continue.
Although substantially all risk elements at December 31, 2007 have been disclosed in the categories presented above, management believes that for a variety of reasons, including economic conditions, certain borrowers may be unable to comply with the contractual repayment terms on certain real estate and commercial loans. As part of the analysis of the loan portfolio, management determined that there were approximately $7.2 million and $7.3 million in potential problem loans at December 31, 2007 and 2006, respectively, which were not classified as non-accrual loans in the non-performing asset table above. Potential problem loans are
defined as performing loans for which management has serious doubts as to the ability of such borrowers to comply with the present loan repayment terms and which may result in a non-performing loan. Valleys decision to include performing loans in potential problem loans does not necessarily mean that management expects losses to occur, but that management recognizes potential problem loans carry a higher probability of default. Of the $7.2 million in potential problem loans as of December 31, 2007, approximately $900 thousand is considered at risk after collateral values and guarantees are taken into consideration. There can be no assurance that Valley has identified all of its potential problem loans.
Asset Quality and Risk Elements
Lending is one of the most important functions performed by Valley and, by its very nature, lending is also the most complicated, risky and profitable part of Valleys business. For commercial loans, construction loans and commercial mortgage loans, a separate credit department is responsible for risk assessment, credit file maintenance and periodically evaluating overall creditworthiness of a borrower. Additionally, efforts are made to limit concentrations of credit so as to minimize the impact of a downturn in any one economic sector. Valleys loan portfolio is diversified as to type of borrower and loan. However, loans collateralized by real estate represent approximately 57 percent of total loans at December 31, 2007. Most of the loans collateralized by real estate are in northern and central New Jersey and New York City, presenting a geographical and credit risk if there was a significant downturn of the economy within the region.
Residential mortgage loans are secured by 1-4 family properties generally located in counties where Valley has a branch presence and counties contiguous thereto (including Pennsylvania). Valley does provide mortgage loans secured by homes beyond this primary geographic area, however, lending outside this primary area is generally made in support of existing customer relationships. Underwriting policies that are based on FNMA and FHLMC guidance are adhered to for loan requests of conforming and non-conforming amounts. The weighted average loan-to-value ratio of all residential mortgage originations in 2007 was 59 percent while FICO® (independent objective criteria measuring the creditworthiness of a borrower) scores averaged 747.
Consumer loans are comprised of home equity loans, credit card loans, automobile loans and other consumer loans. Home equity and automobile loans are secured loans and are made based on an evaluation of the collateral and the borrowers creditworthiness. In addition to New Jersey, automobile loans are originated in several other states. Due to the level of Valleys underwriting standards applied to all loans, management believes the out of the state loans generally present no more risk than those made within New Jersey. However, each loan or group of loans made outside of Valleys primary markets poses some additional geographic risk based upon the economy of that particular region.
Management realizes that some degree of risk must be expected in the normal course of lending activities. Allowances are maintained to absorb such loan losses inherent in the portfolio. The allowance for credit losses and related provision are an expression of managements evaluation of the credit portfolio and economic climate.
The following table summarizes the relationship among loans, loans charged-off, loan recoveries, the provision for credit losses and the allowance for credit losses on the years indicated:
Management maintains the allowance for credit losses at a level estimated to absorb probable loan losses of the loan portfolio and unfunded letter of credit commitments. The allowance is based on ongoing evaluations of the probable estimated losses inherent in the loan portfolio. Valleys methodology for evaluating the appropriateness of the allowance includes segmentation of the loan portfolio into its various components, tracking the historical levels of criticized loans and delinquencies, and assessing the nature and trend of loan charge-offs. Additionally, the volume of non-performing loans, concentration risks by size, type, and geography, new markets, collateral adequacy, credit policies and procedures, staffing, underwriting consistency, and economic conditions are taken into consideration.
VNBs allocated allowance is calculated by applying loss factors to outstanding loans and unfunded commitments. The formula is based on the internal risk grade of loans or pools of loans. Any change in the risk grade of performing and/or non-performing loans affects the amount of the related allowance. Loss factors are based on VNBs historical loss experience and may be adjusted for significant changes in the current loan portfolio quality that, in managements judgment, affect the collectibility of the portfolio as of the evaluation date.
The allowance contains reserves identified as the unallocated portion in the table below to cover inherent losses within a given loan category which have not been otherwise reviewed or measured on an individual basis. Such reserves include managements evaluation of the national and local economy, loan portfolio volumes, the composition and concentrations of credit, credit quality and delinquency trends. These reserves reflect managements attempt to ensure that the overall allowance reflects a margin for imprecision and the uncertainty that is inherent in estimates of probable credit losses. Net charge-off levels have remained relatively low in the last five years, ranging from a high of 0.14 percent of average loans in 2007 to a low of 0.05 percent seen in 2005. There can be no guarantee that these low levels will continue into 2008 as credit cycles can vary from year to year based on the economic climate in Valleys primary market areas.
The provision for credit losses was $11.9 million in 2007 compared to $9.3 million in 2006. The $2.6 million increase was based upon the results of managements quarterly analyses of the allowance for loan losses, including allowance allocations resulting from a $164.5 million increase in total loans during 2007.
The following table summarizes the allocation of the allowance for credit losses to specific loan categories for the past five years: