-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, A6YBM40BJBUbkuA/hvCoEBCYEjONr7DooQrO6n0byYkHix/1d/BoKRVAtlKGab0Y Vcq3WmlAX3GMNqGmh9shZQ== 0000914317-06-000909.txt : 20060328 0000914317-06-000909.hdr.sgml : 20060328 20060328130331 ACCESSION NUMBER: 0000914317-06-000909 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 10 CONFORMED PERIOD OF REPORT: 20051231 FILED AS OF DATE: 20060328 DATE AS OF CHANGE: 20060328 FILER: COMPANY DATA: COMPANY CONFORMED NAME: Naugatuck Valley Financial Corp CENTRAL INDEX KEY: 0001293413 STANDARD INDUSTRIAL CLASSIFICATION: SAVINGS INSTITUTION, FEDERALLY CHARTERED [6035] IRS NUMBER: 000000000 STATE OF INCORPORATION: X1 FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-50876 FILM NUMBER: 06714288 BUSINESS ADDRESS: STREET 1: 333 CHURCH STREET CITY: NAUGATUCK STATE: CT ZIP: 06770 BUSINESS PHONE: 203-720-5000 MAIL ADDRESS: STREET 1: 333 CHURCH STREET CITY: NAUGATUCK STATE: CT ZIP: 06770 10-K 1 form10k-74214_naugatuck.htm FORM 10-K Form 10-K
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K
(Mark One)

ý
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2005

o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 

For the transition period from __________________ to __________________

Commission File Number: 0-50876

NAUGATUCK VALLEY FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)

         United States
  
65-1233977
(State or other jurisdiction of
  
(I.R.S. Employer Identification No.)
incorporation or organization)
    
     
333 Church Street, Naugatuck, Connecticut
  
06770
   (Address of principal executive offices
  
(Zip Code)


Registrant’s telephone number, including area code: (203) 720-5000

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

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

Common Stock, par value $0.01 per share
(Title of Class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No ý

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No ý

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o

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 the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o  Accelerated filer o  Non-accelerated filer ý

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

The aggregate market value of the voting and non-voting common equity held by non-affiliates as of June 30, 2005, was $35,518,059.

The number of shares outstanding of the registrant’s common stock as of March 1, 2006 was 7,604,375.
Of such shares outstanding, 4,182,407 shares were held by Naugatuck Valley Mutual Holding Company.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the 2005 Annual Report to Stockholders and portions of the Proxy Statement for the 2006 Annual Meeting of Stockholders are incorporated by reference in Parts II and III, respectively, of this Form 10-K.





 
  Part I
   
 Page
     
Business
1
Risk Factors
19
Unresolved Staff Comments
21
Properties
22
Legal Proceedings
23
Submission of Matters to a Vote of Securities Holders
23
     
     
Market for Registrant’s Common Equity, Related Stockholder Matters and
  
 
   Issuer Purchases of Equity Securities
23
Selected Financial Data
23
Management’s Discussion and Analysis of Financial Condition and Results of Operation
23
Quantitative and Qualitative Disclosures About Market Risk
23
Financial Statements and Supplementary Data
23
Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
23
Controls and Procedures
23
Other Information
24
     
     
Directors and Executive Officers of the Registrant
24
Executive Compensation
24
Security Ownership of Certain Beneficial Owners and Management and Related
 
 
   Stockholder Matters
24
Certain Relationships and Related Transactions
25
Principal Accountant Fees and Services
25
     
     
Exhibits and Financial Statement Schedules
25
     
 




This report contains certain “forward-looking statements” within the meaning of the federal securities laws. These statements are not historical facts, rather statements based on Naugatuck Valley Financial Corporation’s current expectations regarding its business strategies, intended results and future performance. Forward-looking statements are preceded by terms such as “expects,” “believes,” “anticipates,” “intends” and similar expressions.

Management’s ability to predict results or the effect of future plans or strategies is inherently uncertain. Factors which could affect actual results include interest rate trends, the general economic climate in the market area in which Naugatuck Valley Financial operates, as well as nationwide, Naugatuck Valley Financial’s ability to control costs and expenses, competitive products and pricing, loan delinquency rates and changes in federal and state legislation and regulation. Additional factors that may affect our results are discussed in this Annual Report on Form 10-K under “Item 1A. Risk Factors.” These factors should be considered in evaluating the forward-looking statements and undue reliance should not be placed on such statements. Except as may be required by applicable law or regulation, Naugatuck Valley Financial assumes no obligation to update any forward-looking statements.




General

Naugatuck Valley Financial Corporation was organized as a federal corporation at the direction of Naugatuck Valley Savings and Loan in connection with the mutual holding company reorganization of Naugatuck Valley Savings. The reorganization was completed on September 30, 2004. In the reorganization, Naugatuck Valley Financial sold 43% of its outstanding shares of common stock (3,269,881 shares) to the public, contributed 2% of its outstanding shares of common stock (152,087 shares) to the Naugatuck Valley Savings and Loan Foundation and issued 55% of its outstanding shares of common stock (4,182,407 shares) to Naugatuck Valley Mutual Holding Company, the mutual holding company parent of Naugatuck Valley Savings.

As long as Naugatuck Valley Mutual exists, it will own at least a majority of Naugatuck Valley Financial’s common stock. Naugatuck Valley Financial’s business activity is the ownership of the outstanding capital stock of Naugatuck Valley Savings and management of the investment of offering proceeds retained from the reorganization. Naugatuck Valley Financial neither owns nor leases any property but instead uses the premises, equipment and other property of Naugatuck Valley Savings with the payment of appropriate rental fees, as required by applicable law and regulations. In the future, Naugatuck Valley Financial may acquire or organize other operating subsidiaries; however, there are no current plans, arrangements, agreements or understandings, written or oral, to do so. Naugatuck Valley Financial has no significant assets, other than all of the outstanding shares of Naugatuck Valley Savings and U.S. government and agency securities, and no significant liabilities. Accordingly, the information set forth in this report, including the consolidated financial statements and related financial data, relates primarily to Naugatuck Valley Savings.

Naugatuck Valley Savings is a federally chartered savings bank, and has served its customers in Connecticut since 1922. We operate as a community-oriented financial institution offering traditional financial services to consumers and businesses in our market area. We attract deposits from the general public and use those funds to originate one- to four-family, multi-family and commercial real estate, construction, commercial business, and consumer loans, which we primarily hold for investment.

Naugatuck Valley Mutual is our federally chartered mutual holding company parent. As a mutual holding company, Naugatuck Valley Mutual is a non-stock company that has as its members the depositors of Naugatuck Valley Savings. Naugatuck Valley Mutual does not engage in any business activity other than owning a majority of the common stock of Naugatuck Valley Financial.

Available Information

Naugatuck Valley Financial’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, are made available free of charge on our website, www.nvsl.com, as


soon as reasonably practicable after such reports are electronically filed with, or furnished to, the Securities and Exchange Commission. Information on our website shall not be considered a part of this Form 10-K.

Market Area

We are headquartered in Naugatuck, Connecticut, which is located in south-western Connecticut approximately six miles south of Waterbury and 26 miles north of Bridgeport. In addition to our main office, we operate five branch offices in the Greater Naugatuck Valley which we consider our market area. The Greater Naugatuck Valley encompasses the communities in the central and lower Naugatuck Valley regions in New Haven and Fairfield Counties. The economy in our market area is primarily oriented to the service, retail, construction, and manufacturing industries.

Competition

We face significant competition for the attraction of deposits and origination of loans. Our most direct competition for deposits has historically come from the several financial institutions operating in our market area and, to a lesser extent, from other financial service companies, such as brokerage firms, credit unions and insurance companies. We also face competition for investors’ funds from money market funds and other corporate and government securities. In addition, banks owned by Bank of America Corporation, Wachovia Corporation, J.P. Morgan Chase & Co. and TD Bank Financial Group, all of which are large super-regional bank holding companies, also operate in our market area. These institutions are significantly larger than us and, therefore, have significantly greater resources.

Our competition for loans comes from financial institutions in our market area and from other financial service providers, such as mortgage companies and mortgage brokers. Competition for loans also comes from the increasing number of non-depository financial service companies entering the mortgage market, such as insurance companies, securities companies and specialty finance companies.

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

Lending Activities

General. Our loan portfolio consists primarily of one- to four-family residential mortgage loans. To a lesser but growing extent, our loan portfolio includes multi-family and commercial real estate loans, construction loans, commercial business loans and consumer loans. Substantially all of our loans are made to borrowers residing within Connecticut.

One- to Four-Family Residential Loans. Our primary lending activity is the origination of mortgage loans to enable borrowers to purchase or refinance existing homes or to construct new residential dwellings in our market area. We offer fixed-rate and adjustable-rate mortgage loans with terms up to 30 years. Borrower demand for adjustable-rate loans versus fixed-rate loans is a function of the level of interest rates, the expectations of changes in the level of interest rates, the difference between the interest rates and loan fees offered for fixed-rate mortgage loans and the initial period interest rates and loan fees for adjustable-rate loans. The relative amount of fixed-rate mortgage loans and adjustable-rate mortgage loans that can be originated at any time is largely determined by the demand for each in a competitive environment and the effect each has on our interest rate risk. The loan fees charged, interest rates and other provisions of mortgage loans are determined by us on the basis of our own pricing criteria and competitive market conditions.

We offer fixed-rate loans with terms of either 10, 15, 20, 30 or 40 years. Our adjustable-rate mortgage loans are based on either a 15, 20 or 30-year amortization schedule and interest rates and payments on our


adjustable-rate mortgage loans adjust annually after either a one, three, five or seven year initial fixed period. Interest rates and payments on our adjustable-rate loans generally are adjusted to a rate typically equal to 2.75% above the one-year constant maturity Treasury index. The maximum amount by which the interest rate may be increased or decreased is generally 2% per adjustment period and the lifetime interest rate cap is generally 6% over the initial interest rate of the loan.

Due to historically low interest rate levels, borrowers generally have preferred fixed-rate loans in recent years. While we anticipate that our adjustable-rate loans will better offset the adverse effects on our net interest income of an increase in interest rates as compared to fixed-rate mortgages, the increased mortgage payments required of adjustable-rate loans in a rising interest rate environment could cause an increase in delinquencies and defaults. The marketability of the underlying property also may be adversely affected in a high interest rate environment. In addition, although adjustable-rate mortgage loans help make our asset base more responsive to changes in interest rates, the extent of this interest sensitivity is limited by the annual and lifetime interest rate adjustment limits.

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

We generally do not make conventional loans with loan-to-value ratios exceeding 97% and generally make loans with a loan-to-value ratio in excess of 80% only when secured by first liens on owner-occupied one- to four-family residences. Loans with loan-to-value ratios in excess of 80% generally require private mortgage insurance or additional collateral. We require all properties securing mortgage loans to be appraised by a Board-approved independent appraiser. We require title insurance on all first mortgage loans. Borrowers must obtain hazard insurance, or flood insurance for loans on property located in a flood zone, before closing the loan.

In an effort to provide financing for first-time buyers, we offer a first-time home buyers program. We offer fixed-rate residential mortgage loans through this program to qualified individuals and originate the loans using modified underwriting guidelines, lower rates and terms of up to 40 years.

Multi-Family and Commercial Real Estate Loans. We offer fixed-rate and adjustable-rate mortgage loans secured by multi-family and commercial real estate. Our multi-family and commercial real estate loans are generally secured by condominiums, apartment buildings, single-family subdivisions and owner-occupied properties used for businesses. We intend to continue to grow this segment of our loan portfolio.

We originate multi-family and commercial real estate loans for terms generally up to 20 years. Interest rates and payments on adjustable-rate loans adjust every one, three or five years. Interest rates and payment on our adjustable rate loans generally are adjusted to a rate typically equal to 2.5% above the one-year, three-year or five-year Federal Home Loan Bank classic advance rate. There are no adjustment period or lifetime interest rate caps. Loan amounts generally do not exceed 80% of the appraised value.

Loans secured by multi-family and commercial real estate generally have larger balances and involve a greater degree of risk than one- to four-family residential mortgage loans. Of primary concern in multi-family and commercial real estate lending is the borrower’s creditworthiness and the feasibility and cash flow potential of the project. Payments on loans secured by income properties often depend on successful operation and management of the properties. As a result, repayment of such loans may be subject to a greater extent than residential real estate loans to adverse conditions in the real estate market or the economy. To monitor cash flows on income properties, we require borrowers and loan guarantors, if any, to provide annual financial statements on multi-family and commercial real estate loans. In reaching a decision on whether to make a multi-family or commercial real estate loan, we consider the net operating income of the property, the borrower’s expertise, credit history and profitability and the value of the underlying property. We require either an environmental survey or impaired property insurance for all multi-family and commercial real estate loans.


Construction Loans.  We originate loans to individuals to finance the construction of residential dwellings for personal use. Our construction loans generally provide for the payment of interest only during the construction phase, which is usually nine months. At the end of the construction phase, the loan converts to a permanent mortgage loan. Loans generally can be made with a maximum loan to value ratio of 80% of the appraised value with a maximum term of 30 years. The largest outstanding residential construction loan at December 31, 2005 was $799,000, $676,000 of which was outstanding. This loan was performing according to its terms at December 31, 2005. We also make commercial construction loans for commercial development projects, including condominiums, apartments buildings, single family subdivisions, as well as owner-occupied properties used for business. These loans provide for payment of interest only during the construction phase and may, in the case of an apartment or commercial building, convert to a permanent mortgage loan or, in the case of a single family subdivision or construction or builder loan, be paid in full with the sale of the property after construction is complete. In the case of a commercial construction loan, the construction period may be from nine months to two years. Loans are generally made to a maximum of 80% of the appraised value as determined by an appraisal of the property made by an independent licensed appraiser. We also require an inspection of the property before disbursement of funds during the term of the construction loan for both residential and commercial construction loans. The largest outstanding commercial construction loan at December 31, 2005 was $3.2 million, of which $1.4 million was outstanding. This loan was performing according to its terms at December 31, 2005.

We originate land loans to individuals on approved residential building lots for personal use for terms of up to 20 years and to a maximum loan-to-value ratio of 75% of the lower of the appraisal value or purchase price. Our land loans adjust annually after a five-year initial fixed period. Interest rates are equal to 3.75% above the one-year constant maturity Treasury index.

We also originate loans to local contractors and developers for the purpose of making improvements to, and on, approved subdivisions and condominium projects within two years of the date of the original loan. Such loans generally are written with a maximum loan-to-value ratio of 80% of the lower of the appraised value or purchase price of the land. These loans adjust when and as the index changes at a rate that is generally equal to the prime rate as published in The Wall Street Journal plus 1%. We require title insurance and, if applicable, a hazardous waste survey reporting that the land is free of hazardous or toxic waste.

Construction financing is generally considered to involve a higher degree of risk of loss than long-term financing on improved, occupied real estate. Risk of loss on a construction loan depends largely upon the accuracy of the initial estimate of the property’s value at completion of construction or development and the estimated cost (including interest) of construction. During the construction phase, a number of factors could result in delays and cost overruns. If the estimate of construction costs proves to be inaccurate, we may be required to advance funds beyond the amount originally committed to permit completion of the development. If the estimate of value proves to be inaccurate, we may be confronted, at or before the maturity of the loan, with a project having a value which is insufficient to assure full repayment. As a result of the foregoing, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project rather than the ability of the borrower or guarantor to repay principal and interest. If we are forced to foreclose on a project before or at completion due to a default, there can be no assurance that we will be able to recover all of the unpaid balance of, and accrued interest on, the loan as well as related foreclosure and holding costs.

Commercial Business Loans. We make commercial business loans to a variety of professionals, sole proprietorships and small businesses primarily in our market area. We offer a variety of commercial lending products. These loans are typically secured, primarily by business assets. These loans are originated with maximum loan-to-value ratios of 75% of the value of the personal property. We originate one- to seven-year term loans for the acquisition of equipment or business expansion, lines of credit for seasonal financing needs and demand loans for short term financing needs with specific repayment sources. Commercial business loans are usually written at variable rates which use the prime rate as published in The Wall Street Journal as an index and, depending on the qualifications of the borrower, a 0.5% to 3.0% margin is added. These rates will change when and as the index rate changes without caps. Fixed-rate loans are written at market rates determined at the time the loan is granted and are based on the length of the term and the qualifications of the borrower. Our largest commercial business loan relationship was a $1.1 million loan secured by a leasehold interest in commercial real estate. This loan was performing according to its original terms at December 31, 2005.


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

Unlike residential mortgage loans, which generally are made on the basis of the borrower’s ability to make repayment from his or her employment or other income, and which are secured by real property whose value tends to be more easily ascertainable, commercial business loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business. As a result, the availability of funds for the repayment of commercial business loans may depend substantially on the success of the business itself. Further, any collateral securing such loans may depreciate over time, may be difficult to appraise and may fluctuate in value.

Consumer Loans. We offer a variety of consumer loans, primarily second mortgage loans and home equity lines of credit, and, to a much lesser extent, loans secured by passbook or certificate accounts, automobiles and unsecured loans. Unsecured loans generally have a maximum borrowing limit of $5,000 and a maximum term of three years.

The procedures for underwriting consumer loans include an assessment of the applicant’s payment history on other debts and ability to meet existing obligations and payments on the proposed loans. Although the applicant’s creditworthiness is a primary consideration, the underwriting process also includes a comparison of the value of the collateral, if any, to the proposed loan amount. Second mortgage loans have fixed rates of interest for terms of up to 15 years. These loans are originated with maximum loan-to-value ratios of 80% of the appraised value of the property. Home equity lines of credit have adjustable rates of interest that are indexed to the prime rate as published in The Wall Street Journal for terms of up to 10 years. These loans are originated with maximum loan-to-value ratios of 80% of the value of the appraised value of the property and we require that we have a second lien position on the property.

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

Loan Originations, Purchases and Sales. Loan originations come from a number of sources. The primary source of loan originations are our in-house loan originators, and to a lesser extent, local mortgage brokers, advertising and referrals from customers. We occasionally purchase loans or participation interests in loans.

We consider loan sales as part of our interest rate risk management efforts. We sell longer-term fixed-rate loans in the secondary market based on prevailing market interest rate conditions, an analysis of the composition and risk of the loan portfolio, liquidity needs and interest rate risk management goals. Generally, loans are sold without recourse and with servicing retained. We did not sell any loans during the year ended December 31, 2005. We sold $1.9 million and $8.9 million of loans in the years ended December 31, 2004 and 2003, respectively. We occasionally sell participation interests in loans.

Loan Approval Procedures and Authority. Our lending activities follow written, nondiscriminatory, underwriting standards and loan origination procedures established by our Board of Directors and management.

For one- to four-family loans and owner occupied residential construction loans, two members of the mortgage loan committee, one of whom must be the President and Chief Executive Officer or a vice president, may approve loans up to $417,000 and a majority of the members of the Board loan committee must approve loans over $417,000. For unsecured commercial business loans, a majority of the members of the Board must approve loans over $500,000 and two members of the Board of Directors loan committee must approve loans over $250,000 and up to $500,000. Unsecured business loans of $250,000 or less must be approved by two members of the officers’


loan committee. Loans of $50,000 or less which are unsecured can be approved by one member of the officers’ loan committee and later presented to the officers’ loan committee for ratification. For secured commercial loans and commercial construction loans, a majority of the members of the Board must approve loans over $1.2 million and two members of the Board of Directors loan committee must approve loans over $500,000 and up to $1.2 million. Loans of $500,000 or less secured by real estate where the loan-to-value is 80% or less can be approved by two members of the officers’ loan committee and for $100,000 or less secured by real estate with an 80% loan-to-value one member of the officers’ loan committee can approve with a later ratification by the officers’ loan committee. The Board of Directors must approve all consumer loans over $200,000. Various bank personnel have been delegated authority to approve smaller commercial loans and consumer loans.

Loans to One Borrower. The maximum amount that we may lend to one borrower and the borrower’s related entities is limited, by regulation, to generally 15% of our stated capital and reserves. At December 31, 2005, our regulatory limit on loans to one borrower was $6.2 million. At that date, our largest lending relationship was $3.7 million and included a home mortgage loan and a commercial construction loan, all of which were performing according to the original repayment terms at December 31, 2005.

Loan Commitments.  We issue commitments for fixed-rate and adjustable-rate mortgage loans conditioned upon the occurrence of certain events. Commitments to originate mortgage loans are legally binding agreements to lend to our customers and generally expire in 60 days or less.

Delinquencies. When a borrower fails to make a required loan payment, we take a number of steps to have the borrower cure the delinquency and restore the loan to current status. We make initial contact with the borrower when the loan becomes 15 days past due. If payment is not then received by the 30th day of delinquency, additional letters and phone calls generally are made. We send a letter notifying the borrower that we will commence foreclosure proceedings if the loan is not brought current within 91 days. When the loan becomes 91 days past due, we generally commence foreclosure proceedings against any real property that secures the loan or attempt to repossess any personal property that secures a consumer loan. If a foreclosure action is instituted and the loan is not brought current, paid in full, or refinanced before the foreclosure sale, the real property securing the loan generally is sold at foreclosure. We may consider loan workout arrangements with certain borrowers under certain circumstances.

Management informs the Board of Directors on a monthly basis of the amount of loans delinquent more than 90 days, all loans in foreclosure and all foreclosed and repossessed property that we own.

Investment Activities

We have legal authority to invest in various types of liquid assets, including U.S. Treasury obligations, securities of various federal agencies and of state and municipal governments, mortgage-backed securities and certificates of deposit of federally insured institutions. Within certain regulatory limits, we also may invest a portion of our assets in corporate securities and mutual funds. We also are required to maintain an investment in Federal Home Loan Bank of Boston stock.

At December 31, 2005, our investment portfolio consisted of U.S. government and agency securities with maturities primarily less than three years, mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae with stated final maturities of 30 years or less, collateralized mortgage obligations with stated final maturities of 30 years or less, municipal securities with maturities of 15 years or less, preferred money market securities with terms of 91 days or less, and insured certificates of deposit at other financial institutions.

Our investment objectives are to provide and maintain liquidity, to maintain a balance of high quality, diversified investments to minimize risk, to provide collateral for pledging requirements, to establish an acceptable level of interest rate risk, to provide an alternate source of low-risk investments when demand for loans is weak, and to generate a favorable return. Considering our interest rate risk position and with the objective of enhancing earnings, we implemented two leverage strategies during 2005. In the first strategy, we borrowed $28.8 million from the Federal Home Loan Bank of Boston on a short-term basis to fund the purchase of a like amount of long-term securities. In the second strategy, we borrowed up to $11.0 million of short-term funds from the Federal Home Loan Bank of Boston to fund the purchase of same term money market preferred securities. Our Board of Directors has the overall responsibility for our investment portfolio, including approval of our investment policy and


appointment of our Asset/Liability Committee. The Asset/Liability Committee is responsible for approval of investment strategies and monitoring of investment performance. Our Executive Vice President and our Controller are co-designated investment portfolio managers and are responsible for the daily investment activities and are authorized to make investment decisions consistent with our investment policy. The Asset/Liability Committee meets regularly with the Controller, the Executive Vice President and President and Chief Executive Officer in order to determine and review investment strategies and transactions.

Deposit Activities and Other Sources of Funds

General. Deposits and loan repayments are the major sources of our funds for lending and other investment purposes. Loan repayments are a relatively stable source of funds, while deposit inflows and outflows and loan prepayments are significantly influenced by general interest rates and money market conditions.
 
Deposit Accounts. The vast majority of our depositors are residents of the State of Connecticut. Deposits are attracted from within our primary market area through the offering of a broad selection of deposit instruments, including NOW accounts, checking accounts, money market accounts, regular savings accounts, club savings accounts, certificate accounts and various retirement accounts. Generally, we do not utilize brokered funds. Deposit account terms vary according to the minimum balance required, the time periods the funds must remain on deposit and the interest rate, among other factors. In determining the terms of our deposit accounts, we consider the rates offered by our competition, profitability to us, matching deposit and loan products and customer preferences and concerns. We generally review our deposit mix and pricing weekly. Our current strategy is to offer competitive rates, and even higher rates on long-term deposits, but not be the market leader in every type and maturity. 

Borrowings. We borrow from the Federal Home Loan Bank of Boston to supplement our supply of lendable funds and to meet deposit withdrawal requirements. The Federal Home Loan Bank functions as a central reserve bank providing credit for member financial institutions. As a member, we are required to own capital stock in the Federal Home Loan Bank of Boston and are authorized to apply for advances on the security of such stock and certain of our mortgage loans and other assets (principally securities which are obligations of, or guaranteed by, the United States), provided certain standards related to creditworthiness have been met. Advances are made under several different programs, each having its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based either on a fixed percentage of an institution’s net worth or on the Federal Home Loan Bank’s assessment of the institution’s creditworthiness. Under its current credit policies, the Federal Home Loan Bank generally limits advances to 25% of a member’s assets, and short-term borrowings of less than one year may not exceed 10% of the institution’s assets. The Federal Home Loan Bank determines specific lines of credit for each member institution.

In addition, we occasionally borrow short-term from correspondent banks to cover temporary cash needs.

Subsidiaries

Naugatuck Valley Mortgage Servicing Corporation, established in 1999 under Connecticut law as a subsidiary of Naugatuck Valley Savings and Loan, is a passive investment corporation organized in order to take advantage of certain tax benefits. Its primary business is to service mortgage loans which we have originated and subsequently transferred to Naugatuck Valley Mortgage Servicing. At December 31, 2005, Naugatuck Valley Mortgage Servicing had $196.3 million in assets.

Personnel

At December 31, 2005, we had 88 full-time employees and 16 part-time employees, none of whom is represented by a collective bargaining unit. We believe our relationship with our employees is good.



Regulation and Supervision

General

Naugatuck Valley Savings and Loan is subject to extensive regulation, examination and supervision by the Office of Thrift Supervision, as its primary federal regulator, and the Federal Deposit Insurance Corporation, as its deposits insurer. Naugatuck Valley Savings and Loan is a member of the Federal Home Loan Bank System and its deposit accounts are insured up to applicable limits by the Savings Association Insurance Fund managed by the Federal Deposit Insurance Corporation. Naugatuck Valley Savings and Loan must file reports with the Office of Thrift Supervision and the Federal Deposit Insurance Corporation concerning its activities and financial condition in addition to obtaining regulatory approvals before entering into certain transactions such as mergers with, or acquisitions of, other financial institutions. There are periodic examinations by the Office of Thrift Supervision and, under certain circumstances, the Federal Deposit Insurance Corporation to evaluate Naugatuck Valley Savings and Loan’s safety and soundness and compliance with various regulatory requirements. This regulatory structure is intended primarily for the protection of the insurance fund and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such policies, whether by the Office of Thrift Supervision, the Federal Deposit Insurance Corporation or Congress, could have a material adverse impact on our operations.

Naugatuck Valley Financial and Naugatuck Valley Mutual, as savings and loan holding companies, are required to file certain reports with, are subject to examination by, and otherwise have to comply with the rules and regulations of the Office of Thrift Supervision. Naugatuck Valley Financial is also subject to the rules and regulations of the Securities and Exchange Commission under the federal securities laws.

Certain of the regulatory requirements that are applicable to Naugatuck Valley Savings and Loan, Naugatuck Valley Financial and Naugatuck Valley Mutual are described below. This description of statutes and regulations is not intended to be a complete explanation of such statutes and regulations and their effects on Naugatuck Valley Savings and Loan, Naugatuck Valley Financial and Naugatuck Valley Mutual and is qualified in its entirety by reference to the actual statutes and regulations.

Regulation of Federal Savings Associations

Business Activities. Federal law and regulations, primarily the Home Owners’ Loan Act and the regulations of the Office of Thrift Supervision, govern the activities of federal savings banks, such as Naugatuck Valley Savings and Loan. These laws and regulations delineate the nature and extent of the activities in which federal savings banks may engage. In particular, certain lending authority for federal savings banks, e.g., commercial, non-residential real property loans and consumer loans, is limited to a specified percentage of the institution’s capital or assets. Naugatuck Valley Savings and Loan complies with all lending limits imposed by the Office of Thrift Supervision.

Branching. Federal savings banks are authorized to establish branch offices in any state or states of the United States and its territories, subject to the approval of the Office of Thrift Supervision.

Capital Requirements. The Office of Thrift Supervision’s capital regulations require federal savings institutions to meet three minimum capital standards: a 1.5% tangible capital to total assets ratio, a 4% leverage ratio (3% for institutions receiving the highest rating on the CAMELS examination rating system) and an 8% risk-based capital ratio. In addition, the prompt corrective action standards discussed below also establish, in effect, a minimum 2% tangible capital standard, a 4% Tier 1 capital to total assets leverage ratio (3% for institutions receiving the highest rating on the CAMELS system) and, together with the risk-based capital standard itself, a 4% Tier 1 risk-based capital standard. The Office of Thrift Supervision regulations also require that, in meeting the tangible, leverage and risk-based capital standards, institutions must generally deduct investments in and loans to subsidiaries engaged in activities as principal that are not permissible for a national bank.


The risk-based capital standard requires federal savings institutions to maintain Tier 1 (core) and total capital (which is defined as core capital and supplementary capital) to risk-weighted assets of at least 4% and 8%, respectively. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, recourse obligations, residual interests and direct credit substitutes, are multiplied by a risk-weight factor of 0% to 100%, assigned by the Office of Thrift Supervision capital regulation based on the risks believed inherent in the type of asset. Core (Tier 1) capital is generally defined as common stockholders’ equity (including retained earnings), certain noncumulative perpetual preferred stock and related surplus and minority interests in equity accounts of consolidated subsidiaries, less intangibles other than certain mortgage servicing rights and credit card relationships. The components of supplementary capital (Tier 2 capital) currently include cumulative preferred stock, long-term perpetual preferred stock, mandatory convertible securities, subordinated debt and intermediate preferred stock, the allowance for loan and lease losses limited to a maximum of 1.25% of risk-weighted assets and up to 45% of unrealized gains on available-for-sale equity securities with readily determinable fair market values. Overall, the amount of supplementary capital included as part of total capital cannot exceed 100% of core capital.

The Office of Thrift Supervision also has authority to establish individual minimum capital requirements in appropriate cases upon a determination that an institution’s capital level is or may become inadequate in light of the particular circumstances. At December 31, 2005, Naugatuck Valley Savings and Loan met each of these capital requirements.

Prompt Corrective Regulatory Action. The Office of Thrift Supervision is required to take certain supervisory actions against undercapitalized institutions, the severity of which depends upon the institution’s degree of undercapitalization. Generally, a savings institution that has a ratio of total capital to risk weighted assets of less than 8%, a ratio of Tier 1 (core) capital to risk-weighted assets of less than 4% or a ratio of core capital to total assets of less than 4% (3% or less for institutions with the highest examination rating) is considered to be “undercapitalized.” A savings institution that has a total risk-based capital ratio of less than 6%, a Tier 1 capital ratio of less than 3% or a leverage ratio that is less than 3% is considered to be “significantly undercapitalized” and a savings institution that has a tangible capital to assets ratio equal to or less than 2% is deemed to be “critically undercapitalized.” Subject to a narrow exception, the Office of Thrift Supervision is required to appoint a receiver or conservator within specified time frames for an institution that is “critically undercapitalized.” An institution must file a capital restoration plan with the Office of Thrift Supervision within 45 days of the date it is deemed to have received notice that it is “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” Compliance with the plan must be guaranteed by any parent holding company in an amount of up to the lesser of 5% of the savings association’s total assets when it was deemed to be undercapitalized or the amount necessary to achieve compliance with applicable capital regulations. In addition, numerous mandatory supervisory actions become immediately applicable to an undercapitalized institution, including, but not limited to, increased monitoring by regulators and restrictions on growth, capital distributions and expansion. “Significantly undercapitalized” and “critically undercapitalized” institutions are subject to more extensive mandatory regulatory actions. The Office of Thrift Supervision could also take any one of a number of discretionary supervisory actions, including the issuance of a capital directive and the replacement of senior executive officers and directors.

Loans to One Borrower. Federal law provides that savings institutions are generally subject to the limits on loans to one borrower applicable to national banks. Generally, subject to certain exceptions, savings institutions may not make a loan or extend credit to a single or related group of borrowers in excess of 15% of its unimpaired capital and surplus. An additional amount may be lent, equal to 10% of unimpaired capital and surplus, if secured by specified readily-marketable collateral.

Standards for Safety and Soundness. As required by statute, the federal banking agencies have adopted Interagency Guidelines prescribing Standards for Safety and Soundness. The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. If the Office of Thrift Supervision determines that a savings institution fails to meet any standard prescribed by the guidelines, the Office of Thrift Supervision may require the institution to submit an acceptable plan to achieve compliance with the standard. Naugatuck Valley has not received any notice that it has failed to meet any standard prescribed by the guidelines.

Limitation on Capital Distributions. Office of Thrift Supervision regulations impose limitations upon all capital distributions by a savings institution, including cash dividends, payments to repurchase its shares and payments to shareholders of another institution in a cash-out merger. Under the regulations, an application to and


the prior approval of the Office of Thrift Supervision is required before any capital distribution if the institution does not meet the criteria for “expedited treatment” of applications under Office of Thrift Supervision regulations (i.e., generally, examination and Community Reinvestment Act ratings in the two top categories), the total capital distributions for the calendar year exceed net income for that year plus the amount of retained net income for the preceding two years, the institution would be undercapitalized following the distribution or the distribution would otherwise be contrary to a statute, regulation or agreement with the Office of Thrift Supervision. If an application is not required, the institution must still provide prior notice to the Office of Thrift Supervision of the capital distribution if, like Naugatuck Valley Savings and Loan, it is a subsidiary of a holding company. If Naugatuck Valley Savings and Loan’s capital were ever to fall below its regulatory requirements or the Office of Thrift Supervision notified it that it was in need of increased supervision, its ability to make capital distributions could be restricted. In addition, the Office of Thrift Supervision could prohibit a proposed capital distribution that would otherwise be permitted by the regulation, if the agency determines that such distribution would constitute an unsafe or unsound practice.

Qualified Thrift Lender Test. Federal law requires savings institutions to meet a qualified thrift lender test. Under the test, a savings association is required to either qualify as a “domestic building and loan association” under the Internal Revenue Code or maintain at least 65% of its “portfolio assets” (total assets less: (i) specified liquid assets up to 20% of total assets; (ii) intangibles, including goodwill; and (iii) the value of property used to conduct business) in certain “qualified thrift investments” (primarily residential mortgages and related investments, including certain mortgage-backed securities) in at least 9 months out of each 12-month period.

A savings institution that fails the qualified thrift lender test is subject to certain operating restrictions and may be required to convert to a bank charter. Recent legislation has expanded the extent to which education loans, credit card loans and small business loans may be considered “qualified thrift investments.” At December 31, 2005, Naugatuck Valley Savings and Loan met the qualified thrift lender test.

Transactions with Related Parties. Federal law limits Naugatuck Valley Savings and Loan’s authority to lend to, and engage in certain other transactions with (collectively, “covered transactions”), “affiliates” (e.g., any entity that controls or is under common control with an institution, including Naugatuck Valley Financial, Naugatuck Valley Mutual and their non-savings institution subsidiaries). The aggregate amount of covered transactions with any individual affiliate is limited to 10% of the capital and surplus of the savings institution. The aggregate amount of covered transactions with all affiliates is limited to 20% of the savings institution’s capital and surplus. Loans and other specified transactions with affiliates are required to be secured by collateral in an amount and of a type specified by federal law. The purchase of low quality assets from affiliates is generally prohibited. Transactions with affiliates must be on terms and under circumstances that are at least as favorable to the institution as those prevailing at the time for comparable transactions with non-affiliated companies. In addition, savings institutions are prohibited from lending to any affiliate that is engaged in activities that are not permissible for bank holding companies and no savings institution may purchase the securities of any affiliate other than a subsidiary.

The Sarbanes-Oxley Act of 2002 generally prohibits a company from making loans to its executive officers and directors. However, the law contains a specific exception for loans by a depository institution to its executive officers and directors in compliance with federal banking laws. Under such laws, Naugatuck Valley Savings and Loan’s authority to extend credit to executive officers, directors and 10% shareholders (“insiders”), as well as entities such persons control, is limited. The law restricts both the individual and aggregate amount of loans Naugatuck Valley Savings and Loan may make to insiders based, in part, on Naugatuck Valley Savings and Loan’s capital position and requires certain Board approval procedures to be followed. Such loans must be made on terms substantially the same as those offered to unaffiliated individuals and not involve more than the normal risk of repayment. There is an exception for loans made pursuant to a benefit or compensation program that is widely available to all employees of the institution and does not give preference to insiders over other employees. There are additional restrictions applicable to loans to executive officers.
 
Enforcement. The Office of Thrift Supervision has primary enforcement responsibility over federal savings institutions and has the authority to bring actions against the institution and all institution-affiliated parties, including stockholders, and any attorneys, appraisers and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on an insured institution. Formal enforcement action may range from the issuance of a capital directive or cease and desist order to removal of officers and/or directors to appointment of a receiver or conservator or termination of deposit insurance. Civil penalties cover a wide range of
 
violations and can amount to $25,000 per day, or even $1 million per day in especially egregious cases. The Federal Deposit Insurance Corporation has authority to recommend to the Director of the Office of Thrift Supervision that enforcement action to be taken with respect to a particular savings institution. If action is not taken by the Director, the Federal Deposit Insurance Corporation has authority to take such action under certain circumstances. Federal law also establishes criminal penalties for certain violations.

Assessments. Federal savings banks are required to pay assessments to the Office of Thrift Supervision to fund its operations. The general assessments, paid on a semi-annual basis, are computed based upon the savings institution’s (including consolidated subsidiaries) total assets, condition and complexity of portfolio. The OTS assessments paid by the Bank for the fiscal year ended December 31, 2005 totaled $71,672.

Insurance of Deposit Accounts. Naugatuck Valley Savings and Loan is a member of the Savings Association Insurance Fund. The Federal Deposit Insurance Corporation maintains a risk-based assessment system by which institutions are assigned to one of three categories based on their capitalization and one of three subcategories based on examination ratings and other supervisory information. An institution’s assessment rate depends upon the categories to which it is assigned. Assessment rates for Savings Association Insurance Fund member institutions are determined semi-annually by the Federal Deposit Insurance Corporation and currently range from zero basis points of assessable deposits for the healthiest institutions to 27 basis points of assessable deposits for the riskiest.

The Federal Deposit Insurance Corporation has authority to increase insurance assessments. A material increase in Savings Association Insurance Fund insurance premiums would likely have an adverse effect on the operating expenses and results of operations of Naugatuck Valley Savings and Loan. Management cannot predict what insurance assessment rates will be in the future.

In addition to the assessment for deposit insurance, institutions are required to make payments on bonds issued in the late 1980s by the Financing Corporation to recapitalize the predecessor to the Savings Association Insurance Fund. During the year ended December 31, 2005, Financing Corporation payments for Savings Association Insurance Fund members averaged 1.39 basis points of assessable deposits. At December 31, 2005, Naugatuck Valley Savings and Loan had paid all fees and assessments for deposit insurance.

The Federal Deposit Insurance Corporation may terminate an institution’s insurance of deposits upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the Federal Deposit Insurance Corporation or the Office of Thrift Supervision. The management of Naugatuck Valley Savings and Loan does not know of any practice, condition or violation that might lead to termination of deposit insurance.

The Federal Deposit Insurance Reform Act of 2005 (the “Act”), signed by the President on February 8, 2006, revised the laws governing the federal deposit insurance system. The Act provides for the consolidation of the Bank and Savings Association Insurance Funds into a combined “Deposit Insurance Fund.”

Under the Act, insurance premiums are to be determined by the Federal Deposit Insurance Corporation (“FDIC”) based on a number of factors, primarily the risk of loss that insured institutions pose to the Deposit Insurance Fund. The legislation eliminates the current minimum 1.25% reserve ratio for the insurance funds, the mandatory assessments when the ratio fall below 1.25% and the prohibition on assessing the highest quality banks when the ratio is above 1.25%. The Act provides the FDIC with flexibility to adjust the new insurance fund’s reserve ratio between 1.15% and 1.5%, depending on projected losses, economic changes and assessment rates at the end of a calendar year.

The Act increased deposit insurance coverage limits from $100,000 to $250,000 for certain types of Individual Retirement Accounts, 401(k) plans and other retirement savings accounts. While it preserved the $100,000 coverage limit for individual accounts and municipal deposits, the FDIC was furnished with the discretion to adjust all coverage levels to keep pace with inflation beginning in 2010. Also, institutions that become undercapitalized will be prohibited from accepting certain employee benefit plan deposits.

The consolidation of the Bank and Savings Association Insurance Funds must occur no later than the first day of the calendar quarter that begins 90-days after the date of the Act’s enactment, i.e., July 1, 2006. The Act also


 states that the FDIC must promulgate final regulations implementing the remainder of its provisions not later than 270 days after its enactment.

At this time, management cannot predict the effect, if any, that the Act will have on insurance premiums paid by Naugatuck Valley Savings and Loan.

Federal Home Loan Bank System. Naugatuck Valley Savings and Loan is a member of the Federal Home Loan Bank System, which consists of 12 regional Federal Home Loan Banks. The Federal Home Loan Bank provides a central credit facility primarily for member institutions. Naugatuck Valley Savings and Loan, as a member of the Federal Home Loan Bank of Boston, is required to acquire and hold shares of capital stock in that Federal Home Loan Bank. The Bank was in compliance with this requirement with an investment in Federal Home Loan Bank stock at December 31, 2005 of $3.2 million.

The Federal Home Loan Banks are required to provide funds for the resolution of insolvent thrifts in the late 1980s and to contribute funds for affordable housing programs. These requirements could reduce the amount of dividends that the Federal Home Loan Banks pay to their members and could also result in the Federal Home Loan Banks imposing a higher rate of interest on advances to their members. If dividends were reduced, or interest on future Federal Home Loan Bank advances increased, our net interest income would likely also be reduced.

Community Reinvestment Act. Under the Community Reinvestment Act, as implemented by Office of Thrift Supervision regulations, a savings association has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The Community Reinvestment Act does not establish specific lending requirements or programs for financial institutions nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the Community Reinvestment Act. The Community Reinvestment Act requires the Office of Thrift Supervision, in connection with its examination of a savings association, to assess the institution’s record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by such institution.

The Community Reinvestment Act requires public disclosure of an institution’s rating and requires the Office of Thrift Supervision to provide a written evaluation of an association’s Community Reinvestment Act performance utilizing a four-tiered descriptive rating system.

Naugatuck Valley Savings received a “Satisfactory” rating as a result of its most recent Community Reinvestment Act assessment.

Federal Reserve System

The Federal Reserve Board regulations require savings institutions to maintain non-interest earning reserves against their transaction accounts (primarily Negotiable Order of Withdrawal (NOW) and regular checking accounts). The regulations generally provided that reserves be maintained against aggregate transaction accounts as follows: a 3% reserve ratio is assessed on net transaction accounts up to and including $48.3 million; a 10% reserve ratio is applied above $48.3 million. The first $8.0 million of otherwise reservable balances (subject to adjustments by the Federal Reserve Board) are exempted from the reserve requirements. The amounts are adjusted annually. Naugatuck Valley Savings complies with the foregoing requirements.

Holding Company Regulation

General. Naugatuck Valley Financial and Naugatuck Valley Mutual are savings and loan holding companies within the meaning of federal law. As such, they are registered with the Office of Thrift Supervision and are subject to Office of Thrift Supervision regulations, examinations, supervision, reporting requirements and regulations concerning corporate governance and activities. In addition, the Office of Thrift Supervision has enforcement authority over Naugatuck Valley Financial and Naugatuck Valley Mutual and their non-savings institution subsidiaries. Among other things, this authority permits the Office of Thrift Supervision to restrict or prohibit activities that are determined to be a serious risk to Naugatuck Valley Savings and Loan.


 
Restrictions Applicable to Mutual Holding Companies. According to federal law and Office of Thrift Supervision regulations, a mutual holding company, such as Naugatuck Valley Mutual, may generally engage in the following activities: (1) investing in the stock of insured depository institutions and acquiring them by means of a merger or acquisition; (2) investing in a corporation the capital stock of which may be lawfully purchased by a savings association under federal law; (3) furnishing or performing management services for a savings association subsidiary of a savings and loan holding company; (4) conducting an insurance agency or escrow business; (5) holding, managing or liquidating assets owned or acquired from a savings association subsidiary of the savings and loan holding company; (6) holding or managing properties used or occupied by a savings association subsidiary of the savings and loan holding company; (7) acting as trustee under deed or trust; (8) any activity permitted for multiple savings and loan holding companies by Office of Thrift Supervision regulations; (9) any activity permitted by the Board of Governors of the Federal Reserve System for bank holding companies and financial holding companies; and (10) any activity permissive for service corporations. Recent legislation, which authorized mutual holding companies to engage in activities permitted for financial holding companies, expanded the authorized activities. Financial holding companies may engage in a broad array of financial services activities, including insurance and securities.

Federal law prohibits a savings and loan holding company, including a federal mutual holding company, from directly or indirectly, or through one or more subsidiaries, acquiring more than 5% of the voting stock of another savings institution, or its holding company, without prior written approval of the Office of Thrift Supervision. Federal law also prohibits a savings and loan holding company from acquiring or retaining control of a depository institution that is not insured by the Federal Deposit Insurance Corporation. In evaluating applications by holding companies to acquire savings institutions, the Office of Thrift Supervision must consider the financial and managerial resources and future prospects of the company and institution involved, the effect of the acquisition on the risk to the insurance funds, the convenience and needs of the community and competitive factors.

The Office of Thrift Supervision is prohibited from approving any acquisition that would result in a multiple savings and loan holding company controlling savings institutions in more than one state, except: (1) the approval of interstate supervisory acquisitions by savings and loan holding companies, and (2) the acquisition of a savings institution in another state if the laws of the state of the target savings institution specifically permit such acquisitions. The states vary in the extent to which they permit interstate savings and loan holding company acquisitions.

If the savings institution subsidiary of a savings and loan holding company fails to meet the qualified thrift lender test set, the holding company must register with the Federal Reserve Board as a bank holding company within one year of the savings institution’s failure to so qualify.

Stock Holding Company Subsidiary Regulation. The Office of Thrift Supervision has adopted regulations governing the two-tier mutual holding company form of organization and subsidiary stock holding companies that are controlled by mutual holding companies. We have this two-tier form of organization. Naugatuck Valley Financial is the stock holding company subsidiary of Naugatuck Valley Mutual. Naugatuck Valley Financial is only permitted to engage in activities that are permitted for Naugatuck Valley Mutual subject to the same restrictions and conditions.

Waivers of Dividends by Naugatuck Valley Mutual. Office of Thrift Supervision regulations require Naugatuck Valley Mutual to notify the Office of Thrift Supervision if it proposes to waive receipt of our dividends from Naugatuck Valley Financial. The Office of Thrift Supervision reviews dividend waiver notices on a case-by-case basis, and, in general, does not object to any such waiver if: (i) the waiver would not be detrimental to the safe and sound operation of the savings association; and (ii) the mutual holding company’s Board of Directors determines that such waiver is consistent with such directors’ fiduciary duties to the mutual holding company’s members. We anticipate that Naugatuck Valley Mutual will waive dividends that Naugatuck Valley Financial may pay, if any.
 
Conversion of Naugatuck Valley Mutual to Stock Form. Office of Thrift Supervision regulations permit Naugatuck Valley Mutual to convert from the mutual form of organization to the capital stock form of organization. There can be no assurance when, if ever, a conversion transaction will occur, and the Board of Directors has no current intention or plan to undertake a conversion transaction. In a conversion transaction a new holding company would be formed as our successor, Naugatuck Valley Mutual’s corporate existence would end, and
certain depositors of Naugatuck Valley Savings and Loan would receive the right to subscribe for additional shares of the new holding company. In a conversion transaction, each share of common stock held by stockholders other than Naugatuck Valley Mutual would be automatically converted into a number of shares of common stock of the new holding company based on an exchange ratio determined at the time of conversion that ensures that stockholders other than Naugatuck Valley Mutual own the same percentage of common stock in the new holding company as they owned in us immediately before conversion. Under Office of Thrift Supervision regulations, stockholders other than Naugatuck Valley Mutual would not be diluted because of any dividends waived by Naugatuck Valley Mutual (and waived dividends would not be considered in determining an appropriate exchange ratio), in the event Naugatuck Valley Mutual converts to stock form. The total number of shares held by stockholders other than Naugatuck Valley Mutual after a conversion transaction also would be increased by any purchases by stockholders other than Naugatuck Valley Mutual in the stock offering conducted as part of the conversion transaction.

Acquisition of Control. Under the federal Change in Bank Control Act, a notice must be submitted to the Office of Thrift Supervision if any person (including a company), or group acting in concert, seeks to acquire “control” of a savings and loan holding company or savings association. An acquisition of “control” can occur upon the acquisition of 10% or more of the voting stock of a savings and loan holding company or savings institution or as otherwise defined by the Office of Thrift Supervision. Under the Change in Bank Control Act, the Office of Thrift Supervision has 60 days from the filing of a complete notice to act, taking into consideration certain factors, including the financial and managerial resources of the acquirer and the anti-trust effects of the acquisition. Any company that so acquires control would then be subject to regulation as a savings and loan holding company.

Remutualization Transactions. Current Office of Thrift Supervision regulations permit a mutual holding company to be acquired by a mutual institution in a remutualization transaction. However, the Office of Thrift Supervision has issued a policy statement indicating that it views remutualization transactions as raising significant issues concerning disparate treatment of minority stockholders and mutual members of the target entity and as raising issues concerning the effect on the mutual members of the acquiring entity. Under certain circumstances, the Office of Thrift Supervision intends to give these issues special scrutiny and reject applications for the remutualization of a mutual holding company unless the applicant can clearly demonstrate that the Office of Thrift Supervision’s concerns are not warranted in the particular case.

Federal Securities Laws

Naugatuck Valley Financial’s common stock is registered with the Securities and Exchange Commission under the Securities Exchange Act of 1934. Naugatuck Valley Financial is subject to the information, proxy solicitation, insider trading restrictions and other requirements under the Securities Exchange Act of 1934.

Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002 implemented legislative reforms intended to address corporate and accounting fraud. The Sarbanes-Oxley Act restricts the scope of services that may be provided by accounting firms to their public company audit clients and any non-audit services being provided to a public company audit client will require preapproval by the company’s audit committee. In addition, the Sarbanes-Oxley Act requires chief executive officers and chief financial officers, or their equivalent, to certify to the accuracy of periodic reports filed with the Securities and Exchange Commission, subject to civil and criminal penalties if they knowingly or willingly violate this certification requirement.

Under the Sarbanes-Oxley Act, bonuses issued to top executives before restatement of a company’s financial statements are now subject to disgorgement if such restatement was due to corporate misconduct. Executives are also prohibited from insider trading during retirement plan “blackout” periods, and loans to company executives (other than loans by financial institutions permitted by federal rules and regulations) are restricted. The legislation accelerates the time frame for disclosures by public companies and changes in ownership in a company’s securities by directors and executive officers.

The Sarbanes-Oxley Act also increases the oversight of, and codifies certain requirements relating to audit committees of public companies and how they interact with the company’s “registered public accounting firm.”


Among other requirements, companies must disclose whether at least one member of the committee is a “financial expert” (as such term is defined by the Securities and Exchange Commission) and if not, why not.

Although we anticipate that we will incur additional expense in complying with the provisions of the Sarbanes-Oxley Act and the resulting regulations, management does not expect that such compliance will have a material impact on our results of operations or financial condition.

Privacy Requirements of the GLBA

The Gramm-Leach-Bliley Act of 1999 provided for sweeping financial modernization for commercial banks, savings banks, securities firms, insurance companies, and other financial institutions operating in the United States. Among other provisions, the Gramm-Leach-Bliley Act places limitations on the sharing of consumer financial information with unaffiliated third parties. Specifically, the Gramm-Leach-Bliley Act requires all financial institutions offering financial products or services to retail customers to provide such customers with the financial institution’s privacy policy and provide such customers the opportunity to “opt out” of the sharing of personal financial information with unaffiliated third parties.

Anti-Money Laundering

The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (referred to as the “USA PATRIOT Act”) significantly expands the responsibilities of financial institutions, including savings and loan associations, in preventing the use of the U.S. financial system to fund terrorist activities. Title III of the USA PATRIOT Act provides for a significant overhaul of the U.S. anti-money laundering regime. Among other provisions, it requires financial institutions operating in the United States to develop new anti-money laundering compliance programs, due diligence policies and controls to ensure the detection and reporting of money laundering. Such required compliance programs are intended to supplement existing compliance requirements, also applicable to financial institutions, under the Bank Secrecy Act and the Office of Foreign Assets Control Regulations. We have established policies and procedures to ensure compliance with the USA PATRIOT Act’s provisions, and the impact of the USA PATRIOT Act on our operations has not been material.

Other Regulations

Interest and other charges collected or contracted for by Naugatuck Valley Savings and Loan are subject to state usury laws and federal laws concerning interest rates. Naugatuck Valley Savings and Loan’s loan operations are also subject to federal laws applicable to credit transactions, such as the:

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

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

 
•
Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit;
     
 
•
Fair Credit Reporting Act of 1978, governing the use and provision of information to credit reporting agencies; of identity theft and provide for accuracy, privacy, limits on information sharing and new consumer rights to disclosure.

 
•
Fair and Accurate Credit Transaction Act of 2003, intended to help consumers fight the growing crime of identity theft and provide for accuracy, privacy, limits on information sharing and new consumer rights to disclosure.
 
 
•
Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies; and
 
 
•
rules and regulations of the various federal agencies charged with the responsibility of implementing such federal laws.

The deposit operations of Naugatuck Valley Savings and Loan also are subject to the:

 
•
Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records;

 
•
Electronic Funds Transfer Act and Regulation E promulgated thereunder, which governs automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services; and

 
•
Check Clearing for the 21st Century Act (also known as “Check 21"), which gives “substitute checks,” such as digital check images and copies made from that image, the same legal standing as the original paper check.

Federal and State Taxation

Federal Income Taxation

General. We report our income on a fiscal year basis using the accrual method of accounting. The federal income tax laws apply to us in the same manner as to other corporations with some exceptions, including particularly our reserve for bad debts discussed below. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to us. Our federal income tax returns have been either audited or closed under the statute of limitations through tax year 2000. For its 2005 year, Naugatuck Valley Savings and Loan’s maximum federal income tax rate was 34%.

Bad Debt Reserves.  For fiscal years beginning before June 30, 1996, thrift institutions that qualified under certain definitional tests and other conditions of the Internal Revenue Code were permitted to use certain favorable provisions to calculate their deductions from taxable income for annual additions to their bad debt reserve. A reserve could be established for bad debts on qualifying real property loans, generally secured by interests in real property improved or to be improved, under the percentage of taxable income method or the experience method. The reserve for nonqualifying loans was computed using the experience method. Federal legislation enacted in 1996 repealed the reserve method of accounting for bad debts and the percentage of taxable income method for tax years beginning after 1995 and require savings institutions to recapture or take into income certain portions of their accumulated bad debt reserves. Approximately $1.4 million of our accumulated bad debt reserves would not be recaptured into taxable income unless Naugatuck Valley Savings and Loan makes a “non-dividend distribution” to Naugatuck Valley Savings and Loan as described below.

Distributions. If Naugatuck Valley Savings and Loan makes “non-dividend distributions” to us, the distributions will be considered to have been made from Naugatuck Valley Savings and Loan’s unrecaptured tax bad debt reserves, including the balance of its reserves as of December 31, 1987, to the extent of the “non-dividend distributions,” and then from Naugatuck Valley Savings and Loan’s supplemental reserve for losses on loans, to the extent of those reserves, and an amount based on the amount distributed, but not more than the amount of those reserves, will be included in Naugatuck Valley Savings and Loan’s taxable income. Non-dividend distributions include distributions in excess of Naugatuck Valley Savings and Loan’s current and accumulated earnings and profits, as calculated for federal income tax purposes, distributions in redemption of stock, and distributions in partial or complete liquidation. Dividends paid out of Naugatuck Valley Savings and Loan’s current or accumulated earnings and profits will not be so included in Naugatuck Valley Savings and Loan’s taxable income.

The amount of additional taxable income triggered by a non-dividend is an amount that, when reduced by the tax attributable to the income, is equal to the amount of the distribution. Therefore, if Naugatuck Valley Savings and Loan makes a non-dividend distribution to us, approximately one and one-half times the amount of the distribution not in excess of the amount of the reserves would be includable in income for federal income tax


purposes, assuming a 34% federal corporate income tax rate. Naugatuck Valley Savings and Loan does not intend to pay dividends that would result in a recapture of any portion of its bad debt reserves.

State Taxation

Naugatuck Valley Mutual, Naugatuck Valley Financial and its subsidiaries are subject to the Connecticut corporation business tax. Naugatuck Valley Mutual, Naugatuck Valley Financial and its subsidiaries will be eligible to file a combined Connecticut income tax return and will pay the larger of the regular corporation business tax (income tax) or a capital stock tax, but no less than a nominal minimum tax.

The Connecticut corporation business tax is based on the federal taxable income before net operating loss and special deductions of Naugatuck Valley Mutual, Naugatuck Valley Financial and its subsidiaries and makes certain modifications to federal taxable income to arrive at Connecticut taxable income. Connecticut taxable income is multiplied by the effective state tax rate (7.5% for 2005) to arrive at Connecticut income tax.

In May 1998, the State of Connecticut enacted legislation permitting the formation of passive investment company subsidiaries by financial institutions. This legislation exempts qualifying passive investment companies from the Connecticut corporation business tax and excludes dividends paid from a passive investment company from the taxable income of the parent financial institution. Naugatuck Valley Savings and Loan’s formation of a passive investment company in September 1999 is expected to substantially eliminate the state income tax expense of Naugatuck Valley Mutual, Naugatuck Valley Financial and its subsidiaries. However, we will remain liable for the capital stock tax. The State of Connecticut continues to be under pressure to find new sources of revenue, and therefore could propose legislation to eliminate the passive investment company exemption. If such legislation were enacted, we would be subject to state income taxes in Connecticut.



Executive Officers of the Registrant

The executive officers of Naugatuck Valley Financial, Naugatuck Valley Mutual Holding Company and Naugatuck Valley Savings are elected annually by the Board of Directors and serve at the Board’s discretion. The executive officers of Naugatuck Valley Financial, Naugatuck Valley Mutual Holding Company and Naugatuck Valley Savings are:
 
Name
  
Position
John C. Roman
  
President and Chief Executive Officer of Naugatuck Valley Financial, Naugatuck Valley Mutual and Naugatuck Valley Savings and Loan
     
Dominic J. Alegi, Jr.
 
Executive Vice President of Naugatuck Valley Financial, Naugatuck Valley Mutual and Naugatuck Valley Savings and Loan
     
Jane H. Walsh
  
Senior Vice President of Naugatuck Valley Financial, Naugatuck Valley Mutual and Naugatuck Valley Savings and Loan
     
William C. Nimons
  
Senior Vice President of Naugatuck Valley Financial, Naugatuck Valley Mutual and Naugatuck Valley Savings and Loan
     
Mark S. Graveline
  
Senior Vice President of Naugatuck Valley Financial and Naugatuck Valley Mutual, Senior Vice President and Chief Lending Officer of Naugatuck Valley Savings and Loan
     
Lee R. Schlesinger
  
Vice President and Treasurer of Naugatuck Valley Financial, Naugatuck Valley Mutual and Naugatuck Valley Savings and Loan

Below is information regarding the executive officers who are not also directors. Unless otherwise stated, each executive officer has held his or her current position for at least the last five years. Ages presented are as of December 31, 2005.

Dominic J. Alegi, Jr. has served as Executive Vice President of Naugatuck Valley Financial and Naugatuck Valley Mutual since September 2004 and has been Executive Vice President of Naugatuck Valley Savings and Loan since 1989. Mr. Alegi has served with Naugatuck Valley Savings and Loan since 1970. Age 59.

William C. Nimons has served as Senior Vice President of Naugatuck Valley Financial and Naugatuck Valley Mutual since September 2004 and has been Senior Vice President of Naugatuck Valley Savings and Loan since 2001. Mr. Nimons previously was the Manager-Network Management of Prudential Real Estate and Relocation, a real estate and relocation firm and was an Executive Vice President at Shelton Savings Bank. Age 59.

Mark S. Graveline has served as Senior Vice President of Naugatuck Valley Financial and Naugatuck Valley Mutual and as Senior Vice President and Chief Lending Officer of Naugatuck Valley Savings and Loan since February 2005. Mr. Graveline previously was a Vice President of Banknorth-Connecticut and a Vice President of North American Bank and Trust. Age 49.
 
Lee R. Schlesinger has served as Vice President and Treasurer of Naugatuck Valley Financial and Naugatuck Valley Mutual since September 2004 and has been Vice President and Treasurer of Naugatuck Valley Savings since August 2004. Mr. Schlesinger served as Vice President and Controller of Naugatuck Valley Savings and Loan from 2003 to 2004 and as Assistant Vice President and Controller of Naugatuck Valley Savings and Loan from 2000 to 2003. Mr. Schlesinger has served with Naugatuck Valley Savings and Loan since 1983. Age 45.




Rising interest rates may hurt our profits and asset value.

Interest rates were recently at historically low levels. However, between June 30, 2004 and December 31, 2005, the U.S. Federal Reserve has increased its target for the federal funds rate thirteen times to 4.25%. These increases have led to a “flattening” of the yield curve where there is relatively little differential between short-term and long-term interest rates. If short-term interest rates continue to rise, causing the rates on our deposits and borrowings to reprice upwards faster than the rates on our loans and investments, we would experience continued compression of our interest rate spread and net interest margin, which would have a negative effect on our profitability.

If we do not achieve profitability on new branches, the new branches may negatively impact our earnings.

We opened a new branch in Seymour, Connecticut in January 2005. We also expect to open a new branch in Southbury, Connecticut in the third quarter of 2006.  We intend to continue to pursue opportunities to pursue expansion of our branch network, as well as to upgrade our current branch facilities. We cannot assure you that our branch expansion strategy and our branch upgrading will be accretive to our earnings, or that it will be accretive to earnings within a reasonable period of time. Numerous factors contribute to the performance of a new branch, such as a suitable location, qualified personnel and an effective marketing strategy. Additionally, it takes time for a new branch to generate significant deposits and make sufficient loans to produce enough income to offset expenses, some of which, like salaries and occupancy expense, are relatively fixed costs. In addition to branch employees, we will hire lending and other employees to support our expanded infrastructure.

Our increased emphasis on commercial and construction lending and the unseasoned nature of these loans may expose us to increased lending risks and could impact the level of our allowance for loan losses.

Since December 31, 2001, our commercial real estate, commercial business and residential construction loan portfolio has increased $53.7 million, or 368.5%, and at December 31, 2005, $68.3 million, or 25.9%, of our loan portfolio consisted of these real estate, construction and commercial business loans. We intend to continue to emphasize these types of lending. These types of loans generally expose a lender to greater risk of non-payment and loss than one- to four-family residential mortgage loans because repayment of the loans often depends on the successful operation of the property, the income stream of the borrowers for commercial business loans and for construction loans, the accuracy of the estimate of the property’s value at completion of construction and the estimated cost of construction. These factors can be impacted by many variables including economic events beyond the borrowers’ control. Such loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to one- to four-family residential mortgage loans. Also, many of our commercial and construction borrowers have more than one loan outstanding with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss compared to an adverse development with respect to a one- to four-family residential mortgage loan.

Because of our planned continued emphasis on commercial and construction lending and the unseasoned nature of many of these loans, we may determine it necessary to increase the level of our allowance for loan losses. We make various judgments about the collectibility of our loans, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for our loans. In determining the amount of the allowance for loan losses, we review our loans and our loan loss and delinquency experience, and we evaluate economic conditions. However, as a result of our recent expansion, a significant portion of our commercial and construction loans are unseasoned, with the risk that these loans may not have had sufficient time to perform to properly indicate the potential magnitude of losses. If our judgments are incorrect, our allowance for loan losses may not be sufficient to cover future losses, which will result in additions to our allowance through increased provisions for loan losses. In addition, bank regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs. Increased provisions for loan losses would increase our expenses and reduce our profits. Finally, during our recent expansion, we have also experienced a historically low interest rate environment. Our unseasoned adjustable rate loans have not, therefore, been subject to a rising interest rate environment which could cause them to adjust to their maximum interest rate


level. Such an increase could increase collection risks resulting from potentially higher payment obligations by the borrower.

A decline in our return on equity as a result of the capital we raised in our 2004 stock offering may negatively impact our stock price.

Return on equity, which equals net income divided by average equity, is a ratio used by many investors to compare the performance of a particular company with other companies. Our return on equity for the year ended December 31, 2005 was 3.66%. Over time, we intend to use the net proceeds from our 2004 stock offering to increase earnings per share and book value per share, without assuming undue risk, with the goal of achieving a return on equity that is competitive with other publicly held subsidiaries of mutual holding companies. This goal could take a number of years to achieve, and we cannot assure you that it will be attained. Consequently, you should not expect a competitive return on equity in the near future. Failure to achieve a competitive return on equity might make an investment in our common stock unattractive to some investors and might cause our common stock to trade at lower prices than comparable companies with higher returns on equity.

Expenses from operating as a public company and from new stock-based benefit plans will continue to adversely affect our profitability.

Our noninterest expenses are impacted as a result of the financial accounting, legal and various other additional expenses usually associated with operating as a public company. We also recognize additional annual employee compensation and benefit expenses stemming from the shares that are purchased or granted to employees and executives under new benefit plans. These additional expenses adversely affect our profitability. We recognize expenses for our employee stock ownership plan when shares are committed to be released to participants’ accounts and recognize expenses for restricted stock awards and stock options over the vesting period of awards made to recipients.

Naugatuck Valley Mutual’s majority control of our common stock enables it to exercise voting control over most matters put to a vote of stockholders, including preventing sale or merger transactions you may like or a second-step conversion by Naugatuck Valley Mutual.

Naugatuck Valley Mutual owns a majority of our common stock and, through its Board of Directors, is able to exercise voting control over most matters put to a vote of stockholders. The same directors and officers manage Naugatuck Valley Financial, Naugatuck Valley Savings and Naugatuck Valley Mutual. As a federally chartered mutual holding company, the Board of Directors of Naugatuck Valley Mutual must ensure that the interests of depositors of Naugatuck Valley Savings are represented and considered in matters put to a vote of stockholders of Naugatuck Valley Financial. Therefore, the votes cast by Naugatuck Valley Mutual may not be in your personal best interests as a stockholder. For example, Naugatuck Valley Mutual may exercise its voting control to defeat a stockholder nominee for election to the board of directors of Naugatuck Valley Financial. In addition, stockholders will not be able to force a merger or second-step conversion transaction without the consent of Naugatuck Valley Mutual. Some stockholders may desire a sale or merger transaction, since stockholders typically receive a premium for their shares, or a second-step conversion transaction, since fully converted institutions tend to trade at higher multiples than mutual holding companies.

Office of Thrift Supervision policy on remutualization transactions could prohibit the merger or an acquisition of us, which may lower our stock price.

Current Office of Thrift Supervision regulations permit a mutual holding company to be acquired by a mutual institution in a remutualization transaction. The possibility of a remutualization transaction has recently resulted in a degree of takeover speculation for mutual holding companies which is reflected in the stock prices of mutual holding companies. However, the Office of Thrift Supervision has issued a policy statement indicating that it views remutualization transactions as raising significant issues concerning disparate treatment of minority stockholders and mutual members of the target entity and as raising issues concerning the effect on the mutual members of the acquiring entity. Under certain circumstances, the Office of Thrift Supervision intends to give these issues special scrutiny and reject applications for the remutualization of a mutual holding company unless the applicant can clearly demonstrate that the Office of Thrift Supervision’s concerns are not warranted in the particular case. Should the Office of Thrift Supervision prohibit or otherwise restrict these transactions in the future, our stock


price may be adversely affected. We have no current plans to undertake a remutualization transaction. In addition, Office of Thrift Supervision regulations prohibit, for three years following the completion of a stock offering by a company such as Naugatuck Valley Financial, the acquisition of more than 10% of any class of equity security of the company without the prior approval of the Office of Thrift Supervision.

Strong competition within our market area could hurt our profits and slow growth.

Although we consider ourselves competitive in the Greater Naugatuck Valley, which we consider our market area, we face intense competition both in making loans and attracting deposits. Price competition for loans and deposits might result in us earning less on our loans and paying more on our deposits, which reduces net interest income. Some of the institutions with which we compete have substantially greater resources and lending limits than we have and may offer services that we do not provide. We expect competition to increase in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Our profitability depends upon our continued ability to compete successfully in our market area.

We operate in a highly regulated environment and we may be adversely affected by changes in laws and regulations.

We are subject to extensive government regulation, supervision and examination. Such regulation, supervision and examination govern the activities in which we may engage, and is intended primarily for the protection of the deposit insurance fund and our depositors. Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on our operations, the classification of our assets and determination of the level of our allowance for loan losses. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, legislation or supervisory action, may have a material impact on our operations.


None.




We conduct our business through our main office and branch offices. The following table sets forth certain information relating to these facilities as of December 31, 2005.

Location
  
Year
Opened/
Acquired
  
Net Book Value at
December 31, 2005
  
Square
Footage
  
Owned/
Leased
  
Date of
Lease
Expiration
       
 (Dollars in thousands)
            
                     
Main Office:
                    
333 Church Street
Naugatuck, CT 06770
  
1996
  
$2,845    
 
23,000  
 
Owned
  
—
                     
Branches:
                    
1009 New Haven Road
Naugatuck, CT 06770
  
2001
  
1,319  
 
3,300
  
Owned
  
—
                     
127 South Main Street
Beacon Falls, CT 06403
  
1997
  
 201
  
  960
  
Owned
  
—
                     
49 Pershing Drive
Derby, CT 06418
  
2003
  
215
  
1,950
  
Leased
  
2013 (1)
                     
249 West Street (2)
Seymour, CT 06483
  
2002
  
2,280   
 
9,500
  
Owned
  
—
                     
504 Bridgeport Avenue (3)
Shelton, CT 06484
  
2004
  
599
  
3,000
  
Leased
  
2020 (4)
                     
Other Properties:
                    
1007 New Haven Road
Naugatuck, CT 06770
  
1974
  
 35
  
1,725
  
Leased
  
2014 (5)
                     
135 South Main Street (6)
Beacon Falls, CT 06403
  
2003
  
147 
 
  N/A
  
Owned
  
—
                     
15 Quaker Farms Road (7)
Southbury, CT 06488
  
2004
  
381 
 
 N/A
  
Owned
  
—
_________________________
(1)     
We have an option to renew this lease for three additional five-year periods.
(2)     
This branch opened in January 2005. This branch occupies 3,500 square feet of this office along with 6,000 square feet of rentable space, none of which was rented as of this date.
(3)     
We relocated our previous Shelton branch to this location in July 2005.
(4)     
We have the option to renew this lease for five additional five-year periods.
(5)     
Former branch site. We have an option to renew this lease for two additional ten-year periods. This property has been leased to a subtenant under a lease that expires in 2006. The tenant has an option to renew this lease for one additional five-year period.
(6)     
This property is designated for future parking, additional access and possible future expansions of our Beacon Falls branch. Based on current estimates, we expect the total cost of this project to be approximately $36,000, $11,000 of which had been incurred at December 31, 2005.
(7)     
We expect to open a branch at this location in the third quarter of 2006.




ITEM 3.  LEGAL PROCEEDINGS.

Periodically, there have been various claims and lawsuits against us, such as claims to enforce liens, condemnation proceedings on properties in which we hold security interests, claims involving the making and servicing of real property loans and other issues incident to our business. We are not a party to any pending legal proceedings that we believe would have a material adverse effect on our financial condition, results of operations or cash flows.
 
ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

None.

 
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.

The information regarding the market for Naugatuck Valley Financial’s common equity and related stockholder matters is incorporated herein by reference to Naugatuck Valley Financial’s 2005 Annual Report to Stockholders at “Investor and Corporate Information.”

Naugatuck Valley Financial did not repurchase any of its common stock during the three months ended December 31, 2005.

 
SELECTED FINANCIAL DATA.

The information required by this item is incorporated herein by reference to the Section captioned “Selected Consolidated Financial Information” in the 2005 Annual Report to Stockholders.

 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION.

The information regarding management’s discussion and analysis of financial condition and results of operation is incorporated herein by reference to Naugatuck Valley Financial’s 2005 Annual Report to Stockholders at “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

ITEM 7A.        QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

The information required by this item is incorporated herein by reference to the Section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the 2005 Annual Report to Stockholders.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA.

The information regarding financial statements is incorporated herein by reference to Naugatuck Valley Financial’s 2005 Annual Report to Stockholders in the Consolidated Financial Statements and the Notes thereto.

 
CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.

Not applicable.

ITEM 9A.               CONTROLS AND PROCEDURES.

The Company’s management, including the Company’s principal executive officer and principal financial officer, have evaluated the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”). Based upon their evaluation, the principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective for


the purpose of ensuring that the information required to be disclosed in the reports that the Company files or submits under the Exchange Act with the Securities and Exchange Commission (the “SEC”) (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.

ITEM 9B.        OTHER INFORMATION.

Not applicable.


ITEM 10.         DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

The information relating to the directors and officers of Naugatuck Valley Financial and information regarding compliance with Section 16(a) of the Exchange Act is incorporated herein by reference to Naugatuck Valley Financial’s Proxy Statement for the 2006 Annual Meeting of Stockholders and to Part I, Item 1, “Description of Business — Executive Officers of the Registrant.”

Naugatuck Valley Financial has adopted a Code of Ethics and Business Conduct. See the Exhibits to this Annual Report on Form 10-K.

ITEM 11.         EXECUTIVE COMPENSATION.

The information regarding executive compensation is incorporated herein by reference to Naugatuck Valley Financial’s Proxy Statement for the 2006 Annual Meeting of Stockholders.

ITEM 12.         SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERS MATTERS.

(a)       Security Ownership of Certain Beneficial Owners

   
Information required by this item is incorporated herein by reference to the section captioned “Stock Ownership” in Naugatuck Valley Financial’s Proxy Statement for the 2006 Annual Meeting of Stockholders.

(b)         Security Ownership of Management

Information required by this item is incorporated herein by reference to the section captioned “Stock Ownership” in Naugatuck Valley Financial’s Proxy Statement for the 2006 Annual Meeting of Stockholders.

(c)         Changes in Control

Management of Naugatuck Valley Financial knows of no arrangements, including any pledge by any person or securities of Naugatuck Valley Financial, the operation of which may at a subsequent date result in a change in control of the registrant.

(d)        Equity Compensation Plan Information

   
The following table sets forth information as of December 31, 2005 about Company common stock that may be issued under the Naugatuck Valley Financial Corporation 2005 Equity Incentive Plan. The plan was approved by the Company’s stockholders.
 
 

PLAN CATEGORY
  
Number of securities
to be issued upon
the exercise of
outstanding options,
warrants and rights
  
Weighted-average
exercise price of
outstanding options,
warrants and rights
  
Number of securities
remaining available
for future issuance
under equity
compensation plans
(excluding securities
reflected in the first
column)
             
Equity compensation plans
approved by security holders
  
352,430
  
$11.10
  
29,517
             
Equity compensation plans
not approved by security holders
  
n/a
  
n/a
  
n/a
             
Total
  
352,430
  
$11.10
  
29,517

 
ITEM 13.         CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

The information relating to certain relationships and related transactions is incorporated herein by reference to Naugatuck Valley Financial’s Proxy Statement for the 2006 Annual Meeting of Stockholders.

ITEM 14.        PRINCIPAL ACCOUNTANT FEES AND EXPENSES.

The information relating to the principal accountant fees and expenses is incorporated herein by reference to Naugatuck Valley Financial’s Proxy Statement for the 2006 Annual Meeting of Stockholders.


ITEM 15.         EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.

 
(1)
The following are filed as a part of this report by means of incorporation to Naugatuck Valley Financial’s 2005 Annual Report to Stockholders:

●           Report of Independent Registered Public Accounting Firm

 
●
Consolidated Statements of Financial Condition as of December 31, 2005 and 2004

 
●
Consolidated Statements of Income for the Years Ended December 31, 2005, 2004 and 2003

 
●
Consolidated Statements of Changes in Capital Accounts for the Years Ended December 31, 2005, 2004 and 2003

 
●
Consolidated Statements of Cash Flows for the Years Ended December 31, 2005, 2004 and 2003

 
●
Notes to Consolidated Financial Statements

 
(2)
All financial statement schedules are omitted because they are not required or applicable, or the required information is shown in the consolidated financial statements or the notes thereto.



  (3)         Exhibits
 
              Exhibit No.       Description

 
3.1
Charter of Naugatuck Valley Financial Corporation (1)
 
3.2
Bylaws of Naugatuck Valley Financial Corporation (1)
 
4.0
Specimen Stock Certificate of Naugatuck Valley Financial Corporation (2)
 
10.1
Naugatuck Valley Financial Corporation and Naugatuck Valley Savings and Loan Employment Agreement with John C. Roman (1)*
 
10.2
Naugatuck Valley Savings and Loan Change in Control Agreement with Jane H. Walsh (1)*
 
10.3
Naugatuck Valley Savings and Loan Change in Control Agreement with Dominic J. Alegi, Jr. (4)*
 
10.4
Naugatuck Valley Savings and Loan Directors’ Retirement Plan (2)*
 
10.5
Form of Naugatuck Valley Savings and Loan Employee Severance Compensation Plan (2)*
 
10.6
Naugatuck Valley Savings and Loan Death Benefit Agreement with John C. Roman,
   
as amended (4)*
 
10.7
Naugatuck Valley Savings and Loan Death Benefit Agreement with Dominic J. Alegi, Jr. (2)*
 
10.8
Naugatuck Valley Financial Corporation 2005 Equity Incentive Plan (3)*
 
Naugatuck Valley Savings and Loan Change in Control Agreement with William C. Nimons*
 
Annual Report to Stockholders
 
14.0
Code of Ethics and Business Conduct (4)
 
21.0
List of Subsidiaries (4)
 
Consent of Whittlesey & Hadley, P.C.
 
Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer
 
Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer
 
Section 1350 Certification of Chief Executive Officer and Chief Financial Officer
 
______________________________
*Management contract or compensation plan arrangement
 
(1)
Incorporated by reference to the Company’s Form 10-Q for the three months ended September 30, 2004.
 
(2)
Incorporated by reference to the Company’s Registration Statement on Form S-1, as amended, initially filed on June 18, 2004.
 
(3)
Incorporated by reference to Appendix C to the Proxy Statement for the 2005 Annual Meeting of Stockholders filed on April 1, 2005.
 
(4)
Incorporated by reference to the Company’s Form 10-K for the fiscal year ended December 31, 2004.
 

 



Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 
NAUGATUCK VALLEY FINANCIAL CORPORATION
   
   
Date: March 28, 2006
By: /s/ John C. Roman
 
    John C. Roman
 
    President and Chief Executive Officer


Pursuant to the requirements of the Exchange Act, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

Name
  
Title
  
Date
         
         
/s/ John C. Roman
  
President, Chief Executive Officer
  
March 28, 2006
John C. Roman
  
  and Director
    
   
(principal executive officer)
    
         
         
/s/ Lee R. Schlesinger
  
Vice President and Treasurer
  
March 28, 2006
Lee R. Schlesinger
  
(principal accounting and
    
   
  financial officer)
    
         
         
/s/ Ronald D. Lengyel
  
Director
  
March 28, 2006
Ronald D. Lengyel
        
         
         
/s/ Carlos S. Batista
  
Director
  
March 28, 2006
Carlos S. Batista
        
         
         
/s/ Richard M. Famiglietti
  
Director
  
March 28, 2006
Richard M. Famiglietti
        
         
         
/s/ James A. Mengacci
  
Director
  
March 28, 2006
James A. Mengacci
        
         
         
/s/ Michael S. Plude
  
Director
  
March 28, 2006
Michael S. Plude
        
         
         
/s/ Camilo P. Vieira
  
Director
  
March 28, 2006
Camilo P. Vieira
        
         
         
/s/ Jane H. Walsh
  
Director
  
March 28, 2006
Jane H. Walsh
        
 
 EX-10.9 2 ex10-9.htm EX-10.9 EX-10.9
Exhibit 10.9


Naugatuck Valley Savings and Loan Change in Control Agreement
with William C. Nimons
 
 
 
 
 
 
 

CHANGE IN CONTROL AGREEMENT


This AGREEMENT (“Agreement”) is hereby entered into as of September 30, 2004, by and between NAUGATUCK VALLEY SAVINGS AND LOAN (the “Bank”), a federally chartered savings bank, with its principal offices at 333 Church Street, Naugatuck, Connecticut 06770, William C. Nimons (“Executive”), and NAUGATUCK VALLEY FINANCIAL CORPORATION (the “Company”), a federally chartered corporation and the holding company of the Bank, as guarantor.

WHEREAS, the Bank recognizes the importance of Executive to the Bank’s operations and wishes to protect his position with the Bank in the event of a change in control of the Bank or the Company for the period provided for in this Agreement; and

WHEREAS, Executive and the Board of Directors of the Bank desire to enter into an agreement setting forth the terms and conditions of payments due to Executive in the event of a change in control and the related rights and obligations of each of the parties.

NOW, THEREFORE, in consideration of the promises and mutual covenants herein contained, it is hereby agreed as follows:

1.
Term of Agreement.

a.    The term of this Agreement shall be (i) the initial term, consisting of the period commencing on the date of this Agreement (the “Effective Date”) and ending on the third anniversary of the Effective Date, plus (ii) any and all extensions of the initial term made pursuant to this Section 1.

b.    Commencing on the first anniversary of the Effective Date and continuing each anniversary date thereafter, the Board of Directors of the Bank (the “Board of Directors”) may extend the term of this Agreement for an additional one (1) year period beyond the then effective expiration date, provided that Executive shall not have given at least sixty (60) days’ written notice of his desire that the term not be extended.

c.    Notwithstanding anything in this Section to the contrary, this Agreement shall terminate if Executive or the Bank terminates Executive’s employment prior to a Change in Control.

2.
Change in Control.

a.    Upon the occurrence of a Change in Control of the Bank or the Company followed at any time during the term of this Agreement by the termination of Executive’s employment in accordance with the terms of this Agreement, other than for Cause, as defined in Section 2c. of this Agreement, the provisions of Section 3 of this Agreement shall apply. Upon the occurrence of a Change in Control, Executive shall have the right

 
 
 

to elect to voluntarily terminate his employment at any time during the term of this Agreement following an event constituting “Good Reason.”

“Good Reason” means, unless Executive has consented in writing thereto, the occurrence following a Change in Control, of any of the following:

 
i.
the assignment to Executive of any duties materially inconsistent with Executive’s position, including any material diminution in status, title, authority, duties or responsibilities, excluding for this purpose an isolated, insubstantial and inadvertent action not taken in bad faith and that is remedied by the Bank or Executive’s employer reasonably promptly after receipt of notice from Executive;

 
ii.
a reduction by the Bank or Executive’s employer of Executive’s base salary in effect immediately prior to the Change in Control;

 
iii.
the relocation of Executive’s office to a location more than twenty-five (25) miles from its location as of the date of this Agreement;

 
iv.
the taking of any action by the Bank or any of its affiliates or successors that would materially adversely affect Executive’s overall compensation and benefits package, unless such changes to the compensation and benefits package are made on a non-discriminatory basis and affect substantially all employees; or


 
v.
the failure of the Bank or the affiliate of the Bank by which Executive is employed, or any affiliate that directly or indirectly owns or controls any affiliate by which Executive is employed, to obtain the assumption in writing of the Bank’s obligation to perform this Agreement by any successor to all or substantially all of the assets of the Bank or such affiliate within thirty (30) days after a reorganization, merger, consolidation, sale or other disposition of assets of the Bank or such affiliate.
 
b.        For purposes of this Agreement, a “Change in Control” shall be deemed to occur on the earliest of any of the following events:

i.     Merger: The Company merges into or consolidates with another corporation, or merges another corporation into the Company, and as a result less than a majority of the combined voting power of the resulting corporation immediately after the merger or consolidation is held by persons who were stockholders of the Company immediately before the merger or consolidation.

ii.     Acquisition of Significant Share Ownership: There is filed, or is required to be filed, a report on Schedule 13D or another form or schedule (other than Schedule 13G) required under Sections 13(d) or 14(d) of the Securities Exchange

 
2
 

 Act of 1934, if the schedule discloses that the filing person or persons acting in concert has or have become the beneficial owner of 25% or more of a class of the Company’s voting securities, but this clause (b) shall not apply to beneficial ownership of Company voting shares held in a fiduciary capacity by an entity of which the Company directly or indirectly beneficially owns 50% or more of its outstanding voting securities.

iii.     Change in Board Composition: During any period of two consecutive years, individuals who constitute the Company’s Board of Directors at the beginning of the two-year period cease for any reason to constitute at least a majority of the Company’s Board of Directors; provided, however, that for purposes of this clause (iii), each director who is first elected by the board (or first nominated by the board for election by the stockholders) by a vote of at least two-thirds (2/3) of the directors who were directors at the beginning of the two-year period shall be deemed to have also been a director at the beginning of such period; or

iv.     Sale of Assets: The Company sells to a third party all or substantially all of its assets.

Notwithstanding anything in this Agreement to the contrary, in no event shall the reorganization of the Bank from the mutual holding company form of organization to the full stock holding company form of organization (including the elimination of the mutual holding company) constitute a “Change in Control” for purposes of this Agreement.

c.     Executive shall not have the right to receive termination benefits pursuant to Section 3 hereof upon termination for “Cause.” Termination for Cause shall mean termination of employment because of Executive’s personal dishonesty, incompetence, willful misconduct, any breach of fiduciary duty involving personal profit, intentional failure to perform stated duties, willful violation of any law, rule, regulation (other than traffic violations or similar offenses), final cease and desist order, or any material breach of any provision of this Agreement. Notwithstanding the foregoing, Executive shall not be deemed to have been terminated for Cause unless and until there shall have been delivered to him a copy of a resolution duly adopted by the affirmative vote of a majority of the entire membership of the Board of Directors at a meeting of the Board of Directors called and held for that purpose (after reasonable notice to Executive and an opportunity for him, together with counsel, to be heard before the Board of Directors), finding that, in the good faith opinion of the Board of Directors, Executive was guilty of conduct justifying termination for Cause and specifying the particulars thereof in detail. Executive shall not have the right to receive compensation or other benefits for any period after termination for Cause. During the period beginning on the date of the Notice of Termination for Cause pursuant to Section 4 hereof through the Date of Termination (as defined in Section 4), stock options granted to Executive under any stock option plan shall not be exercisable nor shall any unvested stock awards granted to Executive under any stock benefit plan of the Bank, the Company or any

 
3
 

subsidiary or affiliate thereof, vest. At the Date of Termination, such stock options and any such unvested stock awards shall become null and void and shall not be exercisable by or delivered to Executive at any time subsequent to such termination for Cause.

3.
Termination Benefits.

a.     If Executive’s employment is voluntarily (in accordance with Section 2a. of this Agreement) or involuntarily terminated within three (3) years of a Change in Control, Executive shall receive:

 
i.
a lump sum cash payment equal to three (3) times the Executive’s “base amount,” within the meaning of Section 280G(b)(3) of the Internal Revenue Code of 1986, as amended (the “Code”). Such payment shall be made not later than five (5) days following Executive’s termination of employment under this Section 3.

 
ii.
Continued benefit coverage under all Bank health and welfare plans (as defined in accordance with Section (3)(1) of the Employee Retirement Income Security Act of 1974 (“ERISA”), 29 U.S.C. Sec. 1002(1), and applicable regulations thereunder) which Executive participated in as of the date of the Change in Control (collectively, the “Employee Benefit Plans”) for a period of thirty-six (36) months following Executive’s termination of employment. Said coverage shall be provided under the same terms and conditions in effect on the date of Executive’s termination of employment. Solely for purposes of benefits continuation under the Employee Benefit Plans, Executive shall be deemed to be an active employee. To the extent that benefits required under this Section 3a. cannot be provided under the terms of any Employee Benefit Plan, the Bank shall enter into alternative arrangements that will provide Executive with comparable benefits.

b.     Notwithstanding the preceding provisions of this Section 3, in no event shall the aggregate payments or benefits to be made or afforded to Executive under said paragraphs (the “Termination Benefits”) constitute an “excess parachute payment” under Section 280G of the Code or any successor thereto, and to avoid such a result, Termination Benefits will be reduced, if necessary, to an amount (the “Non-Triggering Amount”), the value of which is one dollar ($1.00) less than an amount equal to three (3) times Executive’s “base amount,” as determined in accordance with said Section 280G. The allocation of the reduction required hereby among the Termination Benefits provided by this Section 3 shall be determined by Executive.
 
4.
Notice of Termination.

a.     Any purported termination by the Bank or by Executive shall be communicated by Notice of Termination to the other party hereto. For purposes of this Agreement, a “Notice of Termination” shall mean a written notice which shall indicate the specific termination provision in this Agreement relied upon and shall set forth in detail the facts and circumstances claimed to

 
4
 

provide a basis for termination of Executive’s employment under the provision so indicated.

b.     “Date of Termination” shall mean the date specified in the Notice of Termination (which, in the case of a termination for Cause, shall not be less than thirty (30) days from the date such Notice of Termination is given).

5.
Source of Payments.

All payments provided in this Agreement shall be timely paid in cash or check from the general funds of the Bank. The Company, however, unconditionally guarantees payment and provision of all amounts and benefits due hereunder to Executive and, if such amounts and benefits due from the Bank are not timely paid or provided by the Bank, such amounts and benefits shall be paid or provided by the Company.

6.     Effect on Prior Agreements and Existing Benefit Plans.

This Agreement contains the entire understanding between the parties hereto and supersedes any prior agreement between the Bank and Executive, except that this Agreement shall not affect or operate to reduce any benefit or compensation inuring to Executive of a kind elsewhere provided. No provision of this Agreement shall be interpreted to mean that Executive is subject to receiving fewer benefits than those available to him without reference to this Agreement. Nothing in this Agreement shall confer upon Executive the right to continue in the employ of the Bank or shall impose on the Bank any obligation to employ or retain Executive in its employ for any period.

7.     No Attachment.

a.     Except as required by law, no right to receive payments under this Agreement shall be subject to anticipation, commutation, alienation, sale, assignment, encumbrance, charge, pledge, or hypothecation or to execution, attachment, levy or similar process or assignment by operation of law, and any attempt, voluntary or involuntary, to affect any such action shall be null, void and of no effect.

b.     This Agreement shall be binding upon, and inure to the benefit of, Executive, the Bank and their respective successors and assigns.

8.     Modification and Waiver.

a.     This Agreement may not be modified or amended except by an instrument in writing signed by the parties hereto.

b.     No term or condition of this Agreement shall be deemed to have been waived, nor shall there be any estoppel against the enforcement of any provision of this Agreement, except by written instrument of the party charged with such waiver or estoppel. No such written waiver shall be deemed a continuing waiver unless specifically stated therein, and each such waiver shall operate only as to the specific term or condition waived and shall not constitute a waiver of

 
5
 

such term or condition for the future or as to any act other than that specifically waived.

9.     Severability.

If, for any reason, any provision of this Agreement, or any part of any provision, is held invalid, such invalidity shall not affect any other provision of this Agreement or any part of such provision not held so invalid, and each such other provision and part thereof shall to the full extent consistent with law continue in full force and effect.

10.
Headings for Reference Only.

The headings of sections and paragraphs herein are included solely for convenience of reference and shall not control the meaning or interpretation of any of the provisions of this Agreement. In addition, references herein to the masculine shall apply to both the masculine and the feminine.

11.
Governing Law.

Except to the extent preempted by federal law, the validity, interpretation, performance, and enforcement of this Agreement shall be governed by the laws of the State of Connecticut, without regard to principles of conflicts of law of that State.

12.
Arbitration.

Any dispute or controversy arising under or in connection with this Agreement shall be settled exclusively by arbitration, conducted before a panel of three arbitrators sitting in a location selected by Executive within fifty (50) miles from the location of the Bank, in accordance with the rules of the American Arbitration Association then in effect. Judgment may be entered on the arbitrator’s award in any court having jurisdiction; provided, however, that Executive shall be entitled to seek specific performance of his right to be paid until the Date of Termination during the pendency of any dispute or controversy arising under or in connection with this Agreement.

13.
Payment of Legal Fees.

All reasonable legal fees and expenses paid or incurred by Executive pursuant to any dispute or question of interpretation relating to this Agreement shall be paid or reimbursed by the Bank, only if Executive is successful pursuant to a legal judgment, arbitration or settlement.

14.           Indemnification.

The Company or the Bank shall provide Executive (including his heirs, executors and administrators) with coverage under a standard directors’ and officers’ liability insurance policy at its expense and shall indemnify Executive (and his heirs, executors and administrators) to the fullest extent permitted under applicable law against all expenses and liabilities reasonably incurred by him in connection with or arising out of any action, suit or proceeding in which he

 
6
 

may be involved by reason of his having been a director or officer of the Company or the Bank (whether or not he continues to be a director or officer at the time of incurring such expenses or liabilities), such expenses and liabilities to include, but not be limited to, judgments, court costs, attorneys’ fees and the costs of reasonable settlements.

15.           Successors to the Bank and the Company.

The Bank and the Company shall require any successor or assignee, whether direct or indirect, by purchase, merger, consolidation or otherwise, to all or substantially all of the business or assets of the Bank or the Company, expressly and unconditionally to assume and agree to perform the Bank’s and the Company’s obligations under this Agreement, in the same manner and to the same extent that the Bank and the Company would be required to perform if no such succession or assignment had taken place.


 
7
 


SIGNATURES

IN WITNESS WHEREOF, Naugatuck Valley Savings and Loan and Naugatuck Valley Financial Corporation have caused this Agreement to be executed and their seals to be affixed hereunto by their duly authorized officers, and Executive has signed this Agreement, on the 30th day of September, 2004.


ATTEST:
  
NAUGATUCK VALLEY SAVINGS AND LOAN
       
       
       
/s/ Bernadette A. Mole
  
By:
/s/ John C. Roman
Corporate Secretary
    
For the Entire Board of Directors
       
       
ATTEST:
  
NAUGATUCK VALLEY FINANCIAL CORPORATION
   
(Guarantor)
       
/s/ Bernadette A. Mole
  
By:
/s/ John C. Roman
Corporate Secretary
    
For the Entire Board of Directors
       
[SEAL]
      
       
       
WITNESS:
  
EXECUTIVE
       
       
       
/s/ Bernadette A. Mole
  
/s/ William C. Nimons
Corporate Secretary
  
William C. Nimons




8


 EX-13.0 3 ex13-0.htm EX-13.0 EX-23.0
 
 

Exhibit 13.0


Annual Report to Stockholders
 
 
 
 


The following table sets forth certain consolidated summary historical financial information concerning the financial position of Naugatuck Valley Financial and its subsidiary, Naugatuck Valley Savings, at the dates and for the periods indicated. The financial data is derived in part from, and should be read in conjunction with, the consolidated financial statements and related notes of Naugatuck Valley Financial appearing later in this annual report.


   
At December 31,
  
   
2005
  
2004
  
2003
  
2002
  
2001
  
   
(In thousands)
  
Financial Condition Data:
                                
Total assets 
  
$
355,346
  
$
265,449
  
$
243,956
  
$
227,998
  
$
201,105
  
Securities held to maturity 
    
5,002
    
5,168
    
1,561
    
1,364
    
596
  
Securities available for sale 
    
58,047
    
31,096
    
37,166
    
32,512
    
20,407
  
Loans receivable, net 
    
259,427
    
203,820
    
180,378
    
166,046
    
158,456
  
Cash and cash equivalents 
    
8,951
    
7,575
    
9,775
    
18,158
    
12,643
  
Deposits 
    
240,846
    
193,366
    
183,455
    
173,231
    
156,662
  
FHLB advances 
    
57,059
    
15,826
    
34,990
    
31,119
    
23,372
  
Total capital 
    
50,964
    
51,571
    
21,217
    
19,850
    
17,497
  

 
   
Year Ended December 31,
  
   
2005
  
2004
  
2003
  
2002
  
2001
  
   
(In thousands, except per share data)
  
Operating Data:
                                
Interest and dividend income 
  
$
15,908
  
$
12,713
  
$
12,644
  
$
13,178
  
$
12,631
  
Interest expense 
    
4,941
    
3,559
    
4,241
    
5,299
    
6,178
  
Net interest income 
    
10,967
    
9,154
    
8,403
    
7,879
    
6,453
  
Provision for loan losses 
    
32
    
-
    
45
    
231
    
80
  
Net interest income after provision for loan losses 
    
10,935
    
9,154
    
8,358
    
7,648
    
6,373
  
Noninterest income 
    
1,517
    
1,078
    
1,115
    
972
    
743
  
Noninterest expense 
    
10,097
    
9,803
    
6,845
    
5,820
    
5,392
  
Income before provision for income taxes 
    
2,355
    
429
    
2,628
    
2,800
    
1,724
  
Provision for income taxes 
    
450
    
14
    
822
    
880
    
542
  
Net income 
  
$
1,905
  
$
415
  
$
1,806
  
$
1,920
  
$
1,182
  
Net income per share
  
$
0.26
  
$
0.07
(1)
$
-
  
$
-
  
$
-
  

__________________
(1)
Net income per share is for the fourth quarter 2004. Before September 30, 2004, Naugatuck Valley Financial did not exist and Naugatuck Valley Savings operated as a mutual institution and, accordingly, had no per share data.


 
2




   
At or For the Year Ended December 31,
  
   
2005
  
2004
  
2003
  
2002
  
2001
  
       
Performance Ratios:
                                
Return on average assets
    
0.62
%
  
0.16
%
  
0.77
%
  
0.91
%
  
0.65
%
                                 
Return on average equity
    
3.66
    
1.42
    
8.59
    
10.23
    
6.95
  
                                 
Interest rate spread (1)
    
3.68
    
3.78
    
3.77
    
3.77
    
3.50
  
                                 
Net interest margin (2)
    
3.87
    
3.85
    
3.85
    
3.90
    
3.71
  
                                 
Noninterest expense to average assets
    
3.27
    
3.81
    
2.94
    
2.75
    
2.96
  
                                 
Efficiency ratio (3)
    
80.61
    
95.47
    
71.62
    
65.20
    
74.43
  
                                 
Dividend payout ratio (4)
    
61.54
    
-
    
-
    
-
    
-
  
                                 
Average interest-earning assets to average interest-bearing liabilities
    
111.20
    
104.98
    
103.69
    
105.20
    
105.87
  
                                 
Average equity to average assets
    
16.87
    
11.37
    
9.02
    
8.86
    
9.35
  
                                 
Capital Ratios:
                                
Total capital to risk-weighted assets
    
17.88
%
  
23.61
%
  
16.21
%
  
15.37
%
  
14.74
%
                                 
Tier 1 capital to risk-weighted assets
    
17.07
    
22.52
    
14.96
    
14.12
    
13.47
  
                                 
Tier 1 capital to adjusted total assets (5)
    
12.93
    
14.78
    
8.64
    
8.30
    
8.40
  
                                 
Total equity to total assets
    
14.34
    
19.43
    
8.70
    
8.71
    
8.70
  
                                 
Asset Quality Ratios:
                                
Allowance for loan losses as a percent of total loans
    
0.72
%
  
0.89
%
  
0.99
%
  
1.19
%
  
1.16
%
                                 
Allowance for loan losses as a percent of nonperforming loans
    
638.78
    
306.88
    
199.78
    
162.91
    
144.66
  
                                 
Net charge-offs (recoveries) to average loans outstanding
   during the period
    
0.01
    
(0.01
)
  
0.13
    
0.05
    
(0.02
)
                                 
Nonperforming loans as a percent of total loans
    
0.11
    
0.29
    
0.50
    
0.73
    
0.80
  
                                 
Nonperforming assets as a percent of total assets
    
0.10
    
0.25
    
0.46
    
0.58
    
0.72
  
                                 
Other Data:
                                
Number of:
                                
    Deposit accounts
    
25,592
    
22,599
    
22,447
    
22,059
    
21,823
  
    Full service customer service facilities
    
6
    
5
    
5
    
4
    
4
  
_________________________
(1)
Represents the difference between the weighted average yield on average interest-earning assets and the weighted average cost of interest-bearing liabilities.
(2)
Represents net interest income as a percent of average interest-earning assets.
(3)
Represents noninterest expense (less intangible amortization) divided by the sum of net interest income and noninterest income.
(4)
 
Represents dividends declared per share divided by basic net income per share.
(5)
  
Data for 2003 represents Tier 1 capital to average assets.

 
3


Financial Condition and Results of Operations

The objective of this section is to help the reader understand our views on our financial condition and results of operations. You should read this discussion in conjunction with the consolidated financial statements and notes to the financial statements that appear at the end of this annual report.

Overview

Income. We have two primary sources of pre-tax income. The first is net interest income, which is the difference between interest income, the income that we earn on our loans and investments, and interest expense, the interest that we pay on our deposits and borrowings.

To a much lesser extent, we also recognize pre-tax income from fees and service charges, which is the compensation we receive from providing products and services. Our primary noninterest income comes from fees and service charges on loan and deposit accounts. We also earn income from bank owned life insurance, sales of loans and investments and investment advisory services.

Expenses. The expenses we incur in operating our business consist of compensation, taxes and benefits, office occupancy, computer processing fees, advertising and professional fees and other expenses.

Compensation, taxes and benefits consist primarily of the salaries and wages paid to our employees and directors, payroll taxes and expenses for retirement and other employee benefits.

Occupancy expenses, which are the fixed and variable costs of buildings and equipment, consist primarily of lease payments, real estate taxes, depreciation charges, maintenance, and costs of utilities.

Computer processing fees includes fees paid to our third-party data processing servicer and our network security expenses.

Professional fees include fees paid for our attorneys, accountants and consultants.

Other expenses include expenses for insurance (including Federal Deposit Insurance Corporation insurance), postage, expenses associated with being a public company, expenses related to checking accounts, supervisory examinations and other miscellaneous operating activities.

Critical Accounting Policies

We consider accounting policies involving significant judgments and assumptions by management that have, or could have, a material impact on the carrying value of certain assets or on income to be critical accounting policies. We consider the following to be critical accounting policies: allowance for loan losses and deferred income taxes.

Allowance for Loan Losses. Determining the amount of the allowance for loan losses necessarily involves a high degree of judgment. Management reviews the level of the allowance on a quarterly basis, at a minimum, and establishes the provision for loan losses based on the composition of the loan portfolio, delinquency levels, loss experience, economic conditions, and other factors related to the collectibility of the loan portfolio.

Although we believe that we use the best information available to establish the allowance for loan losses, future additions to the allowance may be necessary based on estimates that are susceptible to change as a result of changes in economic conditions and other factors. We engage an independent review of our commercial loan portfolio annually and adjust our loan ratings based upon this review. In addition, our banking regulators as an integral part of their examination process, periodically review our allowance for loan losses. Such agencies may

 
4

require us to recognize adjustments to the allowance based on its judgments about information available to it at the time of its examination. See notes 2 and 4 of the notes to the financial statements included in this annual report.

Deferred Income Taxes. We use the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. If current available information raises doubt as to the realization of the deferred tax assets, a valuation allowance is established. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. We exercise significant judgment in evaluating the amount and timing of recognition of the resulting tax liabilities and assets, including projections of future taxable income. These judgments and estimates are reviewed periodically as regulatory and business factors change. See note 11 of the notes to the financial statements in this annual report.

Operating Strategy

At Naugatuck Valley Financial we are driven to grow and become more profitable by delivering the products our customers want, expanding our branch facilities and providing superior service. We manage our assets and liabilities using strategies to increase our net interest margin and limit interest rate risk. In order to decrease our reliance on net interest income, we continue to pursue initiatives to increase non-interest income. In addition, we apply conservative underwriting practices to maintain the quality of our loan portfolio and we are dedicated to regulatory compliance.

New products, branch expansion and superior service

We currently offer a wide array of products designed to meet the financial needs of existing and potential customers. We continue to enhance delivery of these products through branch expansion and through the training of existing employees and hiring of new employees skilled in the delivery of superior customer service. We have improved the presentation of our internet banking and bill pay systems and maintain a “voice response” inquiry phone line to provide service to customers without internet access. During 2005, we supplemented our existing product offerings with an overdraft privilege product, a tiered money market account, a bump-up certificate of deposit product, the origination of reverse mortgages and a brokerage arrangement for mortgages which do not meet our underwriting standards.

In addition, we have expanded and improved our branch facilities in the Greater Naugatuck Valley of Connecticut. During 2005, we opened a new branch in Seymour and moved our Shelton Branch to a larger and more convenient location. Early in 2006, we broke ground for a new office in the Southford section of Southbury. During 2006, we will improve the accessibility and convenience of our Beacon Falls branch with enhancements to the drive-up and ATM facilities. We will continue to upgrade our current branch facilities and to pursue expansion in the Greater Naugatuck Valley in future years through de novo branching and branch acquisitions. We also may consider exploring expansion opportunities in surrounding counties.

We differentiate ourselves from our larger competitors through our community orientation and through the delivery of superior customer service. We provide sales training to our customer contact employees and provide incentives for them to cross sell and maintain high levels of service. We have also increased marketing expenditures to more effectively “get the word out” about our products, services and image. We have been successful in attracting new employees with skill sets needed to help us to accomplish our goal of profitable growth. During 2005, we hired an experienced Chief Lending Officer, a commercial and industrial lender and two employees experienced in the origination of residential mortgages. In addition, we also supplemented our financial staff with an experienced controller.

Asset and liability management

Historically, we have pursued a strategy of maintaining a high loan-to-asset ratio. This strategy requires us to prudently deploy our sources of funds, primarily deposits, into new loans. As of December 31, 2005, our loan to asset ratio was 73%, down from 77% as of December 31, 2004. During 2005 we experienced significant loan and deposit growth as a result of the sales efforts of our employees combined with focused marketing efforts. We are

 
5

experienced in operating with a high loan-to-asset ratio and this experience served us well in 2005 as we successfully managed our net interest margin and net interest income by investing funds in high quality residential mortgages, consumer lines of credit and small business and development loans.

We utilize a number of tools to increase net interest income and decrease interest rate risk. These tools include the purchase of short-term investments and the pursuit of a leverage strategy under which we fund our investments with lower cost borrowings.

Increasing non-interest income

We strive to decrease reliance on net interest income by increasing our sources and amount of non-interest income. Income from investment advisory services grew in 2005 and was supplemented with new income from our overdraft protection services, reverse mortgages and the brokerage arrangement for mortgages that do not meet our underwriting standards. We also increased our investment in bank-owned life insurance during 2005 which provides an additional source of non-interest income. We intend to continue to explore opportunities to increase non-interest income in the future.

Credit quality

We are dedicated to strict adherence to our conservative underwriting standards that we believe allows us to limit charge-offs and limit additions to our loan loss reserves in the future. At the same time we are committed to the maintenance of adequate loan loss reserves.

Regulatory compliance and protection of confidential customer data

We operate in a highly regulated industry and understand the importance of regulatory compliance to the safety and soundness of our bank system. We have an excellent record of compliance and it is our goal to maintain that record. We have also taken steps necessary to assure that all of our customers personal data is safeguarded from unauthorized access. 

Balance Sheet

Loans. Our principal lending activity is the origination of loans secured by real estate primarily located in our market area. We originate real estate loans secured by one- to four-family residential homes and, to a much lesser but growing extent, we originate multi-family and commercial real estate and construction loans. At December 31, 2005, real estate loans totaled $215.5 million, or 81.6% of total loans compared to $174.8 million, or 84.0% of total loans at December 31, 2004 and $159.7 million, or 86.3% of total loans at December 31, 2003. Real estate loans have increased since December 31, 2001 due to historically low interest rates, our expanding branch network and significant growth in both residential and commercial real estate development, which we believe is attributable to the availability of lower cost land in the Greater Naugatuck Valley area and the expansion of commuting patterns out of southwestern Connecticut.

The largest segment of our real estate loans is one- to four-family residential loans. At December 31, 2005, these loans totaled $156.9 million and represented 72.8% of real estate loans and 59.4% of total loans compared to $134.8 million, which represented 77.1% of real estate loans and 64.8% of total loans, at December 31, 2004. One- to four-family residential loans increased $22.1 million, or 16.4%, from December 31, 2004 to December 31, 2005 and increased $3.4 million, or 2.6%, from December 31, 2003 to December 31, 2004, reflecting a large volume of loan originations offset by loan repayments. In periods of low and falling interest rates, loan demand increases, but repayments of loans also increase as borrowers refinance in order to benefit from lower available interest rates.
 
Multi-family and commercial real estate loans are the second largest segment of our real estate loan portfolio. This portfolio was $33.6 million and represented 15.6% of real estate loans and 12.7% of total loans at December 31, 2005 compared to $22.6 million, which represented 12.9% of real estate loans and 10.8% of total loans, at December 31, 2004. Multi-family and commercial real estate loans increased $11.0 million, or 49.0%, for the year ended December 31, 2005 and $8.3 million, or 58.1%, in the year ended December 31, 2004 due to significant new development within parts of our market area and increased market share.

 
6


We also originate construction loans secured by residential and commercial real estate. This portfolio was $24.9 million and represented 11.6% of real estate loans and 9.5% of total loans at December 31, 2005 compared to $17.5 million, which represented 10.0% of real estate loans and 8.4% of total loans at December 31, 2004. Construction loans increased $7.4 million, or 42.6%, for the year ended December 31, 2005 and $3.4 million, or 24.1%, in the year ended December 31, 2004 primarily due to significant new development within parts of our market area and increased market share.

We originate commercial business loans secured by business assets other than real estate, such as business equipment, inventory and accounts receivable and letters of credit. Commercial business loans totaled $9.7 million, and represented 3.7% of total loans at December 31, 2005, compared to $5.0 million, representing 2.4% of total loans, at December 31, 2004.
 
We also originate a variety of consumer loans, including second mortgage loans, home equity lines of credit and loans secured by savings accounts and automobiles. Consumer loans totaled $38.8 million and represented 14.7% of total loans at December 31, 2005, compared to $28.3 million, which represented 13.6% of total loans at December 31, 2004. The $10.5 million, or 36.9%, increase for the year ended December 31, 2005 and the $7.3 million, or 34.4%, increase for the 2004 fiscal year was due to targeted increased marketing activities and competitive pricing on our home equity products.




 
7


The following table sets forth the composition of our loan portfolio at the dates indicated.

   
At December 31,
  
   
2005
  
2004
  
2003
  
2002
  
2001
  
   
Amount
  
Percent
  
Amount
  
Percent
  
Amount
  
Percent
  
Amount
  
Percent
  
Amount
  
Percent
  
   
(Dollars in thousands)
  
Real estate loans:
                                                              
    One- to four-family
  
$
156,900
    
59.44
%
$
134,785
    
64.75
%
$
131,353
    
70.98
%
$
132,134
    
77.85
%
$
126,482
    
78.07
%
    Construction
    
24,943
    
9.45
    
17,486
    
8.40
    
14,094
    
7.62
    
6,888
    
4.06
    
6,526
    
4.03
  
    Multi-family and commercial
      real estate
    
33,608
    
12.73
    
22,559
    
10.84
    
14,273
    
7.71
    
10,285
    
6.06
    
7,172
    
4.43
  
        Total real estate loans
    
215,451
    
81.62
    
174,830
    
83.99
    
159,720
    
86.31
    
149,307
    
87.97
    
140,180
    
86.52
  
Commercial business loans
    
9,728
    
3.69
    
4,989
    
2.40
    
4,240
    
2.29
    
1,693
    
1.00
    
875
    
0.54
  
Consumer loans:
                                                              
    Savings accounts
    
785
    
0.30
    
679
    
0.33
    
592
    
0.32
    
519
    
0.31
    
738
    
0.46
  
    Personal
    
212
    
0.08
    
217
    
0.10
    
139
    
0.08
    
153
    
0.09
    
116
    
0.07
  
    Automobile
    
160
    
0.06
    
98
    
0.05
    
143
    
0.08
    
181
    
0.11
    
291
    
0.18
  
    Home equity
    
37,628
    
4.25
    
27,342
    
13.13
    
20,212
    
10.92
    
17,873
    
10.53
    
19,815
    
12.23
  
        Total consumer loans
    
38,785
    
14.69
    
28,336
    
13.61
    
21,086
    
11.40
    
18,726
    
11.03
    
20,960
    
12.94
  
            Total loans
    
263,964
    
100.00
%
  
208,155
    
100.00
%
  
185,046
    
100.00
%
  
169,726
    
100.00
%
  
162,015
    
100.00
%
                                                               
Less:
                                                              
    Allowance for loan losses
    
1,878
          
1,829
          
1,810
          
1,994
          
1,856
        
    Undisbursed construction loans
    
2,258
          
2,094
          
2,519
          
1,168
          
1,071
        
    Deferred loan origination fees
    
401
          
412
          
339
          
518
          
632
        
            Loans receivable, net
  
$
259,427
        
$
203,820
        
$
180,378
        
$
166,046
        
$
158,456
        






 
8


The following table sets forth certain information at December 31, 2005 regarding the dollar amount of loans repricing or maturing during the periods indicated. The table does not include any estimate of prepayments which significantly shorten the average life of all loans and may cause our actual repayment experience to differ from that shown below. Demand loans having no stated maturity are reported as due in one year or less.

   
At December 31, 2005
  
   
Real Estate
Loans
  
Commercial
Business
Loans
  
Consumer
Loans
  
Total
Loans
  
   
(In thousands)
  
One year or less
  
$
34,232
  
$
5,442
  
$
19,686
  
$
59,360
  
More than one year to five years
    
34,685
    
2,591
    
3,399
    
40,675
  
More than five years
    
146,534
    
1,695
    
15,700
    
163,929
  
    Total
  
$
215,451
  
$
9,728
  
$
38,785
  
$
263,964
  

The following table sets forth the dollar amount of all loans at December 31, 2005 that are due after December 31, 2006 and have either fixed interest rates or floating or adjustable interest rates. The amounts shown below exclude applicable loans in process, nonperforming loans and deferred loan fees, net.

   
Fixed-Rates
  
Floating or
Adjustable-
Rates
  
Total
  
   
(In thousands)
  
Real estate loans:
                    
    One- to four-family
  
$
122,673
  
$
21,633
  
$
144,306
  
    Construction
    
5,068
    
995
    
6,063
  
    Multi-family and commercial
    
3,138
    
27,712
    
30,850
  
Commercial business loans
    
1,693
    
2,593
    
4,286
  
Consumer loans
    
17,160
    
1,939
    
19,099
  
        Total
  
$
149,732
  
$
54,872
  
$
204,604
  
 
The following table shows loan origination activity during the periods indicated.

   
Year Ended December 31,
  
   
2005
  
2004
  
2003
  
   
(In thousands)
  
               
Total loans at beginning of period
  
$
208,155
  
$
185,046
  
$
169,726
  
Loans originated:
                    
    Real estate loans:
                    
        One- to four-family
    
42,144
    
30,002
    
64,689
  
        Construction
    
27,695
    
20,598
    
13,489
  
        Multi-family and commercial
    
23,389
    
10,865
    
5,365
  
    Commercial business loans
    
6,308
    
3,962
    
3,196
  
    Consumer loans
    
24,664
    
18,416
    
14,307
  
            Total loans originated
    
124,200
    
83,843
    
101,046
  
Loans purchased
    
—
    
—
    
—
  
Deduct:
                    
    Real estate loan principal repayments
    
(52,607
)
  
(44,622
)
  
(67,857
)
    Loan sales
    
—
    
(1,927
)
  
(8,851
)
    Other repayments
    
(15,784
)
  
(14,185
)
  
(9,018
)
Net loan activity
    
55,809
    
23,109
    
15,320
  
Total loans at end of period
  
$
263,964
  
$
208,155
  
$
185,046
  


 
9

Allowance for Loan Losses and Asset Quality. The allowance for loan losses is a valuation allowance for the probable losses inherent in the loan portfolio. We evaluate the need to establish allowances against losses on loans on a quarterly basis. When additional allowances are needed a provision for loan losses is charged against earnings. The recommendations for increases or decreases to the allowance are presented by management to the Board of Directors.

The allowance for loan losses is established to recognize the inherent losses associated with lending activities. Loss and risk factors are based on our historical loss experience and industry averages and may be adjusted for significant factors that in management’s judgment affect the collectibility of the portfolio as of the evaluation date. These significant factors may include changes in lending policies and procedures, changes in existing general economic and business conditions affecting our primary lending area, credit quality trends, collateral value, loan volumes and concentrations, seasoning of the loan portfolio, specific industry conditions within portfolio segments, recent loss experience in particular segments of the portfolio, duration of the current business cycle, and bank regulatory examination results.

Our methodology for assessing the appropriateness of the allowance for loan losses consists of the following procedures. The loan portfolio is segregated first between passed and classified assets.

Passed Assets. Our assets designated as pass or bankable with care by our internal classification system are aggregated by loan category and an allowance percentage is assigned based on estimated inherent losses associated with each type of lending. Our passed and bankable with care assets are loans for which the borrower is established and represents a reasonable credit risk.

We retain a general loan loss allowance on loans classified as passed. This portion of our allowance is determined based on our historical loss experience, delinquency trends, and management’s evaluation of the loan portfolio and may be adjusted for significant factors that in management’s judgment affect the collectibility of the portfolio as of the evaluation date. These significant factors may include changes in general economic and business conditions affecting our primary lending areas, credit quality trends, collateral value, loan volumes and concentrations, seasoning of the loan portfolio, recent loss experience in particular segments of the portfolio, duration of the current business cycle and bank regulatory examination results. These factors are reviewed regularly to ensure their relevance in the prevailing business environment.

Classified Assets. Our assets classified internally as special mention, substandard or doubtful (all regulatory classifications for problem assets) by our internal classification system are individually evaluated by management and an allowance percentage, increasing as the probability of loss increases, is assigned to each classified asset based on the collateral value and loan balance. The level of the allowance percentage is further dependent on whether the loan is secured by real estate, secured by assets other than real estate or unsecured. Loans classified as loss are charged off and, if the loan is secured by real estate collateral, the real estate is transferred to foreclosed real estate.

The loss factors allowance percentages which are presently used to determine the reserve level were updated in 2005 based on various risk factors such as type of loan, collateral and loss history. These factors are subject to ongoing evaluation to ensure their relevance to our loan portfolio in the current economic environment.

When we determine that a loan is troubled and where, based on current information and events, it is probable that we will not be able to collect all amounts due, the excess of the recorded investment in the loan over the fair market value of any collateral, net of estimated costs to sell the asset, is classified as loss, and we classify the remainder of the loan balance is classified as substandard the remainder.

We identify loans which may require charge off as a loss are identified by reviewing all delinquent loans, significant credits, loans classified as substandard, doubtful, loss, or special mention by our internal classification system, all classified loans, and other loans that management may have concerns about collectibility, such as loans to a specific industry. For individually reviewed loans, a borrower’s inability to service a credit according to the contractual terms based on the borrower’s cash flow and or a shortfall in collateral value would result in the recording of a charge off of the loan or the portion of the loan that was impaired.

 
10



Our banking regulators, as an integral part of their examination process, periodically review our allowance for loan losses. The examinations may require us to make additional provisions for loan losses based on judgments different from ours. In addition, we engage an independent consultant to review our commercial loan portfolio and make recommendations based on their review as to the classification of specific credits in the portfolio.

The following table sets forth the breakdown of the allowance for loan losses based on the components of our allowance at the dates indicated.

   
At December 31, 2005
  
At December 31, 2004
  
   
(In thousands)
  
       
Passed assets
  
$
1,425
  
$
1,343
  
Classified assets
    
450
    
389
  
Unallocated
    
3
    
97
  
Total
  
$
1,425
  
$
1,829
  
 
At December 31, 2005, our allowance for loan losses represented 0.72% of total gross loans and 638.78% of nonperforming loans. The allowance for loan losses increased $49,000 from December 31, 2004 to December 31, 2005. The increase in the allowance was the result of net recoveries and provisions for loan losses.

At December 31, 2004, our allowance for loan losses represented 0.89% of total gross loans and 306.88% of nonperforming loans. The allowance for loan losses increased $19,000 from December 31, 2003 to December 31, 2004 due to net recoveries.

Total nonperforming loans decreased during the year ended December 31, 2005 due to improved asset quality and favorable economic conditions. The Company recorded a provision for loan losses of $32,000 during the year ended December 31, 2005. There were no additions to the provisions made in the 2004 period.

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


 
11

Summary of Loan Loss Experience. The following table sets forth an analysis of the allowance for loan losses for the periods indicated. Where specific loan loss allowances have been established, any difference between the loss allowance and the amount of loss realized has been charged or credited to current income.

   
Year Ended December 31,
  
   
2005
  
2004
  
2003
  
2002
  
2001
  
   
(Dollars in thousands)
  
                       
Allowance at beginning of period
  
$
1,829
  
$
1,810
  
$
1,994
  
$
1,856
  
$
1,749
  
Provision for loan losses
    
32
    
—
    
45
    
231
    
80
  
Less: Charge offs:
                                
    Real estate loans
    
—
    
—
    
265
    
112
    
28
  
    Commercial business loans
    
3
    
51
    
—
    
—
    
—
  
    Consumer loans
    
1
    
5
    
2
    
5
    
3
  
        Total charge-offs
    
4
    
56
    
267
    
117
    
31
  
                                 
Plus: Recoveries:
                                
    Real estate loans
    
18
    
43
    
38
    
23
    
57
  
    Commercial business loans
    
3
    
—
    
—
    
—
    
—
  
    Consumer loans
    
—
    
32
    
—
    
1
    
1
  
        Total recoveries
    
21
    
75
    
38
    
24
    
58
  
Net charge-offs (recoveries)
    
(17
)
  
(19
)
  
229
    
93
    
(27
)
                                 
    Allowance at end of period
  
$
1,878
  
$
1,829
  
$
1,810
  
$
1,994
  
$
1,856
  
                                 
Allowance to nonperforming loans
    
638.78
%
  
306.88
%
  
199.78
%
  
162.91
%
  
144.66
%
Allowance to total loans outstanding at the end of the period
    
0.72
%
  
0.89
%
  
0.99
%
  
1.19
%
  
1.16
%
Net charge-offs (recoveries) to average loans outstanding during the period
    
0.01
%
  
(0.01
)%
  
0.13
%
  
0.05
%
  
(0.02
)%

The following table sets forth the breakdown of the allowance for loan losses by loan category at the dates indicated. 
 
   
At December 31,
  
   
2005
  
2004
  
2003
  
   
Amount
  
% of
Allowance
to Total
Allowance
  
% of
Loans in
Category
to Total
Loans
  
Amount
  
% of
Allowance
to Total
Allowance
  
% of
Loans in
Category
to Total
Loans
  
Amount
  
% of
Allowance
to Total
Allowance
  
% of
Loans in
Category
to Total
Loans
  
   
(Dollars in thousands)
  
One- to four-family
  
$
724
    
38.55
%
  
59.44
%
$
864
    
47.25
%
  
64.75
%
$
927
    
51.22
%
  
70.98
%
Construction
    
376
    
20.02
    
9.45
    
142
    
7.76
    
8.40
    
185
    
10.22
    
7.62
  
Multi-family and commercial real estate
    
379
    
20.18
    
12.73
    
374
    
20.45
    
10.84
    
321
    
17.73
    
7.71
  
Commercial business
    
113
    
6.02
    
3.69
    
50
    
2.73
    
2.40
    
92
    
5.08
    
2.29
  
Consumer loans
    
283
    
15.07
    
14.69
    
302
    
16.51
    
13.61
    
232
    
12.82
    
11.40
  
Unallocated
    
3
    
0.16
    
—
    
97
    
5.30
    
—
    
53
    
2.93
    
—
  
    Total allowance for loan losses
  
$
1,878
    
100.00
%
  
100.00
%
$
1,829
    
100.00
%
  
100.00
%
$
1,810
    
100.00
%
  
100.00
%



 
12


   
At December 31,
  
   
2002
  
2001
  
   
Amount
  
% of
Allowance
to Total
Allowance
  
% of
Loans in
Category
to Total
Loans
  
Amount
  
% of
Allowance
to Total
Allowance
  
% of
Loans in
Category
to Total
Loans
  
   
(Dollars in thousands)
  
                           
One- to four-family
  
$
1,566
    
78.54
%
  
77.85
%
$
1,633
    
87.98
%
  
78.07
%
Construction
    
100
    
5.02
    
4.06
    
44
    
2.37
    
4.03
  
Multi-family and commercial real estate
    
148
    
7.42
    
6.06
    
37
    
1.99
    
4.43
  
Commercial business
    
59
    
2.96
    
1.00
    
4
    
0.22
    
0.54
  
Consumer loans
    
78
    
3.91
    
11.03
    
83
    
4.47
    
12.93
  
Unallocated
    
43
    
2.16
    
—
    
55
    
2.96
    
—
  
    Total allowance for loan losses
  
$
1,994
    
100.00
%
  
100.00
%
$
1,856
    
100.00
%
  
100.00
%


Nonperforming and Classified Assets. When a loan becomes 90 days delinquent, the loan is placed on nonaccrual status at which time the accrual of interest ceases, the interest previously accrued to income is reversed and the loan is placed on a cash basis. Payments on a nonaccrual loan are applied to the outstanding principal and interest as determined at the time of collection of the loan.

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

Nonperforming assets totaled $341,000, or 0.10% of total assets, at December 31, 2005, which was a decrease of $323,000, or 48.6%, from December 31, 2004. Nonaccrual loans accounted for 86.2% of the total nonperforming assets at December 31, 2005. At December 31, 2005, $40,000 of the allowance for loan losses was related to nonaccrual real estate loans.

Nonperforming assets totaled $664,000, or 0.25% of total assets, at December 31, 2004, which was a decrease of $450,000, or 40.4%, from December 31, 2003. Nonaccrual loans accounted for 89.8% of the total nonperforming assets at December 31, 2004. At December 31, 2004, $74,000 of the allowance for loan losses was related to nonaccrual real estate loans.

Under current accounting guidelines, a loan is defined as impaired when, based on current information and events, it is probable that the creditor will be unable to collect all amounts due under the contractual terms of the loan agreement. We consider one- to four-family mortgage loans and consumer loans to be homogeneous and only evaluate them for impairment separately when they are delinquent or classified. Other loans are evaluated for impairment on an individual basis. At December 31, 2005, no loans were considered impaired.


 
13

The following table provides information with respect to our nonperforming assets at the dates indicated. We did not have any troubled debt restructurings or any accruing loans past due 90 days or more at the dates presented.

   
At December 31,
  
   
2005
  
2004
  
2003
  
2002
  
2001
  
   
(Dollars in thousands)
  
Nonaccrual loans:
                                
    One- to four-family
  
$
165
  
$
474
  
$
500
  
$
1,041
  
$
1,217
  
    Multi-family and commercial real estate
    
120
    
119
    
315
    
117
    
—
  
    Commercial business
    
9
    
3
    
15
    
—
    
—
  
    Consumer
    
—
    
—
    
76
    
66
    
66
  
        Total
    
294
    
596
    
906
    
1,224
    
1,283
  
                                 
Foreclosed real estate
    
47
    
68
    
208
    
108
    
160
  
                                 
Total nonperforming assets
  
$
341
  
$
664
  
$
1,114
  
$
1,332
  
$
1,443
  
                                 
Total nonperforming loans to total loans
    
0.11
%
  
0.29
%
  
0.50
%
  
0.73
%
  
0.80
%
                                 
Total nonperforming loans to total assets
    
0.08
%
  
0.22
%
  
0.37
%
  
0.54
%
  
0.64
%
                                 
Total nonperforming assets to total assets
    
0.10
%
  
0.25
%
  
0.46
%
  
0.58
%
  
0.72
%

Other than disclosed above, there are no other loans at December 31, 2005 that we have serious doubts about the ability of the borrowers to comply with the present loan repayment terms.

Interest income that would have been recorded for the years ended December 31, 2005 and December 31, 2004 had nonaccruing loans been current according to their original terms amounted to $20,900 and $44,600, respectively. Income related to nonaccrual loans included in interest income for the years ended December 31, 2005 and December 31, 2004 amounted to $19,600 and $20,000, respectively.

Federal regulations require us to regularly review and classify our assets. In addition, our regulators have the authority to identify problem assets and, if appropriate, require them to be classified. There are three classifications for problem assets: substandard, doubtful and loss. “Substandard assets” must have one or more defined weaknesses and are characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected. “Doubtful assets” have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified “loss” is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. The regulations also provide for a “special mention” category, described as assets which do not currently expose us to a sufficient degree of risk to warrant classification but do possess credit deficiencies or potential weaknesses deserving our close attention. When we classify an asset as substandard or doubtful, we must establish a general allowance for loan losses. If we classify an asset as loss, we must charge off such amount.


 
14

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

   
At December 31,
  
   
2005
  
2004
  
   
(In thousands)
  
           
Special mention assets
  
$
5,197
  
$
3,022
  
Substandard assets
   
1,360
    
2,058
  
Doubtful assets
    
10
    
—
  
Loss assets
    
—
    
—
  
    Total classified assets
  
$
6,567
  
$
5,080
  

Special mention assets at December 31, 2005 and December 31, 2004 did not include any nonaccrual loans. Substandard assets at December 31, 2005 and December 31, 2004 included nonaccrual loans of $284,000 and $581,000, respectively. All doubtful assets at December 31, 2005 and December 31, 2004 were nonaccrual loans and all loss assets at December 31, 2005 were nonaccrual loans.

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

   
At December 31,
  
   
2005
  
2004
  
2003
  
   
30-59 Days
Past Due
  
60-89 Days
Past Due
  
30-59 Days
Past Due
  
60-89 Days
Past Due
  
30-59 Days
Past Due
  
60-89 Days
Past Due
  
   
(In thousands)
  
                           
One- to four-family
  
$
792
  
$
498
  
$
2,017
  
$
581
  
$
999
  
$
670
  
Multi-family and commercial real estate
    
—
    
—
    
510
    
150
    
272
    
62
  
Commercial business
    
164
    
—
    
64
    
15
    
20
    
—
  
Consumer loans
    
7
   
—
    
135
    
12
    
61
    
75
  
    Total
  
$
963
  
$
498
  
$
2,726
  
$
758
  
$
1,352
  
$
807
  

Securities. Our securities portfolio consists primarily of U.S. Government and agency obligations as well as mortgage-backed securities and collateralized mortgage obligations with maturities of 30 years or less. Securities increased by $26.8 million in the year ended December 31, 2005 primarily due to the purchase of securities funded primarily through Federal Home Loan Bank advances. Securities decreased by $2.5 million in the year ended December 31, 2004 primarily due to the sale of $9.3 million of securities with a weighted average rate of 3.56%. This was partially offset by the purchase of new securities using proceeds from the stock offering. Substantially all of our mortgage-backed securities and collateralized mortgage obligations were issued either by Ginnie Mae, Fannie Mae or Freddie Mac. Our securities portfolio also includes a private label collateralized mortgage obligation along with municipal obligations, money market preferred obligations and, to a lesser extent, corporate obligations and interest-bearing balances (certificates of deposits) at other institutions. The interest-bearing balances are all held-to-maturity and all mature within three years.


 
15

The following table sets forth the amortized costs and fair values of our securities portfolio at the dates indicated.

   
At December 31,
  
   
2005
  
2004
  
2003
  
   
Amortized
Cost
  
Fair
Value
  
Amortized
Cost
  
Fair
Value
  
Amortized
Cost
  
Fair
Value
  
   
(In thousands)
  
Available-for-sale securities:
                                      
    U.S. Government and agency obligations 
  
$
8,497
  
$
8,369
  
$
15,072
  
$
15,210
  
$
22,861
  
$
23,356
  
    Mortgage-backed securities
    
22,544
    
22,082
    
12,249
    
12,092
    
7,865
    
7,748
  
    Collateralized mortgage obligations
    
4,199
    
4,098
    
3,812
    
3,794
    
6,031
    
6,062
  
    Municipal obligations
    
8,715
    
8,769
    
—
    
—
    
—
    
—
  
    Money market preferred obligations
    
6,000
    
6,000
    
—
    
—
    
—
    
—
  
    Corporate obligations
    
1,928
    
1,923
    
—
    
—
    
—
    
—
  
                                       
Held-to-maturity securities:
                                      
    U.S. Government and agency obligations
    
1,202
    
1,189
    
703
    
708
    
706
    
722
  
    Interest-bearing balances
    
3,800
    
3,800
    
4,465
    
4,465
    
855
    
855
  
        Total
  
$
56,885
  
$
56,230
  
$
36,301
  
$
36,269
  
$
38,318
  
$
38,743
  

At December 31, 2005, we did not own any securities, other than U.S. Government and agency securities, that had an aggregate book value in excess of 10% of our total capital at that date.




 
16


The following table sets forth the final maturities and weighted average yields of securities at December 31, 2005. Mortgage-backed securities and collateralized mortgage obligations are secured by mortgages and as a result produce monthly principal repayments which are not reflected in the table below. Certain mortgage-backed securities, collateralized mortgage obligations and money market preferred obligations have adjustable interest rates and reprice within the various maturity ranges. These repricing schedules are not reflected in the table below. At December 31, 2005, mortgage-backed securities and collateralized mortgage obligations with adjustable rates totaled $26.5 million.

   
Less Than
One Year
  
More than
One Year to
Five Years
  
More than
Five Years to
Ten Years
  
More than
Ten Years
  
Total
  
   
Carrying
Value
  
Weighted
Average
Yield
  
Carrying
Value
  
Weighted
Average
Yield
  
Carrying
Value
  
Weighted
Average
Yield
  
Carrying
Value
  
Weighted
Average
Yield
  
Carrying
Value
  
Weighted
Average
Yield
  
   
(Dollars in thousands)
  
Available-for-sale securities:
                                                              
  U.S. Government and agency
    obligations
  
$
6,806
    
4.22
%
$
7,404
    
4.13
%
$
965
    
5.52
%
$
—
    
—
%
$
15,175
    
4.26
%
  Mortgage-backed securities
    
—
    
—
    
1,836
    
3.70
    
—
    
—
    
20,246
    
4.44
    
22,082
    
4.38
  
  Collateralized mortgage
    obligations
    
—
    
—
    
—
    
—
    
—
    
—
    
4,098
    
4.17
    
4,098
    
4.17
  
  Municipal obligations
    
—
    
—
    
—
    
—
    
—
    
—
    
8,769
    
4.77
    
8,769
    
4.77
  
  Money market preferred
    obligations
    
6,000
    
3.66
   
—
    
—
    
—
    
—
    
—
    
—
    
6,000
    
3.66
  
  Corporate obligations
    
—
    
—
    
192
    
5.21
    
—
    
—
    
—
    
—
    
1,923
    
5.21
  
      Total available-for-sale securities
    
12,806
    
3.96
    
11,163
    
4.25
    
965
    
5.52
    
33,113
    
4.49
    
58,047
    
4.34
  
                                                               
Held-to-maturity securities:
                                                              
  U.S. Government and agency
    obligations
    
—
          
1,202
    
4.10
    
—
    
—
    
—
    
—
    
1,202
    
4.10
  
Interest-bearing balances
    
2,470
    
2.34
    
1,330
    
3.16
    
—
    
—
    
—
    
—
    
3,800
    
2.63
  
        Total held-to-maturity securities
    
2,470
    
2.34
    
2,532
    
3.61
    
—
    
—
    
—
    
—
    
5,002
    
2.98
  
        Total
  
$
15,276
    
3.70
  
$
13,695
    
4.13
  
$
965
    
5.52
  
$
33,113
    
4.49
  
$
63,049
    
4.24
  
                                                               



 
17


Bank Owned Life Insurance. During 2003, we purchased life insurance policies on certain key executives. We purchased $2.5 million of additional policies in the fourth quarter of 2005. Bank owned life insurance is recorded as an asset at the lower of its cash surrender value or the amount that can be realized.

Deposits. Our primary source of funds are retail deposit accounts held principally by individuals and businesses within our market area. The deposit base is comprised of certificate accounts, regular savings accounts, checking and NOW accounts and money market savings accounts. At December 31, 2005, we had no brokered deposits. Total deposits increased $47.5 million or 24.6% in the year ended December 31, 2005. During that time period, certificate accounts increased 50.8%, regular savings accounts increased by 16.9%, checking and NOW accounts increased by 26.5% while money market deposit accounts decreased by 35.3%. The increases in our deposit accounts were primarily due to increased advertising and more aggressive pricing. The decrease in money market accounts was primarily due to the transfer of funds to a new savings product with higher pricing.

The following table sets forth the balances of our deposit products at the date indicated.

   
At December 31,
  
   
2005
  
2004
  
2003
  
   
(In thousands)
  
               
Certificate accounts
  
$
122,431
  
$
81,200
  
$
86,192
  
Regular savings accounts
    
51,375
    
43,941
    
40,185
  
Checking and NOW accounts
    
46,825
    
37,003
    
32,723
  
Money market savings accounts
    
20,215
    
31,222
    
24,355
  
    Total
  
$
240,846
  
$
193,366
  
$
183,455
  

The following table indicates the amount of jumbo certificate accounts by time remaining until maturity at December 31, 2005. Jumbo certificate accounts require minimum deposits of $100,000.

Maturity Period
  
 Certificate
Accounts
  
   
 (In thousands)
  
        
Three months or less
 
$
2,610
  
Over three through six months
    
6,104
  
Over six through twelve months
    
6,442
  
Over twelve months
    
16,845
  
    Total
  
$
32,001
  

The following table sets forth the certificate accounts classified by rates at the dates indicated.

   
At December 31,
  
   
2005
  
2004
  
2003
  
   
(In thousands)
  
               
0.00 - 0.99%
  
$
2,416
  
$
13,094
  
$
15,170
  
1.00 - 1.99
    
17,633
    
31,371
    
34,215
  
2.00 - 2.99
    
16,699
    
14,704
    
14,026
  
3.00 - 3.99
    
50,729
    
14,228
    
12,953
  
4.00 - 4.99
    
34,954
    
6,884
    
8,546
  
5.00 - 5.99
    
—
    
919
    
1,282
  
    Total
  
$
122,431
  
$
81,200
  
$
86,192
  


 
18

The following table sets forth the amount and maturities of certificate accounts at December 31, 2005.

   
Amount Due
          
   
Less Than
One Year
  
More Than
One Year to
Two Years
  
More Than
Two Years to
Three Years
  
More Than
Three to
Four Years
  
More Than
Four Years
  
Total
  
Percent of Total Certificate Accounts
  
   
(Dollars in thousands)
      
                               
0.00 - 0.99%
  
$
2,367
  
$
49
  
$
—
  
$
—
  
$
—
  
$
2,416
    
1.97
%
1.00 - 1.99
    
14,386
    
2,985
    
262
    
—
    
—
    
17,633
    
14.40
  
2.00 - 2.99
    
14,249
    
1,533
    
917
    
—
    
—
    
16,699
    
13.64
  
3.00 - 3.99
    
28,306
    
11,660
    
7,707
    
2,813
    
243
    
50,729
    
41.43
  
4.00 - 4.99
    
3,886
    
20,840
    
4,678
    
1,262
    
4,288
    
34,954
    
28.55
  
    Total
  
$
63,194
  
$
37,067
  
$
13,564
  
$
4,075
  
$
4,531
  
$
122,431
    
100.00
%

The following table sets forth the savings activity for the periods indicated.

   
Year Ended December 31,
  
   
2005
  
2004
  
2003
  
   
(In thousands)
  
               
Beginning balance
  
$
193,366
  
$
183,455
  
$
173,231
  
Increase before interest credited
    
44,086
    
7,654
    
7,376
  
Interest credited
    
3,394
    
2,257
    
2,848
  
Net increase in savings deposits
    
47,480
    
9,911
    
10,224
  
Ending balance
  
$
240,846
  
$
193,366
  
$
183,455
  
 
Borrowings. We borrow funds from the Federal Home Loan Bank of Boston during periods of low liquidity to match fund increases in our fixed-rate mortgage portfolio and to provide long-term fixed-rate funding with the goal of decreasing our exposure to an increase in interest rates. In 2005 we also borrowed funds from the Federal Home Loan Bank of Boston to purchase securities. In addition, we occasionally borrow short-term from correspondent banks to cover temporary cash needs. At December 31, 2005, we had the ability to borrow a total of $2.5 million from a correspondent bank, $1.9 million of which was borrowed at such date.

The following table presents certain information regarding our Federal Home Loan Bank advances during the periods and at the dates indicated.

   
Year Ended December 31,
  
   
2005
  
2004
  
2003
  
   
(Dollars in thousands)
  
               
Maximum amount of advances outstanding at any month end during the period
  
$
57,059
  
$
34,643
  
$
34,990
  
Average advances outstanding during the period
    
38,530
    
27,379
    
27,765
  
Weighted average interest rate during the period
    
3.93
%
  
4.59
%
  
5.02
%
Balance outstanding at end of period
  
$
57,059
  
$
15,826
  
$
34,990
  
Weighted average interest rate at end of period
    
4.20
%
  
4.42
%
  
4.37
%



 
19

Capital. Total capital decreased by $600,000, or 1.2%, to $51.0 million at December 31, 2005 from $51.6 million at December 31, 2004. Total capital increased $30.4 million, or 143.4%, to $51.6 million at December 31, 2004 from $21.2 million at December 31, 2003. Our average equity to average assets ratio was 16.87% at December 31, 2005 compared to 11.37% at December 31, 2004 and 9.02% at December 31, 2003. Total capital increased in 2003 and 2004 primarily due to net income in 2003 and the minority stock issuance in 2004. The decrease in 2005 was due to net income of $1.9 million, $1.8 million in capital adjustments related to the Company’s 2005 Equity Incentive Plan, year-to-date dividends of $500,000 paid to stockholders, a net increase to the unrealized loss on available-for-sale securities of $427,000 and $218,000 in capital adjustments related to the release of 19,889 shares of our employee stock ownership plan.

Comparison of Operating Results for the Years Ended December 31, 2005, 2004 and 2003

 
Overview. 
   
2005
  
2004
  
2003
  
%
Change
2005/2004
  
%
Change
2004/2003
  
   
(Dollars in thousands)
  
                       
Net income
  
$
1,905
  
$
415
  
$
1,806
    
359.04
%
  
(77.02
)%
Return on average assets
    
0.62
%
  
0.16
%
  
0.77
%
  
287.50
%
  
(79.22
)%
Return on average equity
    
3.66
%
  
1.42
%
  
8.59
%
  
157.75
%
  
(83.47
)%
 
2005 v. 2004.  Net income increased primarily due to an increase in net interest income and non-interest income. These increases were partially offset by increases in non-interest expense and increases in tax and loan loss provisions.
 
2004 v. 2003. Net income decreased primarily due to an increase in noninterest expense. The increase in noninterest expense was primarily the result of a charitable contribution expense of $1.5 million to establish the Naugatuck Valley Savings and Loan Foundation and a prepayment fee of $498,000 paid to the Federal Home Loan Bank of Boston for the early payoff of $9.6 million in advances.

Net Interest Income.  

2005 v. 2004. Net interest income increased $1.9 million, or 19.8%, to $11.0 million for 2005. The increase in net interest income for 2005 was the result of an increase in the average balances of interest earning assets combined with an increase in the average rate earned on these assets, partially offset by higher cost of funds.

Interest and dividend income for 2005 was $15.9 million, compared to $12.7 million for 2004, an increase of $3.2 million, or 25.1%. This increase was the result of an increase in the average balances of interest earning assets of 19.1% combined with an increase in the average rate earned on these assets of 27 basis points over the 2004 rates. The increase in interest earning assets is attributed primarily to an increase in the loan and investment portfolios. The average balances in the loan portfolio increased by 18.4% to $225.8 million in 2005, up from $190.7 million in 2004, while the average balance of investments increased by 59.1% to $53.0 million in 2005 from $33.3 million in 2004.

Interest expense for 2005 was $4.9 million compared to $3.6 million for 2004, an increase of $1.3 million or 38.8%. This increase resulted from a 37 basis point increase in the rates paid on interest-bearing liabilities to 1.94% in 2005 from 1.57% in 2004 due to rising market rates on deposits and borrowings along with increases in the average balances of deposits and borrowings of $28.1 million, or 12.4%, to $254.5 million in 2005 from $226.4 in 2004. The increase in the average interest-bearing liabilities was due to increases in certificates of deposit, regular savings, checking and advances from the Federal Home Loan Bank, partially offset by a decrease in the average balance of money market savings accounts.

2004 v. 2003. Net interest income increased $751,000, or 8.9%, to $9.2 million for 2004. This increase in net interest income for 2004 can be attributed primarily to a lower cost of funds along with higher balances of interest earning assets.

 
20

Interest and dividend income for 2004 was $12.7 million, compared to $12.6 million for 2003, an increase of $69,000, or 0.55%. This increase is attributable to an increase in average interest-earning assets of $19.2 million, or 8.8%, from $218.5 million in 2003 to $237.7 million in 2004, partially offset by a 44 basis point decrease in the average yield from 5.79% to 5.35%. The increase in the average balance was primarily in the loan portfolio.

Interest expense for 2004 was $3.6 million compared to $4.2 million for 2003, a decrease of $682,000 or 16.1%. This decrease resulted from a 44 basis point decrease in the rates paid on interest-bearing liabilities to 1.57% in 2004 from 2.01% in 2003 due to a decline in market interest rates, partially offset by an increase in the average balance of interest-bearing liabilities of $15.6 million, or 7.4%, to $226.4 million in 2004 from $210.8 in 2003. The increase in the average interest-bearing liabilities was due to increases in regular savings, checking and money market savings accounts.



 
21

Average Balances and Yields. The following table presents information regarding average balances of assets and liabilities, the total dollar amounts of interest income and dividends, the total dollar amount of interest expense and the resulting average yields and costs. The yields and costs for the periods indicated are derived by dividing income or expense by the average balances of assets or liabilities, respectively, for the periods presented. For purposes of this table, average balances have been calculated using the average of daily balances and nonaccrual loans are included in average balances only. During the 2005 period, we held tax-exempt municipal securities with an average balance of $6.3 million. The yields below do not reflect the tax benefits of these securities.  
            
   
2005
  
2004
  
2003
  
   
Average Balance
  
Interest and Dividends
  
Yield/
Cost
  
Average
Balance
  
Interest and
Dividends
  
Yield/
Cost
  
Average
Balance
  
Interest and
Dividends
  
Yield/
Cost
  
   
(Dollars in thousands)
  
                                       
Interest-earning assets:
                                                        
    Loans
  
$
225,804
  
$
13,642
    
6.04
%
$
190,713
  
$
11,240
    
5.89
%
$
171,796
  
$
11,052
    
6.43
%
    Fed Funds sold
    
1,756
    
56
    
3.19
    
11,726
    
174
    
1.48
    
6,024
    
64
    
1.06
  
    Investment securities
    
52,987
    
2,102
    
3.97
    
33,307
    
1,245
    
3.74
    
39,150
    
1,480
    
3.78
  
    Federal Home Loan Bank
      stock
    
2,481
    
108
    
4.35
    
1,950
    
54
    
2.77
    
1,562
    
48
    
3.07
  
        Total interest-earning assets
    
283,028
    
15,908
    
5.62
    
237,696
    
12,713
    
5.35
    
218,532
    
12,644
    
5.79
  
Noninterest-earning assets
    
25,386
                
19,731
                
14,534
              
        Total assets
  
$
308,414
              
$
257,427
              
$
233,066
              
                                                         
                                                         
Interest-bearing liabilities:
                                                        
    Certificate accounts
  
$
99,487
  
$
2,772
    
2.79
  
$
84,890
  
$
1,784
    
2.10
  
$
89,938
  
$
2,315
    
2.57
  
    Regular savings accounts and
      escrow 
    
51,326
    
360
    
0.70
    
48,929
    
209
    
0.43
    
40,905
    
229
    
0.56
  
    Checking and NOW accounts
    
39,857
    
46
    
0.12
    
37,620
    
49
    
0.13
    
30,544
    
81
    
0.27
  
    Money market savings
      accounts
    
25,160
    
245
    
0.97
    
27,547
    
261
    
0.95
    
21,599
    
223
    
1.03
  
        Total interest-bearing
          deposits
    
215,830
    
3,423
    
1.59
    
198,986
    
2,303
    
1.16
    
182,986
    
2,848
    
1.56
  
                                                         
FHLB advances
    
38,530
    
1,512
    
3.92
    
27,379
    
1,256
    
4.59
    
27,765
    
1,393
    
5.02
  
Other borrowings
    
161
    
6
    
3.73
    
16
    
—
          
—
    
—
        
        Total interest-bearing
          liabilities
    
254,521
    
4,941
    
1.94
    
226,381
    
3,559
    
1.57
    
210,751
    
4,241
    
2.01
  
                                                         
Noninterest-bearing liabilities
    
1,869
                
1,767
                
1,285
              
        Total liabilities
    
256,390
                
228,148
                
212,036
              
                                                         
Capital
    
52,024
                
29,279
                
21,030
              
        Total liabilities and capital
  
$
308,414
              
$
257,427
              
$
233,066
              
    Net interest income
        
$
10,967
              
$
9,154
              
$
8,403
        
    Interest rate spread
                
3.68
%
              
3.78
%
              
3.77
%
    Net interest margin
                
3.87
%
              
3.85
%
              
3.85
%
    Average interest-earning assets
      to average interest-bearing
      liabilities
                
111.20
%
              
105.00
%
              
103.69
%




 
22

Rate/Volume Analysis. The following table sets forth the effects of changing rates and volumes on our net interest income. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). For purposes of this table, changes attributable to changes in both rate and volume that cannot be segregated have been allocated proportionately based on the changes due to rate and the changes due to volume. The net column represents the sum of the prior columns.

   
2005 Compared to 2004
  
2004 Compared to 2003
  
   
Increase (Decrease)
Due to
      
Increase (Decrease)
Due to
      
   
Volume
  
Rate
  
Net
  
Volume
  
Rate
  
Net
  
   
(In thousands)
  
Interest income:
                                      
    Loans
  
$
2,114
  
$
288
  
$
2,402
  
$
789
  
$
(601
)
$
188
  
    Fed Funds sold
    
340
    
(458
)
  
(118
)
  
77
    
33
    
110
  
    Investment securities
    
775
    
82
    
857
    
(218
)
  
(17
)
  
(235
)
    Federal Home Loan Bank stock
    
17
    
37
    
54
    
10
    
(4
)
  
6
  
        Total interest income
    
3,247
    
(52
)
  
3,195
    
658
    
(589
)
  
69
  
                                       
    Interest expense:
                                      
    Certificate accounts
    
341
    
647
    
988
    
(124
)
  
(407
)
  
(531
)
    Regular savings accounts
    
11
    
140
    
151
    
28
    
(48
)
  
(20
)
    Checking and NOW accounts
    
3
    
(6
)
  
(3
)
  
27
    
(59
)
  
(32
)
    Money market savings accounts
    
(24
)
  
8
    
(16
)
  
54
    
(16
)
  
38
  
        Total deposit expense
    
332
    
788
    
1,120
    
(16
)
  
(529
)
  
(545
)
    FHLB advances
    
397
    
(141
)
  
256
    
(19
)
  
(118
)
  
(137
)
    Other borrowings
    
—
    
6
    
6
    
—
    
—
    
—
  
           Total interest expense
    
729
    
653
    
1,382
    
(35
)
  
(647
)
  
(682
)
    Net interest income
  
$
2,518
  
$
(705
)
$
1,813
  
$
693
  
$
58
  
$
751
  

Provision for Loan Losses. 

2005 v. 2004. In 2005, a $32,000 provision was made to the allowance for loan losses. The provision in 2005 is due to the increasing size of the loan portfolio, in particular, the increasing size of our construction, multi-family and commercial real estate and commercial business loan portfolios. In addition, there was an increase in the allowance due to net recoveries. During 2005 there was a decrease in nonperforming loans and assets. As a result there was an increase in the ratio of the allowance to nonperforming loans and assets.

2004 v. 2003. In 2004, no provision was made to the allowance for loan losses. During 2004 there was a decrease in nonperforming loans and assets as well as improved asset quality ratios. Although no provision for loan losses was made in 2004, there was an increase in the allowance due to net recoveries. As a result there was an increase in the ratio of the allowance to nonperforming loans.

An analysis of the changes in the allowance for loan losses is presented under “-Allowance for Loan Losses and Asset Quality.”



 
23

Noninterest Income. The following table shows the components of noninterest income and the percentage changes from 2005 to 2004 and from 2004 to 2003.

   
2005
  
2004
  
2003
  
% Change
2005/2004
  
% Change
2004/2003
  
   
(Dollars in thousands) 
  
                       
Fees for services
  
$
974
  
$
872
  
$
851
    
11.70
%
  
2.47
%
Income from bank owned life insurance
    
218
    
201
    
133
    
8.46
    
51.13
  
Gain on sale of mortgages
    
—
    
5
    
14
    
(100.00
)
  
(64.29
)
Gain (loss) on sale of investments
    
47
    
(156
)
  
1
    
130.13
    
(15,700.00
)
Income from investment advisory services, net
    
167
    
93
    
45
    
79.57
    
106.67
  
Other income
    
111
    
63
    
71
    
76.19
    
(11.27
)
    Total
  
$
1,517
  
$
1,078
  
$
1,115
    
40.72
%
  
(3.32)%

2005 v. 2004. Income from investment advisory services increased $74,000, or 79.6%, to $167,000 for the year ended December 31, 2005 compared to $93,000 for the year ended December 31, 2004 due to increased volume in this area. Fees for services increased by $102,000 or 11.7% to $974,000 for the year ended December 31, 2005 up from $872,000 for the year ended December 31, 2004. The 2004 period included a net loss on sale of investments of $156,000, while the 2005 period included a gain of $47,000. An increase of $17,000, or 8.5%, in income earned from investments in bank-owned life insurance was also recorded in the 2005 period.

2004 v. 2003. Income from investment advisory services totaled $93,000 for the year ended December 31, 2004 compared to $45,000 for the year ended December 31, 2003. Income from bank owned life insurance increased to $201,000 for the year ended December 31, 2004 up from $133,000 for the year ended December 31, 2003. The overall decrease of 3.32% in non-interest income for the year ended December 31, 2004 was primarily due to the $156,000 loss on the sale of investments.

Noninterest Expense. The following table shows the components of noninterest expense and the percentage changes from 2005 to 2004 and from 2004 to 2003.

   
2005
  
2004
  
2003
  
% Change
2005/2004
  
% Change
2004/2003
  
   
(Dollars in thousands) 
  
                       
Compensation, taxes and benefits
  
$
5,912
  
$
4,636
  
$
4,024
    
27.52
%
  
15.21
%
Charitable contributions
    
34
    
1,587
    
50
    
(97.86
)
  
3,074.00
  
Office occupancy
    
1,538
    
1,191
    
1,140
    
29.14
    
4.47
  
Computer processing
    
624
    
547
    
507
    
14.08
    
7.89
  
Prepayment fee on Federal Home Loan Bank advances
    
—
    
498
    
—
    
(100.00
)
  
N/A
  
Advertising
    
523
    
318
    
240
    
64.47
    
32.50
  
Professional fees
    
448
    
272
    
143
    
64.71
    
90.21
  
Office supplies
    
232
    
190
    
201
    
22.11
    
(5.47
)
(Gain) Loss on foreclosed real estate, net
    
(35
)
  
(57
)
  
2
    
(38.60
)
  
(2,950.00
)
Other expenses
    
821
    
621
    
538
    
32.21
    
15.43
  
    Total
  
$
10,097
  
$
9,803
  
$
6,845
    
3.00
%
  
43.21
%

Other expenses for all periods include, among other items, insurance, postage and expenses related to checking accounts. Expenses associated with being a public company and supervisory examinations are included in the 2005 and 2004 periods.

2005 v. 2004 The increase in noninterest expense increase was primarily due to an increase of $1.3 million in compensation costs, an increase of $347,000 in office occupancy expenses, an increase of $205,000 in advertising expenditures, an increase of $176,000 in legal, accounting and consulting fees and an increase of $77,000 in computer processing costs. The increase in advertising expense relates to more aggressive advertising for deposit products, while the increase in legal, accounting and consulting fees are the result of being a public

 
24

company. The compensation costs in the 2005 periods include expenses related to the adoption of the equity incentive plan previously approved by shareholders. Occupancy expenses increased in both 2005 periods as a result of the opening of new branches in January and July 2005. The 2004 period included a charitable contribution of $1.5 million to establish the Naugatuck Valley Savings and Loan Foundation and a prepayment charge of $498,000 on the early payoff of $9.6 million of FHLB borrowings.

2004 v. 2003. Compensation, taxes and benefits increased due to salary increases, benefits increases and additional compensation related to new employees and resulting payroll taxes. The increase in employees is the result of additional back-office staff and new employees to staff the office in Seymour. Charitable contributions increased in 2004 due to the formation and funding of the Naugatuck Valley Savings and Loan Foundation. The increase in professional fees is primarily the result of increases in legal, consulting and accounting services associated with the new holding company structure.

Income Taxes

2005 v. 2004. Income taxes increased due to a higher level of taxable income in the 2005 period. The 2004 period included the charitable contribution resulting from the formation and funding of the Naugatuck Valley Savings and Loan Foundation. The Company continues to benefit from income exempt from income taxes including income from bank-owned life insurance and municipal securities, along with deferred tax benefits related to tax bad debt reserves in the calculation of the effective tax rate. The effective tax rate for 2005 was 19.1% compared to 3.3% for 2004.

2004 v. 2003. Income taxes decreased due to a lower level of taxable income primarily due to the charitable contribution resulting from the formation and funding of Naugatuck Valley Savings and Loan Foundation, an increase in non-taxable income, and deferred tax benefits related to tax bad debt reserves. The effective tax rate for 2004 was 3.3% compared to 31.3% for 2003.

Market Risk Analysis

Qualitative Aspects of Market Risk. Our most significant form of market risk is interest rate risk. We manage the interest rate sensitivity of our interest-bearing liabilities and interest-earning assets in an effort to minimize the adverse effects of changes in the interest rate environment. Deposit accounts typically react more quickly to changes in market interest rates than mortgage loans because of the shorter maturities of deposits. As a result, sharp increases in interest rates may adversely affect our earnings while decreases in interest rates may beneficially affect our earnings. To reduce the potential volatility of our earnings, we have sought to improve the match between assets and liability maturities (or rate adjustment periods), while maintaining an acceptable interest rate spread, by originating adjustable-rate mortgage loans for retention in our loan portfolio, variable-rate home equity lines and variable-rate commercial loans and by purchasing variable-rate investments and investments with expected maturities of less than 10 years. In 2002-2004 we sold a small percentage of our originations of longer term fixed-rate one- to four-family mortgage loans in the secondary market based on prevailing market interest rate conditions, an analysis of the composition and risk of the loan portfolio, liquidity needs and interest rate risk management goals. We did not sell any loans in 2005. Generally, loans are sold without recourse and with servicing retained. We currently do not participate in hedging programs, interest rate swaps or other activities involving the use of off-balance sheet derivative financial instruments.

Our Asset/Liability Committee communicates, coordinates and controls all aspects of asset/liability management. The committee establishes and monitors the volume and mix of assets and funding sources with the objective of managing assets and funding sources.

Quantitative Aspects of Market Risk. We use an interest rate sensitivity analysis prepared by the Office of Thrift Supervision to review our level of interest rate risk. This analysis measures interest rate risk by computing changes in net portfolio value of our cash flows from assets, liabilities and off-balance sheet items in the event of a range of assumed changes in market interest rates. Net portfolio value represents the market value of portfolio equity and is equal to the market value of assets minus the market value of liabilities, with adjustments made for off-balance sheet items. This analysis assesses the risk of loss in market risk sensitive instruments in the event of a sudden and sustained a 100 to 300 basis point increase or a 100 to 200 basis point decrease in market interest rates with no effect given to any steps that we might take to counter the effect of that interest rate movement. We measure interest rate risk by modeling the changes in net portfolio value over a variety of interest rate scenarios.

 
25

The following table, which is based on information that we provide to the Office of Thrift Supervision, presents the change in our net portfolio value at December 31, 2005 that would occur in the event of an immediate change in interest rates based on Office of Thrift Supervision assumptions, with no effect given to any steps that we might take to counteract that change.


Basis Point (“bp”)
  
Net Portfolio Value
  
Net Portfolio Value as % of
Present Value of Assets
Change in Rates
  
$ Amount
  
$ Change
  
% Change
  
NPV Ratio
  
Change
   
(Dollars in thousands)
              
                               
300 bp 
  
$
34,847
    
$
(17,063
)
    
(33
)%
    
10.39
% 
 
  
(4.07
)%
200
    
40,579
      
(11,331
)
    
(22
)
    
11.83
      
(2.63
)
100
    
46,417
      
(5,493
)
    
(11
)
    
13.22
      
(1.24
)
0
    
51,910
      
—
      
—
      
14.46
      
—
  
          (100) 
    
55,471
      
3,561
      
7
      
15.20
      
0.74
  
          (200) 
    
54,958
      
3,048
      
6
      
14.98
      
0.52
  

The Office of Thrift Supervision uses certain assumptions in assessing the interest rate risk of savings associations. These assumptions relate to interest rates, loan prepayment rates, deposit decay rates, and the market values of certain assets under differing interest rate scenarios, among others. As with any method of measuring interest rate risk, certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as adjustable-rate mortgage loans, have features that restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, expected rates of prepayments on loans and early withdrawals from certificates could deviate significantly from those assumed in calculating the table.

Liquidity and Capital Resources

Liquidity is the ability to meet current and future short-term financial obligations. Our primary sources of funds consist of deposit inflows, loan repayments and maturities and sales of investment securities and advances from the Federal Home Loan Bank of Boston. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition.

Each quarter we project liquidity availability and demands on this liquidity for the next 90 days. We regularly adjust our investments in liquid assets based upon our assessment of (1) expected loan demand, (2) expected deposit flows, (3) yields available on interest-earning deposits and securities, and (4) the objectives of our asset/liability management program. Excess liquid assets are invested generally in interest-earning deposits, Federal funds and short- and intermediate-term U.S. Government agency obligations.

Our most liquid assets are cash and cash equivalents and interest-bearing deposits. The levels of these assets depend on our operating, financing, lending and investing activities during any given period. At December 31, 2005, December 31, 2004 and December 31, 2003, cash and cash equivalents totaled $9.0 million, $7.6 million and $9.8 million, respectively, including Federal funds of $29,000, $23,000 and $5.0 million, respectively. Securities classified as available for sale, which provide additional sources of liquidity, totaled $58.0 million, $31.1 million and $37.2 million at December 31, 2005, December 31, 2004 and December 31, 2003, respectively. At December 31, 2005, December 31, 2004 and December 31, 2003, we had the ability to borrow a total of $112.3 million, $95.9 million and $97.1 million, respectively, from the Federal Home Loan Bank of Boston, of which $57.1 million, $15.8 million and $35.0 million was outstanding, respectively. At December 31, 2005, December 31, 2004 and December 31, 2003, we had arranged overnight lines of credit of $2.5 million with the Federal Home Loan Bank of Boston for all periods. We had no overnight advances outstanding with the Federal Home Loan Bank of Boston on these dates. In addition, at December 31, 2005, December 31, 2004 and December 31, 2003, we had ability to borrow $2.5 million, $2.0 million and $2.0 million respectively from a correspondent bank, of which $1.9 million was outstanding on this line at December 31, 2005. There were no advances outstanding of this line at December 31, 2004 or December 31, 2003.

 
26


At December 31, 2005, we had $18.2 million in unused line availability on home equity lines of credit, $3.3 million in unadvanced commercial lines, $2.9 million in mortgage commitments, $3.8 million in commercial mortgage loan commitments, $15.0 million in unadvanced construction mortgage commitments, $2.0 million in letters of credit, $850,000 in commercial business loan commitments and $210,000 in overdraft line of credit availability. Certificates of deposit due within one year of December 31, 2005 totaled $63.2 million, or 26.2% of total deposits. If these deposits do not remain with us, we will be required to seek other sources of funds, including other certificates of deposit and lines of credit. Depending on market conditions, we may be required to pay higher rates on such deposits or other borrowings than we currently pay on the certificates of deposit due on or before December 31, 2006. We believe, however, based on past experience, that a significant portion of our certificates of deposit will remain with us. We have the ability to attract and retain deposits by adjusting the interest rates offered.

Historically, we have remained highly liquid, with our liquidity position increasing substantially over the past two fiscal years. We expect that all of our liquidity needs, including the contractual commitments set forth in the table below, the estimated costs of our branch expansion plans and increases in loan demand can be met by our currently available liquid assets and cash flows. If loan demand were to increase at a pace greater than expected, or any unforeseen demand or commitment were to occur, we would access our borrowing capacity with the Federal Home Loan Bank of Boston. We expect that our currently available liquid assets and our ability to borrow from the Federal Home Loan Bank of Boston would be sufficient to satisfy our liquidity needs without any material adverse effect on our liquidity. We are not aware of any trends and/or demands, commitments, events or uncertainties that could result in a material decrease in liquidity.

The following table presents certain of our contractual obligations at December 31, 2005.

   
 Payments Due by Period
  
Contractual Obligations
  
 Total
  
Less than
1 year
  
1-3 years
  
3-5 years
  
More than 5
years
  
   
 (In thousands)
  
                        
Long-term debt obligations
  
$
57,059
  
$
35,503
  
$
10,955
  
$
8,671
  
$
1,930
  
Operating lease obligations
    
1,887
    
149
    
301
    
316
    
1,121
  
    Total
  
$
58,946
  
$
35,652
  
$
11,256
  
$
8,987
  
$
3,051
  

Our primary investing activities are the origination of loans and the purchase of securities. For the year ended December 31, 2005 we originated $124.2 million of loans and purchased $51.1 million of securities. In 2004, we originated $83.8 million of loans and purchased $24.4 million of securities. In 2003, we originated $101.0 million of loans and purchased $20.5 million of securities. During the year ended December 31, 2005, these activities were funded primarily by an increase in deposits of $47.5 million, net advances from the Federal Home Loan Bank of Boston of $41.2 million, proceeds from sales and maturities of available-for-sale securities of $23.0 million and proceeds from held-to-maturity securities of $665,000. During the year ended December 31, 2004, these activities were funded primarily by the net proceeds from the stock issuance of $31.6 million, proceeds from sales and maturities of available-for-sale securities of $26.2 million, an increase of deposits of $9.9 million and proceeds from the sale of loans of $1.9 million. During 2003, these activities were funded primarily by the proceeds from maturities of available-for-sale securities of $14.4 million, advances from the Federal Home Loan Bank of Boston of $13.9 million, an increase of deposits of $10.2 million, proceeds from the sale of loans of $8.9 million and uninvested cash and cash equivalents of $8.0 million.

Historically, our investment portfolio had been funded by excess liquidity when deposit inflows exceed loan demand. During 2005, we implemented two leverage strategies with the objective of enhancing earnings. In the first strategy, we borrowed $28.8 million from the Federal Home Loan Bank of Boston on a short term basis to fund the purchase of a like amount of long term securities. In the second strategy, we have borrowed up to $11.0 million short-term from the Federal Home Loan Bank of Boston throughout the year to fund the purchase of same term money market preferred securities. Both strategies were accretive to earnings.

Financing activities consist primarily of activity in deposit accounts and in Federal Home Loan Bank advances. We experienced a net increase in total deposits of $47.5 million, $9.9 million and $10.2 million for the year ended December 31, 2005, 2004 and 2003, respectively. Deposit flows are affected by the overall level of interest rates, the interest rates and products offered by us and our local competitors and other factors. We generally

 
27

manage the pricing of our deposits to be competitive and to increase core deposit relationships. Occasionally, we offer promotional rates on certain deposit products in order to attract deposits. We experienced an increase in Federal Home Loan Bank advances of $41.2 million for the year ended December 31, 2005, a decrease in Federal Home Loan Bank advances of $19.1 million for the year ended December 31, 2004 and an increase in Federal Home Loan Bank advances of $3.9 million for the year ended December 31, 2003. The increase in advances in 2005 was primarily used for our lending and investing activities. During 2004, $9.6 million of advances with an average rate of 5.29% were prepaid in an effort to reduce the cost of funds.

We are subject to various regulatory capital requirements administered by the Office of Thrift Supervision, including a risk-based capital measure. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk-weighted assets by assigning balance sheet assets and off-balance sheet items to broad risk categories. At December 31, 2005, we exceeded all of our regulatory capital requirements. We are considered “well capitalized” under regulatory guidelines. See note 13 of the notes to the financial statements in this annual report.

Off-Balance Sheet Arrangements

In the normal course of operations, we engage in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in our financial statements. These transactions involve, to varying degrees, elements of credit, interest rate, and liquidity risk. Such transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments, unused lines of credit, amounts due mortgagors on construction loans, amounts due on commercial loans, commercial letters of credit and commitments to sell loans. See note 15 of the notes to the financial statements in this annual report.

For the years ended December 31, 2005, 2004 and 2003, we engaged in no off-balance-sheet transactions reasonably likely to have a material effect on our financial condition, results of operations or cash flows.

Impact of Recent Accounting Pronouncements

In September 2004, the Financial Accounting Standards Board, or FASB, approved issuing a Staff Position to delay the requirement to record impairment losses under EITF 03-1, but broadened the scope to include additional types of securities.  As proposed, the delay would have applied only to those debt securities described in paragraph 16 of EITF 03-1, the Consensus that provides guidance for determining whether an investment’s impairment is other than temporary and should be recognized in income.  On June 29, 2005, the FASB directed the EITF to issue EITF Issue 03-1-a, “Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1,” as final.  On November 3, 2005, the FASB issued FASB Staff Position, or FSP, FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.”  The FSP addresses determining when an investment is considered impaired and whether that impairment is other than temporary, and measuring an impairment loss.  The FSP also addresses the accounting after an entity recognizes another-than-temporary impairment, and requires certain disclosures about unrealized losses that the entity did not recognize as other-than-temporary impairments.  The FSP is effective for reporting periods beginning after December 15, 2005.   The Company does not expect a significant effect on its financial statements when the FSP is adopted.

In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No.123(R), “Share-Based Payment”, that will require compensation costs related to share-based payment transactions to be recognized in the financial statements. That cost will be measured based on the grant-date fair value of equity or liability instruments issued. Statement 123(R) replaces Statement No. 123, “Accounting for Stock-Based Compensation”, and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”. The Company adopted SFAS 123(R) in the third quarter of 2005. See note 2 and note 10 of the notes to the financial statements in this annual report for details on the impact of SFAS 123 (R) on the Company’s financial statements.

In December 2004, the Financial Accounting Standards Board also issued Statement of Financial Accounting Standards No. 153, “Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29.” Statement No. 153 amends APB Opinion 29, “Accounting for Nonmonetary Transactions,” to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange.

 
28

Statement No. 153 is effective for financial statements for fiscal years beginning after June 15, 2005. The Company does not engage in exchanges of nonmonetary assets and expects no change to its financial statements as a result of this standard.

In May 2005, the FASB issued SFAS No. 154 -Accounting Changes and Error Corrections.  SFAS No. 154, a replacement of APB Opinion No. 20- Accounting Changes and FASB Statement No. 3 - Reporting Accounting Changes in Interim Financial Statements.  SFAS No. 154 requires retrospective application for voluntary changes in accounting principles unless it is impracticable to do so.  SFAS No. 154 is effective for accounting changes and corrections of errors in fiscal years beginning after December 15, 2005.  Early application is permitted for accounting changes and corrections of errors during fiscal years beginning after June 1, 2005.  At this time, the Company is uncertain how the application of SFAS 154 will impact prior period financial statements for the implementation of future accounting pronouncements.

In July 2005, the FASB issued an exposure draft titled Accounting for Uncertain Tax Positions, an Interpretation of SFAS No. 109 - Accounting for Income Taxes.  This exposure draft addresses accounting for tax uncertainties that arise when a position that an entity takes on its tax return may be different from the position that the taxing authority may take, and provides guidance about the accounting for tax benefits associated with uncertain tax positions, classification of a liability recognized for those tax positions, and interim reporting considerations.  The proposed interpretation is not expected to be issued until the first quarter of 2006, at which time the FASB will decide on a revised effective date and transition period.  The Company does not anticipate any change in its financial statements as a result of the exposure draft.

Effect of Inflation and Changing Prices

We have prepared the financial statements and related financial data presented in this report in accordance with generally accepted accounting principles in the United States, which require the measurement of financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time due to inflation. The primary impact of inflation on our operations is reflected in increased operating costs. Unlike most industrial companies, virtually all of our assets and liabilities are monetary in nature. As a result, interest rates generally have a more significant impact on our performance than do general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.
 
 
 
 
 
 
 
 
 
29
 
 
Whittlesey & Hadley, P.C.


 
 


To The Board of Directors and Shareholders
Naugatuck Valley Financial Corporation


We have audited the accompanying consolidated statements of financial condition of Naugatuck Valley Financial Corporation (the “Company”) and subsidiary as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the years ended December 31, 2005, 2004 and 2003. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Companies Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Naugatuck Valley Financial Corporation and subsidiary at December 31, 2005 and 2004, and the results of its operations and its cash flows for the each of the years ended December 31, 2005, 2004 and 2003, in conformity with accounting principles generally accepted in the United States of America.


Hartford, Connecticut
February 19, 2006
 
 
 
 
 
30
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December 31,
  
   
2005
  
2004
  
ASSETS
              
Cash and due from depository institutions
  
$
8,922
  
$
7,552
  
Investment in federal funds
    
29
   
23
 
Investment securities
    
63,049
   
36,264
 
Loans receivable, net
    
259,427
   
203,820
 
Accrued income receivable
    
1,525
   
1,077
 
Premises and equipment, net
    
9,087
   
7,765
 
Bank owned life insurance asset
    
7,652
   
4,934
 
Federal Home Loan Bank of Boston stock
    
3,159
   
2,180
 
Other assets
    
2,496
   
1,834
 
               
        Total assets
  
$
355,346
  
$
265,449
  
               
LIABILITIES AND STOCKHOLDERS' EQUITY
              
Liabilities
              
    Deposits
  
$
240,846
  
$
193,366
  
    Advances from Federal Home Loan Bank
    
57,059
   
15,826
 
    Mortgagors' escrow accounts
    
3,202
   
3,058
 
    Other liabilities
    
3,275
   
1,628
 
               
            Total liabilities
    
304,382
   
213,878
 
               
Commitments and contingencies
              
               
Stockholders' Equity
              
    Common stock, $.01 par value; 25,000,000 shares authorized;
              
      7,604,375 shares issued and outstanding
    
76
   
76
 
    Preferred stock, $.01 par value; 1,000,000 shares authorized;
              
      no shares issued or outstanding
    
-
   
-
 
    Paid-in capital
    
33,157
   
33,089
 
    Retained earnings
    
22,588
   
21,362
 
    Unearned ESOP shares (273,291 shares at December 31, 2005
              
      and 293,180 shares at December 31, 2004)
    
(2,733
)
  
(2,932
)
    Unearned stock awards (139,712 shares)
    
(1,551
)
  
-
 
    Treasury Stock, at cost (9,333 shares)
    
(122
)
  
-
 
    Accumulated other comprehensive income (loss)
    
(451
)
  
(24
)
               
            Total stockholders' equity
    
50,964
   
51,571
 
               
        Total liabilities and stockholders' equity
  
$
355,346
  
$
265,449
  
 
See notes to consolidated financial statements.
 
 
31
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(Dollars in thousands, except earnings per share)
   
   
For the Years Ended December 31,
 
   
2005
  
2004
  
2003
  
Interest and dividend income
                    
Interest on loans
  
$
13,642
  
$
11,240
  
$
11,052
  
Interest and dividends on investments and deposits
    
2,266
   
1,473
   
1,592
 
        Total interest income
    
15,908
   
12,713
   
12,644
 
                     
Interest expense
                    
Interest on deposits
    
3,423
   
2,303
   
2,848
 
Interest on borrowed funds
    
1,518
   
1,256
   
1,393
 
        Total interest expense
    
4,941
   
3,559
   
4,241
 
                     
Net interest income
    
10,967
   
9,154
   
8,403
 
                     
Provision for loan losses
    
32
   
-
   
45
 
                     
Net interest income after provision for loan losses
    
10,935
   
9,154
   
8,358
 
                     
Noninterest income
                    
Fees for services
    
974
   
872
   
851
 
Income from bank owned life insurance
    
218
   
201
   
133
 
Income from investment advisory services, net
    
167
   
93
   
45
 
Gain (loss) on sale of investments
    
47
   
(156
)
  
1
 
Gain on sale of mortgages
    
-
   
5
   
14
 
Other income
    
111
   
63
   
71
 
        Total noninterest income
    
1,517
   
1,078
   
1,115
 
                     
Noninterest expense
                    
Compensation, taxes and benefits
    
5,912
   
4,636
   
4,024
 
Office occupancy
    
1,538
   
1,191
   
1,140
 
Computer processing
    
624
   
547
   
507
 
Advertising
    
523
   
318
   
240
 
Professional fees
    
448
   
272
   
143
 
Office supplies
    
232
   
190
   
201
 
Contributions
    
34
   
1,587
   
50
 
Prepayment fee on Federal Home Loan Bank advances
    
-
   
498
   
-
 
(Gain) loss on foreclosed real estate, net
    
(35
)
  
(57
)
  
2
 
Other expenses
    
821
   
621
   
538
 
        Total noninterest expense
    
10,097
   
9,803
   
6,845
 
                     
Income before provision for income taxes
    
2,355
   
429
   
2,628
 
                     
Provision for income taxes
    
450
   
14
   
822
 
                     
        Net income
  
$
1,905
  
$
415
  
$
1,806
  
                     
Earnings per share - basic and diluted
  
$
0.26
    
N/M
   
N/A
 
 
See notes to consolidated financial statements.
 
 
32
 
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(Dollars in thousands)
   
   
Common
  
Paid-in
  
Retained
  
Unearned
ESOP
  
Unearned
Stock
  
Treasury
  
Accumulated
Other
Comprehensive
      
   
Stock
  
Capital
  
Earnings
  
Shares
  
Awards
  
Stock
  
Income (Loss)
  
Total
  
                                   
Balance at December 31, 2003
  
$
-
  
$
-
  
$
20,947
  
$
-
  
$
-
  
$
-
  
$
270
  
$
21,217
  
Issuance of 7,604,375 shares of common stock related to
                                                  
    initial public offering, net of costs
    
76
   
33,085
   
-
   
-
   
-
   
-
   
-
   
33,161
 
298,091 shares of common stock acquired by ESOP
    
-
   
-
   
-
   
(2,981
)
  
-
   
-
   
-
   
(2,981
)
ESOP shares released - 4,911 shares
    
-
   
4
   
-
   
49
   
-
   
-
   
-
   
53
 
Comprehensive income:
                                                  
    Net income
    
-
   
-
   
415
   
-
   
-
   
-
   
-
       
    Net change in unrealized holding gain on available-for-
                                                  
        sale securities, net of tax effect
                                        
(294
)
      
            Comprehensive income
    
-
   
-
   
-
   
-
   
-
   
-
         
121
 
                                                   
Balance at December 31, 2004
    
76
   
33,089
   
21,362
   
(2,932
)
  
-
   
-
   
(24
)
  
51,571
 
ESOP shares released - 19,889 shares
    
-
   
19
   
-
   
199
   
-
   
-
   
-
   
218
 
Dividends paid ($0.16 per common share)
    
-
   
-
   
(500
)
  
-
   
-
   
-
   
-
   
(500
)
Stock acquired for future stock awards - 9,333 shares
    
-
   
-
   
-
   
-
   
-
   
(122
)
  
-
   
(122
)
Stock based compensation - 139,712 shares
    
-
   
49
   
(179
)
  
-
   
(1,551
)
  
-
   
-
   
(1,681
)
Comprehensive income:
                                                  
    Net income
    
-
   
-
   
1,905
   
-
   
-
   
-
   
-
       
    Net change in unrealized holding gain on available-for-
                                                  
        sale securities, net of tax effect
                                        
(427
)
      
            Comprehensive income
    
-
   
-
   
-
   
-
   
-
   
-
         
1,478
 
                                                   
Balance at December 31, 2005
  
$
76
  
$
33,157
  
$
22,588
  
$
(2,733
)
  
(1,551
)
$
(122
)
$
(451
)
$
50,964
  
 
See notes to consolidated financial statements.
 
 
33
 
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For the Years Ended December 31,
 
   
2005
  
2004
  
2003
  
Cash flows from operating activities
                    
Net income
  
$
1,905
  
$
415
  
$
1,806
  
Adjustments to reconcile net income to cash
                   
    provided by operating activities:
                    
        Provision for loan losses
    
32
   
-
   
45
 
        Contribution of common stock to charitable foundation
    
-
   
1,519
   
-
 
        Depreciation and amortization expense
    
686
   
642
   
662
 
        Provision for deferred tax (benefit)
    
(177
)
  
(464
)
  
171
 
        Net gain on sale of real estate owned
    
(46
)
  
(68
)
  
(53
)
        Gain on sale of mortgages
    
-
   
(5
)
  
(14
)
        Loans originated for sale
    
-
   
(1,930
)
  
(8,851
)
        Proceeds from sale of loans
    
-
   
1,935
   
8,865
 
        (Gain) loss on sale of investments
    
(47
)
  
156
   
(1
)
        Loss on disposal of premises and equipment
    
14
   
-
   
-
 
        Stock-based compensation
    
397
   
53
   
-
 
        Increase in accrued income receivable
    
(448
)
  
(5
)
  
(27
)
        (Decrease) increase in deferred loan fees
    
(11
)
  
73
   
(178
)
        Increase in cash surrender value of life insurance
    
(218
)
  
(201
)
  
(133
)
        (Increase) decrease in other assets
    
(319
)
  
2
   
(283
)
        Increase (decrease) in other liabilities
    
1,518
   
(33
)
  
420
 
Net cash provided by operating activities
    
3,286
   
2,089
   
2,429
 
                     
Cash flows from investing activities
                    
Proceeds from maturities and repayments of
                    
    available-for-sale securities
    
19,245
   
9,222
   
9,907
 
Proceeds from sale of available-for-sale securities
    
3,742
   
16,982
   
4,488
 
Proceeds from maturities of held-to-maturity securities
    
665
   
-
   
450
 
Purchase of available-for-sale securities
    
(50,593
)
  
(20,830
)
  
(19,838
)
Purchase of held-to-maturity securities
    
(500
)
  
(3,610
)
  
(647
)
Loan originations net of principal payments
    
(55,674
)
  
(23,582
)
  
(14,504
)
Purchase of Federal Home Loan Bank of Boston stock
    
(980
)
  
(423
)
  
(196
)
Proceeds from the sale of foreclosed real estate
    
113
   
277
   
258
 
Proceeds from sale of property and equipment
    
11
   
-
   
-
 
Purchase of property and equipment
    
(1,943
)
  
(2,157
)
  
(497
)
Purchase of bank owned life insurance asset
    
(2,500
)
  
-
   
(4,600
)
Net cash used by investing activities
    
(88,414
)
  
(24,121
)
  
(25,179
)
                     
 
See notes to consolidated financial statements.
 
 
34
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For the Years Ended December 31,
 
   
2005
  
2004
  
2003
  
Cash flows from financing activities
                    
Net change in time deposits
    
41,231
   
(4,992
)
  
(3,091
)
Net change in other deposit accounts
    
6,249
   
14,903
   
13,316
 
Advances from Federal Home Loan Bank
    
62,193
   
19,650
   
13,903
 
Repayment of Advances from Federal Home Loan Bank
    
(20,960
)
  
(38,814
)
  
(10,032
)
Net change in mortgagors' escrow accounts
    
143
   
424
   
271
 
Common stock repurchased
    
(1,852
)
  
-
   
-
 
Cash dividends to common shareholders
    
(500
)
  
-
   
-
 
Proceeds from issuance of common stock
    
-
   
32,601
   
-
 
Cost of issuance of common stock
    
-
   
(959
)
  
-
 
Payments to acquire common stock for ESOP
    
-
   
(2,981
)
  
-
 
Net cash provided by financing activities
    
86,504
   
19,832
   
14,367
 
                     
Increase (Decrease) in cash and cash equivalents
    
1,376
   
(2,200
)
  
(8,383
)
Cash and cash equivalents at beginning of year
    
7,575
   
9,775
   
18,158
 
                     
        Cash and cash equivalents at end of year
  
$
8,951
  
$
7,575
  
$
9,775
  
                     
Supplemental disclosures
                    
        Non-cash investing activities:
                    
            Transfer of loans to foreclosed real estate
  
$
47
  
$
67
  
$
305
  
                     
        Cash paid during the year for:
                    
            Interest
  
$
4,939
  
$
3,562
  
$
4,243
  
            Income taxes
    
683
   
454
   
701
 
 
See notes to consolidated financial statements.
 
 
35
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Naugatuck Valley Financial Corporation (the “Company”) is a federally chartered holding company formed on September 30, 2004 for the purpose of acquiring all of the common stock of the Naugatuck Valley Savings and Loan (the “Bank”) concurrent with its reorganization from a mutual savings institution to the mutual holding company form of organization. The reorganization was consummated on September 30, 2004. In connection with the reorganization, the Company sold 3,269,881 shares of its common stock, par value $.01 per share, in a subscription offering and issued 4,182,407 shares to Naugatuck Valley Mutual Holding Company, raising approximately $31.7 million, net of costs. Approximately $15.9 million of the proceeds were contributed to the Bank. The Company is a majority owned subsidiary of Naugatuck Valley Mutual Holding Company, a federally chartered mutual holding company.

In addition, at the time of the reorganization, the Company contributed 152,087 shares of its stock to the Naugatuck Valley Savings and Loan Foundation. The foundation is a 501(c)(3) organization formed by the Company to support charitable activities within its community.

Originally organized in 1922, the Bank is a federally charted stock savings bank which is headquartered in Naugatuck, Connecticut. The Bank provides a full range of personal banking services to individual and small business customers located primarily in the Naugatuck Valley and the immediate surrounding vicinity. It is subject to competition from other financial institutions throughout the region. The Bank is also subject to the regulations of various federal agencies and undergoes periodic examinations by those regulatory authorities.

The Bank owns the Naugatuck Valley Mortgage Servicing Corporation, which qualifies and operates as a Connecticut passive investment company pursuant to legislation.
 
 
The accounting and reporting policies of the Company and its subsidiary conform to generally accepted accounting principles in the United States of America and to general practices within the thrift industry. Such policies have been followed on a consistent basis. The significant accounting policies of the Company are summarized below.
Use of estimates
In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet, and income and expenses for the period. Actual results could differ from those estimates.

Material estimates that are particularly
  
 
susceptible to significant change in the near-term relate to the determination of the reserve for losses on loans and the valuation of real estate acquired in connection with foreclosure or in satisfaction of loans. While management uses available information to recognize losses on loans and foreclosed real estate, future additions to the allowance may be necessary based on
     

 
36
 
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Notes to Consolidated Financial Statements
 
 
changes in economic conditions, particularly in Connecticut.
 
Principles of consolidation
The consolidated financial statements include the accounts of the Company, the Bank and the Bank’s wholly-owned subsidiary, Naugatuck Valley Mortgage Servicing Corporation. All significant intercompany accounts and transactions have been eliminated in consolidation.
 
Investment securities
Investments are accounted for in accordance with the intent of management at the time of purchase. If management has the intent and the Company has the ability at the time of purchase to hold debt securities until maturity, they are classified as held-to-maturity. These securities are carried at historical cost adjusted for the amortization of premiums and accretion of discounts, which are recognized as adjustments to interest income.

Securities to be held for indefinite periods of time are classified as available-for-sale and are carried at fair value with unrealized gains and losses reported as a separate component of capital net of estimated income taxes.
 
The Company has no securities held for trading.

Gains or losses on the sales of securities are recognized at trade date utilizing the specific identification method.
 
Loans receivable and allowance for loan losses
Loans receivable are stated at unpaid principal balance less loans in process, deferred loan fees, and allowances for loan losses.

Uncollected interest on loans receivable is accrued as earned based on rates applied to

 
  
principal amounts outstanding. Recognition of income on the accrual basis is discontinued when there is sufficient question as to the collectibility of the interest. In these cases, the interest previously accrued to income is reversed, and the loans are placed on the cash basis.

Loan origination fees and certain direct loan origination costs are being deferred and the net amount amortized on a level-yield basis as an adjustment to the related loan yield over its contractual life. Unamortized net fees are recognized upon early repayment of the loans.

The allowance for loan losses is established by a provision charged to earnings and is maintained at a level considered adequate to provide for potential loan losses based on management's evaluation of known and inherent risks in the loan portfolio. When a loan or portion of a loan is considered uncollectible, it is charged against the allowance for loan losses. Recoveries of loans previously charged-off are credited to the allowance when collected.

Management makes regular evaluations of the loan portfolio to determine the adequacy of the level of the allowance for loan losses. Numerous factors are considered in the evaluation, including a review of certain borrowers' current financial status and credit standing, available collateral, loss experience in relation to outstanding loans, the overall loan portfolio quality, management's judgment regarding prevailing and anticipated economic conditions, and other relevant factors.

In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses. Such agencies may require the Bank to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.
 
 
 
 
 
 
 
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Notes to Consolidated Financial Statements
 
2.     Summary of Significant Accounting Policies - (Continued)
 
 
Loan sales and mortgage-servicing rights
 
Residential mortgage loans originated and held for sale are classified separately in the consolidated statement of financial condition and reported at the lower of amortized cost or market value (based on secondary market prices). There were no loans held for sale at December 31, 2005 and 2004. Gains or losses on the sale of loans are determined using the specific identification method.

 
The Bank sells residential mortgage loans with servicing rights retained. At the time of the sale, the Bank determines the value of the retained servicing rights, which represents the present value of the differential between the contractual servicing fee and adequate compensation, defined as the fee a sub-servicer would require to assume the role of servicer, after considering the estimated effects of prepayments. If material, a portion of the gain on the sale of the loan is recognized as due to the value of the servicing rights, and a servicing asset is recorded. The Bank has had no loan sales which have resulted in the recording of a servicing asset, due to the immaterial differential between the contractual servicing fee (25 basis points) and adequate compensation, as described above.
 
Foreclosed real estate
Real estate properties acquired through loan foreclosure and other partial or total satisfaction of problem loans are carried at the lower of fair value or the related loan balance at the date of foreclosure.

Valuations are periodically performed by management and an allowance for losses is established if the carrying value of a property subsequently exceeds its fair value less

 
estimated disposal costs. Losses arising at the time of acquisition of such properties are charged against the allowance for loan losses. Subsequent write-downs in the carrying value and expenses incurred to maintain the properties are charged to expense.
 
Premises and equipment
Premises and equipment are stated at cost less accumulated depreciation computed on the straight-line method at rates based on estimated useful lives.

Expenditures for replacements or major improvements are capitalized. Expenditures for normal maintenance and repairs are charged to expense as incurred. Upon the sale or retirement of premises and equipment, the cost and accumulated depreciation are removed from their respective accounts and any gain or loss is included in income.
 
Bank owned life insurance asset
The cash surrender value of bank owned life insurance relates to policies on employees of the Bank for which the Bank is the beneficiary. Increases in cash surrender value are included in non-interest income in the consolidated income statements.
 
Income from investment advisory services, net
In conjunction with a third party, an employee of the Bank is licensed to sell non-deposit investment products, including mutual funds, annuities and other insurance products. The Bank records, as non-interest income, revenues earned from product sales in accordance with the terms of revenue sharing agreements with the third party, net of certain marketing and other
 
 
 
38
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Notes to Consolidated Financial Statements
 
 
expenses shared with the third party. The Bank currently employs the individual authorized to sell these products and pays most of the direct costs related to the sales activities. These costs are charged to expense as incurred, and are classified primarily in compensation and benefits expense.
 
Income taxes
The Company accounts for certain income and expense items differently for financial reporting purposes than for income tax purposes. Provisions for deferred taxes are being made in recognition of these temporary differences.
 
Earnings per share
When presented, basic earnings per share is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Because the formation of the Company was completed on September 30, 2004, per share earnings data is not meaningful for 2004. The Company did not have any shares outstanding in 2003.
 
Computation of fair values
The calculation of fair value estimates of financial instruments is dependent upon certain subjective assumptions and involves significant uncertainties. Changes in assumptions could significantly affect the estimates. These estimates do not reflect any possible tax ramifications, estimated transaction costs or any premium or discount that could result from offering the Company's entire holdings of a particular financial instrument.

The following methods and assumptions were utilized by the Company in estimating the fair values of its on-balance sheet financial instruments:
 
Cash and cash equivalents - The carrying amounts reported in the statement of financial condition approximate these assets' fair value.
 
Investment securities - Fair values for investment securities are based on quoted market prices where available. If quoted market prices are not available, fair values are based on market prices for comparable instruments.
 
Loans receivable - For variable rate loans that reprice frequently and without significant change in credit risk, fair values are based on carrying values. The fair value of other loans are estimated using discounted cash flow analyses using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. The fair value of nonaccrual loans was estimated using the estimated fair values of the underlying collateral.
 
Deposits liabilities - The fair values of non-interest-bearing demand and savings deposits are, by definition, equal to the amount payable on demand at the reporting date, i.e., their carrying amounts. Fair values for time certificates of deposit are estimated using a discounted cash flow technique that applies interest rates currently being offered to a schedule of aggregated expected monthly maturities on time deposits.
 
Advances from Federal Home Loan Bank ("FHLB") - Fair values are estimated using discounted cash flow analyses based on the Bank's current incremental borrowing rates for similar types of borrowing arrangements.

Mortgagors’ escrow accounts - The carrying amounts reported in the statement of financial condition approximate the fair value of the mortgagors’ escrow accounts.
     
 
 
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Notes to Consolidated Financial Statements
 
2.     Summary of Significant Accounting Policies - (Continued)
 
 
Recent Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board revised Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123R"). This Statement eliminates the alternative intrinsic value method of accounting, in accordance with the Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" for recognizing the cost of employee services received in share-based payment transactions, thereby reflecting the economic consequences of those transactions in the financial statements. SFAS 123R requires all entities to follow the same accounting standard and account for such transactions using the fair-value-based method. This Statement does not address the accounting for employee stock ownership plans.. The Company has elected to comply with SFAS 123R beginning with the period ended September 30, 2005. See “Note 10 - Equity Incentive Plan”, for details on the impact of SFAS 123R on the Company's financial statements.

In May 2005, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 154, "Accounting Changes and Error Corrections" ("SFAS 154"). This Statement replaces Accounting Principles Board Opinion No. 20 ("APB 20"), "Accounting Changes" and Statement of Financial Accounting Standard No. 3, "Reporting Accounting Changes in Interim Financial
  
Statements," and changes the requirements for the accounting for and reporting of a change in accounting principle. In accordance with the prior guidance of APB 20, most voluntary changes in an accounting principle required recognizing the cumulative effect of a change in accounting principle in net income in the period of change. SFAS 154 requires retrospective application to prior periods' financial statements for the direct effects of a change in accounting principle, unless it is impracticable to determine either the period-specific effects of the cumulative effect of the change. Indirect effects of a change in accounting principle should be recognized in the period of accounting change. SFAS 154 carries forward the guidance of APB 20 relating to the reporting for correction of an error in previously issued financial statements, change in accounting estimate and the justification requirement for a change in accounting principle on the basis of preferability. Provisions of this statement are effective for accounting changes made in the fiscal years beginning after December 15, 2005. At this time, the Company is uncertain how the application of SFAS 154 will impact prior period financial statements for the implementation of future accounting pronouncements.
 
Reclassification
The financial statements for the prior years have been reclassified to conform with changes in the current financial statement presentation.
     
 
 
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Notes to Consolidated Financial Statements

 
A summary of investment securities at December 31, 2005 and 2004 follows:
 
   
2005
  
2004
  
   
Carrying
 
Estimated
 
Carrying
 
Estimated
 
(In thousands)
  
Amount
 
Market Value
 
Amount
 
Market Value
 
Available-for-sale securities
  
$
58,047
  
$
58,047
  
$
31,096
  
$
31,096
  
Held-to-maturity securities
    
5,002
   
4,989
   
5,168
   
5,173
 
        Total investment securities
  
$
63,049
  
$
63,036
  
$
36,264
  
$
36,269
  
                           
At December 31, 2005, the composition of the investment portfolio was:
   
   
Amortized
 
Gross Unrealized
  
Estimated
 
(In thousands)
  
Cost Basis
 
Gain
 
Loss
 
Market Value
 
Available-for-sale securities:
                          
U.S. government and agency obligations
                          
    Less than one year
  
$
6,847
  
$
8
  
$
(49
)
$
6,806
  
    From one through five years
    
7,497
   
2
   
(95
)
  
7,404
 
    From five through ten years
    
1,000
   
-
   
(35
)
  
965
 
     
15,344
   
10
   
(179
)
  
15,175
 
Municipal obligations
                          
    After ten years
    
8,715
   
61
   
(7
)
  
8,769
 
Corporate bonds
                          
    From one through five years
    
1,928
   
-
   
(5
)
  
1,923
 
Mortgage-backed securities
    
22,544
   
1
   
(463
)
  
22,082
 
Collateralized mortgage obligations
    
4,199
   
-
   
(101
)
  
4,098
 
                        Total debt securities
    
52,730
   
72
   
(755
)
  
52,047
 
Money market preferred stocks
    
6,000
   
-
   
-
   
6,000
 
                           
        Total available-for-sale securities
  
$
58,730
  
$
72
  
$
(755
)
$
58,047
  
                           
Held-to-maturity securities:
                          
U.S. government and agency obligations
                          
    From one through five years
  
$
1,202
  
$
1
  
$
(14
)
$
1,189
  
Interest bearing balances
                          
    From one through five years
    
3,800
   
-
   
-
   
3,800
 
                           
        Total held-to-maturity securities
  
$
5,002
  
$
1
  
$
(14
)
$
4,989
  
                           
For the year ended December 31, 2005, the Company realized gross gains of $47,046 compared with realized gross gains of $23,787 and gross losses of $179,952 for the year ended December 31, 2004, and realized gross gains of $6,213 and gross losses of $5,377 on sales of investment securities during the year ended December 31, 2003. There were no gross losses realized in 2005.
 
 
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Notes to Consolidated Financial Statements
 
3. Investment Securities - (Continued)
 
At December 31, 2005 and 2004, securities with a carrying value of $1,200,000 and $700,000, and market values of approximately $1,188,000 and $709,000, respectively, were pledged as collateral to secure municipal deposits.

The Company has certain investment securities in which the market value of the security is less than the cost of the security. Management believes that these unrealized losses are temporary and are the result of changes in market interest rates. In making this determination, management considered the period of time the securities have been in a loss position, the percentage decline in comparison to the securities’ amortized cost, the financial condition of the issuer and the Company’s ability and intent to hold these securities until their fair value recovers to their amortized cost. At December 31, 2005, these securities had an aggregate market value of $41,314,000 which resulted in unrealized losses of $769,000.

The following is a summary of the market value and related unrealized losses aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2005.
   
   
Securities in Continuous Unrealized
  
   
Loss Position Less Than 12 Months
  
   
Number of
  
Market
 
Unrealized
  
(Dollars in thousands)
  
Securities
  
Value
 
Loss
 
               
U.S. government and agency obligations
    
9
 
$
5,107
  
$
(42
)
Municipal obligations
    
6
   
2,199
   
(7
)
Corporate bonds
    
2
   
1,923
   
(6
)
Mortgage-backed securities
    
13
   
15,652
   
(242
)
        Total securities in unrealized loss position
    
30
 
$
24,881
  
$
(297
)
   
   
Securities in Continuous Unrealized
  
   
Loss Position 12 or More Consecutive Months
  
   
Number of
  
Market
 
Unrealized
  
(Dollars in thousands)
  
Securities
  
Value
 
Loss
 
               
U.S. government and agency obligations
    
10
 
$
6,894
  
$
(150
)
Mortgage-backed securities
    
11
   
9,539
   
(322
)
        Total securities in unrealized loss position
    
21
 
$
16,433
  
$
(472
)
 
 
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Notes to Consolidated Financial Statements

At December 31, 2004, the composition of the investment portfolio was:
   
   
Amortized
 
Gross Unrealized
  
Estimated
 
(In thousands)
  
Cost Basis
 
Gain
 
Loss
 
Market Value
 
Available-for-sale securities:
                          
U.S. government and agency obligations
                          
    From one through five years
  
$
14,072
  
$
193
  
$
(36
)
$
14,229
  
    From five through ten years
    
1,000
   
-
   
(19
)
  
981
 
Mortgage-backed securities
    
12,249
   
6
   
(163
)
  
12,092
 
Collateralized mortgage obligations
    
3,812
   
13
   
(31
)
  
3,794
 
                           
        Total available-for-sale securities
  
$
31,133
  
$
212
  
$
(249
)
$
31,096
  
                           
Held-to-maturity securities:
                          
U.S. government and agency obligations
                          
    From one through five years
  
$
703
  
$
9
  
$
(4
)
$
708
  
Interest bearing balances
                          
    From one through five years
    
4,465
   
-
   
-
   
4,465
 
                           
        Total held-to-maturity securities
  
$
5,168
  
$
9
  
$
(4
)
$
5,173
  
 
 
A summary of loans receivable at December 31, 2005 and 2004 is as follows:
   
(Dollars in thousands)
  
2005
  
2004
  
           
Loans secured by first mortgages on real estate:
              
Conventional:
              
    Fixed rate mortgage loans
  
$
127,924
  
$
108,786
  
    Adjustable rate mortgage loans
    
28,245
   
23,439
 
    Construction loans
    
6,063
   
6,547
 
Commercial loans
    
62,946
   
41,047
 
Loans on savings accounts
    
785
   
679
 
Personal, auto and property improvement loans
    
38,001
   
27,657
 
     
263,964
   
208,155
 
Less:    Allowance for loan losses
    
1,878
   
1,829
 
        Undisbursed construction loans
    
2,258
   
2,094
 
        Deferred loan origination fees
    
401
   
412
 
               
    Loans receivable, net
  
$
259,427
  
$
203,820
  
               
    Weighted average yield
    
6.07
%
  
5.71
%
 
 
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Notes to Consolidated Financial Statements
 
4. Loans Receivable - (Continued)
 
The Bank's lending activities are conducted principally in the Naugatuck Valley area of Connecticut. The Bank's investment in loans includes both adjustable and fixed rate loans. At December 31, 2005 and 2004, the composition of the Bank's investment in fixed rate loans was as follows:

Fixed Rate  
  
Term to Maturity
  
 2005
  
2004
  
 
  
  (In thousands)
  
Less than 1 year
  
$
5,907
  
$
4,040
  
1 - 3 years
    
1,683
   
817
 
3 - 5 years
    
1,970
   
2,449
 
5 - 10 years
    
19,222
   
16,955
 
10 - 20 years
    
52,887
   
49,928
 
Over 20 years
    
73,970
   
55,612
 
Total loans at fixed rates
  
$
155,639
  
$
129,801
  

Adjustable rate loans have interest rate adjustment limitations and are indexed to treasury notes or FHLB classic advances with similar repricing durations, or prime rate. At December 31, 2005 and 2004, the Bank had the following adjustable rate loans:

Adjustable Rate  
  
Rate Adjustment
  
 2005
  
2004
  
 
  
(In thousands)  
  
Less than 1 year
  
$
53,453
  
$
49,944
  
1 - 3 years
    
15,792
   
7,875
 
3 - 5 years
    
21,230
   
8,597
 
5 - 10 years
    
16,990
   
11,938
 
Over 10 years
    
860
   
-
 
Total loans at adjustable rates
  
$
108,325
  
$
78,354
  

Nonperforming loans totaled approximately $294,000 and $596,000 at December 31, 2005 and 2004, respectively. These loans, primarily delinquent 90 days or more, were accounted for on a nonaccrual basis. The amount of income that was contractually due but not recognized on nonperforming loans totaled approximately $20,900, $44,600 and $50,100 in 2005, 2004 and 2003, respectively.

There were no loans considered to be impaired by the Bank at December 31, 2005 or 2004.
 
 
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Notes to Consolidated Financial Statements

Transactions in the allowance for loan losses account for the years ended December 31, 2005, 2004 and 2003 were as follows:
   
(In thousands)
  
2005
  
2004
  
2003
  
               
    Balance at beginning of year
  
$
1,829
  
$
1,810
  
$
1,994
  
    Provision for loan losses
    
32
   
-
   
45
 
    Loans written off
    
(4
)
  
(56
)
  
(267
)
    Recoveries of loans written off
    
21
   
75
   
38
 
    Balance at end of year
  
$
1,878
  
$
1,829
  
$
1,810
  

As of December 31, 2005 and 2004, loans to related parties totaled approximately $3,269,000 and $3,480,000, respectively. For the year ended December 31, 2005, new loans of approximately $375,000 were granted to these parties and principal payments of approximately $586,000 were received. For the year ended December 31, 2004, new loans of approximately $1,422,000 were granted to these parties and principal payments of approximately $788,000 were received. Related parties include directors and officers of the Bank, any respective affiliates in which they have a controlling interest, and their immediate families. For the years ended December 31, 2005 and 2004, all loans to related parties were performing in accordance with the original terms.
 
The Bank services loans for other financial institutions and agencies. These loans are originated by the Bank and then sold. The Bank continues to service these loans and remits the payments received to the purchasing institution. The amounts of these loans were approximately $10,632,000 and $11,888,000 at December 31, 2005 and 2004, respectively.
 
 
Premises and equipment at December 31, 2005 and 2004 are summarized as follows:

   
(In thousands)
  
 2005
  
2004
  
    Banking offices and branch buildings
  
$
6,819
  
$
5,916
  
    Furniture and equipment
    
2,535
   
2,170
 
    Land
    
1,538
   
1,538
 
    Leasehold improvements
    
1,067
   
604
 
     
11,959
   
10,228
 
    Accumulated depreciation and amortization
    
(2,872
)
  
(2,463
)
        Premises and equipment, net
  
$
9,087
  
$
7,765
  
 
 
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Notes to Consolidated Financial Statements
 
5. Premises and Equipment - (Continued)
 
Depreciation and amortization expense is computed using the straight-line method over the estimated useful life of an asset. Estimated useful lives range from three to ten years for furniture and equipment, 39 years for the banking offices, and the initial lease term for leasehold improvements. Land is not depreciated.

Depreciation and amortization expenses were $596,670, $511,159 and $503,425 for the years ended December 31, 2005, 2004 and 2003, respectively.

At December 31, 2005, future minimum rental income and lease payment expense were expected to be:
   
(In thousands)
  
 Income
  
Expense
  
            
2006
  
$
26
  
$
149
  
2007
    
-
   
150
 
2008
    
-
   
151
 
2009
    
-
   
153
 
2010
    
-
   
163
 
Thereafter
    
-
   
1,121
 
Total future minimum rents
  
$
26
  
$
1,887
  
 
 
Deposits and weighted average rates at December 31, 2005 and 2004 are summarized as follows:
 
   
2005
  
2004
       
Weighted
      
Weighted 
       
Average
      
Average
(Dollars in thousands)
  
Amount
  
Cost
  
Amount
  
 Cost
Certificate accounts
  
$
122,431
    
3.38
%
  
$
81,200
    
2.24
%
Regular savings accounts
    
51,375
   
0.85
%
    
43,941
   
0.35
%
Checking and NOW accounts
    
46,825
   
0.10
%
    
37,003
   
0.15
%
Money market savings accounts
    
20,215
   
0.88
%
    
31,222
   
1.05
%
        Total deposits
  
$
240,846
    
1.99
%
  
$
193,366
    
1.22
%
 
The aggregate amount of individual certificate accounts of $100,000 or more at December 31, 2005 and 2004 was $32,001,000 and $16,644,000 respectively. Deposits up to $100,000 are federally insured.
 
 
46
 
 
Notes to Consolidated Financial Statements

At December 31, 2005 and 2004 the remaining maturities for certificate accounts were:
   
(In thousands)
  
 2005
  
2004
  
            
Certificate accounts maturing in:
              
    Under 12 months
  
$
63,194
  
$
49,379
  
    12 to 24 months
    
37,067
   
13,243
 
    24 to 36 months
    
13,564
   
6,805
 
    Over 36 months
    
8,606
   
11,773
 
        Total certificate accounts
  
$
122,431
  
$
81,200
  
 
 
The Bank has an agreement with Federal Home Loan Bank of Boston providing for future credit availability of up to twenty times the amount of FHLB stock held by the Bank, not to exceed 30% of its total assets. The Bank held $3,159,400 in Federal Home Loan Bank stock at December 31, 2005. In additional to the outstanding advances, the Bank has a $2,540,000 line of credit available from FHLB and a $2,500,000 line of credit available from another correspondent bank, of which $1,899,000 was outstanding at December 31, 2005.

During 2004, the Bank prepaid $9,561,780 of FHLB advances with a weighted-average rate of 5.29%. The Bank incurred a prepayment penalty of $498,000 as a part of the transaction.

FHLB advances are secured by a blanket lien on the Bank’s assets. Outstanding advances with calendar-year maturity dates and weighted average cost of funds at December 31, 2005 and 2004 were as follows:
 
(Dollars in thousands)
  
2005
  
2004
       
Weighted
      
Weighted
   
Amount
  
Average
  
Amount
  
Average
Year of Maturity
  
Due
  
 Cost
  
Due
  
 Cost
2005
  
$
-
    
-
    
$
3,724
    
5.84
%
2006
    
35,503
   
4.27
%
    
2,818
   
4.31
%
2007
    
5,034
   
3.92
%
    
3,349
   
3.82
%
2008
    
5,921
   
4.06
%
    
1,384
   
3.65
%
2009
    
6,468
   
4.19
%
    
1,918
   
3.89
%
2010
    
2,203
   
4.32
%
    
703
   
4.01
%
2011
    
657
   
4.09
%
    
657
   
4.09
%
2012
    
684
   
4.09
%
    
684
   
4.09
%
2013
    
579
   
4.13
%
    
579
   
4.13
%
2014
    
10
   
3.94
%
    
10
   
3.94
%
Total advances
  
$
57,059
    
4.20
%
  
$
15,826
    
4.42
%
 
 
47
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Notes to Consolidated Financial Statements
 
 
Pension Plan
Prior to September 1, 2005, the Bank participated in a multi-employer defined benefit pension plan covering all of its full time (as defined) employees who had been employed by the Bank for more than six months and were at least twenty-one years of age. Benefits under this plan became fully vested after five years of service. The Bank's net pension cost for the period is the amount of contributions due. Total pension expense was $439,000 for the year ended December 31, 2005 compared with $441,000 and $335,300 for 2004 and 2003, respectively. Current valuations of the Bank's allocation of the plan's pooled assets are not available. Effective September 1, 2005, the Plan was amended and as a result, is considered frozen, with no new participants being accepted. No future compensation will be considered for benefit accruals, and there will be no future credited service, service accruals, or additional accrued benefits.
 
Defined Contribution Plan
The Bank has a defined contribution 401(k) plan for eligible employees. The Bank provides 75% matching of employee contributions, with a maximum contribution on up to 6% of the employee’s salary. The Bank=s contribution vests over a 6 year graded vesting schedule. The Bank’s contribution to the plan approximated $89,000, $65,000 and $59,000 for the years ended December 31, 2005, 2004 and 2001, respectively.
 
Directors Retirement Plan
The Bank sponsors a retirement and benefits plan for non-employee directors who attain age 70 and meet certain other qualifying criteria. Annual retirement benefits for qualifying individuals are payable in ten semi-annual installments.

 
Healthcare Benefits
In addition to providing pension benefits, the Bank provides certain health care benefits to retired employees. Substantially all of the Bank's employees may become eligible for those benefits. The Bank's policy is to accrue the expected cost of providing those benefits during the years that the employee renders the necessary service.
 
 
 
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Notes to Consolidated Financial Statements
 

Obligation and Funded Status
 
The following table summarizes the obligation and funded status, as well as the amounts recognized in the consolidated statements of financial condition for the Directors Retirement Plan and the Healthcare Benefits plan as of December 31, 2005 and 2004:
   
   
Directors Retirement Plan
  
Healthcare Benefit Plan
  
(In thousands)
 
2005
 
2004
 
2005
 
2004
 
                   
Measurement date
    
12/31/2005
    
12/31/2004
    
12/31/2005
    
12/31/2004
  
                           
Projected benefit obligation
  
$
(388
)
$
(300
)
$
(425
)
$
(419
)
Fair value of plan assets
    
-
   
-
   
-
   
-
 
    Funded status
  
$
(388
)
$
(300
)
$
(425
)
$
(419
)
                           
Accrued benefit cost recognized in the
                          
    statement of financial condition
  
$
(204
)
$
(228
)
$
(425
)
$
(419
)
 
Net Periodic Benefit Cost and Contributions
 
The benefit costs and contributions the Directors Retirement Plan and the Healthcare Benefits plan for the years ended December 31, 2005 and 2004 were:
   
   
Directors Retirement Plan
  
Healthcare Benefit Plan
  
(In thousands)
 
2005
 
2004
 
2005
 
2004
 
                   
Net periodic benefit cost
  
$
55
  
$
24
  
$
6
  
$
5
  
Employer contributions
    
-
   
-
   
-
   
-
 
Plan participants' contributions
    
-
   
-
   
-
   
-
 
Benefits paid during the year
    
79
   
106
   
19
   
16
 

Due to the unfunded status of the plans, the Bank expects to contribute the amount of the estimated benefit payments for the next fiscal year, which is $39,428 and $18,124 for Directors Retirement Plan and the Healthcare Benefits Plan, respectively.
 
 
49
 
Notes to Consolidated Financial Statements
 
8. Pension and Other Post-Retirement Benefits - (Continued)
 
Assumptions and Effects

The actuarial assumptions used to determine the projected benefit obligations and net periodic benefit cost for the years ended December 31, 2005 and 2004 were as follows:
 
 
   
Directors Retirement Plan
  
Healthcare Benefit Plan
Weighted-average assumptions:
 
2005
2004
 
2005
2004
                     
Discount rate
    
5.75
%
  
7.00
%
    
5.75
%
  
5.75
%
Rate of compensation increase
    
2.00
%
  
4.25
%
    
-
   
-
 
Medical trend rate next year
    
-
   
-
     
5.00
%
  
7.00
%
Ultimate medical trend rate
    
-
   
-
     
5.00
%
  
5.00
%
Year ultimate trend rate is achieved
    
-
   
-
     
2006
   
2006
 
 
Assumed health care cost trend rates have a significant effect on the amounts reported for the Healthcare Benefits plan. At December 31, 2005, a one percentage-point increase in the assumed health care trend rates would increase the projected benefit obligation by $81,289 compared with a decrease of $65,802 if the assumed health care trend rate were to decrease by one percentage-point.
 
 
On September 30, 2004, the date the reorganization was consummated, the Bank implemented the Naugatuck Valley Savings and Loan Employee Stock Ownership Plan (the “ESOP”). On September 30, 2004, the ESOP purchased 298,091 shares of the common stock of the Company. To fund the purchase, the ESOP borrowed $2,980,910 from the Company. The borrowing is at an interest rate of 4.75% and is to be repaid on a pro-rata basis in fifteen annual installments of $282,520 commencing with the quarter ended December 31, 2004 through September 30, 2019. In addition, dividends paid on the unreleased shares are used to reduce the principal balance of the loan. The collateral for the loan is the common stock of the Company purchased by the ESOP. Contributions by the Bank to the ESOP are discretionary, however, the Bank intends to make annual contributions in an aggregate amount at least equal to the principal and interest requirement on the debt.
 
 
50
LOGO
 
Notes to Consolidated Financial Statements
 
The shares of stock purchased by the ESOP are held in a suspense account until they are released for allocation among participants. The shares will be released annually from the suspense account and the released shares will be allocated among the participants on the basis of each participant’s compensation for the year of allocation. As shares are released from collateral, the Bank recognizes compensation expense equal to the average market price of the shares during the period and the shares will be outstanding for earning-per-share purposes. The shares not released are reported as unearned ESOP shares in the capital accounts of the consolidated statements of financial condition. ESOP expense for the years ended December 31, 2005 and 2004 was $218,381 and $53,284 respectively. At December 31, 2005 and 2004, there were 19,889 and 4,911 unallocated ESOP shares and 273,291 and 293,180 unreleased ESOP shares respectively. At December 31, 2005 the unreleased shares had an aggregate fair value of $2,801,000.
 
 
At the annual meeting of stockholders on May 5, 2005, stockholders of the Company approved the Naugatuck Valley Financial Corporation 2005 Equity Incentive Plan (the “Incentive Plan”). Under the Incentive Plan, the Company may grant up to 372,614 stock options and 149,045 shares of restricted stock to its employees, officers and directors for an aggregate amount of up to 521,659 shares of the Company’s common stock for issuance upon the grant or exercise of awards. Both incentive stock options and non-statutory stock options may be granted under the Incentive Plan.

On July 26, 2005, the Company awarded 354,580 options to purchase the Company’s common stock and 139,712 shares of restricted stock. Stock option awards were granted with an exercise price equal to the market price of the Company’s stock at the date of grant ($11.10) with maximum term of ten years. Both stock option and restricted stock awards vest at 20% per year beginning on the first anniversary of the date of grant.

Stock options and restricted stock awards are considered common stock equivalents for the purpose of computing earnings per share on a diluted basis.

The Company adopted Financial Accounting Standards Board’s SFAS No.123(R), “Share Based Payment”, during 2005, prior to the mandatory compliance date for the Company of January 1, 2006. In accordance with Statement No.123 (R), the Company has recorded share-based compensation expense related to outstanding stock option and restricted stock awards based upon the fair value at the date of grant over the vesting period of such awards on a straight-line basis.

The fair value of each restricted stock allocation, based on the market price at the date of grant, is recorded to unearned stock awards. Compensation expenses related to unearned restricted shares are amortized to compensation, taxes and benefits expense over the vesting period of the restricted stock awards.
 
 
51
 
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Notes to Consolidated Financial Statements
 
10. Equity Incentive Plan - (Continued)
The fair value of each stock option award is estimated on the date of grant using the Black-Scholes option pricing method which includes several assumptions such as volatility, expected dividends, expected term and risk-free rate for each stock option award.

In detrmining the expected term of the option awards, the Company elected to follow the simplified method as permited by the SEC Staff Accounting Bulletin 107, which was issued to provide guidance on the implemenation of SFAS 123(R). Under this method, the Company has estimated the expected term of the options as being equal to the avearge of the vesting term plus the original contractual term. The Company estimated its volatility using the historical volatiliy of other, similar companies during a period of time equal to the expected life of the options. The risk-free rate for the periods within the contractual life of the options is based upon the U.S. Treasury yield curve in effect at the time of grant. The weighted-average fair value of stock options granted on July 26, 2005 using the Black-Scholes option pricing method was $2.53 per share. Assumptions used to determine the weighted-average fair value of stock options granted were as follows:
   
Dividend yield:
1.44%
Expected volatility:
 11.47% 
Risk-free rate:
4.18%
Expected term in years:
6.5
 
The Company recorded share-based compensation expense of $178,282 for the year ended December 31, 2005 in connection with the stock option and restricted stock awards.
 
 
Retained earnings at December 31, 2005 includes approximately $1,417,000 for which no provision for Federal income tax has been made. This amount represents aggregate allocations of income to bad debt deductions for tax purposes only. Reduction of amounts so allocated for purposes other than tax bad debt losses will create income for tax purposes only, which will be subjected to the then current corporate income tax rate.

The Bank’s wholly-owned subsidiary, the Naugatuck Valley Mortgage Servicing Corporation, qualifies and operates as a Connecticut passive investment company pursuant to legislation. Because the subsidiary earns income from passive investments which is exempt from Connecticut Corporation Business Tax and its dividends to the Bank are exempt
 
from state tax, the Bank no longer expects to incur state income tax expense.

Deferred income taxes reflect the impact of "temporary differences" between the amount of assets and liabilities for financial reporting purposes and such amounts as measured by tax laws and regulations. Principal items making up the deferred income tax provision include a carry forward of charitable contributions, the provision for loan losses, accelerated tax depreciation and deferred mortgage fee income. The Company records a valuation allowance against deferred tax assets if, based on the weight of available evidence, it is more likely than not, that some or all of the deferred tax assets will not be realized. The Company believes that all deferred tax assets will be realized in the future and that no valuation allowance is necessary.
     
 
 
52
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Notes to Consolidated Financial Statements
 
Income taxes receivable and payable included in the balance sheet at December 31, 2005 and 2004 were:
   
(In thousands)
  
2005
  
2004
  
           
Current tax receivable
  
$
57
  
$
1
  
               
Deferred tax receivable
              
    Charitable contributions carryforward
  
$
428
  
$
465
  
    Reserve for loan losses
    
552
   
382
 
    Post-retirement benefits
    
214
   
220
 
    Deferred income
    
138
   
142
 
    Available-for-sale securities
    
232
   
12
 
            Total deferred tax receivable
    
1,564
   
1,221
 
               
Deferred tax payable
              
    Depreciation
  
$
(104
)
$
(153
)
    Other items
    
(21
)
  
(26
)
            Total deferred tax payable
    
(125
)
  
(179
)
               
    Net deferred tax receivable
  
$
1,439
  
$
1,042
  

The provision for income tax expense for the year ended December 31, 2004, 2003 and 2002 consisted of:
   
(In thousands)
  
2005
  
2004
  
2003
  
Current income tax expense
  
$
627
  
$
478
  
$
651
  
                     
Deferred income tax expense (benefit), due to:
                    
    Charitable contributions
    
37
   
(465
)
  
-
 
    Reserve for loan losses
    
(170
)
  
(42
)
  
(26
)
    Deferred income
    
4
   
(25
)
  
60
 
    Post retirement benefits
    
6
   
26
   
8
 
    Depreciation
    
(49
)
  
43
   
131
 
    Other items
    
(5
)
  
(1
)
  
(2
)
        Total deferred income tax expense (benefit)
    
(177
)
  
(464
)
  
171
 
                     
        Provision for income taxes
  
$
450
  
$
14
  
$
822
  
 
 
53
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Notes to Consolidated Financial Statements
 
11. Income Taxes - (Continued)
 
A reconciliation of the statutory federal income tax rate applied to income before income taxes with the income tax provision is as follows:
   
   
Year Ended December 31,
  
(Dollars in thousands)
  
2005
  
2004
  
2003
  
Income tax expense at statutory rate of 34%
  
$
801
  
$
146
  
$
894
  
                     
Increase (decrease) in income tax expense resulting from:
                    
    Income exempt from income tax
    
(193
)
  
(68
)
  
(46
)
    Changes in tax bad debt base year reserves
    
(160
)
  
(65
)
  
(28
)
    Other items, net
    
2
   
1
   
2
 
                     
        Provision for income taxes
  
$
450
  
$
14
  
$
822
  
                     
Effective rate of income tax expense
    
19.1
%
  
3.3
%
  
31.3
%
 
 
The source of the Company’s other comprehensive income is the unrealized gains and losses on its available for sale securities.
   
   
For the Years Ended December 31,
 
(In thousands)
  
2005
  
2004
  
2003
  
               
Net income
  
$
1,905
  
$
415
  
$
1,806
  
                     
Other comprehensive loss:
                    
Unrealized loss on securities available-for-sale
    
(600
)
  
(601
)
  
(664
)
Reclassification adjustment for (gains) losses
                    
    realized in net income
    
(47
)
  
156
   
(1
)
                     
Other comprehensive loss before tax effect
    
(647
)
  
(445
)
  
(665
)
                     
Income tax benefit related to items of other
                    
    comprehensive loss
    
(220
)
  
(151
)
  
(226
)
                     
Other comprehensive loss net of tax benefit
    
(427
)
  
(294
)
  
(439
)
                     
    Total comprehensive income
  
$
1,478
  
$
121
  
$
1,367
  
 
 
54
LOGO
 
Notes to Consolidated Financial Statements
 
 
The Company, as a federally chartered holding company, is not subject to regulatory capital requirements. The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements.

The Office of Thrift Supervision (OTS) regulations require savings institutions to maintain minimum levels of regulatory capital. Under the regulations in effect at December 31, 2005, the Bank was required to maintain a minimum ratio of tangible capital to total adjusted assets of 1.5%; a minimum ratio of Tier 1 (core) capital to total adjusted assets of 4.0%; a minimum ratio of Tier I capital to risk-weighted assets of 4.0% and a minimum ratio of total (core and supplementary) capital to risk-weighted assets of 8.0%. As of December 31, 2005 the Bank meets all capital requirements to which it is subject.

At December 31, 2005 the Bank was considered “well capitalized” for regulatory purposes. To be categorized as well capitalized, the Bank must maintain a minimum ratio of tangible capital to total adjusted assets of 2.00%; a minimum ratio of Tier 1 (core) capital to total adjusted assets of 5.00%; a minimum ratio of Tier I capital to risk-weighted assets of 6.00% and a minimum ratio of total (core and supplementary) capital to risk-weighted assets of 10.00%. There have been no subsequent conditions or events which management believes have changed the Bank’s status.

The following is a summary of the Bank’s actual capital as computed under the standards established by the OTS at December 31, 2005 and 2004, respectively.
 
   
2005
  
2004
(Dollars in thousands)
  
Amount
Ratio
  
Amount
Ratio
                     
Tier I Capital (to Adjusted Total Assets)
  
$
39,885
    
11.42
%
  
$
37,937
    
14.78
%
                             
Tier I Risk-Based Capital (to Risk-Weighted Assets)
    
39,885
   
17.07
%
    
37,937
   
22.52
%
                             
Total Risk-Based Capital (to Risk-Weighted Assets)
    
41,763
   
17.88
%
    
39,766
   
23.61
%
                             
Tangible Equity Capital (to Tangible Assets)
    
39,885
   
11.42
%
    
37,937
   
14.78
%
 
The ability of the Company to pay dividends depends, in part, on the ability of the Bank to pay dividends to the Company. The Bank will not be able to declare or pay a cash dividend on, or repurchase any of its common stock, if the effect thereof would be to reduce the regulatory capital of the Bank to an amount below amounts required under OTS rules and regulations.
 
55
LOGO
 
Notes to Consolidated Financial Statements
 
13. Regulatory Capital - (Continued)
 
The measurement of the Bank’s capital as computed under regulatory standards differs from its measurement under generally accepted accounting principles. A reconcilement of the Bank’s capital follows:
   
   
December 31,
  
(In thousands)
  
2005
  
2004
  
Total capital as calculated under generally accepted
             
    accounting principles (GAAP Capital)
  
$
39,795
  
$
38,256
  
Adjustments to reconcile Total GAAP Capital to Regulatory Capital:
              
        Intangible assets
    
(222
)
  
(256
)
        Accumulated other comprehensive income
              
            from available-for-sale securities
    
312
   
(63
)
Tier I Risk-Based Capital
    
39,885
   
37,937
 
        Includible portion of allowance for loan losses
    
1,878
   
1,829
 
               
Total Risk-Based Capital
  
$
41,763
  
$
39,766
  
 
 
Basic net income per common share is calculated by dividing the net income available to common stockholders by the weighted-average number of common shares outstanding during the period. Diluted net income per common share is computed in a manner similar to basic net income per common share except that the weighted-average number of common shares outstanding is increased to include the incremental common shares (as computed using the treasury stock method) that would have been outstanding if all potentially dilutive common stock equivalents were issued during the period. The Company's common stock equivalents relate solely to stock option and restricted stock awards. Anti-dilutive shares are common stock equivalents with weighted-average exercise prices in excess of the weighted-average market value for the periods presented. The Company had no anti-dilutive common shares outstanding for the year ended December 31, 2005. Unallocated common shares held by the ESOP are not included in the weighted-average number of common shares outstanding for purposes of calculating either basic or diluted net income per common share.
       
   
2005
 
2004
 
Net income and income available to common stockholders
  
$
1,905,000
  
$
415,000
  
               
Weighted-average shares outstanding during the period
              
    Basic
    
7,311,249
   
N/M
 
    Effect of dilutive stock options and restrictive stock awards
    
5,707
   
N/M
 
               
    Diluted
    
7,316,956
       
               
Net income per common share:
              
        Basic and Diluted Earnings per share
  
$
0.26
    
N/M
  
               
 
 
56
LOGO
 
Notes to Consolidated Financial Statements
 
Earnings per share amounts for the year ended December 31, 2004 are not meaningful because the Company did not complete its initial public offering until September 30, 2004. The weighted-average number of shares outstanding during the quarter ended December 31, 2004 was 7,306,337 shares. Net income and income available to common shareholders for the quarter ended December 31, 2004 was $530,000. The basic earnings per share for the quarter was $0.07. The Company had no dilutive securities outstanding during 2004.
 
 
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the balance sheet.

The following table summarizes these financial instruments and other commitments and contingent liabilities as of December 31, 2005 and 2004:
   
(In thousands)
  
2005
  
2004
  
Commitments to extend credit:
              
    Loan commitments
  
$
7,578
  
$
4,694
  
    Unused lines of credit
    
18,363
   
14,463
 
    Amounts due mortgagors on construction loans
    
15,025
   
14,491
 
    Amounts due on commercial loans
    
3,434
   
1,485
 
Commercial letters of credit
    
1,969
   
2,185
 
 
The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments are principally collateralized by mortgages on real estate, generally have fixed expiration dates or other termination clauses and may require payment of fees. Since some of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
 
 
57
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Notes to Consolidated Financial Statements

15. Financial Instruments - (Continued)

The estimated fair value of the Company's financial instruments follows:
   
   
December 31,
  
   
2005
  
2004
  
   
Carrying
 
Estimated
 
Carrying
 
Estimated
 
(In thousands)
  
Amount
 
Fair Value
 
Amount
 
Fair Value
 
Financial assets
                          
    Cash and cash equivalents
  
$
8,951
  
$
8,951
  
$
7,575
  
$
7,575
  
    Investment securities
    
63,049
   
63,036
   
36,264
   
36,269
 
    Loans receivable, net
    
259,427
   
256,278
   
203,820
   
205,659
 
    Accrued income receivable
    
1,525
   
1,525
   
1,077
   
1,077
 
                           
Financial Liabilities
                          
    Deposits
  
$
240,846
  
$
239,514
  
$
193,366
  
$
193,018
  
    Federal Home Loan Bank advances
    
57,059
   
56,449
   
15,826
   
15,612
 
    Mortgagors' escrow accounts
    
3,202
   
3,202
   
3,058
   
3,058
 
 
 
 
 
 
 
58
LOGO
 
Notes to Consolidated Financial Statements
 
 
 
The following tables present quarterly consolidated information for the Company for 2005 and 2004.
   
 For the Year Ended December 31, 2005
  
   
 Fourth
  
Third
  
Second
  
First
  
(In thousands)
  
 Quarter
  
Quarter
  
Quarter
  
Quarter
  
                    
Interest and dividend income
 
$
4,545
  
$
4,124
  
$
3,807
  
$
3,432
  
Interest expense
   
1,668
   
1,367
   
1,093
   
813
 
    Net interest income
   
2,877
   
2,757
   
2,714
   
2,619
 
Provision for loan losses
   
-
   
-
   
17
   
15
 
Net interest income after
                          
    provision for loan losses
   
2,877
   
2,757
   
2,697
   
2,604
 
Noninterest income
   
425
   
372
   
384
   
336
 
Noninterest expense
   
2,604
   
2,594
   
2,523
   
2,376
 
Income before provision for
                          
    income tax (benefit)
    
698
   
535
   
558
   
564
 
Provision for income tax (benefit)
    
151
   
(2
)
  
140
   
161
 
        Net income
 
$
547
  
$
537
  
$
418
  
$
403
  

   
 For the Year Ended December 31, 2004
  
   
 Fourth
  
Third
  
Second
  
First
  
(In thousands)
  
 Quarter
  
Quarter
  
Quarter
  
Quarter
  
                    
Interest and dividend income
 
$
3,365
  
$
3,265
  
$
3,057
  
$
3,026
  
Interest expense
   
765
   
942
   
916
   
936
 
    Net interest income
   
2,600
   
2,323
   
2,141
   
2,090
 
Provision for loan losses
   
-
   
-
   
-
   
-
 
Net interest income after
                          
    provision for loan losses
   
2,600
   
2,323
   
2,141
   
2,090
 
Noninterest income
   
290
   
149
   
306
   
333
 
Noninterest expense
   
2,168
   
3,891
   
1,865
   
1,879
 
Income (loss) before provision
                          
    (benefit) for income taxes
   
722
   
(1,419
)
  
582
   
544
 
Provision (benefit) for income taxes
   
192
   
(526
)
  
182
   
166
 
        Net income (loss)
  
$
530
  
$
(893
)
$
400
  
$
378
  
 
 
59
LOGO
 
Notes to Consolidated Financial Statements
 
 
The following financial statements are for the Company (Naugatuck Valley Financial Corporation) only, and should be read in conjunction with the consolidated financial statements of the Company.

Statement of Financial Condition
December 31, 2005 and 2004
   
   
December 31,
  
(In thousands)
  
2005
  
2004
  
ASSETS
              
Cash on deposit with Naugatuck Valley Savings and Loan
  
$
1,581
  
$
1,738
  
Investment in subsidiary, Naugatuck Valley Savings and Loan
    
39,794
   
38,256
 
Investment securities
    
9,194
   
10,880
 
Loan to ESOP
    
2,804
   
2,947
 
Deferred income taxes
    
551
   
510
 
Other assets
    
51
   
221
 
               
            Total assets
  
$
53,975
  
$
54,552
  
               
LIABILITIES AND STOCKHOLDERS' EQUITY
              
Liabilities - due to subsidiary
  
$
3,011
  
$
2,981
  
Stockholders' equity
    
50,964
   
51,571
 
               
            Total liabilities and stockholders' equity
  
$
53,975
  
$
54,552
  
 
Statement of Operations
For the Year Ended December 31, 2005 and the Period From Inception (September 30, 2004) through December 31, 2004
   
(In thousands)
  
2005
  
2004
  
           
Interest income
  
$
506
  
$
90
  
               
Other expense
              
    Charitable contribution
    
-
   
1,521
 
    Other expenses
    
444
   
26
 
        Total other expense
    
444
   
1,547
 
Income (loss) before income tax (benefit) and equity in
             
    undistributed net income of subsidiary
    
62
   
(1,457
)
Income tax (benefit)
    
21
   
(495
)
Income (loss) before equity in undistributed net income of subsidiary
    
41
   
(962
)
Equity in undistributed net income of subsidiary
    
1,864
   
488
 
               
            Net income (loss)
  
$
1,905
  
$
(474
)
 
 
60
LOGO
 
Notes to Consolidated Financial Statements
 
 
17. Parent Company Only Financial Statements - (Continued)
 
Statement of Cash flows

For the Year Ended December 31, 2005 and the Period From Inception (September 30, 2004) through December 31, 2004

            
(In thousands)
  
2005
  
2004
  
           
Net cash provided (used) by operating activities
  
$
243
  
$
(39
)
               
Cash flows from investing activities
              
Purchase of available-for-sale securities
    
-
   
(11,014
)
Paydowns and maturities of available-for-sale securities
    
1,591
   
-
 
Loan to ESOP
    
-
   
(2,981
)
Principal payments received from ESOP
    
143
       
Investment in subsidiary, Naugatuck Valley Savings and Loan
    
-
   
(15,870
)
Net cash provided (used) by investing activities
    
1,734
   
(29,865
)
               
Cash flows from financing activities
              
Common stock repurchased
    
(1,851
)
  
-
 
Cash dividends to common shareholders
    
(500
)
  
-
 
Release of ESOP shares
    
217
   
-
 
Proceeds from issuance of common stock
    
-
   
32,601
 
Cost of issuance of common stock
    
-
   
(959
)
Net cash (used) provided by financing activities
    
(2,134
)
  
31,642
 
               
(Decrease) increase in cash and cash equivalents
    
(157
)
  
1,738
 
Cash and cash equivalents at beginning of year
    
1,738
   
-
 
               
        Cash and cash equivalents at end of year
  
$
1,581
  
$
1,738
  
               
Supplemental Disclosures:
              
        Non-cash investing activities:
              
            Loan to acquire ESOP shares
  
$
-
  
$
2,981
  
            Capital contributed on acquisition of subsidiary
    
-
   
22,010
 
               
Cash paid during the year for:
              
            Interest
  
$
-
  
$
-
  
            Income taxes
    
-
   
-
 
 
 
 
 
 
61
 


Directors of Naugatuck Valley Financial Corporation,
Naugatuck Valley Mutual Holding Company
and Naugatuck Valley Savings and Loan


Carlos S. Batista
Vice President - Bristol Babcock, Inc.
Michael S. Plude, CPA
Managing Partner - Kaskie, Plude & Pacowta, LLC
   
Richard M. Famiglietti
Owner - CM Property Management
John C. Roman
President and Chief Executive Officer - Naugatuck Valley Financial Corporation, Naugatuck Valley Mutual Holding Company and Naugatuck Valley Savings and Loan
   
Ronald D. Lengyel
Chairman of the Board - Naugatuck Valley
Financial Corporation, Naugatuck Valley Mutual
Holding Company and Naugatuck Valley
Savings and Loan
 
Director - Connecticut Water Service, Inc.
Camilo P. Vieira
Consultant - CM Property Management
   
James A. Mengacci
Owner - James A. Mengacci Associates LLC
 
Jane H. Walsh
Senior Vice President - Naugatuck Valley
Financial Corporation, Naugatuck Valley Mutual
Holding Company and Naugatuck Valley Savings
and Loan

Executive Officers of
Naugatuck Valley Financial Corporation,
Naugatuck Valley Mutual Holding Company
and Naugatuck Valley Savings and Loan

John C. Roman
President and Chief Executive Officer
William C. Nimons
Senior Vice President
   
Dominic J. Alegi, Jr.
Executive Vice President
Mark S. Graveline
Senior Vice President
   
Jane H. Walsh
Senior Vice President
Lee R. Schlesinger 
Vice President and Treasurer


 
62


Annual Meeting

The annual meeting of stockholders will be held at 10:30 a.m., local time, on May 4, 2006 in the Community Room at Naugatuck Valley Savings and Loan’s main office at 333 Church Street, Naugatuck, Connecticut 06770.

Stock Listing

Naugatuck Valley Financial Corporation common stock is listed on the Nasdaq National Market under the symbol "NVSL."

Price Range of Common Stock

On October 1, 2004, Naugatuck Valley Financial common stock commenced trading on the Nasdaq National Market. At March 1, 2006, there were 877 holders of record of Naugatuck Valley Financial common stock. The following table sets forth the high and low sales prices of the common stock, as reported on the Nasdaq National Market, and the dividend paid by Naugatuck Valley Financial during each quarter since trading commenced.
 
   
Dividends
  
High
  
Low
  
2004:
                    
Fourth Quarter
  
$
0.00
  
$
11.34
  
$
10.26
  
                     
2005:
                    
First Quarter
  
$
0.04
  
$
11.85
  
$
10.32
  
Second Quarter
    
0.04
    
10.84
    
9.80
  
Third Quarter
    
0.04
    
13.09
    
10.45
  
Fourth Quarter
    
0.04
   
13.00
    
10.20
  

Stockholder and General Inquiries

John C. Roman
President and Chief Executive Officer
Naugatuck Valley Financial Corporation
333 Church Street
Naugatuck, Connecticut 06770
(203) 720-5000

Annual and Other Reports

A copy of the Naugatuck Valley Financial Annual Report on Form 10-K, without exhibits, for the year ended December 31, 2005, as filed with the Securities and Exchange Commission, may be obtained without charge by contacting Bernadette A. Mole, Corporate Secretary, Naugatuck Valley Financial Corporation, 333 Church Street, Naugatuck, Connecticut 06770.

Independent Registered Public Accounting Firm
Transfer Agent
   
Whittlesey & Hadley, P.C.
Registrar and Transfer Company
147 Charter Oak Avenue
10 Commerce Drive
Hartford, Connecticut 06106
Cranford, New Jersey 07016
 
Corporate Counsel
 
Muldoon Murphy & Aguggia LLP
5101 Wisconsin Avenue, NW
Washington, DC 20016

 
63
 



Main Office
 
333 Church Street
Naugatuck, Connecticut 06770
 
Branch Offices
 
1009 New Haven Road
Naugatuck, Connecticut 06770
 
127 South Main Street
Beacon Falls, Connecticut 06403
 
49 Pershing Drive
Derby, Connecticut 06418
 
249 West Street
Seymour, Connecticut 06483
 
504 Bridgeport Avenue
Shelton, Connecticut 06484
 
15 Quaker Farms Road
Southbury, Connecticut 06488
(Opening Summer 2006)

 

64
 EX-23.0 4 ex23-0.htm EX-23.0 EX-23.0
Exhibit 23.0

Consent of Whittlesey & Hadley, P.C.
 
 
 
 
 
 

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


We consent to the incorporation by reference in Registration Statements No. 333-124840 and No. 333-119499 on Form S-8 of Naugatuck Valley Financial Corporation of our report, dated February 19, 2006 appearing in this annual report on Form 10-K of Naugatuck Valley Financial Corporation for the year ended December 31, 2005.

/s/ Whittlesey & Hadley, P.C.

Hartford, Connecticut
March 28, 2006

 EX-31.1 5 ex31-1.htm EX-31.1 EX-31.1
Exhibit 31.1

Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer
 

 

CERTIFICATION

I, John C. Roman, certify that:

 
1.
I have reviewed this report on Form 10-K of Naugatuck Valley Financial Corporation;

 
2.
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

 
3.
Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

 
4.
The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

 
(a)
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

 
(b)
Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as the end of the period covered by this report based on such evaluation; and

   
(c)
Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and

 
5.
The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

 
(a)
All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

 
(b)
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.



Date: March 28, 2006
/s/ John C. Roman
 
John C. Roman
 
President and Chief Executive Officer
 
(principal executive officer)
EX-31.2 6 ex31-2.htm EX-31.2 EX-31.2
Exhibit 31.2

Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer


CERTIFICATION

I, Lee R. Schlesinger, Vice President and Treasurer of Naugatuck Valley Financial Corporation, certify that:

 
1.
I have reviewed this report on Form 10-K of Naugatuck Valley Financial Corporation;

 
2.
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

 
3.
Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

 
4.
The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

 
(a)
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

 
(b)
Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as the end of the period covered by this report based on such evaluation; and

 
(c)
Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and

 
5.
The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

 
(a)
All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

 
(b)
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.


Date: March 28, 2006
/s/ Lee R. Schlesinger
 
Lee R. Schlesinger
 
Vice President and Treasurer
 
(principal financial and accounting officer
EX-32.0 7 ex32-0.htm EX-32.0 EX-32.0
Exhibit 32.0


Section 1350 Certification of Chief Executive Officer and Chief Financial Officer


CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADDED BY
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002


In connection with the Annual Report of Naugatuck Valley Financial Corporation (the “Company”) on Form 10-K for the period ended December 31, 2005 as filed with the Securities and Exchange Commission (the “Report”), the undersigned hereby certify, pursuant to 18 U.S.C. §1350, as added by § 906 of the Sarbanes-Oxley Act of 2002, that:

 
(1)
The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

 
(2)
The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company as of and for the period covered by the Report.




 
/s/ John C. Roman
 
John C. Roman
 
President and Chief Executive Officer
   
   
 
/s/ Lee R. Schlesinger
 
Lee R. Schlesinger
 
Vice President and Treasurer
 
(Principal Financial and Accounting Officer)



March 28, 2006

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