10-K 1 d444238d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

þ

Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Fiscal Year Ended December 31, 2012

OR

¨

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 001-33898

 

 

Meridian Interstate Bancorp, Inc.

(Exact name of registrant as specified in its charter)

 

Massachusetts   20-4652200

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

10 Meridian Street,

East Boston, Massachusetts

 

02128

Zip Code

(Address of Principal Executive Offices)  

(617) 567-1500

(Registrant’s telephone number, including area code)

Securities Registered Pursuant to Section 12(b) of the Act:

Title of Each Class

 

Name of Each Exchange on Which Registered

Common Stock, no par value   The NASDAQ Stock Market, LLC

Securities Registered Pursuant to Section 12(g) of the Act:

None

 

 

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

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days.    Yes  þ    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  þ    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of 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.  þ

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

 

Large Accelerated Filer  

 

¨

              Accelerated Filer    

þ

 

                Non-Accelerated Filer  

 

¨

 

      Smaller Reporting Company  

 

¨

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

The aggregate market value of the common stock held by non-affiliates of the Registrant, computed by reference to the closing price of such stock on June 30, 2012 was approximately $108,314,541. As of March 1, 2013, there were 22,138,805 outstanding shares of the Registrant’s common stock.

 

 

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the 2013 Annual Meeting of Stockholders of the Registrant are incorporated by reference in Part III of this Form 10-K.

 

 

 


Table of Contents

MERIDIAN INTERSTATE BANCORP, INC.

2012 FORM 10-K ANNUAL REPORT

TABLE OF CONTENTS

 

         Page  
  PART I   
 

Forward Looking Statements

     3   

Item 1.

 

Business

     3   

Item 1A.

 

Risk Factors

     26   

Item 1B.

 

Unresolved Staff Comments

     34   

Item 2.

 

Properties

     35   

Item 3.

 

Legal Proceedings

     36   

Item 4.

 

Mine Safety Disclosures

     36   
  PART II   

Item 5.

 

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

     36   

Item 6.

 

Selected Financial Data

     39   

Item 7.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     40   

Item 7A.

 

Quantitative and Qualitative Disclosures about Market Risk

     62   

Item 8.

 

Financial Statements and Supplementary Data

     63   

Item 9.

 

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

     124   

Item 9A.

 

Controls and Procedures

     124   

Item 9B.

 

Other Information

     124   
  PART III   

Item 10.

 

Directors, Executive Officers, and Corporate Governance

     125   

Item 11.

 

Executive Compensation

     125   

Item 12.

 

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

     125   

Item 13.

 

Certain Relationships and Related Transactions, and Director Independence

     125   

Item 14.

 

Principal Accounting Fees and Services

     125   
  PART IV   

Item 15.

 

Exhibits and Financial Statement Schedules

     126   

Signatures

     129   

 

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PART I

Forward Looking Statements

This report contains certain “forward-looking statements,” which can be identified by the use of such words as estimate, project, believe, intend, anticipate, plan, seek and similar expressions. These forward looking statements include:

 

   

statements of our goals, intentions and expectations;

 

   

statements regarding our business plans, prospects, growth and operating strategies;

 

   

statements regarding the quality of our loan and investment portfolios; and

 

   

estimates of our risks and future costs and benefits.

These forward-looking statements are subject to significant risks and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:

 

   

general economic conditions, either nationally or in our market area, that are worse than expected;

 

   

inflation and changes in the interest rate environment that reduce our interest margins or reduce the fair value of financial instruments;

 

   

increased competitive pressures among financial services companies;

 

   

changes in consumer spending, borrowing and savings habits;

 

   

our ability to enter new markets successfully and take advantage of growth opportunities, and the possible dilutive effect of potential acquisitions or de novo branches, if any;

 

   

legislative or regulatory changes that adversely affect our business;

 

   

adverse changes in the securities markets;

 

   

changes in accounting policies and practices, as may be adopted by the bank regulatory agencies, the Financial Accounting Standards Board or the Securities and Exchange Commission;

 

   

inability of third-party providers to perform their obligations to us; and

 

   

changes in our organization, compensation and benefit plans.

Any of the forward-looking statements that we make in this report and in other public statements we make may later prove incorrect because of inaccurate assumptions we might make, the factors illustrated above or other factors that we cannot foresee. Because of these and other uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements and you should not rely on such statements. In addition, please see “Item 1A. Risk Factors.” Except as may be required by law, we disclaim any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

 

ITEM 1. BUSINESS

Meridian Interstate Bancorp, Inc.

Meridian Interstate Bancorp, Inc. (the “Company”) is a Massachusetts mid-tier stock holding company that was formed in 2006 by East Boston Savings Bank to be its holding company. The Company owns all of East Boston Savings Bank’s capital stock and directs, plans and coordinates East Boston Savings Bank’s business activities. The Company previously owned 43% of the capital stock of Hampshire First Bank, a New Hampshire chartered bank, organized in 2006 and headquartered in Manchester, New Hampshire. On November 16, 2011, Hampshire First Bank entered into an Agreement and Plan of Merger with NBT Bancorp, Inc. (“NBTB”) and NBT Bank, N.A. which was completed on June 8, 2012. For more information about this transaction, see “Item 1 — Business — Subsidiaries and Affiliates.” At December 31, 2012, the Company had total assets of $2.279 billion, deposits of $1.865 billion and stockholders’ equity of $233.9 million.

 

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Meridian Financial Services, Incorporated

Meridian Financial Services, Incorporated (“Meridian”) is the Company’s Massachusetts-chartered mutual holding company parent. As a mutual holding company, Meridian is a non-stock company. Meridian owns 59.5% of the Company’s common stock. So long as Meridian exists, it will own a majority of the voting stock of the Company and, through its Board of Trustees, will be able to exercise voting control over most matters put to a vote of stockholders. Of the 12 directors of the Company, 10 are also members of the Board of Trustees of Meridian, which is composed of 30 members. Meridian does not currently intend to engage in any business activity other than those relating to owning a majority of the common stock of the Company.

East Boston Savings Bank

East Boston Savings Bank (the “Bank”) is a Massachusetts-chartered stock savings bank that operates from 26 full-service locations and three loan centers in the greater Boston metropolitan area. The Bank operates nine of its full-service locations and a loan center under the name Mt. Washington Bank, a Division of East Boston Savings Bank. The Bank was originally founded in 1848. We offer a variety of deposit and loan products to individuals and businesses located in our primary market, which consists of Suffolk, Middlesex and Essex Counties, Massachusetts.

We operate as a community-oriented financial institution offering 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 real estate, multi-family and commercial real estate, construction, commercial business and consumer loans which we primarily hold for investment. Our lending business also involves the purchase and sale of loan participation interests. We also offer non-deposit financial products through a third-party network arrangement. On January 4, 2010, the Bank completed its acquisition of Mt. Washington Co-operative Bank (“Mt. Washington”). Refer to Item 8 Financial Statements and Supplementary Data, Note 2 to the consolidated financial statements for information regarding the transaction.

Available Information

The Company is a public company and files interim, quarterly and annual reports with the Securities and Exchange Commission. These respective reports are on file and a matter of public record with the Securities and Exchange Commission and may be read and copied at the Securities and Exchange Commission’s Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the Securities and Exchange Commission at 1-800-SEC-0330. The Securities and Exchange Commission maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC (http://www.sec.gov).

Our website address is www.ebsb.com. Information on our website should not be considered a part of this report.

Market Area

We consider the greater Boston metropolitan area to be our primary market area. While our primary deposit-gathering area is concentrated in the greater Boston metropolitan area, our lending area encompasses a broader market that includes most of eastern Massachusetts east of Route 93, including Cape Cod, and portions of south-eastern New Hampshire and Maine. We conduct our operations through our 26 full-service offices and three loan centers located in the following counties, all of which are located in the greater Boston metropolitan area: Essex (five offices and two loan centers), Middlesex (six offices) and Suffolk (15 offices and one loan center). The greater Boston metropolitan area is the 10th largest metropolitan area in the United States. Located adjacent to major transportation corridors, the Boston metropolitan area provides a highly diversified economic base, with major employment sectors ranging from services, manufacturing and wholesale retail trade, to finance, technology and medical care. Based on data from the Federal Reserve Bank of Boston, the unemployment rate for Massachusetts decreased to 6.7% for December 2012 from 6.9% from December 2011. Home prices in Massachusetts rose at an annual rate of 2.6% in the third quarter of 2012 compared to 2.6% for the third quarter of 2011.

 

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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 many financial institutions operating in our market area and, to a lesser extent, from other financial service companies such as brokerage firms and insurance companies. Several large holding companies operate banks in our market area. These institutions are significantly larger than us and, therefore, have greater resources. We also face competition for investors’ funds from money market funds, mutual funds and other corporate and government securities. Based on data from the Federal Deposit Insurance Corporation (the “FDIC”) as of June 30, 2012, the Bank had 0.73% of the deposit market share within the Boston-Cambridge-Quincy, Massachusetts — New Hampshire metropolitan statistical area.

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 remain intense in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Technological advances, for example, have lowered barriers to entry, allowed banks to expand their geographic reach by providing services over the internet and made it possible for non-depository institutions to offer products and services that traditionally have been provided by banks. Changes in federal law permit affiliation among banks, securities firms and insurance companies, which promotes a competitive environment in the financial services industry.

Lending Activities

Commercial Real Estate Loans

At December 31, 2012, commercial real estate loans were $795.6 million, or 44.0%, of our total loan portfolio. The commercial real estate loan portfolio consisted of $167.9 million of fixed-rate loans and $627.7 million of adjustable-rate loans at December 31, 2012. We currently target new individual commercial real estate loan originations to small- and mid-size owner occupants and investors in our market area and can, by policy, originate loans to one borrower up to $25.0 million, with exceptions greater than $25.0 million as approved by the Bank’s Executive Committee of the Board of Directors. Our commercial real estate loans are generally secured by properties used for business purposes such as office buildings, industrial facilities and retail facilities. We intend to continue to grow our commercial real estate loan portfolio while maintaining prudent underwriting standards. In addition to originating these loans, we also participate in loans with other financial institutions.

We originate a variety of fixed- and adjustable-rate commercial real estate loans for terms up to 30 years. Interest rates and payments on our adjustable-rate loans adjust every three or five years and generally are adjusted to a rate equal to a percentage above the corresponding U.S. Treasury rate or Federal Home Loan Bank borrowing rate. Most of our adjustable-rate commercial real estate loans adjust every five years and amortize over terms of 20 to 25 years. The maximum amount by which the interest rate may be increased or decreased is generally 2.5% per adjustment period, with a lifetime interest rate cap of 5% over the initial interest rate of the loan. Loan amounts generally do not exceed 75% to 80% of the property’s appraised value at the time the loan is originated.

At December 31, 2012, loan participations purchased totaled $57.9 million. The properties securing these loans are located primarily in eastern Massachusetts and southern New Hampshire. Our underwriting practices with respect to loan participations generally do not differ from loans that we originate.

One-to Four-Family Residential Loans

Our one-to four-family residential loan portfolio consists of mortgage loans that enable borrowers to purchase or refinance existing homes, most of which serve as the primary residence of the owner. At December 31, 2012, one-to four-family residential loans were $443.2 million, or 24.5% of our total loan portfolio, consisting of $134.1 million and $309.1 million of fixed-rate and adjustable-rate loans, respectively. We generally offer fixed-rate loans with terms up to 30 years and adjustable-rate loans with terms up to 40 years.

 

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Generally, our fixed-rate loans conform to Fannie Mae and Freddie Mac underwriting guidelines and those with longer terms (more than 15 years) are originated with the intention to sell. Our adjustable-rate mortgage loans generally adjust annually or every three years after an initial fixed period that ranges from three to seven years. Management has the intent and ability to hold the remaining fixed-rate bi-weekly loans in the Company’s loan portfolio for the foreseeable future or until maturity or pay-off. Interest rates and payments on our adjustable-rate loans generally are adjusted to a rate equal to a percentage above the one or three year U.S. Treasury index. Depending on the loan type, the maximum amount by which the interest rate may be increased or decreased is generally 2% per adjustment period and the lifetime interest rate caps range from 2% to 4% over the initial interest rate of the loan. Our residential loans generally do not have prepayment penalties.

Borrower demand for adjustable-rate compared to fixed-rate loans is a function of the level of interest rates, the expectations of changes in the level of interest rates, and the difference between the interest rates and loan fees offered for fixed-rate mortgage loans as compared to the interest rates and loan fees for adjustable-rate loans. The relative amount of fixed-rate and adjustable-rate mortgage loans that can be originated at any time is largely determined by the demand for each in a competitive environment. The loan fees, interest rates and other provisions of mortgage loans are determined by us on the basis of our own pricing criteria and competitive market conditions.

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 either 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. We do not offer loans with negative amortization and generally do not offer interest-only one-to four-family residential real estate loans. Additionally, our current practice is generally (1) to sell to the secondary market newly originated longer term (more than 15 year terms) fixed-rate one-to four-family residential real estate loans, and (2) to hold in our portfolio shorter-term fixed-rate loans, bi-weekly amortization loans and adjustable-rate loans. We sell residential real estate loans in the secondary market, primarily with servicing released. We also sell loans to Fannie Mae, the Federal Home Loan Bank Mortgage Partnership Finance Program and other investors with servicing retained.

We will make loans with loan-to-value ratios up to 95% (100% for first time home buyers) with such value measured at origination; however, we generally require private mortgage insurance for loans with a loan-to-value ratio over 80%. We require all properties securing mortgage loans to be appraised by a licensed real estate appraiser. We generally require title insurance on all first mortgage loans. Borrowers must obtain hazard insurance, and flood insurance is required for loans on properties located in a flood zone.

In an effort to provide financing for first-time buyers, we offer five-year adjustable-rate and fixed-rate 30-year residential real estate loans through the Massachusetts Housing Finance Agency First Time Home Buyer Program. We offer mortgage loans through this program to qualified individuals and originate the loans using modified underwriting guidelines, reduced interest rates and loan conditions.

We also offer loans secured by one-to four-family properties that are not owner-occupied. These loans consist primarily of bi-weekly fixed-rate loans with terms up to 30 years and adjustable-rate loans which adjust annually after an initial fixed period of three years or adjust every three years after an initial fixed period of five years. Non-owner-occupied one-to four-family residential loans generally can be made with a loan-to-value ratio of up to 80% with such value measured at origination. At December 31, 2012, these loans totaled $62.2 million.

To a lesser extent we also originate land loans primarily to local contractors and developers for making improvements on approved one-to four-family building lots. Such loans are generally written with a maximum 75% loan-to-value ratio based upon the appraised value or purchase price, whichever is less, for a term of up to three years. Interest rates on our land loans are fixed for three years. At December 31, 2012, land loans totaled $1.2 million.

 

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Multi-Family Real Estate Loans

At December 31, 2012, multi-family real estate loans were $178.9 million, or 9.9%, of our total loan portfolio. The multi-family loan portfolio consisted of $6.7 million of fixed-rate loans and $172.2 million of adjustable-rate loans at December 31, 2012. We currently target new individual multi-family real estate loan originations to small- and mid-size owners and investors in our market area and can, by policy, originate loans to one borrower up to $25.0 million, with exceptions greater than $25.0 million as approved by the Bank’s Executive Committee of the Board of Directors. Our multi-family real estate loans are generally secured by apartment buildings. We intend to continue to grow our multi-family loan portfolio, while maintaining prudent underwriting standards. In addition to originating these loans, we also participate in loans with other financial institutions.

We originate a variety of adjustable-rate multi-family real estate loans for terms up to 30 years. Interest rates and payments on our adjustable-rate loans adjust every three, five or seven years and generally are adjusted to a rate equal to a percentage above the corresponding U.S. Treasury rate or Federal Home Loan Bank borrowing rate. Most of our adjustable-rate multi-family real estate loans adjust every five years and amortize over terms of 20 to 25 years. The maximum amount by which the interest rate may be increased or decreased is generally 2.5% per adjustment period. Loan amounts generally do not exceed 75% to 80% of the property’s appraised value at the time the loan is originated.

Construction Loans

At December 31, 2012, construction loans were $173.3 million, or 9.6% of our total loan portfolio. We expect to continue some level of construction lending, when appropriate, while maintaining a guarded, disciplined approach given the current decline in demand in the local real estate market. We remain focused on a strong credit culture and underwriting standards, as described below. In addition, we continue to carefully monitor the existing construction portfolio for performance and project completion, with a goal of moving completed commercial projects to the commercial real estate portfolio and reviewing sales based projects for tracking toward construction goals.

We primarily make construction loans for commercial development projects, including apartment buildings, small industrial buildings and retail and office buildings. We also originate adjustable loans to individuals and to builders to finance the construction of residential dwellings. Most of our construction loans are interest-only loans that provide for the payment of only interest during the construction phase, which is usually up to 12 to 24 months, although some construction loans are renewed, generally for one or two additional years. At the end of the construction phase, the loan may convert to a permanent mortgage loan or the loan may be paid in full. Loans generally can be made with a maximum loan-to-value ratio of 80% of the appraised market value upon completion of the project. As appropriate to the underwriting, a “discounted cash flow analysis” is utilized. Before making a commitment to fund a construction loan, we require an appraisal of the property by an independent licensed appraiser. We also will generally require an inspection of the property before disbursement of funds during the term of the construction loan.

We also originate construction and site development loans to contractors and builders to finance the construction of single-family homes and subdivisions. While we may originate these loans whether or not the collateral property underlying the loan is under contract for sale, we consider each project carefully in light of the current slow-down in the residential real estate market. Residential real estate construction loans include single-family tract construction loans for the construction of entry level residential homes. Loans to finance the construction of single-family homes and subdivisions are generally offered to experienced builders in our primary market areas. The maximum loan-to-value limit applicable to these loans is generally 75% to 80% of the appraised market value upon completion of the project. Development plans are required from builders prior to making the loan. Our loan officers are required to personally visit the proposed site of the development and the sites of competing developments. We require that builders maintain adequate insurance coverage. While maturity dates for residential construction loans are largely a function of the estimated construction period of the project, and generally do not exceed one year, land development loans generally are for 18 to 24 months. Substantially all of our residential construction loans have adjustable rates of interest based on U.S. Treasury rates, Federal Home

 

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Loan Bank rates or The Wall Street Journal prime rate, and during the term of construction, the accumulated interest is added to the principal of the loan through an interest reserve. Construction loan proceeds are disbursed periodically in increments as construction progresses and as inspection by our approved inspectors warrant.

At December 31, 2012, we had $39.8 million in construction loans for one-to four-family residential properties that will convert to permanent loans. Also at that date, we had $133.5 million in construction loans on commercial and multi-family real estate consisting of mixed-use and non-residential loans.

Commercial Business Loans

We make commercial business loans primarily in our market area to a variety of professionals, sole proprietorships, nonprofit organizations and small businesses. At December 31, 2012, commercial business loans were $147.8 million, or 8.2% of our total loan portfolio, and we intend to increase the amount of commercial business loans that we originate. In the third quarter of 2011, we significantly expanded our commercial business lending capacity with the establishment of a new corporate banking division comprised of a veteran team of bankers that is expected to enhance our presence in all of our market areas and add strength to our business platform.

Commercial lending products include term loans and revolving lines of credit. Commercial loans and lines of credit are made with either variable or fixed rates of interest. Variable rates are based on the prime rate as published in The Wall Street Journal, plus a margin. Initial rates on fixed-rate business loans are generally based on a corresponding U.S. Treasury or Federal Home Loan Bank rate, plus a margin. Commercial business loans typically have shorter maturity terms and higher interest rates than commercial real estate loans, but may involve more credit risk because of the type and nature of the collateral. We are focusing our efforts on small- to medium-sized, privately-held companies with local or regional businesses that operate in our market area and can, by policy, originate loans to one borrower up to $25.0 million, with exceptions greater than $25.0 million as approved by the Bank’s Executive Committee of the Board of Directors.

When making commercial loans, we consider the financial statements of the borrower, our lending history with the borrower, the debt service capabilities of the borrower, the projected cash flows of the business and the value of the collateral, primarily real estate, accounts receivable, inventory and equipment. Depending on the collateral used to secure the loans, commercial loans are made in amounts of up to 80% of the value of the collateral securing the loan. All of these loans are secured by assets of the respective borrowers.

Home Equity Lines of Credit

We offer home equity lines of credit, which are secured by owner-occupied one-to four-family residences. At December 31, 2012, the outstanding balance owed on home equity lines of credit amounted to $60.9 million, or 3.4% of our total loan portfolio. Home equity lines of credit have adjustable rates of interest with ten-year draws amortized over 15 years that are indexed to the Prime Rate as published by The Wall Street Journal on the last business day of the month. Our home equity lines either have a monthly variable interest rate or an interest rate that is fixed for five years and that adjusts in years six and 11. We offer home equity lines of credit with cumulative loan-to-value ratios generally up to 80%, when taking into account both the balance of the home equity loans and first mortgage loan.

The procedures for underwriting home equity lines of credit include an assessment of the applicant’s payment history on other debts and ability to meet existing obligations and payments on the proposed loan. Although the applicant’s creditworthiness is a primary consideration, the underwriting process also includes a comparison of the value of the collateral to the proposed loan amount. The procedures for underwriting one-to four-family residential real estate loans apply equally to home equity loans.

Consumer Loans

We offer automobile loans, loans secured by passbook or certificate accounts and overdraft loans. At December 31, 2012, consumer loans were $7.1 million, or 0.4% of total loans. The procedures for underwriting consumer loans include an assessment of the applicant’s payment history on other debts and ability to meet

 

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existing obligations and payments on the proposed loan. 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.

Loan Underwriting Risks

Adjustable-Rate Loans

While we anticipate that adjustable-rate loans will better offset the adverse effects of an increase in interest rates as compared to fixed-rate mortgages, an increased monthly mortgage payment required of adjustable-rate loan borrowers in a rising interest rate environment could cause an increase in delinquencies and defaults. The marketability of the underlying property also may be adversely affected in a high interest rate environment. In addition, although adjustable-rate mortgage loans 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 on residential loans.

Commercial and Multi-Family Real Estate Loans

Loans secured by commercial and multi-family 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 commercial and multi-family 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 commercial and multi-family real estate loans. In reaching a decision on whether to make a commercial or multi-family real estate loan, we consider and review a global cash flow analysis of the borrower and consider the net operating income of the property, the borrower’s expertise, credit history and profitability and the value of the underlying property. We have generally required that the properties securing these real estate loans have debt service coverage ratios (the ratio of earnings before debt service to debt service) of at least 1.20x. An environmental phase one report is obtained when the possibility exists that hazardous materials may have existed on the site, or the site may have been impacted by adjoining properties that handled hazardous materials. Land loans secured by improved lots generally involve greater risks than residential mortgage lending because land loans are more difficult to evaluate. If the estimate of value proves to be inaccurate, in the event of default and foreclosure, we may be confronted with a property the value of which is insufficient to assure full payment.

Construction Loans

Our construction loans are based upon estimates of costs and values associated with the completed project. Construction lending involves additional risks when compared with permanent residential lending because funds are advanced upon the security of the project, which is of uncertain value prior to its completion. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation of real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the related loan-to-value ratio. This type of lending also typically involves higher loan principal amounts and is often concentrated with a small number of builders. In addition, generally during the term of a construction loan, interest may be funded by the borrower or disbursed from an interest reserve set aside from the construction loan budget. These loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project and the ability of the borrower to sell or lease the property or obtain permanent take-out financing, rather than the ability of the borrower or guarantor to repay principal and interest. If our appraisal of the value of a completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project and may incur a loss. A discounted cash flow analysis is utilized for determining the value of any construction project of five or more units. Our ability to continue to originate a significant amount of construction loans is dependent on the strength of the housing market in our market areas.

 

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Commercial Business Loans

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 and the collateral securing these loans may fluctuate in value. Our commercial business loans are originated primarily based on the identified cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. Most often, this collateral consists of real estate, accounts receivable, inventory or equipment. Credit support provided by the borrower for most of these loans and the probability of repayment is based on the liquidation of the pledged collateral and enforcement of a personal guarantee, if any. 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

Consumer loans may entail greater risk than residential mortgage loans, particularly in the case of consumer loans that are unsecured or secured by assets that depreciate rapidly, such as motor vehicles. Repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan and a small remaining deficiency often does not warrant further substantial collection efforts against the borrower. Consumer loan collections depend on the borrower’s continuing financial stability, and therefore are likely to be adversely affected by various factors, including 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 that can be recovered on such loans.

Loan Originations, Purchase and Sales

Loan originations come from a variety of sources. The primary sources of loan originations are current customers, walk-in traffic, our website, advertising and referrals from customers as well as our directors, trustees and corporates. We advertise in newspapers that are widely circulated throughout our market area and on local radio. We also participate in loans with others to supplement our origination efforts. We generally do not purchase whole loans.

We generally originate loans for our portfolio; however, we generally agree to sell to the secondary market newly originated conforming fixed-rate, 16- to 30-year one-to four-family residential real estate loans. Our decision to sell loans is based on prevailing market interest rate conditions and interest rate risk management. We sell residential real estate loans in the secondary market, primarily with servicing released. We also sell loans to Fannie Mae, the Federal Home Loan Bank Mortgage Partnership Finance Program and other investors with servicing retained. In addition, we sell participation interests in commercial real estate loans to local financial institutions, primarily on the portion of loans exceeding our borrowing limits, or as is prudent in concert with recognition of credit risk. For the years ended December 31, 2012 and December 31, 2011, we originated $191.6 million and $97.6 million of residential real estate loans for sale, respectively, and sold $183.0 million and $106.4 million of loans, respectively. At December 31, 2012, we were servicing $174.3 million of residential real estate loans for others.

Loan Approval Procedures and Authority

Our lending activities follow written, non-discriminatory, underwriting standards and loan origination procedures established by the Bank’s Board of Directors and management. The Bank’s Board of Directors has granted loan approval authority to certain officers up to prescribed limits, depending on the officer’s experience, the type of loan and whether the loan is secured or unsecured. Loans below $1.0 million require approval by members of senior management. Loans from $1.0 million up to $2.0 million require approval by management’s loan committee. Loans in excess of $2.0 million generally must be authorized by the Bank’s Executive Committee of the Board of Directors.

 

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Loans-to-One Borrower Limit and Loan Category Concentration

The maximum amount that we may lend to one borrower and the borrower’s related entities is generally limited, by statute, to 20% of our capital, which is defined under Massachusetts law as the sum of our capital stock, surplus account and undivided profits. At December 31, 2012, our regulatory limit on loans-to-one borrower was $40.1 million. At that date, our largest lending relationship consisted of one loan for $25.2 million and was secured by commercial real estate. This loan was performing in accordance with its original repayment terms at December 31, 2012.

Loan Commitments

We issue commitments for fixed- 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. Generally, our loan commitments expire after 60 days.

Investment Activities

We have legal authority to invest in various types of liquid assets, including U.S. Treasury obligations, securities of various government-sponsored enterprises, residential mortgage-backed securities and municipal governments, deposits at the Federal Home Loan Bank of Boston, certificates of deposit of federally insured institutions, investment grade corporate bonds and investment grade marketable equity securities, including common stock and money market mutual funds. Our equity securities generally pay dividends. We also are required to maintain an investment in Federal Home Loan Bank of Boston stock, which investment is based on the level of our FHLB borrowings. While we have the authority under applicable law to invest in derivative securities, we had no investments in derivative securities at December 31, 2012.

At December 31, 2012, our investment portfolio consisted primarily of corporate bonds, municipal bonds, investment-grade marketable equity securities, money market mutual fund investments, short-term obligations of government-sponsored enterprises and mortgage-backed securities.

Our investment objectives are to provide and maintain liquidity, to establish an acceptable level of interest rate and credit risk, to provide a use of funds when demand for loans is weak and to generate a favorable return. Our Board of Directors has the overall responsibility for the investment portfolio, including approval of our investment policy. The Executive Committee of the Board of Directors and management are responsible for implementation of the investment policy and monitoring our investment performance. Our Executive Committee reviews the status of our investment portfolio monthly.

Each reporting period, the Company evaluates all securities with a decline in fair value below the amortized cost of the investment to determine whether or not the impairment is deemed to be other-than-temporary (“OTTI”). OTTI is required to be recognized if (1) the Company intends to sell the security; (2) it is “more likely than not” that the Company will be required to sell the security before recovery of its amortized cost basis; or (3) for debt securities, the present value of expected cash flows is not sufficient to recover the entire amortized cost basis. Marketable equity securities are evaluated for OTTI based on the severity and duration of the impairment and, if deemed to be other than temporary, the declines in fair value are reflected in earnings as realized losses. For impaired debt securities that the Company intends to sell, or more likely than not will be required to sell, the full amount of the depreciation is recognized as OTTI through earnings. For all other impaired debt securities, credit-related OTTI is recognized through earnings and non-credit related OTTI is recognized in other comprehensive income/loss, net of applicable taxes.

Deposit Activities and Other Sources of Funds

General

Deposits, borrowings and loan repayments are the major sources of our funds for lending and other investment purposes. Scheduled 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 market conditions.

 

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Deposit Accounts

The substantial majority of our depositors reside in our market area. Deposits are attracted by advertising and through our website, primarily from within our market area through the offering of a broad selection of deposit instruments, including non-interest-bearing demand deposits (such as checking accounts), interest-bearing demand accounts (such as NOW and money market accounts), savings accounts and certificates of deposit. In addition to accounts for individuals, we also offer several commercial checking accounts designed for the businesses operating in our market area.

Deposit account terms vary according to the minimum balance required, the time period that 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, our liquidity needs, profitability, and customer preferences and concerns. We generally review our deposit mix and pricing on a weekly basis. Our deposit pricing strategy has generally been to offer competitive rates and to periodically offer special rates in order to attract deposits of a specific type or term.

Borrowings

We may utilize advances from the Federal Home Loan Bank of Boston to supplement our supply of investable funds. The Federal Home Loan Bank functions as a central reserve bank providing credit for its member financial institutions. As a member, we are required to own capital stock in the Federal Home Loan Bank and are authorized to apply for advances on the security of such stock and certain of our whole first 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. As of December 31, 2012, we had $69.3 million of available borrowing capacity with the Federal Home Loan Bank of Boston, including an available line of credit of $9.4 million at an interest rate that adjusts daily. All of our borrowings from the Federal Home Loan Bank are secured by a blanket lien on qualified collateral, including certain investment securities and first mortgage loans on owner-occupied residential property held in the Bank’s portfolio.

Financial Services

We offer customers a range of non-deposit products, including mutual funds, annuities, stocks and bonds which are offered and cleared by a third-party broker-dealer. We receive a portion of the commissions generated by our sales to our customers. We also offer customers long-term care insurance through a third-party insurance company which generates commissions for us. Our non-deposit products generated $432,000, $198,000 and $302,000 of non-interest income during the years ended December 31, 2012, 2011 and 2010, respectively.

Personnel

As of December 31, 2012, we had 348 full-time and 85 part-time employees, none of whom is represented by a collective bargaining unit. We believe our working relationship with our employees is excellent.

Subsidiaries and Affiliates

In addition to the Bank, the Company has another wholly-owned subsidiary, Meridian Interstate Funding Corporation, a Massachusetts corporation established in 2008 to loan funds to the Company’s Employee Stock Ownership Plan (“ESOP”) to purchase stock in our initial public offering. At December 31, 2012, Meridian Interstate Funding Corporation had total assets of $10.0 million and total equity of $9.8 million.

The Company previously owned a 43% share in Hampshire First Bank, a New Hampshire chartered bank, organized and headquartered in Manchester, New Hampshire, which was accounted for using the equity method. On November 16, 2011, Hampshire First Bank entered into an Agreement and Plan of Merger with NBTB and NBT Bank, N.A. which was completed on June 8, 2012, with the Company recognizing a pre-tax gain of

 

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$4.8 million and receiving $6.6 million of cash and 547,481 NBTB shares totaling $11.1 million as proceeds from the sale.

The Bank’s subsidiaries include Prospect, Inc., which engages in securities transactions on its own behalf, EBOSCO, LLC and Berkeley Riverbend Estates, LLC, both of which hold foreclosed real estate; and East Boston Investment Services, Inc. which is authorized for third-party investment sales and is currently inactive.

Regulation and Supervision

General

The Bank is currently a Massachusetts-charted stock savings bank, and is the wholly-owned subsidiary of the Company, a Massachusetts corporation and registered bank holding company, which is a 59.5% owned subsidiary of Meridian, a Massachusetts mutual holding company and registered bank holding company. The Bank’s deposits are insured up to applicable limits by the FDIC and by the Depositors Insurance Fund for amounts in excess of the FDIC insurance limits. The Bank is subject to extensive regulation by the Massachusetts Commissioner of Banks, as its chartering agency, and by the FDIC, as its deposit insurer. The Bank is required to file reports with, and is periodically examined by, the FDIC and the Massachusetts Commissioner of Banks concerning its activities and financial condition and must obtain regulatory approvals prior to entering into certain transactions, including, but not limited to, mergers with or acquisitions of other financial institutions. The Bank is a member of the Federal Home Loan Bank of Boston. The Company and Meridian are regulated as bank holding companies by the Federal Reserve Board and the Massachusetts Commissioner of Banks.

The regulation and supervision of the Bank establish a comprehensive framework of activities in which an institution can engage and is intended primarily for the protection of depositors and borrowers and, for purposes of the FDIC, the protection of the insurance fund. 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 regulatory requirements and policies, whether by the applicable state legislature, the FDIC or Congress, could have a material adverse impact on Meridian, the Company or the Bank and their operations.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) made extensive changes in the regulation of depository institutions and their holding companies. Certain provisions of the Dodd-Frank Act have had a near term impact on the Bank and the Company. For example, the Dodd-Frank Act created a new Consumer Financial Protection Bureau as an independent bureau of the Federal Reserve Board. On July 21, 2011, the Consumer Financial Protection Bureau assumed responsibility for the implementation of the federal financial consumer protection and fair lending laws and regulations, a function currently assigned to prudential regulators, and will have authority to impose new requirements. However, institutions of less than $10 billion in assets, such as the Bank, will continue to be examined for compliance with consumer protection and fair lending laws and regulations by, and be subject to the enforcement authority of, their prudential regulator, although the Consumer Financial Protection Bureau will have back-up authority to examine and enforce consumer protection laws against all institutions, including institutions with less than $10 billion in assets.

In addition to creating the Consumer Financial Protection Bureau, the Dodd-Frank Act, among other things, directs changes in the way that institutions are assessed for deposit insurance, mandates the imposition of tougher consolidated capital requirements on holding companies, requires the issuance of regulations requiring originators of securitized loans to retain a percentage of the risk for the transferred loans, imposes regulatory rate-setting for certain debit card interchange fees, repealed restrictions on the payment of interest on commercial demand deposits and contained a number of reforms related to mortgage originations. Many of the provisions of the Dodd-Frank Act are subject to delayed effective dates and/or require the issuance of implementing regulations. Their impact on operations cannot yet be fully assessed. However, there is significant possibility that the Dodd-Frank Act will, at a minimum, result in increased regulatory burden, compliance costs and interest expense for the Bank and the Company.

 

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Certain regulatory requirements applicable to the Bank, the Company and Meridian are referred to below or elsewhere herein. The description of statutory provisions and regulations applicable to savings banks and their holding companies set forth below and elsewhere in this document does not purport to be a complete description of such statutes and regulations and their effects on the Bank, the Company and Meridian and is qualified in its entirety by reference to the actual laws and regulations involved.

Massachusetts Banking Laws and Supervision

The Bank, as a Massachusetts savings bank, is regulated and supervised by the Massachusetts Commissioner of Banks. The Massachusetts Commissioner of Banks is required to regularly examine each state-chartered bank. The approval of the Massachusetts Commissioner of Banks is required to establish or close branches, to merge with another bank, to form a holding company, to issue stock or to undertake many other activities. Any Massachusetts bank that does not operate in accordance with the regulations, policies and directives of the Massachusetts Commissioner of Banks may be sanctioned. The Massachusetts Commissioner of Banks may suspend or remove directors or officers of a bank who have violated the law, conducted a bank’s business in a manner that is unsafe, unsound or contrary to the depositors’ interests, or been negligent in the performance of their duties. In addition, the Massachusetts Commissioner of Banks has the authority to appoint a receiver or conservator if it is determined that the bank is conducting its business in an unsafe or unauthorized manner, and under certain other circumstances.

The powers that Massachusetts-chartered savings banks can exercise under these laws are summarized as follows:

Lending Activities

A Massachusetts-chartered savings bank may make a wide variety of mortgage loans including fixed-rate loans, adjustable-rate loans, variable-rate loans, participation loans, graduated payment loans, construction and development loans, condominium and co-operative loans, second mortgage loans and other types of loans that may be made in accordance with applicable regulations. Commercial loans may be made to corporations and other commercial enterprises with or without security. Consumer and personal loans may also be made with or without security.

Insurance Sales

Massachusetts banks may engage in insurance sales activities if the Massachusetts Commissioner of Banks has approved a plan of operation for insurance activities and the bank obtains a license from the Massachusetts Division of Insurance. A bank may be licensed directly or indirectly through an affiliate or a subsidiary corporation established for this purpose. Customers of the Bank are offered certain insurance products through a third party. The Bank has not been approved for insurance sales activities.

Investment Activities

In general, Massachusetts-chartered savings banks may invest in preferred and common stock of any corporation organized under the laws of the United States or any state provided such investments do not involve control of any corporation and do not, in the aggregate, exceed 4.0% of the bank’s deposits. Massachusetts-chartered savings banks may in addition invest an amount equal to 1.0% of their deposits in stocks of Massachusetts corporations or companies with substantial employment in the Commonwealth which have pledged to the Massachusetts Commissioner of Banks that such monies will be used for further development within the Commonwealth. At the present time, the Bank has the authority to invest in equity securities. However, such investment authority is constrained by federal law. See “— Federal Bank Regulation — Investment Activities” for such federal restrictions.

Dividends

A Massachusetts stock bank may declare from net profits cash dividends not more frequently than quarterly and non-cash dividends at any time. No dividends may be declared, credited or paid if the bank’s capital stock is

 

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impaired. The approval of the Massachusetts Commissioner of Banks is required if the total of all dividends declared in any calendar year exceeds the total of its net profits for that year combined with its retained net profits of the preceding two years. Net profits for this purpose means the remainder of all earnings from current operations plus actual recoveries on loans and investments and other assets after deducting from the total thereof all current operating expenses, actual losses, accrued dividends on preferred stock, if any, and all federal and state taxes.

Protection of Personal Information

Massachusetts has adopted regulatory requirements intended to protect personal information. The requirements, which are similar to existing federal laws such as the Gramm-Leach-Bliley Act, discussed below under “— Federal Regulations — Privacy Regulations”, that require organizations to establish written information security programs to prevent identity theft. The Massachusetts regulation also contains technology system requirements, especially for the encryption of personal information sent over wireless or public networks or stored on portable devices.

Parity Regulation

A Massachusetts bank may engage in any activity or offer any product or service if the activity, product or service is engaged in or offered in accordance with regulations promulgated by the Massachusetts Commissioner of Banks and has been authorized for national banks, federal thrifts or state banks in a state other than Massachusetts; provided that the activity is permissible under applicable federal and Massachusetts law and subject to the same limitations and restrictions imposed on the national bank, federal thrift or out-of-state bank that had previously been granted the power.

Loans to One Borrower Limitations

Massachusetts banking law grants broad lending authority. However, with certain limited exceptions, total obligations of one borrower to a bank may not exceed 20.0% of the total of the bank’s capital, which is defined under Massachusetts law as the sum of the bank’s capital stock, surplus account and undivided profits.

Loans to a Bank’s Insiders

The Massachusetts banking laws prohibit any executive officer, director or trustee from borrowing, otherwise becoming indebted, or becoming liable for a loan or other extension of credit by such bank to any other person, except for any of the following loans or extensions of credit: (i) loans or extension of credit, secured or unsecured, to an officer of the bank in an amount not exceeding $100,000; (ii) loans or extensions of credit intended or secured for educational purposes to an officer of the bank in an amount not exceeding $200,000; (iii) loans or extensions of credit secured by a mortgage on residential real estate to be occupied in whole or in part by the officer to whom the loan or extension of credit is made, in an amount not exceeding $750,000; and (iv) loans or extensions of credit to a director or trustee of the bank who is not also an officer of the bank in an amount permissible under the bank’s loan to one borrower limit. Massachusetts banking laws also prohibit officers and directors from receiving a preferential interest rate or terms on loans or extensions of credit.

Loans to insiders as described above require approval of the majority of the members of the Bank’s Board of Directors, excluding any member involved in the loan or extension of credit. No such loan or extension of credit may be granted with an interest rate or other terms that are preferential in comparison to loans granted to persons not affiliated with the savings bank.

Regulatory Enforcement Authority

Any Massachusetts bank that does not operate in accordance with the regulations, policies and directives of the Massachusetts Commissioner of Banks may be subject to sanctions for non-compliance, including seizure of the property and business of the bank and suspension or revocation of its charter. The Massachusetts Commissioner of Banks may, under certain circumstances, suspend or remove officers or directors who have violated the law, conducted the bank’s business in a manner which is unsafe, unsound or contrary to the

 

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depositors interests or been negligent in the performance of their duties. In addition, upon finding that a bank has engaged in an unfair or deceptive act or practice, the Massachusetts Commissioner of Banks may issue an order to cease and desist and impose a fine on the bank concerned. Finally, Massachusetts consumer protection and civil rights statutes applicable to the Bank permit private individual and class action law suits and provide for the rescission of consumer transactions, including loans, and the recovery of statutory and punitive damage and attorney’s fees in the case of certain violations of those statutes.

Depositors Insurance Fund

All Massachusetts-chartered savings banks are required to be members of the Depositors Insurance Fund, a corporation that insures savings bank deposits in excess of federal deposit insurance coverage. The Depositors Insurance Fund is authorized to charge savings banks a risk-based assessment on deposits balances in excess of the amounts insured by the FDIC.

Massachusetts has other statutes and regulations that are similar to the federal provisions discussed below.

Federal Bank Regulation

Capital Requirements

Under FDIC regulations, federally insured state-chartered banks that are not members of the Federal Reserve System (“state non-member banks”), such as the Bank, are required to comply with minimum leverage capital requirements. For an institution determined by the FDIC to not be anticipating or experiencing significant growth and to be, in general, a strong banking organization rated composite 1 under the Uniform Financial Institutions Ranking System established by the Federal Financial Institutions Examination Council, the minimum capital leverage requirement is a ratio of Tier 1 capital to total assets of 3.0%. For all other institutions, the minimum leverage capital ratio is not less than 4.0%. Tier 1 capital is the sum of common stockholders’ equity, noncumulative perpetual preferred stock (including any related surplus) and minority investments in certain subsidiaries, less intangible assets (except for certain servicing rights and credit card relationships) and certain other specified items.

The FDIC regulations require state non-member banks to maintain certain levels of regulatory capital in relation to regulatory risk-weighted assets. The ratio of regulatory capital to regulatory risk-weighted assets is referred to as a bank’s “risk-based capital ratio.” Risk-based capital ratios are determined by allocating assets and specified off-balance sheet items (including recourse obligations, direct credit substitutes and residual interests) to risk-weighted categories ranging from 0.0% to 200.0%, with higher levels of capital being required for the categories perceived as representing greater risk.

State non-member banks must maintain a minimum ratio of total capital to risk-weighted assets of at least 8.0%, of which at least one-half must be Tier 1 capital. Total capital consists of Tier 1 capital plus Tier 2 or supplementary capital items, which include allowances for loan losses in an amount of up to 1.25% of risk-weighted assets, cumulative preferred stock and certain other capital instruments, and a portion of the net unrealized gain on equity securities. The includable amount of Tier 2 capital cannot exceed the amount of the institution’s Tier 1 capital. Banks that engage in specified levels of trading activities are subject to adjustments in their risk based capital calculation to ensure the maintenance of sufficient capital to support market risk.

On June 6, 2012, the FDIC and the other federal bank regulatory agencies issued a series of proposed rules that would revise their leverage and risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with agreements that were reached by the Basel Committee on Banking Supervision and certain provisions of the Dodd-Frank Act. The proposed rules would apply to all depository institutions, top-tier bank holding companies with total consolidated assets of $500 million or more and top-tier savings and loan holding companies. Among other things, the proposed rules establish a new common equity Tier 1 minimum capital requirement (4.5% of risk-weighted assets) and a higher minimum Tier 1 capital to risk-based assets requirement (6% of risk-weighted assets) and assign higher risk weight (150%) to exposures that are more than 90 days past due or are on nonaccrual status and certain commercial real estate facilities that finance the acquisition, development or construction of real property. The proposed rules also require unrealized gains

 

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and losses on certain securities holdings to be included for purposes of calculating regulatory capital requirements. The proposed rules limit a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a “capital conservation buffer” consisting of a specified amount of common equity Tier 1 capital in addition to the amount necessary to meet its minimum risk-based capital requirements. The proposed rules indicated that the final rules would become effective on January 1, 2013, and the changes set forth in the final rules will be phased in from January 1, 2013 through January 1, 2019. However, the agencies have recently indicated that, due to the volume of public comments received, the final rule has been delayed past January 1, 2013.

The Federal Deposit Insurance Corporation Improvement Act (the “FDICIA”) required each federal banking agency to revise its risk-based capital standards for insured institutions to ensure that those standards take adequate account of interest-rate risk, concentration of credit risk, and the risk of nontraditional activities, as well as to reflect the actual performance and expected risk of loss on multi-family residential loans. The FDIC, along with the other federal banking agencies, has adopted a regulation providing that the agencies will take into account the exposure of a bank’s capital and economic value to changes in interest rate risk in assessing a bank’s capital adequacy. The FDIC also has authority to establish individual minimum capital requirements in appropriate cases upon determination that an institution’s capital level is, or is likely to become, inadequate in light of the particular circumstances.

Standards for Safety and Soundness

As required by statute, the federal banking agencies adopted final regulations and Interagency Guidelines Establishing Standards for Safety and Soundness to implement safety and soundness standards. The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. The guidelines address internal controls and information systems, internal audit system, credit underwriting, loan documentation, interest rate exposure, asset growth, asset quality, earnings and compensation, fees and benefits. Most recently, the agencies have established standards for safeguarding customer information. If the appropriate federal banking agency determines that an institution fails to meet any standard prescribed by the guidelines, the agency may require the institution to submit to the agency an acceptable plan to achieve compliance with the standard.

Investment Activities

All state-chartered FDIC insured banks, including savings banks, are generally limited in their investment activities to principal and equity investments of the type and in the amount authorized for national banks, notwithstanding state law, subject to certain exceptions. For example, state chartered banks may, with FDIC approval, continue to exercise state authority to invest in common or preferred stocks listed on a national securities exchange or the NASDAQ Global Market and in the shares of an investment company registered under the Investment Company Act of 1940, as amended. The maximum permissible investment is 100.0% of Tier 1 Capital, as specified by the FDIC’s regulations, or the maximum amount permitted by Massachusetts law, whichever is less. The Bank received approval from the FDIC to retain and acquire such equity instruments equal to the lesser of 100% of the Bank’s Tier 1 capital or the maximum permissible amount specified by Massachusetts law. Any such grandfathered authority may be terminated upon the FDIC’s determination that such investments pose a safety and soundness risk. In addition, the FDIC is authorized to permit such institutions to engage in state authorized activities or investments not permissible for national banks (other than non-subsidiary equity investments) if they meet all applicable capital requirements and it is determined that such activities or investments do not pose a significant risk to the Bank Insurance Fund. The FDIC has adopted procedures for institutions seeking approval to engage in such activities or investments. In addition, a nonmember bank may control a subsidiary that engages in activities as principal that would only be permitted for a national bank to conduct in a “financial subsidiary” if a bank meets specified conditions and deducts its investment in the subsidiary for regulatory capital purposes.

Interstate Banking and Branching

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, or the Interstate Banking Act, permits adequately capitalized bank holding companies to acquire banks in any state subject to specified

 

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concentration limits and other conditions. The Interstate Banking Act also authorizes the interstate merger of banks. In addition, among other things, the Interstate Banking Act, as amended by the Dodd-Frank Act, permits banks to establish new branches on an interstate basis provided that branching is authorized by the law of the host state for the banks chartered by that state.

Prompt Corrective Regulatory Action

Federal law requires, among other things, that federal bank regulatory authorities take “prompt corrective action” with respect to banks that do not meet minimum capital requirements. For these purposes, the law establishes five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized.

The FDIC has adopted regulations to implement the prompt corrective action legislation. An institution is deemed to be “well capitalized” if it has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater and a leverage ratio of 5.0% or greater. An institution is “adequately capitalized” if it has a total risk-based capital ratio of 8.0% or greater, a Tier 1 risk-based capital ratio of 4.0% or greater, and generally a leverage ratio of 4.0% or greater. An institution is “undercapitalized” if it has a total risk-based capital ratio of less than 8.0%, a Tier 1 risk-based capital ratio of less than 4.0%, or generally a leverage ratio of less than 4.0%. An institution is deemed to be “significantly undercapitalized” if it has a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 3.0%, or a leverage ratio of less than 3.0%. An institution is considered to be “critically undercapitalized” if it has a ratio of tangible equity (as defined in the regulations) to total assets that is equal to or less than 2.0%. As of December 31, 2012, the Bank was classified as a “well capitalized” institution.

“Undercapitalized” banks must adhere to growth, capital distribution (including dividend) and other limitations and are required to submit a capital restoration plan. A bank’s compliance with such a plan is required to be guaranteed by any company that controls the undercapitalized institution in an amount equal to the lesser of 5.0% of the institution’s total assets when deemed undercapitalized or the amount necessary to achieve the status of adequately capitalized. If an “undercapitalized” bank fails to submit an acceptable plan, it is treated as if it is “significantly undercapitalized.” “Significantly undercapitalized” banks must comply with one or more of a number of additional restrictions, including but not limited to an order by the FDIC to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets, cease receipt of deposits from correspondent banks or dismiss directors or officers, and restrictions on interest rates paid on deposits, compensation of executive officers and capital distributions by the parent holding company. “Critically undercapitalized” institutions are subject to additional measures including, subject to a narrow exception, the appointment of a receiver or conservator within 270 days after it obtains such status.

The recently proposed rules that would increase regulatory capital requirements would adjust the prompt corrective action categories accordingly.

Transaction with Affiliates and Regulation W of the Federal Reserve Regulations

Transactions between banks and their affiliates are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a bank is any company or entity that controls, is controlled by or is under common control with the bank. In a holding company context, the parent bank holding company and any companies which are controlled by such parent holding company are affiliates of the bank. Generally, Sections 23A and 23B of the Federal Reserve Act and Regulation W (i) limit the extent to which the bank or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10.0% of such institution’s capital stock and surplus, and contain an aggregate limit on all such transactions with all affiliates to an amount equal to 20.0% of such institution’s capital stock and surplus and (ii) require that all such transactions be on terms substantially the same, or at least as favorable, to the institution or subsidiary as those provided to a non-affiliate. The term “covered transaction” includes the making of loans, purchase of assets, issuance of a guarantee and other similar transactions. In addition, loans or other extensions of credit by the financial institution to the affiliate are required to be collateralized in accordance with the requirements set forth in Section 23A of the Federal Reserve Act.

 

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“Financial subsidiaries” of banks are treated as affiliates for purposes of Sections 23A and 23B of the Federal Reserve Act. However, the investment by the bank in the financial subsidiary does not include retained earnings in the financial subsidiary. Certain anti-evasion provisions have been included that relate to the relationship between any financial subsidiary of a bank and sister companies of the bank: (1) any purchase of, or investment in, the securities of a financial subsidiary by any affiliate of the parent bank is considered a purchase or investment by the bank; or (2) if the Federal Reserve Board determines that such treatment is necessary, any loan made by an affiliate of the parent bank to the financial subsidiary is to be considered a loan made by the parent bank.

In addition, Sections 22(h) and (g) of the Federal Reserve Act place restrictions on loans to executive officers, directors and principal stockholders. Under Section 22(h) of the Federal Reserve Act, loans to a director, an executive officer and to a greater than 10.0% stockholder of a financial institution, and certain affiliated interests of these, may not exceed, together with all other outstanding loans to such person and affiliated interests, the financial institution’s loans to one borrower limit, generally equal to 15.0% of the institution’s unimpaired capital and surplus. Section 22(h) of the Federal Reserve Act also requires that loans to directors, executive officers and principal stockholders be made on terms substantially the same as offered in comparable transactions to other persons and also requires prior board approval for certain loans. In addition, the aggregate amount of extensions of credit by a financial institution to insiders cannot exceed the institution’s unimpaired capital and surplus. Furthermore, Section 22(g) of the Federal Reserve Act places additional restrictions on loans to executive officers.

Enforcement

The FDIC has extensive enforcement authority over insured state savings banks, including the Bank. This enforcement authority includes, among other things, the ability to assess civil money penalties, issue cease and desist orders and remove directors and officers. In general, these enforcement actions may be initiated in response to violations of laws and regulations and unsafe or unsound practices. The FDIC has authority under federal law to appoint a conservator or receiver for an insured bank under limited circumstances. The FDIC is required, with certain exceptions, to appoint a receiver or conservator for an insured state non-member bank if that bank was “critically undercapitalized” on average during the calendar quarter beginning 270 days after the date on which the institution became “critically undercapitalized.” The FDIC may also appoint itself as conservator or receiver for an insured state non-member institution under specific circumstances on the basis of the institution’s financial condition or upon the occurrence of other events, including: (1) insolvency; (2) substantial dissipation of assets or earnings through violations of law or unsafe or unsound practices; (3) existence of an unsafe or unsound condition to transact business; and (4) insufficient capital, or the incurring of losses that will deplete substantially all of the institution’s capital with no reasonable prospect of replenishment without federal assistance.

Federal Insurance of Deposit Accounts

The Bank is a member of the Deposit Insurance Fund, which is administered by the FDIC. Deposit accounts in the Bank are insured up to a maximum of $250,000 for each separately insured depositor.

The FDIC imposes an assessment for deposit insurance on all depository institutions. Under the FDIC’s risk-based assessment system, insured institutions are assigned to risk categories based on supervisory evaluations, regulatory capital levels and certain other factors. An institution’s assessment rate depends upon the category to which it is assigned and certain adjustments specified by FDIC regulations, with less risky institutions paying lower rates. Assessment rates (inclusive of possible adjustments) currently range from 2 1/2 to 45 basis points of each institution’s total assets less tangible capital. The FDIC may increase or decrease the scale uniformly, except that no adjustment can deviate more than two basis points from the base scale without notice and comment rulemaking. The FDIC’s current system represents a change, required by the Dodd-Frank Act, from its prior practice of basing the assessment on an institution’s volume of deposits.

The FDIC imposed on all insured institutions a special emergency assessment of five basis points of total assets minus Tier 1 capital, as of June 30, 2009, (capped at ten basis points of an institution’s deposit assessment

 

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base), in order to cover losses to the Deposit Insurance fund. That special assessment was collected on September 30, 2009.

In lieu of further special assessments, however, the FDIC required insured institutions to prepay estimated quarterly risk-based assessments for the fourth quarter of 2009 through the fourth quarter of 2012. The estimated assessments, which included an assumed annual assessment base increase of 5%, were recorded as a prepaid expense asset as of December 30, 2009. As of December 31, 2009, and each quarter thereafter through the fourth quarter of 2012, a charge to earnings was recorded for each regular assessment with an offsetting credit to the prepaid asset. The Bank’s prepayment amounted to $5.1 million.

The Dodd-Frank Act increased the minimum target Deposit Insurance Fund ratio from 1.15% of estimated insured deposits to 1.35% of estimated insured deposits. The FDIC must seek to achieve the 1.35% ratio by September 30, 2020. Insured institutions with assets of $10 billion or more are supposed to fund the increase. The Dodd-Frank Act eliminated the 1.5% maximum fund ratio, instead leaving it to the discretion of the FDIC and the FDIC has recently exercised that discretion by establishing a long range fund of 2%.

The FDIC has authority to increase insurance assessments. A significant increase in insurance premiums would likely have an adverse effect on the operating expenses and results of operations of the Bank. We cannot predict what insurance assessment rates will be in the future.

Insurance of deposits may be terminated by the FDIC 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 regulatory condition imposed in writing. We do not know of any practice, condition or violation that might lead to termination of deposit insurance.

In addition to the FDIC assessments, the Financing Corporation (“FICO”) is authorized to impose and collect, with the approval of the FDIC, assessments for anticipated payments, issuance costs and custodial fees on bonds issued by the FICO in the 1980s to recapitalize the former Federal Savings and Loan Insurance Corporation. The bonds issued by the FICO are due to mature in 2017 through 2019. For the quarter ended December 31, 2012, the annualized FICO assessment was equal to 66 basis points of total assets less tangible capital.

Privacy Regulations

Pursuant to the Gramm-Leach-Bliley Financial Modernization Act of 1999, FDIC regulations generally require that the Bank disclose its privacy policy, including identifying with whom it shares a customer’s “non-public personal information,” to customers at the time of establishing the customer relationship and annually thereafter. In addition, the Bank is required to provide its customers with the ability to “opt-out” of having their personal information shared with unaffiliated third parties and not to disclose account numbers or access codes to non-affiliated third parties for marketing purposes. The Bank currently has a privacy protection policy in place and believes that such policy is in compliance with the regulations. The privacy provisions of the Act affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.

Community Reinvestment Act

Under the Community Reinvestment Act, or CRA, as amended and as implemented by FDIC regulations, a bank has a continuing and affirmative obligation, consistent with its safe and sound operation, to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA does require the FDIC, in connection with its examination of a bank, to assess the 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, including applications to acquire branches and other financial institutions. The CRA requires the FDIC to provide a written evaluation of an institution’s CRA performance utilizing a four-tiered descriptive rating system. The Banks’ latest FDIC CRA rating was “Satisfactory.”

 

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Massachusetts has its own statutory counterpart to the CRA which is also applicable to the Bank. The Massachusetts version is generally similar to the CRA but utilizes a five-tiered descriptive rating system. Massachusetts law requires the Massachusetts Commissioner of Banks to consider, but not be limited to, a bank’s record of performance under Massachusetts law in considering any application by the bank to establish a branch or other deposit-taking facility, to relocate an office or to merge or consolidate with or acquire the assets and assume the liabilities of any other banking institution. The Banks’ most recent rating under Massachusetts law was “Satisfactory.”

Consumer Protection and Fair Lending Regulations

Massachusetts savings banks are subject to a variety of federal and Massachusetts statutes and regulations that are intended to protect consumers and prohibit discrimination in the granting of credit. These statutes and regulations provide for a range of sanctions for non-compliance with their terms, including imposition of administrative fines and remedial orders, and referral to the Attorney General for prosecution of a civil action for actual and punitive damages and injunctive relief. Certain of these statutes authorize private individual and class action lawsuits and the award of actual, statutory and punitive damages and attorneys’ fees for certain types of violations.

USA Patriot Act

The Bank is subject to the USA PATRIOT Act, which gives the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. By way of amendments to the Bank Secrecy Act, Title III of the USA PATRIOT Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions, including banks, thrifts, brokers, dealers, credit unions, money transfer agents, and parties registered under the Commodity Exchange Act.

Other Regulations

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

 

   

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;

 

   

Massachusetts Debt Collection Regulations, establishing standards, by defining unfair or deceptive acts or practices, for the collection of debts from persons within the Commonwealth of Massachusetts and the General Laws of Massachusetts, Chapter 167E, which governs the Bank’s lending powers; and

 

   

Rules and regulations of the various federal and state agencies charged with the responsibility of implementing such federal and state laws.

The deposit operations of the Bank also are subject to, among others, 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;

 

   

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;

 

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Electronic Funds Transfer Act and Regulation E promulgated thereunder, and, as to the Bank Chapter 167B of the General Laws of Massachusetts, which govern 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

 

   

General Laws of Massachusetts, Chapter 167D, which governs the Bank’s deposit powers.

Federal Reserve System

The Federal Reserve Board regulations require depository institutions to maintain non-interest-earning reserves against their transaction accounts (primarily NOW and regular checking accounts). The Federal Reserve Board regulations generally require that reserves be maintained against aggregate transaction accounts as follows: for that portion of transaction accounts aggregating $79.5 million or less (which may be adjusted by the Federal Reserve Board) the reserve requirement is 3.0%; and the amounts greater than $79.5 million require a 10.0% reserve (which may be adjusted annually by the Federal Reserve Board between 8.0% and 14.0%). The first $12.4 million of otherwise reservable balances (which may be adjusted by the Federal Reserve Board) are exempted from the reserve requirements. The Bank is in compliance with these requirements.

Federal Home Loan Bank System

The Bank 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. Members of the Federal Home Loan Bank are required to acquire and hold shares of capital stock in the Federal Home Loan Bank. The Bank was in compliance with this requirement at December 31, 2012. Based on redemption provisions of the FHLB-Boston, the stock has no quoted market value and is carried at cost. The Bank reviews for impairment based on the ultimate recoverability of the cost basis of the FHLB-Boston stock. As of December 31, 2012, no impairment has been recognized.

At its discretion, the FHLB-Boston may declare dividends on the stock. The Federal Home Loan Banks are required to provide funds for certain purposes including the resolution of insolvent thrifts in the late 1980s and to contributing funds for affordable housing programs. These requirements could reduce the amount of dividends that the Federal Home Loan Banks pay to their members and result in the Federal Home Loan Banks imposing a higher rate of interest on advances to their members. As a result of losses incurred, the FHLB-Boston suspended and did not pay dividends in 2009 and 2010. However, the FHLB-Boston resumed payment of quarterly dividends in 2011 equal to an annual yield of 0.30% and continued to pay quarterly dividends in 2012 equal to an annual yield of 0.50%. There can be no assurance that such dividends will continue in the future. Further, there can be no assurance that the impact of recent or future legislation on the Federal Home Loan Banks also will not cause a decrease in the value of the FHLB-Boston stock held by the Bank.

Holding Company Regulation

The Company and Meridian are subject to examination, regulation, and periodic reporting under the Bank Holding Company Act of 1956, as amended, as administered by the Federal Reserve Board. The Company and Meridian are required to obtain the prior approval of the Federal Reserve Board to acquire all, or substantially all, of the assets of any bank or bank holding company. Prior Federal Reserve Board approval would be required for the Company or Meridian to acquire direct or indirect ownership or control of any voting securities of any bank or bank holding company if, after such acquisition, it would, directly or indirectly, own or control more than 5% of any class of voting shares of the bank or bank holding company. In addition to the approval of the Federal Reserve Board, prior approval may also be necessary from other agencies having supervisory jurisdiction over the bank to be acquired before any bank acquisition can be completed.

A bank holding company is generally prohibited from engaging in non-banking activities, or acquiring, direct or indirect control of more than 5% of the voting securities of any company engaged in non-banking activities. One of the principal exceptions to this prohibition is for activities found by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. Some of the principal activities that the Federal Reserve Board has determined by regulation to be so closely related to

 

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banking are: (i) making or servicing loans; (ii) performing certain data processing services; (iii) providing discount brokerage services; (iv) acting as fiduciary, investment or financial advisor; (v) leasing personal or real property; (vi) making investments in corporations or projects designed primarily to promote community welfare; and (vii) acquiring a savings and loan association whose direct and indirect activities are limited to those permitted for bank holding companies.

The Gramm-Leach-Bliley Act of 1999 authorizes a bank holding company that meets specified conditions, including being “well capitalized” and “well managed,” to opt to become a “financial holding company” and thereby engage in a broader array of financial activities than previously permitted. Such activities can include insurance underwriting and investment banking.

The Company and Meridian are subject to the Federal Reserve Board’s capital adequacy guidelines for bank holding companies (on a consolidated basis) which are similar to, though less stringent than, those of the FDIC for the Bank. The Dodd-Frank Act, however, requires the Federal Reserve Board to promulgate consolidated capital requirements for depository institution holding companies that are no less stringent, both quantitatively and in terms of components of capital, than those applicable to institutions themselves. Instruments such as cumulative preferred stock and trust preferred securities will no longer be includable as Tier 1 capital, as is currently the case with bank holding companies. Instruments issued by May 19, 2010 should be grandfathered for mutual holding companies. The Federal Reserve Board issued proposed rules that would implement this requirement but such rules had not been finalized as of December 31, 2012.

A bank holding company is generally required to give the Federal Reserve Board prior written notice of any purchase or redemption of then outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of the company’s consolidated net worth. The Federal Reserve Board may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe and unsound practice, or would violate any law, regulation, Federal Reserve Board order or directive, or any condition imposed by, or written agreement with, the Federal Reserve Board. The Federal Reserve Board has adopted an exception to this approval requirement for well-capitalized bank holding companies that meet certain other conditions.

The Federal Reserve Board has issued a policy statement regarding capital distributions, including dividends, by bank holding companies. In general, the Federal Reserve Board’s policies provide that dividends should be paid only out of current earnings and only if the prospective rate of earnings retention by the bank holding company appears consistent with the organization’s capital needs, asset quality and overall financial condition. The Federal Reserve Board’s policies also require that a bank holding company serve as a source of financial strength to its subsidiary banks by standing ready to use available resources to provide adequate capital funds to those banks during periods of financial stress or adversity and by maintaining the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks where necessary. The Dodd-Frank Act codified the source of strength doctrine and required the issuance of implementing regulations. Under the prompt corrective action laws, the ability of a bank holding company to pay dividends may be restricted if a subsidiary bank becomes undercapitalized. These regulatory policies could affect the ability of the Company or Meridian to pay dividends or otherwise engage in capital distributions.

Under the Federal Deposit Insurance Act, depository institutions are liable to the FDIC for losses suffered or anticipated by the FDIC in connection with the default of a commonly controlled depository institution or any assistance provided by the FDIC to such an institution in danger of default.

The status of the Company and Meridian as registered bank holding companies under the Bank Holding Company Act does not exempt them from certain federal and state laws and regulations applicable to corporations generally, including, without limitation, certain provisions of the federal securities laws.

The Company, Meridian and the Bank will be affected by the monetary and fiscal policies of various agencies of the United States Government, including the Federal Reserve System. In view of changing conditions in the national economy and in the money markets, it is impossible for management to accurately predict future changes in monetary policy or the effect of such changes on the business or financial condition of the Company, Meridian and the Bank.

 

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Massachusetts Holding Company Regulation

Under the Massachusetts banking laws, a company owning or controlling two or more banking institutions, including a savings bank, is regulated as a bank holding company. The term “company” is defined by the Massachusetts banking laws similarly to the definition of “company” under the Bank Holding Company Act. Each Massachusetts bank holding company: (i) must obtain the approval of the Massachusetts Board of Bank Incorporation before engaging in certain transactions, such as the acquisition of more than 5% of the voting stock of another banking institution; (ii) must register, and file reports, with the Division; and (iii) is subject to examination by the Division. In addition, a Massachusetts mutual holding company: (i) may invest in the stock of one or more banking institutions; (ii) may merge with or acquire a mutual banking institution; (iii) may merge with or acquire another bank holding company provided that any such holding company has a subsidiary banking institution; (iv) may invest in a corporation; (v) must register, and file reports, with the Division; (vi) may engage directly or indirectly only in activities permitted by law for a Massachusetts bank holding company; and (vii) may take any action with respect to any securities of any subsidiary banking institution which are held by such mutual holding company.

Federal Securities Laws

Our common stock is registered with the Securities and Exchange Commission under Section 12(b) of the Securities Exchange Act of 1934, as amended. We are subject to information, proxy solicitation, insider trading restrictions, and other requirements under the Exchange Act.

Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002 addresses, among other issues, corporate governance, auditing and accounting, executive compensation, and enhanced and timely disclosure of corporate information. As directed by the Sarbanes-Oxley Act of 2002, the Company’s Chief Executive Officer and Chief Financial Officer each are required to certify that the Company’s quarterly and Annual Reports do not contain any untrue statement of a material fact. The rules adopted by the Securities and Exchange Commission under the Sarbanes-Oxley Act of 2002 have several requirements, including having these officers certify that: they are responsible for establishing, maintaining and regularly evaluating the effectiveness of our internal controls; they have made certain disclosures to our auditors and the audit committee of the Board of Directors about our internal controls; and they have included information in our quarterly and Annual Reports about their evaluation and whether there have been significant changes in our internal controls or in other factors that could significantly affect internal controls.

Federal Income Taxation

General

The Company reports its income on a calendar year basis using the accrual method of accounting. The federal income tax laws apply to the Company in the same manner as to other corporations with some exceptions, including the 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 the Company. The Company’s federal income tax returns have been either audited or closed under the statute of limitations through December 31, 2008. For its 2012 tax year, the Bank’s maximum federal income tax rate was 35%.

Bad Debt Reserves

For taxable years beginning before January 1, 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 non-qualifying loans was computed using the experience method. Federal legislation enacted in 1996 repealed the reserve method of accounting for bad debts and the percentage of taxable income method for tax years beginning after 1995 and required savings institutions to recapture or take into income certain portions

 

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of their accumulated bad debt reserves. However, those bad debt reserves accumulated prior to 1988 (“Base Year Reserves”) were not required to be recaptured unless the savings institution failed certain tests. At December 31, 2012, $9.8 million of the Bank’s accumulated bad debt reserves would not be recaptured into taxable income unless the Bank makes a “non-dividend distribution” to the Company as described below.

Distributions

If the Bank makes “non-dividend distributions” to the Company, the distributions will be considered to have been made from the Bank’s un-recaptured tax bad debt reserves, including the balance of its Base Year Reserves as of December 31, 1987, to the extent of the “non-dividend distributions,” and then from the Bank’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 the Bank’s taxable income. Non-dividend distributions include distributions in excess of the Bank’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 the Bank’s current or accumulated earnings and profits will not be so included in the Company’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 the Bank makes a non-dividend distribution to the Company, approximately one and one-half times the amount of the distribution not in excess of the amount of the reserves would be includable in income for federal income tax purposes, assuming a 35% federal corporate income tax rate. The Bank does not intend to pay dividends that would result in a recapture of any portion of its bad debt reserves.

State Taxation

Financial institutions in Massachusetts are required to file combined income tax returns beginning with the year ended December 31, 2009. Starting in 2010, decreasing over a three year period, the Massachusetts excise tax rate for savings banks changed from 10.5% to 9.0% of federal taxable income, adjusted for certain items. Taxable income includes gross income as defined under the Internal Revenue Code, plus interest from bonds, notes and evidences of indebtedness of any state, including Massachusetts, less deductions, but not the credits, allowable under the provisions of the Internal Revenue Code, except for those deductions relating to dividends received and income or franchise taxes imposed by a state or political subdivision. Carryforwards and carrybacks of net operating losses and capital losses are not allowed. The Company’s state tax returns, as well as those of its subsidiaries, are not currently under audit.

A financial institution or business corporation is generally entitled to special tax treatment as a “security corporation” under Massachusetts law provided that: (a) its activities are limited to buying, selling, dealing in or holding securities on its own behalf and not as a broker; and (b) it has applied for, and received, classification as a “security corporation” by the Commissioner of the Massachusetts Department of Revenue. A security corporation that is also a bank holding company under the Internal Revenue Code must pay a tax equal to 0.33% of its gross income. A security corporation that is not a bank holding company under the Internal Revenue Code must pay a tax equal to 1.32% of its gross income. Prospect, Inc. is qualified as a security corporation. As such, it has received security corporation classification by the Massachusetts Department of Revenue; and does not conduct any activities deemed impermissible under the governing statutes and the various regulations, directives, letter rulings and administrative pronouncements issued by the Massachusetts Department of Revenue.

 

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ITEM 1A. RISK FACTORS

Risks Related to Our Business

Financial reform legislation recently enacted will, among other things, tighten capital standards and result in new laws and regulations that are expected to increase our costs of operations.

The Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted in 2010. This new law is significantly changing the current bank regulatory structure and affects the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies are given significant discretion in drafting the implementing rules and regulations, and consequently, many of the details and much of the impacts of the Dodd-Frank Act may not be known for many months or years.

The Dodd-Frank Act created a new Consumer Financial Protection Bureau with broad powers to supervise and enforce consumer protection laws. The Consumer Financial Protection Bureau has broad rule-making authority for a wide range of consumer protection laws that apply to all banks and savings institutions, including the authority to prohibit “unfair, deceptive or abusive” acts and practices. The Consumer Financial Protection Bureau has examination and enforcement authority over all banks with more than $10 billion in assets. Banks with $10 billion or less in assets will continue to be examined for compliance with the consumer laws by their primary bank regulators. The Dodd-Frank Act also weakened the federal preemption rules that have been applicable for national banks and federal savings associations, and gives state attorneys general the ability to enforce federal consumer protection laws.

The Dodd-Frank Act required minimum leverage (Tier 1) and risk based capital requirements for bank and savings and loan holding companies that are no less than those applicable to banks, which will exclude certain instruments that previously have been eligible for inclusion by bank holding companies as Tier 1 capital, such as trust preferred securities.

A provision of the Dodd-Frank Act eliminated, as of July 21, 2011, the federal prohibitions on paying interest on demand deposits, thus allowing businesses to have interest bearing checking accounts. Depending on competitive responses, this significant change to existing law could have an adverse impact on our interest expense.

The Dodd-Frank Act also broadened the base for FDIC deposit insurance assessments. Assessments are now based on the average consolidated total assets less tangible equity capital of a financial institution, rather than deposits. The Dodd-Frank Act also permanently increased the maximum amount of deposit insurance for banks, savings institutions and credit unions to $250,000 per depositor, retroactive to January 1, 2009, and non-interest bearing transaction accounts had unlimited deposit insurance through December 31, 2012. The legislation also increased the required minimum reserve ratio for the Deposit Insurance Fund, from 1.15% to 1.35% of insured deposits, and directs the FDIC to offset the effects of increased assessments on depository institutions with less than $10 billion in assets.

It is difficult to predict at this time what specific impact the Dodd-Frank Act and the yet to be written implementing rules and regulations will have on community banks. However, it is expected that at a minimum they will increase our operating and compliance costs and could increase our interest expense.

Government responses to economic conditions may adversely affect our operations, financial condition and earnings.

The Company is subject to extensive regulation, supervision and examination by the Massachusetts Commissioner of Banks, the FDIC and the Federal Reserve Board. Such regulation and supervision governs the activities in which an institution and its holding company may engage and are intended primarily for the protection of the insurance fund and the depositors and borrowers of the Bank rather than for holders of the Company’s common stock. 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

 

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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.

Newly enacted financial reform legislation has changed the bank regulatory framework, created an independent consumer protection bureau that has assumed the consumer protection responsibilities of the various federal banking agencies, and established more stringent capital standards for banks and bank holding companies. The legislation will also result in new regulations affecting the lending, funding, trading and investment activities of banks and bank holding companies. Bank regulatory agencies also have been responding aggressively to concerns and adverse trends identified in examinations. Ongoing uncertainty and adverse developments in the financial services industry and the domestic and international credit markets, and the effect of new legislation and regulatory actions in response to these conditions, may adversely affect our operations by restricting our business activities, including our ability to originate or sell loans, modify loan terms, or foreclose on property securing loans. These measures are likely to increase our costs of doing business and may have a significant adverse effect on our lending activities, financial performance and operating flexibility. In addition, these risks could affect the performance and value of our loan and investment securities portfolios, which also would negatively affect our financial performance.

Furthermore, the Board of Governors of the Federal Reserve System, in an attempt to help the overall economy, has, among other things, kept interest rates low through its targeted federal funds rate and the purchase of mortgage-backed securities. If the Federal Reserve Board increases the federal funds rate, overall interest rates will likely rise, which may negatively impact the housing markets and the U.S. economic recovery. In addition, deflationary pressures, while possibly lowering our operating costs, could have a significant negative effect on our borrowers, especially our business borrowers, and the values of underlying collateral securing loans, which could negatively affect our financial performance.

In addition, there have been proposals made by members of Congress and others that would reduce the amount distressed borrowers are otherwise contractually obligated to pay under their mortgage loans and limit an institution’s ability to foreclose on mortgage collateral. Were proposals such as these, or other proposals limiting our rights as a creditor, to be implemented, we could experience increased credit losses or increased expense in pursuing our remedies as a creditor.

We have been negatively affected by current market and economic conditions. A continuation or worsening of these conditions could adversely affect our operations, financial condition and earnings.

Recent economic conditions have resulted in continued uncertainty in the financial markets and continued expectations of slow improvement in general economic conditions. Unemployment remains at very high levels with improvement at a slow rate beginning in late 2011. Our lending business is tied, in large part, to the housing market and real estate markets in general. The continuing housing slump has resulted in reduced demand for the construction of new housing, declines in home prices, and could ultimately result in increased delinquencies on our residential, commercial, multi-family and construction mortgage loans. Further, the ongoing concern about the stability of the financial markets in general has caused many lenders to reduce or cease providing funding to borrowers. These conditions may also cause a further reduction in loan demand, and increases in our non-performing assets, net charge-offs and provisions for loan losses, as well as adversely affect our liquidity and the willingness of certain counterparties and customers to do business with us. Continued negative developments in the financial services industry and the domestic and international credit markets may significantly affect the markets in which we do business, the market for and value of our loans and investments, and our ongoing operations, costs and profitability. Moreover, declines in the stock market in general, or stock values of financial institutions and their holding companies specifically, could adversely affect our stock performance.

Historically low interest rates may adversely affect our net interest income and profitability.

During the past four years it has been the policy of the Federal Reserve Board to maintain interest rates at historically low levels through its targeted federal funds rate and the purchase of mortgage-backed securities. As a result, market rates on the loans we have originated and the yields on securities we have purchased have been at lower levels than available prior to 2008. As a general matter, our interest-bearing liabilities reprice or mature

 

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more quickly than our interest-earning assets, which has been one factor contributing to the increase in our interest rate spread as interest rates decreased. However, our ability to lower our interest expense will be limited at these interest rate levels while the average yield on our interest-earning assets may continue to decrease. The Federal Reserve Board has recently indicated its intention to maintain low interest rates until the unemployment rate is 6.5% or lower. Accordingly, our net interest income may be adversely affected and may even decrease, which may have an adverse effect on our profitability.

Actions to recapitalize the Deposit Insurance Fund could hurt our profits.

The Dodd-Frank Act increased the minimum target Deposit Insurance Fund ratio from 1.15% of estimated insured deposits to 1.35% of estimated insured deposits. The FDIC must seek to achieve the 1.35% ratio by September 30, 2020. Insured institutions with assets of $10 billion or more are supposed to fund the increase. The Dodd-Frank Act eliminated the 1.5% maximum fund ratio, instead leaving it to the discretion of the FDIC and the FDIC has recently exercised that discretion by establishing a long range fund ratio of 2%. The FDIC has authority to increase insurance assessments. A significant increase in insurance premiums would likely have an adverse effect on our operating expenses and results of operations. We cannot predict what insurance assessment rates will be in the future.

Our emphasis on commercial real estate, multi-family, commercial business and construction lending involves risks.

In recent years, the Company has focused on shifting its asset mix from increases in the one-to four-family residential loan portfolio to increases in commercial real estate, multi-family, commercial business and construction loans. As of December 31, 2012, our commercial real estate, multi-family, commercial business and construction loans totaled $1.296 billion, or 71.7% of our loan portfolio. As a result, our credit risk profile is higher than traditional savings institutions that have higher concentrations of one-to four-family residential loans. Also, these types of commercial lending activities, while potentially more profitable than one-to four-family residential lending, are generally more sensitive to regional and local economic conditions, making loss levels more difficult to predict. Collateral evaluation and financial statement analysis in these types of loans requires a more detailed analysis at the time of loan underwriting and on an ongoing basis. A further decline in real estate values would reduce the value of the real estate collateral securing our loans and increase the risk that we would incur losses if borrowers defaulted on their loans. In addition, the repayment of commercial real estate and multi-family loans generally is dependent, in large part, on the successful operation of the property securing the loan or the business conducted on the property securing the loan. In addition, loan balances for commercial real estate, multi-family and construction loans are typically larger than those for permanent single-family and consumer loans. Accordingly, when there are defaults and losses on these types of loans, they are often larger on a per loan basis than those for permanent one-to four-family residential and consumer loans. Commercial business loans expose us to additional risks since they typically are made on the basis of the borrower’s ability to make repayments from the cash flow of the borrower’s business and are secured by non-real estate collateral that may depreciate over time. A secondary market for most types of commercial real estate, multi-family, commercial business and construction loans is not readily liquid, so we have less opportunity to mitigate credit risk by selling part or all of our interest in these loans.

Our construction loans are based upon estimates of costs and values associated with the completed project. These estimates may be inaccurate. Construction lending involves additional risks when compared with permanent residential lending because funds are advanced upon the security of the project, which is of uncertain value prior to its completion. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation of real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the related loan-to-value ratio. This type of lending also typically involves higher loan principal amounts and is often concentrated with a small number of builders. In addition, generally during the term of a construction loan, interest may be funded by the borrower or disbursed from an interest reserve set aside from the construction loan budget. These loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project and the ability of the borrower to sell or lease the property or obtain permanent take-out

 

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financing, rather than the ability of the borrower or guarantor to repay principal and interest. If our appraisal of the value of a completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project and may incur a loss. A “discounted cash flow analysis” is utilized for determining the value of any construction project of five or more units. Our ability to continue to originate a significant amount of construction loans is dependent on the recovery of the strength of the housing market in our market areas.

The credit risk related to commercial real estate and multi-family loans is considered to be greater than the risk related to one-to four-family residential or consumer loans because the repayment of commercial real estate loans and multi-family typically is dependent on the income stream of the real estate securing the loan as collateral and the successful operation of the borrower’s business, which can be significantly affected by conditions in the real estate markets or in the economy. For example, if the cash flow from the borrower’s project is reduced as a result of leases not being obtained or renewed, the borrower’s ability to repay the loan may be impaired. In addition, some of our commercial real estate loans are not fully amortizing and contain large balloon payments upon maturity. These balloon payments may require the borrower to either sell or refinance the underlying property in order to make the balloon payment.

Further, if we foreclose on a commercial real estate and multi-family or construction loan, our holding period for the collateral may be longer than for one-to four-family residential mortgage loans because there are fewer potential purchasers of the collateral. These loans also generally have relatively large balances to single borrowers or related groups of borrowers. Accordingly, if we make any errors in judgment in the collectibility of our commercial real estate loans, any resulting charge-offs may be larger on a per loan basis than those incurred with our residential or consumer loan portfolios.

The Company’s recent business acquisition could have an impact on our earnings and results of operations that may negatively impact the value of the Company’s stock.

The Company completed its acquisition of Mt. Washington on January 4, 2010 and successfully integrated Mt. Washington’s operations and converted Mt. Washington’s accounts to the Company’s data servicing during 2010. The acquisition materially increased the size and complexity of our operations. Although the acquisition did not have an adverse effect upon the Company’s operating results during 2010 and 2011, the acquired operations may not achieve levels of profitability comparable to those achieved by the Company’s existing operations, or otherwise perform as expected. Such adverse effects on the Company’s earnings and results of operations may have a negative impact on the value of the Company’s stock.

Legislative or regulatory actions responding to financial and market weakness could affect us adversely. There can be no assurance that actions of the U.S. government, Federal Reserve and other governmental and regulatory bodies for the purpose of stabilizing the financial markets will achieve the intended effect.

The potential exists for additional federal or state laws and regulations regarding lending and funding practices and liquidity standards, and bank regulatory agencies are expected to be active in responding to concerns and trends identified in examinations, including the expected issuance of many formal enforcement orders. Actions taken to date, as well as potential actions, may not have the beneficial effects that are intended, particularly with respect to the extreme levels of volatility and limited credit availability currently being experienced. In addition, new laws, regulations, and other regulatory changes will increase our costs of regulatory compliance and of doing business, and otherwise affect our operations. Our FDIC insurance premiums may increase because market developments have significantly depleted the insurance fund of the FDIC and reduced the ratio of reserves to insured deposits. New laws, regulations, and other regulatory changes, along with negative developments in the financial services industry and the credit markets, may significantly affect the markets in which we do business, the markets for and value of our loans and investments, and our ongoing operations, costs and profitability.

 

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Our business strategy includes the continuation of significant growth plans, and our financial condition and results of operations could be negatively affected if we fail to grow or fail to manage our growth effectively.

We expect to continue to experience growth in the amount of our assets, the level of our deposits and the scale of our operations. Achieving our growth targets requires us to attract customers that currently bank at other financial institutions in our market, thereby increasing our share of the market. Our ability to successfully grow will depend on a variety of factors, including our ability to attract and retain experienced bankers, the continued availability of desirable business opportunities, the competitive responses from other financial institutions in our market areas and our ability to manage our growth. While we believe we have the management resources and internal systems in place to successfully manage our future growth, there can be no assurance growth opportunities will be available or that we will successfully manage our growth. If we do not manage our growth effectively, we may not be able to achieve our business plan, and our business could be harmed.

A continued downturn in the local economy or a decline in local real estate values could hurt our profits.

Unlike larger financial institutions that are more geographically diversified, our profitability depends on the general economic conditions in the Boston metropolitan area. Local economic conditions have a significant impact on our commercial real estate and construction and consumer loans, the ability of the borrowers to repay these loans and the value of the collateral securing these loans. Almost all of our loans are to borrowers or secured by collateral located in Massachusetts. As a result of this concentration, the downturn in the local economy has resulted in an increase in non-performing loans, which can result in higher levels of loan loss provision expense. Moreover, a significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, an outbreak of hostilities or other international or domestic calamities, unemployment or other factors beyond our control could further impact these local economic conditions and could further negatively affect the financial results of our banking operations. A decline in real estate values in our market area may have caused some of our mortgage loans to become inadequately collateralized, which would expose us to a greater risk of loss on defaulted loans which would negatively impact our net income. The Company’s non-performing assets declined in 2012 compared to 2011 and 2010, while its provision for loan losses increased primarily due to increases in the commercial real estate, construction and commercial business loan categories. Refer to “Management’s Discussion and Analysis of Results of Operations and Financial Condition — Asset Quality.”

If our allowance for loan losses is not sufficient to cover actual loan losses, our earnings could decrease.

The Company maintains an allowance for loan losses, which is established through a provision for loan losses that represents management’s best estimate of probable losses within the existing portfolio of loans. The Company makes various assumptions and judgments about the collectibility of its loan portfolio, including the creditworthiness of borrowers and the value of the real estate and other assets serving as collateral for the repayment of loans. In determining the adequacy of the allowance for loan losses, the Company relies on its experience and its evaluation of economic conditions. If its assumptions prove to be incorrect, its current allowance for loan losses may not be sufficient to cover losses inherent in its loan portfolio and adjustment may be necessary to allow for different economic conditions or adverse developments in its loan portfolio. Consequently, a problem with one or more loans could require the Company to significantly increase the level of its provision for loan losses. In addition, federal and state regulators periodically review the Company’s allowance for loan losses and may require it to increase its provision for loan losses or recognize further loan charge-offs. Material additions to the allowance would materially decrease the Company’s net income.

Changes in interest rates could hurt our profits.

Our profitability, like most financial institutions, depends to a large extent upon our net interest income, which is the difference between our interest income on interest-earning assets, such as loans and securities, and our interest expense on interest-bearing liabilities, such as deposits and borrowed funds. Accordingly, our results of operations depend largely on movements in market interest rates and our ability to manage our interest-rate-sensitive assets and liabilities in response to these movements. Factors such as inflation, recession and instability in financial markets, among other factors beyond the Company’s control, may affect interest rates.

 

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If interest rates rise, and if rates on our deposits reprice upwards faster than the rates on our long-term loans and investments, we would experience compression of our interest rate spread, which would have a negative effect on our profitability. Decreases in interest rates can result in increased prepayments of loans and mortgage-related securities, as borrowers refinance to reduce their borrowing costs. Under these circumstances, we are subject to reinvestment risk as we may have to redeploy such loan or securities proceeds into lower-yielding assets, which might also negatively impact our income.

While the Company pursues an asset/liability strategy designed to mitigate its risk from changes in interest rates, changes in interest rates can still have a material adverse effect on the Company’s financial condition and results of operations. Changes in the level of interest rates also may negatively affect our ability to originate real estate loans, the value of our assets and our ability to realize gains from the sale of our assets, all of which ultimately affect our earnings. For further discussion of how changes in interest rates could impact us, see “Management’s Discussion and Analysis of Results of Operations and Financial Condition — Risk Management — Interest Rate Risk Management.”

The financial services sector represents a significant concentration within our investment portfolio.

Within the investment portfolio, the Company has a significant amount of marketable equity securities and corporate debt securities, including mortgage-backed securities, issued by companies in the financial services sector. Given the current market conditions, this sector has an enhanced level of credit risk.

Changes in the valuation of our securities portfolio could hurt our profits.

Management evaluates securities for other-than-temporary impairment on a monthly basis, with more frequent evaluation for selected issues. In analyzing a debt issuer’s financial condition, management considers whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, industry analysts’ reports and, to a lesser extent given the relatively insignificant levels of depreciation in the Company’s debt portfolio, spread differentials between the effective rates on instruments in the portfolio compared to risk-free rates. In analyzing an equity issuer’s financial condition, management considers industry analysts’ reports, financial performance and projected target prices of investment analysts within a one-year time frame. Market valuation levels of the securities portfolio have increased as of December 31, 2012 following a decline as of December 31, 2011 compared to December 31, 2010. A decline in the market for the securities portfolio could result in impairment charges on some issues. Refer to “Management’s Discussion and Analysis of Results of Operations and Financial Condition — Securities Portfolio.”

The expiration of unlimited Federal Deposit Insurance Corporation insurance on certain non-interest-bearing transaction accounts may increase our costs and reduce our liquidity levels.

On December 31, 2012, unlimited FDIC insurance on certain non-interest-bearing transaction accounts expired. Unlimited insurance coverage did not apply to money market deposit accounts or negotiable order of withdrawal accounts. The reduction in FDIC insurance on other types of accounts to the standard $250,000 maximum amount may cause depositors to place such funds in fully insured interest-bearing accounts, which would increase our costs of funds and negatively affect our results of operations, or may cause depositors to withdraw their deposits and invest uninsured funds in investments perceived as being more secure, such as securities issued by the United States Treasury. This may reduce our liquidity, or require us to pay higher interest rates to maintain our liquidity by retaining deposits.

Impairment of goodwill could require charges to earnings, which could result in a negative impact on our results of operations.

Goodwill arises when a business is purchased for an amount greater than the net fair value of its assets. The Company recognized goodwill as an asset on the balance sheet in connection with its acquisition of Mt. Washington. The Company evaluates goodwill for impairment at least annually. Although the Company determined that goodwill and was not impaired during 2012, a significant and sustained decline in our stock price

 

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and market capitalization, a significant decline in our expected future cash flows, a significant adverse change in the business climate, slower growth rates or other factors could result in impairment of goodwill. If the Company were to conclude that a future write-down of the goodwill was necessary, then the Company would record the appropriate charge to earnings, which could be materially adverse to the results of operations and financial position. For further discussion of the Company’s methodology of evaluating and impairing goodwill, refer to “Management’s Discussion and Analysis of Results of Operations and Financial Condition — Critical Accounting Policies — Evaluation of Goodwill and Analysis for Impairment.”

The suspension of dividends by the Federal Home Loan Bank of Boston will negatively affect our earnings.

After suspending dividends in the fourth quarter of 2008, the Federal Home Loan Bank of Boston resumed payment of dividends in 2011 equal to an annual yield of 0.30% and continued to pay dividends in 2012 equal to an annual yield of 0.50%. We did not receive any such dividends in 2009 and 2010. The inconsistency in the Federal Home Loan Bank of Boston’s ability to pay dividends could reduce our earnings during such periods of nonpayment.

If our investment in stock of the Federal Home Loan Bank of Boston is classified as other-than-temporarily impaired, our earnings and stockholders’ equity would decrease.

We own common stock of the Federal Home Loan Bank of Boston. We hold this stock to qualify for membership in the Federal Home Loan Bank System and to be eligible to borrow funds under the Federal Home Loan Bank of Boston’s advance program. The aggregate cost and fair value of our Federal Home Loan Bank of Boston common stock as of December 31, 2012 was $12.1 million based on its par value. There is no market for our Federal Home Loan Bank of Boston common stock. Recent published reports indicate that certain member banks of the Federal Home Loan Bank System may be subject to accounting rules and asset quality risks that could result in materially lower regulatory capital levels. In an extreme situation, it is possible that the capitalization of a Federal Home Loan Bank, including the Federal Home Loan Bank of Boston, could be substantially diminished. Consequently, we believe that there is a risk that our investment in Federal Home Loan Bank of Boston common stock could be impaired at some time in the future. If this occurs, it would cause our earnings and stockholders’ equity to decrease by the after-tax amount of the impairment charge.

The building of market share through de novo branching and expansion of our residential, commercial real estate and commercial business lending capacity could cause our expenses to increase faster than revenues.

We intend to continue to build market share in the greater Boston metropolitan area through de novo branching and expansion of our residential, commercial real estate and commercial business lending capacity. Since 2002, we have opened 13 de novo branches including the most recent branch opened in February 2013. In the third quarter of 2011, we significantly expanded our commercial business lending capacity with the establishment of a new corporate banking division comprised of a veteran team of bankers that is expected to enhance our presence in all of our market areas and add strength to our business platform. There are considerable costs involved in opening branches and expansion of lending capacity that generally require a period of time to generate the necessary revenues to offset their costs, especially in areas in which we do not have an established presence. Accordingly, any such business expansion can be expected to negatively impact our earnings for some period of time until certain economies of scale are reached. Our expenses could be further increased if we encounter delays in the opening of any of our new branches. Finally, we have no assurance our business expansion will be successful after establishment.

Recent health care legislation could increase our expenses or require us to pass further costs on to our employees, which could adversely affect our operations, financial condition and earnings.

Legislation enacted in 2010 requires companies to provide expanded health care coverage to their employees, such as affordable coverage to part-time employees and coverage to dependent adult children of employees. Companies will also be required to enroll new employees automatically into one of their health plans. Compliance with these and other new requirements of the health care legislation will increase our employee

 

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benefits expense, and may require us to pass these costs on to our employees, which could give us a competitive disadvantage in hiring and retaining qualified employees.

Changes in the structure of Fannie Mae and Freddie Mac (“GSEs”) and the relationship among the GSEs, the federal government and the private markets, or the conversion of the current conservatorship of the GSEs into receivership, could result in significant changes to our securities portfolio.

The GSEs are currently in conservatorship, with its primary regulator, the Federal Housing Finance Agency, acting as conservator. We cannot predict if, when or how the conservatorships will end, or any associated changes to the GSEs’ business structure that could result. We also cannot predict whether the conservatorships will end in receivership. There are several proposed approaches to reform the GSEs which, if enacted, could change the structure of the GSEs and the relationship among the GSEs, the government and the private markets, including the trading markets for agency conforming mortgage loans and markets for mortgage-related securities in which we participate. We cannot predict the prospects for the enactment, timing or content of legislative or rulemaking proposals regarding the future status of the GSEs. Accordingly, there continues to be uncertainty regarding the future of the GSEs, including whether they will continue to exist in their current form. GSE reform, if enacted, could result in a significant change and adversely impact our business operations.

Our funding sources may prove insufficient to replace deposits at maturity and support our future growth.

We must maintain sufficient funds to respond to the needs of depositors and borrowers. As a part of our liquidity management, we use a number of funding sources in addition to core deposit growth and repayments and maturities of loans and investments. As we continue to grow, we are likely to become more dependent on these sources, which include Federal Home Loan Bank advances, proceeds from the sale of loans; federal funds purchased and brokered certificates of deposit. Adverse operating results or changes in industry conditions could lead to difficulty or an inability to access these additional funding sources. Our financial flexibility will be severely constrained if we are unable to maintain our access to funding or if adequate financing is not available to accommodate future growth at acceptable interest rates. Finally, if we are required to rely more heavily on more expensive funding sources to support future growth, our revenues may not increase proportionately to cover our costs. In this case, our operating margins and profitability would be adversely affected.

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

We face intense competition in making loans and attracting deposits. Price competition for loans and deposits sometimes results in us charging lower interest rates on our loans and paying higher interest rates on our deposits and may reduce our net interest income. Competition also makes it more difficult and costly to attract and retain qualified employees. Many 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. If we are not able to effectively compete in our market area, our profitability may be negatively affected, potentially limiting our ability to pay dividends. The greater resources and broader offering of deposit and loan products of some of our competitors may also limit our ability to increase our interest-earning assets. For more information about our market area and the competition we face, see “Item 1 — Business — Market Area” and “Item 1 — Business — Competition.”

The success of the Company is dependent on hiring and retaining certain key personnel.

The Company’s performance is largely dependent on the talents and efforts of highly skilled individuals. The Company relies on key personnel to manage and operate its business, including major revenue generating functions such as loan and deposit generation. The loss of key staff may adversely affect the Company’s ability to maintain and manage these functions effectively, which could negatively affect the Company’s revenues. In addition, loss of key personnel could result in increased recruiting and hiring expenses, which could cause a decrease in the Company’s net income. The Company’s continued ability to compete effectively depends on its ability to attract new employees and to retain and motivate its existing employees. In July 2011, we hired a new

 

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Executive Vice President of Corporate Banking and a veteran team of bankers for the Company’s new corporate banking division.

System failure or breaches of our network security could subject us to increased operating costs as well as litigation and other liabilities.

The computer systems and network infrastructure we use could be vulnerable to unforeseen problems. Our operations are dependent upon our ability to protect our computer equipment against damage from physical theft, fire, power loss, telecommunications failure or a similar catastrophic event, as well as from security breaches, denial of service attacks, viruses, worms and other disruptive problems caused by hackers. Any damage or failure that causes an interruption in our operations could have a material adverse effect on our financial condition and results of operations. Computer break-ins, phishing and other disruptions could also jeopardize the security of information stored in and transmitted through our computer systems and network infrastructure, which may result in significant liability to us and may cause existing and potential customers to refrain from doing business with us. Although we, with the help of third-party service providers, intend to continue to implement security technology and establish operational procedures to prevent such damage, our security measures may not be successful. In addition, advances in computer capabilities, new discoveries in the field of cryptography or other developments could result in a compromise or breach of the algorithms we and our third-party service providers use to encrypt and protect customer transaction data. A failure of such security measures could have a material adverse effect on our financial condition and results of operations.

It is possible that significant amount of time and money may be spent to rectify the harm caused by a breach or hack. While we have general liability insurance and cyber liability insurance, there are limitations on coverage as well as dollar amount. Furthermore, cyber incidents carry a greater risk of injury to our reputation. Finally, depending on the type of incident, banking regulators can impose restrictions on our business and consumer laws may require reimbursement of customer loss.

Our risk management framework may not be effective in mitigating risk and reducing the potential for significant losses.

Our risk management framework is designed to minimize risk and loss to us. We seek to identify, measure, monitor, report and control our exposure to risk, including strategic, market, liquidity, compliance and operational risks. While we use a broad and diversified set of risk monitoring and mitigation techniques, these techniques are inherently limited because they cannot anticipate the existence or future development of currently unanticipated or unknown risks. Recent economic conditions and heightened legislative and regulatory scrutiny of the financial services industry, among other developments, have increased our level of risk. Accordingly, we could suffer losses as a result of our failure to properly anticipate and manage these risks.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

Not applicable.

 

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ITEM 2. PROPERTIES

At December 31, 2012, we conducted business through our 24 full service offices and three loan centers located in Boston, Cambridge, Danvers, East Boston, Revere, South Boston, Dorchester, Jamaica Plain, West Roxbury, Everett, Medford, Melrose, Wakefield, Winthrop, Lynn, Peabody and Saugus, Massachusetts. In January and February 2013, we opened two full service offices located in Allston and Belmont, Massachusetts. During the second quarter of 2013, we are planning to open our 27th full service office in Somerville, Massachusetts and are scheduled to open a loan operation center located in Malden, Massachusetts. We own 18 and lease 14 of our offices. At December 31, 2012, the total net book value of our land, buildings, furniture, fixtures and equipment was $38.7 million.

 

                                                                          

Location

  Size
(Square Feet)
    Owned or
Leased
    Lease
Expiration Date
 

Offices:

     

Suffolk County:

     

10 Meridian Street, East Boston, MA 02128

    6,900        Owned        Not Applicable   

1 Bennington Street, East Boston, MA 02128

    3,285        Owned        Not Applicable   

856 Bennington Street, East Boston, MA 02128

    6,900        Owned        Not Applicable   

575 Broadway, Revere, MA 02151

    4,400        Owned        Not Applicable   

126 Squire Road, Revere, MA 02151

    2,500        Owned        Not Applicable   

430 West Broadway, South Boston, MA 02127

    6,100        Owned        Not Applicable   

455 West Broadway, South Boston, MA 02127

    13,474        Owned        Not Applicable   

708 East Broadway, South Boston, MA 02127

    3,542        Owned        Not Applicable   

501 Southampton Street, South Boston, MA 02127

    3,100        Leased        01/31/2031   

489 Gallivan Boulevard, Dorchester, MA 02124

    3,000        Leased        08/31/2023   

305 Talbot Avenue, Dorchester, MA 02124

    4,478        Owned        Not Applicable   

515 Centre Street, Jamaica Plain, MA 02130

    3,061        Owned        Not Applicable   

1985 Centre Street, West Roxbury, MA 02132

    2,420        Leased        07/31/2030   

15 Barlett Road, Winthrop, MA 02152

    2,600        Owned        Not Applicable   

1134 Washington Street, Boston, MA 02118

    2,507        Leased        05/31/2021   

181 Brighton Avenue, Allston, MA 02134

    2,760        Leased        01/31/2028   

Middelesex County:

     

1755 Revere Beach Parkway, Everett, MA 02149

    8,800        Owned        Not Applicable   

410 Riverside Avenue, Medford, MA 02155

    3,200        Leased        06/01/2018   

108 Main Street, Melrose, MA 02176

    6,052        Owned        Not Applicable   

381 Main Street, Wakefield, MA 01880

    2,200        Leased        03/01/2018   

2172 Massachusetts Avenue, Cambridge, MA 02140

    2,268        Leased        04/30/2016   

70 Concord Avenue, Belmont, MA 02478

    3,892        Leased        01/31/2023   

Essex County:

     

335 Broadway, Lynn, MA 01904

    6,000        Owned        Not Applicable   

220 Broadway, Suite 401, Lynnfield, MA 01940

    1,760        Owned        Not Applicable   

67 Prospect Street, Peabody, MA 01960

    108,000        Owned        Not Applicable   

320 Central Street, Saugus, MA 01906

    14,860        Owned        Not Applicable   

317 Main Street, Saugus, MA 01906

    3,870        Leased        01/31/2017   

8 Essex Center Drive, Peabody, MA 01960

    4,250        Leased        11/30/2018   

10 Elm Street, Danvers, MA 01923

    7,200        Leased        05/31/2016   

51 High Street, Danvers, MA 01923

    2,428        Owned        Not Applicable   

Planned Offices:

     

37 Union Square, Somerville, MA 02143

    3,351        Leased        05/31/2023   

350 Main Street, Malden, MA 02148

    12,217        Leased        04/30/2019   

 

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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. MINE SAFETY DISCLOSURES

Not Applicable.

PART II

 

ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information and Holders

The Company’s shares of common stock are traded on the NASDAQ Global Select Market under the symbol “EBSB”. The approximate number of shareholders of record of the Company’s common stock as of March 1, 2013 was 937. Certain shares of the Company are held in “nominee” or “street” name and accordingly, the number of beneficial owners of such shares is not known or included in the foregoing number.

The following table sets forth for each quarter of 2012 and 2011 the intra-day high and low sales prices per share of common stock as reported by Nasdaq. No cash dividends were declared in either year. On March 1, 2013, the closing market price of the Company’s common stock was $18.12.

 

                                                                          

2012

     High        Low        Dividends
Declared
 

Fourth quarter

     $ 17.98         $ 15.65         $   

Third quarter

       17.35           13.38             

Second quarter

       13.92           12.51             

First quarter

       13.60           12.39             

 

                                                                          

2011

     High        Low        Dividends
Declared
 

Fourth quarter

     $ 13.68         $ 10.76         $   

Third quarter

       13.95           10.68             

Second quarter

       14.30           12.02             

First quarter

       14.05           11.82             

Dividends

The Board of Directors may declare and pay periodic special cash dividends in addition to, or in lieu of, regular cash dividends. In determining whether to declare or pay any dividends, whether regular or special, the Board of Directors will take into account our financial condition and results of operations, tax considerations, capital requirements, industry standards and economic conditions. The regulatory restrictions that affect the payment of dividends by the Bank to the Company discussed below also will be considered. We cannot guarantee that we will pay dividends or that, if paid, we will not reduce or eliminate dividends in the future.

If the Company pays dividends to its stockholders, it will be required to pay dividends to Meridian. The Federal Reserve Board’s current policy prohibits the waiver of dividends by mutual holding companies with subsidiary bank holding companies. In addition, Massachusetts banking regulations prohibit Meridian from waiving dividends declared and paid by the Company unless the Massachusetts Commissioner of Banks does not object to the waiver and provided the waiver is not detrimental to the safe and sound operation of the Bank. Accordingly, we do not currently anticipate that Meridian will be permitted to waive dividends paid by the Company.

 

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The Company is subject to Massachusetts law, which prohibits distributions to stockholders if, after giving effect to the distribution, the Company would not be able to pay its debts as they become due in the usual course of business or the Company’s total assets would be less than the sum of its total liabilities plus the amount that would be needed, if the Company were to be dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution of stockholders whose preferential rights are superior to those receiving the distribution. In addition, the Company is subject to the Federal Reserve Board’s policy that dividends should be paid only out of current earnings and only if the prospective rate of earnings retention by the Company appears consistent with its capital needs, asset quality and overall financial condition. See “Regulation and Supervision — Holding Company Regulation.”

Dividends from the Company may depend, in part, upon receipt of dividends from the Bank because the Company has no source of income other than dividends from the Bank and earnings from investment of net proceeds from the offering retained by the Company. Massachusetts banking law and FDIC regulations limit distributions from the Bank to the Company. For example, the Bank could not pay dividends if it were not in compliance with applicable regulatory capital requirements. See “Regulation and Supervision — State Bank Regulation — Dividends” and “Federal Bank Regulation — Prompt Corrective Regulatory Action.”

Any payment of dividends by the Bank to the Company that would be deemed to be drawn out of the Bank’s bad debt reserves would require the Bank to pay federal income taxes at the then-current income tax rate on the amount deemed distributed. See “Federal and State Taxation — Federal Income Taxation” and Note 10, Income Taxes in the Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data within this report. The Company does not contemplate any distribution by the Bank that would result in this type of tax liability.

Recent Sales of Unregistered Securities; Use of Proceeds from Registered Securities

Not Applicable.

Securities Authorized for Issuance under Equity Compensation Plans

Information regarding stock-based compensation awards outstanding and available for future grants as of December 31, 2012, represents stock-based compensation plans approved by stockholders. Other than our Employee Stock Ownership Plan, there are no plans that have not been approved by stockholders. Additional information is presented in Note 12, Employee Benefits, in the Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, within this report. Additional information regarding the Company’s equity compensation plans is included in Part III, Item 12(d) of this Form 10-K.

Purchases of Equity Securities by the Issuer and Affiliated Purchases

The following table sets forth information with respect to any purchase made by or on behalf of the Company during the indicated periods:

 

                                                                                                   

Period

  (a)
Total Number of
Shares (or Units)
Purchased
    (b) Average Price
Paid Per Share
(or Unit)
    (c)
Total Number of
Shares (or Units)
Purchased as Part
of Publicly
Announced Plans
or Programs (1)
    (d)
Maximum Number
(or Approximate
Dollar Value) of
Shares (or Units)
that May Yet Be
Purchased Under
the Plans or
Programs
 

October 1 - 31, 2012

         $               708,858   

November 1 - 30, 2012

    1,200        15.84        1,200        707,658   

December 1 - 31, 2012

                         707,658   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total

    1,200      $ 15.84        1,200        707,658   
 

 

 

   

 

 

   

 

 

   

 

 

 

 

 

 

(1)

In August 2011, the Company’s Board of Directors voted to adopt a fourth stock repurchase program of up to 10% of its outstanding common stock not held by its mutual holding company parent, or 904,224 shares of its common stock.

 

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Performance Graph

The Company’s shares of common stock began trading on the NASDAQ Global Select Market on January 23, 2008. Accordingly, no comparative stock performance information is available for periods ending prior to this date. The performance graph below compares the Company’s cumulative shareholder return on its common stock since the inception of trading on January 23, 2008 to the cumulative total return of the NASDAQ Composite and the SNL Bank and Thrift Composite. Total shareholder return is measured by dividing total dividends (assuming dividend reinvestment) for the measurement period plus share price change for the period from the share price at the beginning of the measurement period. The return is based on an initial investment of $100.00.

Meridian Interstate Bancorp, Inc.

 

LOGO

 

                                                                                                                                                     
     Period Ending  

Index

  01/22/08     12/31/08     12/31/09     12/31/10     12/31/11     12/31/12  

Meridian Interstate Bancorp, Inc.

    100.00        92.50        87.00        117.90        124.50        167.80   

SNL Bank and Thrift

    100.00        63.90        63.04        70.38        54.73        73.49   

NASDAQ Composite

    100.00        69.43        100.93        119.24        118.29        139.29   

 

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Table of Contents
ITEM 6. SELECTED FINANCIAL DATA

The following table sets forth selected financial data for the Company.

 

                                                                                                                            
    At or For the Years Ended December 31,  

(Dollars in thousands, except per share amounts)

  2012     2011     2010     2009     2008  

Financial Condition Data

         

Total assets

  $ 2,278,771      $ 1,974,380      $ 1,835,830      $ 1,211,386      $ 1,065,352   

Securities available for sale

    262,785        335,230        360,602        293,367        252,529   

Loans, net

    1,786,339        1,341,301        1,173,562        813,300        704,104   

Deposits

    1,865,433        1,604,488        1,459,729        922,475        796,852   

Borrowings

    161,254        131,450        148,683        75,410        65,486   

Total stockholders’ equity

    233,943        219,944        215,611        200,415        189,840   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating Data

         

Interest and dividend income

  $ 84,969      $ 78,812      $ 82,059      $ 56,667      $ 52,897   

Interest expense

    18,945        20,972        21,040        20,392        27,044   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

    66,024        57,840        61,019        36,275        25,853   

Provision for loan losses

    8,581        3,663        3,181        4,082        5,638   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income, after provision for loan losses

    57,443        54,177        57,838        32,193        20,215   

Non-interest income

    21,261        15,388        11,721        5,295        8,373   

Non-interest expenses

    59,948        50,994        48,804        31,566        31,966   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) before income taxes

    18,756        18,571        20,755        5,922        (3,378

Provision (benefit) for income taxes

    6,330        6,601        7,381        2,159        (1,270
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income (loss)

  $ 12,426      $ 11,970      $ 13,374      $ 3,763      $ (2,108
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Key Performance Ratios

         

Return (loss) on average assets

    0.59     0.63     0.77     0.32     (0.20 )% 

Return (loss) on average equity

    5.42        5.45        6.38        1.94        (1.09

Interest rate spread(1)

    3.16        3.06        3.62        2.95        2.01   

Net interest margin(2)

    3.33        3.24        3.80        3.34        2.61   

Non-interest expense to average assets

    2.84        2.66        2.81        2.71        2.99   

Efficiency ratio(3)

    77.96        74.16        65.00        74.88        107.29   

Average interest-earning assets to average interest-bearing liabilities

    117.32        114.97        114.06        120.76        122.16   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Capital Ratios

         

Average equity to average assets

    10.87     11.47     12.05     16.65     18.17

Total capital to risk weighted assets(4)

    10.23        11.36        11.37        14.17        15.26   

Tier I capital to risk weighted assets(4)

    9.10        10.41        10.49        13.17        14.50   

Tier I capital to average assets(4)

    8.15        8.52        8.50        11.20        12.82   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Asset Quality Ratios

         

Allowance for loan losses/total loans

    1.13     0.96     0.86     1.12     0.97

Allowance for loan losses/non-accrual loans

    51.81        24.31        23.54        42.59        48.57   

Net charge-offs/average loans outstanding

    0.07        0.06        0.19        0.23        0.38   

Non-accrual loans/total loans

    2.19        3.97        3.64        2.63        2.00   

Non-performing assets/total assets

    1.85        2.91        2.57        2.03        1.58   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Per Share Data

         

Basic earnings per share

  $ 0.57      $ 0.55      $ 0.61      $ 0.17        N/A   

Diluted earnings per share

    0.57        0.55        0.61        0.17        N/A   

Book value per share

    10.57        9.93        9.59        9.07        8.34   

Tangible book value per share

    9.95        9.31        8.98        9.07        8.34   

Market value per share

    16.78        12.45        11.79        8.70        9.25   

Number of shares outstanding at end of period

    22,135,855        22,149,409        22,480,877        22,098,565        22,750,000   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Other data: Number of offices

    24        23        19        13        12   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

 

 

(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 non-interest expense excluding data processing contract termination costs, divided by the sum of net interest income and non-interest income excluding gains or losses on securities and gain on sale of investment in affiliate bank.

 

(4)

Ratios are for East Boston Savings Bank only.

 

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ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The objective of this section is to help readers understand our views on our results of operations and financial condition. You should read this discussion in conjunction with the consolidated financial statements and notes to the consolidated financial statements that appear elsewhere in this Annual Report.

Critical Accounting Policies

The Company’s summary of significant accounting policies are described in Note 1 to the Consolidated Financial Statements included in this Annual Report on Form 10-K for the year ended December 31, 2012. Critical accounting estimates are necessary in the application of certain accounting policies and procedures and are particularly susceptible to significant change. Critical accounting policies are defined as those involving significant judgments and assumptions by management that could have a material impact on the carrying value of certain assets or on income under different assumptions or conditions. Management believes that the most critical accounting policies, which involve the most complex or subjective decisions or assessments, are as follows:

Allowance for Loan Losses

The determination of the allowance for loan losses is considered critical due to the high degree of judgment involved, the subjectivity of the underlying assumptions used, and the potential for changes in the economic environment that could result in material changes in the amount of the allowance for loan losses considered necessary. The allowance for loan losses is utilized to absorb losses inherent in the loan portfolio. The allowance represents management’s estimate of losses as of the date of the financial statements. The allowance includes an allocated component for impaired loans and a general component for pools of non-impaired loans.

The adequacy of the allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

While management believes that it uses the best information available to establish the allowance for loan losses, future adjustments to the allowance may be necessary and results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making its determinations. Because the estimation of inherent losses cannot be made 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 loan deteriorate as a result of the factors noted above. Any material increase in the allowance for loan losses may adversely affect the financial condition and results of operations and will be recorded in the period in which the circumstances become known.

Valuation of Goodwill and Analysis for Impairment

The Company’s goodwill resulted from the acquisition of another financial institution accounted for under the acquisition method of accounting. The amount of goodwill recorded at acquisition is impacted by the recorded fair value of the assets acquired and liabilities assumed, which is an estimate determined by the use of internal or other valuation techniques.

Goodwill is subject to an annual review by management that first assesses qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. The Company would not be required to calculate the fair value of the Company or the reporting unit unless management determines, based on the qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. If the two-step quantitative goodwill impairment test is necessary, step one compares the book value of the Company or the reporting unit to the fair value of the Company, or to the fair value of the reporting unit. If test one is failed, a more detailed analysis is performed, which involves measuring the excess of the fair value of the reporting unit, as determined in step one, over the aggregate fair value of the individual assets, liabilities, and identifiable intangibles by utilizing a comparable analysis of relevant price multiples in recent market

 

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transactions. In the event of future changes in fair value, the Company may be exposed to an impairment charge that could be material.

Other-than-temporary Impairment of Securities

In analyzing a debt issuer’s financial condition, management considers whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, industry analysts’ reports and, to a lesser extent given the relatively insignificant levels of depreciation in the Company’s debt portfolio, spread differentials between the effective rates on instruments in the portfolio compared to risk-free rates. Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation.

From time to time, management’s intent to hold depreciated debt securities to recovery or maturity may change as a result of prudent portfolio management. If management’s intent changes, unrealized losses are recognized either as impairment charges to the consolidated income statement or as realized losses if a sale has been executed. In most instances, management sells the securities at the time their intent changes.

In analyzing an equity issuer’s financial condition, management considers industry analysts’ reports, financial performance and projected target prices of investment analysts within a one-year time frame. A decline of 10% or more in the value of an acquired equity security is generally the triggering event for management to review individual securities for liquidation and/or classification as other-than-temporarily impaired. Impairment losses are recognized when management concludes that declines in the value of equity securities are other than temporary, or when they can no longer assert that they have the intent and ability to hold depreciated equity securities for a period of time sufficient to allow for any anticipated recovery in fair value. Unrealized losses on marketable equity securities that are in excess of 25% of cost and that have been sustained for more than twelve months are generally considered-other-than temporary and charged to earnings as impairment losses, or realized through sale of the security.

Income Taxes

The Company reduces deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is not “more likely than not” that some portion or all of the deferred tax assets will be realized. The Company assesses the realizability of its deferred tax assets by assessing the likelihood of the Company generating federal and state tax income, as applicable, in future periods in amounts sufficient to offset the deferred tax charges in the periods they are expected to reverse. Based on this assessment, management concluded that a valuation allowance was not required as of December 31, 2012, 2011 and 2010.

Operating Strategies

Our mission is to operate and grow a profitable community-oriented financial institution. We plan to achieve this by executing our strategies of:

1. Managing credit risk to maintain a low level of nonperforming assets, and interest rate risk to optimize our net interest margin;

2. Growing our franchise through the opening of additional branch offices, expanding lending capacity and the possible acquisition of existing financial service companies or their assets;

3. Increasing core deposits through aggressive marketing and offering new deposit products; and

4. Continuing to grow and diversify our sources of non-interest income.

Managing credit risk to maintain a low level of nonperforming assets, and interest rate risk to optimize our net interest margin

Managing risk is an essential part of successfully managing a financial institution. Credit risk and interest rate risk are two prominent risk exposures that we face. Credit risk is the risk of not collecting the interest and/or the principal balance of a loan or investment when it is due. Our strategy for credit risk management focuses on

 

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having well-defined credit policies and uniform underwriting criteria and providing prompt attention to potential problem loans. We believe that strong asset quality is a key to long-term financial success. We have sought to grow and diversify the loan portfolio, while maintaining a strong asset quality and moderate credit risk, using underwriting standards that we believe are conservative, as well as diligent monitoring of the portfolio and loans in non-accrual status and on-going collection efforts. Although we will continue to originate commercial real estate, commercial business and construction loans, we intend to continue our philosophy of managing large loan exposures through our experienced, risk-based approach to lending. In addition, we intend to remain focused on lending within the Bank’s immediate market area, with a specific focus on commercial customers disaffected by their relationships with larger banks as a result of turmoil in the industry.

We continually monitor the investment portfolio for credit risk, with a monthly formal review by the Company’s Executive Committee of any issuers that have heightened credit risk factors such as rating agency and analyst downgrades and declines in market valuation. In addition, the Executive Committee reviews new investments for credit-worthiness before purchase. The Company generally purchases marketable equity securities in lots over time, while debt securities are purchased individually. We intend to replace maturing investments in 2013 as determined to be appropriate in accordance with our risk management policies and our funding needs. The Company also invests in money market mutual fund accounts which it utilizes as an alternative to investing excess cash in federal funds.

Interest rate risk is the potential reduction of net interest income as a result of changes in interest rates. Our earnings and the market value of our assets and liabilities are subject to fluctuations caused by changes in the level of interest rates. 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. To reduce the potential volatility of our earnings, we have sought to improve the match between asset and liability maturities and rates, while maintaining an acceptable interest rate spread. Our strategy for managing interest rate risk emphasizes: originating loans with adjustable interest rates; selling the residential real estate fixed-rate loans with terms greater than 10 years that we originate; promoting core deposit products; and gradually extending the maturity of funding sources, as borrowing and term deposit rates are historically low.

In order to improve our risk management, we utilize a Risk Management Officer to oversee the bank-wide risk management process. These responsibilities include the implementation of an overall risk program and strategy, determining risks and implementing risk mitigation strategies in the following areas: interest rates, operational/compliance, liquidity, strategic, reputation, credit and legal/regulatory. This position provides counsel to members of our senior management team on all issues that affect our risk positions.

Expanding our franchise through the opening of additional branch offices, additions to lending capacity and the possible acquisition of existing financial service companies or their assets

We are always looking to expand our franchise in the greater Boston metropolitan area. Since 2002, we have opened 13 de novo branches, the most recent in February 2013. In the third quarter of 2011, we significantly expanded our commercial business lending capacity with the establishment of a new corporate banking division comprised of a veteran team of bankers that is expected to enhance our presence in all of our market areas and add strength to our business platform. We intend to continue our geographic expansion in the greater Boston metropolitan area by opening de novo branches in communities contiguous to those currently served by the Bank, as opportunities present themselves in favorable locations. There are considerable costs involved in opening branches and expansion of lending capacity that generally require a period of time to generate the necessary revenues to offset their costs, especially in areas in which we do not have an established presence. Accordingly, any such business expansion can be expected to negatively impact our earnings for some period of time until certain economies of scale are reached.

On January 4, 2010, the Company completed its acquisition of Mt. Washington Co-operative Bank (“Mt. Washington”). The combination of Mt. Washington and the Bank resulted in a community bank with 19 full service branch offices located throughout the Boston metropolitan area. The transaction increased the Company’s deposits from $922.5 million to $1.3 billion as of January 4, 2010. We hope to continue to increase our franchise by pursuing expansion through the acquisition of existing financial service companies or their assets, although we currently have no specific plans or agreements regarding any acquisitions.

 

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In addition to branching, lending expansion and acquisitions, we are focusing on upgrading existing facilities in an effort to better serve our customers. The new facilities and the renovations to our existing facilities are expected to be funded by cash generated by our business. Consequently, we do not currently expect to borrow funds specifically for these expansion projects.

Increasing core deposits through aggressive marketing and the offering of new deposit products

Retail deposits are our primary source of funds for investing and lending. Core deposits, which include all deposit account types except certificates of deposit, comprised 66.3% of our total deposits at December 31, 2012, up from 59.7% of total deposits at December 31, 2011. We value our core deposits because they represent a lower cost of funding and are generally less sensitive to withdrawal when interest rates fluctuate as compared to certificate of deposit accounts. We market core deposits through the internet, in-branch and local mail, print and television advertising, as well as programs that link various accounts and services together, minimizing service fees. We will continue to customize existing deposit products and introduce new products to meet the needs of our customers.

Continuing to grow and diversify our sources of non-interest income

Our profits rely heavily on the spread between the interest earned on loans and securities and interest paid on deposits and borrowings. In order to decrease our reliance on interest rate spread income, we have pursued initiatives to increase non-interest income. We generated income from customer service fees of $6.6 million, $5.9 million and $5.8 million in 2012, 2011 and 2010, respectively. We offer reverse mortgages, which generated $105,000, $161,000 and $135,000 of loan fee income in 2012, 2011 and 2010, respectively. We also offer non-deposit investment products, including mutual funds, annuities, stocks, bonds, life insurance and long-term care. Our non-deposit financial products generated $432,000, $198,000 and $302,000 of non-interest income during the years ended December 31, 2012, 2011 and 2010, respectively.

Balance Sheet Analysis

Assets

Our total assets increased $304.4 million, or 15.4%, to $2.279 billion at December 31, 2012 from $1.974 billion at December 31, 2011. Net loans increased $445.0 million, or 33.2%, to $1.786 billion at December 31, 2012 from $1.341 billion at December 31, 2011. Cash and cash equivalents decreased $63.5 million, or 40.5%, to $93.2 million at December 31, 2012 from $156.7 million at December 31, 2011. Securities available for sale decreased $72.4 million, or 21.6%, to $262.8 million at December 31, 2012 from $335.2 million at December 31, 2011.

Loans

At December 31, 2012, net loans were $1.786 billion, or 78.4% of total assets. During the year ended December 31, 2012, total loans increased $445.0 million, or 33.2%. The net increase in loans for the year ended December 31, 2012 was primarily due to increases of $267.1 million in commercial real estate loans, $80.1 million in construction loans, $76.3 million in commercial business loans and $25.3 million in one-to four-family residential loans.

 

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Loan Portfolio Analysis

Our loan portfolio consists primarily of residential real estate, commercial real estate, construction, commercial and consumer segments. The residential real estate loans include classes for one-to four-family, multi-family and home equity lines of credit. There are no foreign loans outstanding. Interest rates charged on loans are affected principally by the demand for such loans, the supply of money available for lending purposes and the rates offered by our competitors. Loan detail by category was as follows:

 

                                                                                                                                                                                                                                                         
    At December 31,  
    2012     2011     2010     2009     2008  

(Dollars in thousands)

  Amount     %     Amount     %     Amount     %     Amount     %     Amount     %  

Real estate loans:

                   

Residential real estate:

                   

One-to four-family

  $ 443,228        24.5   $ 417,889        30.9   $ 402,887        34.0   $ 276,122        33.5   $ 274,716        38.6

Multi-family

    178,948        9.9        176,668        13.0        135,290        11.4        53,402        6.5        31,212        4.4   

Home equity lines of credit

    60,907        3.4        60,989        4.5        62,750        5.3        29,979        3.6        28,253        4.0   

Commercial real estate

    795,642        44.0        528,585        39.0        433,504        36.6        350,648        42.6        269,454        37.7   

Construction

    173,255        9.6        93,158        6.9        113,142        9.6        94,102        11.4        91,652        12.9   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total real estate loans

    1,651,980        91.4        1,277,289        94.3        1,147,573        96.9        804,253        97.6        695,287        97.6   

Commercial business loans

    147,814        8.2        71,544        5.3        30,189        2.6        18,029        2.2        15,355        2.2   

Consumer

    7,143        0.4        5,195        0.4        6,043        0.5        1,205        0.2        1,379        0.2   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans

    1,806,937        100.0     1,354,028        100.0     1,183,805        100.0     823,487        100.0     712,021        100.0
   

 

 

     

 

 

     

 

 

     

 

 

     

 

 

 

Allowance for loan losses

    (20,504       (13,053       (10,155       (9,242       (6,912  

Net deferred loan origination costs (fees)

    (94       326          (88       (945       (1,005  
 

 

 

     

 

 

     

 

 

     

 

 

     

 

 

   

Loans, net

  $ 1,786,339        $ 1,341,301        $ 1,173,562        $ 813,300        $ 704,104     
 

 

 

     

 

 

     

 

 

     

 

 

     

 

 

   

 

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Loan Maturity

The following table sets forth certain information at December 31, 2012 regarding the dollar amount of loan principal repayments becoming due during the period 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 schedule of repayments and no stated maturity are reported as due in one year or less. The amounts shown below exclude net deferred loan origination fees. Our adjustable-rate mortgage loans generally do not provide for downward adjustments below the initial discounted contract rate, other than declines due to a decline in the index rate.

 

                                                                                                   
       December 31, 2012  

(In thousands)

     Real Estate        Commercial
Business
       Consumer        Total  

Amounts due in:

                   

One year or less

     $ 246,003         $ 33,807         $ 478         $ 280,288   

More than one to five years

       894,282           56,963           6,661           957,906   

More than five to ten years

       255,096           48,656                     303,752   

More than ten years

       256,599           8,388           4           264,991   
    

 

 

      

 

 

      

 

 

      

 

 

 

Total

     $ 1,651,980         $ 147,814         $ 7,143         $ 1,806,937   
    

 

 

      

 

 

      

 

 

      

 

 

 

Interest rate terms on amounts due after one year:

                   

Fixed-rate loans

     $ 341,469         $ 28,011         $ 6,665         $ 376,145   

Adjustable-rate loans

       1,064,508           85,996                     1,150,504   
    

 

 

      

 

 

      

 

 

      

 

 

 

Total

     $ 1,405,977         $ 114,007         $ 6,665         $ 1,526,649   
    

 

 

      

 

 

      

 

 

      

 

 

 

At December 31, 2012, our loan portfolio consisted of $419.8 million of fixed-rate loans and $1.387 billion of adjustable-rate loans.

Asset Quality

Credit Risk Management

Our strategy for credit risk management focuses on having well-defined credit policies and uniform underwriting criteria and providing prompt attention to potential problem loans.

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, including contacting the borrower by letter and phone at regular intervals. When the borrower is in default, we may commence collection proceedings. 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. Management informs the Executive Committee monthly of the amount of loans delinquent more than 30 days. Management provides detailed information to the Board of Directors on loans 60 or more days past due and all loans in foreclosure and repossessed property that we own.

Delinquencies

Total past due loans decreased $16.7 million, or 34.3%, to $32.0 million at December 31, 2012 from $48.7 million at December 31, 2011, reflecting decreases of $7.1 million in loans 90 days or more past due and $9.6 million in loans 30 to 89 days past due. Delinquent loans at December 31, 2012 included $15.7 million of loans acquired in the Mt. Washington merger, including $3.5 million that were 30 to 59 days past due, $1.9 million that were 60 to 89 days past due and $10.3 million that were 90 days or more past due. At December 31, 2012, non-accrual loans exceeded loans 90 days or more past due primarily due to loans which were placed on non-accrual status based on a determination that the ultimate collection of all principal and interest due was not expected and certain loans that remain on non-accrual status until they attain a sustained payment history of six months.

 

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Non-performing Assets

Non-performing assets include loans that are 90 or more days past due or on non-accrual status and real estate and other loan collateral acquired through foreclosure and repossession. Loans 90 days or more past due may remain on an accrual basis if adequately collateralized and in the process of collection. At December 31, 2012, we did not have any accruing loans past due 90 days or more. For non-accrual loans, interest previously accrued but not collected is reversed and charged against income at the time a loan is placed on non-accrual status. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

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 initially recorded at the fair value less costs to sell at the date of foreclosure, establishing a new cost basis. Holding costs and declines in fair value after acquisition of the property result in charges against income. The following table provides information with respect to our non-performing assets at the dates indicated.

 

                                                                                                                            
     At December 31,  

(Dollars in thousands)

   2012     2011     2010     2009     2008  

Loans accounted for on a non-accrual basis:

          

Real estate loans:

          

Residential real estate:

          

One-to four-family

   $ 18,870      $ 15,795      $ 11,529      $ 4,098      $ 3,962   

Multi-family

     976        1,605        2,246        850          

Home equity lines of credit

     2,674        1,765        2,408                 

Commercial real estate

     8,844        11,588        11,290        7,388        883   

Construction

     7,785        22,434        15,326        9,224        9,387   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total real estate loans

     39,149        53,187        42,799        21,560        14,232   

Commercial business loans

     424        508        335                 

Consumer

                          138          
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total non-accrual loans(1)

     39,573        53,695        43,134        21,698        14,232   

Foreclosed assets

     2,604        3,853        4,080        2,869        2,604   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total non-performing assets

   $ 42,177      $ 57,548      $ 47,214      $ 24,567      $ 16,836   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Non-accrual loans to total loans

     2.19     3.97     3.64     2.63     2.00

Non-accrual loans to total assets

     1.74     2.72     2.35     1.79     1.34

Non-performing assets to total assets

     1.85     2.91     2.57     2.03     1.58

 

 

 

(1)

TDRs on accrual status not included above totaled $6.8 million at December 31, 2012, $1.3 million at December 31, 2011, $1.3 million at December 31, 2010, $189,000 at December 31, 2009 and $0 at December 31, 2008.

Non-accrual loans declined $14.1 million to $39.6 million, or 2.19% of total loans outstanding at December 31, 2012, from $53.7 million, or 3.97% of total loans outstanding at December 31, 2011, primarily due to decreases of $14.6 million in non-accrual construction loans, $2.7 million in non-accrual commercial real estate loans and $629,000 in non-accrual multi-family loans, partially offset by increases of $3.1 million in non-accrual one-to four-family loans and $909,000 in non-accrual home equity lines of credit. Foreclosed real estate decreased $1.2 million, or 32.4%, to $2.6 million at December 31, 2012 from $3.9 million at December 31, 2011. Non-performing assets declined $15.4 million to $42.2 million, or 1.85% of total assets, at December 31, 2012, from $57.5 million, or 2.91% of total assets, at December 31, 2011. Non-performing assets at December 31, 2012 included $19.5 million of assets acquired in the Mt. Washington merger, comprised of $18.5 million of non-accrual loans and $1.0 million of foreclosed real estate. Interest income that would have been recorded for the

 

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year ended December 31, 2012 had non-accruing loans been current according to their original terms amounted to $1.1 million.

Troubled Debt Restructurings

In the course of resolving non-accrual loans, the Bank may choose to restructure the contractual terms of certain loans, with terms modified to fit the ability of the borrower to repay in line with its current financial status. A loan is considered a troubled debt restructure if, for reasons related to the debtor’s financial difficulties, a concession is granted to the debtor that would not otherwise be considered.

The following table summarizes the Company’s troubled debt restructurings (“TDRs”) at the dates indicated.

 

                                                                          
       At December 31,  

(In thousands)

     2012        2011        2010  

TDRs on accrual status:

              

One-to four-family

     $ 1,992         $ 1,269         $ 1,289   

Multi-family

       110                       

Home equity lines of credit

       22                       

Commercial real estate

       1,393                       

Construction

       3,319                       
    

 

 

      

 

 

      

 

 

 

Total TDRs on accrual status

       6,836           1,269           1,289   
    

 

 

      

 

 

      

 

 

 

TDRs on non-accrual status:

              

One-to four-family

       2,493           2,052           288   

Commercial real estate

       4,466           4,663           4,797   

Construction

       3,838           7,715           3,487   
    

 

 

      

 

 

      

 

 

 

Total TDRs on non-accrual status

       10,797           14,430           8,572   
    

 

 

      

 

 

      

 

 

 

Total TDRs

     $ 17,633         $ 15,699         $ 9,861   
    

 

 

      

 

 

      

 

 

 

Construction TDRs on accrual status were the result of a two loan relationship that was returned to accrual status during the year ended December 31, 2012. The increases in commercial real estate and multi-family TDRs on accrual status were due to a loan restructured into two loans during the year ended December 31, 2012. The commercial real estate TDR reflects a 30 year note with a variable interest rate tied to the 5 year FHLB classic advance rate plus 300 basis points with a rate at the time of origination of 3.75% (rate was previously fixed at 8.25%). The multi-family TDR reflects a one year interest-only balloon with variable interest rate tied to Prime plus 100 basis points with a rate at the time of origination of 4.25%.

The increase in one-to-four family TDRs was due to one residential loan modification completed for the year ended December 31, 2012 and two one-to-four family TDRs that were returned to accrual status. The increase in one-to-four family non-accrual TDRs was due to six residential loan modifications completed for the year ended December 31, 2012 and two one-to-four family TDRs that were returned to accrual status. Modifications of one-to-four family TDRs consist of rate reductions, loan term extensions or provisions for interest-only payments for specified periods up to 12 months. The Company has generally been successful with the concessions it has offered to borrowers to date. The Company generally returns TDRs to accrual status when they have sustained payments for six months based on the restructured terms. Interest income that would have been recorded for the year ended December 31, 2012 had TDRs been current according to their original terms amounted to $474,000.

Potential Problem Loans

Certain loans are identified during the Company’s loan review process that are currently performing in accordance with their contractual terms and we expect to receive payment in full of principal and interest, but it

 

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is deemed probable that we will be unable to collect all the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. This may result from deteriorating conditions such as cash flows, collateral values or creditworthiness of the borrower. These loans are classified as impaired but are not accounted for on a non-accrual basis. There were no potential problem loans identified at December 31, 2012 other than those already classified as non-performing, impaired or troubled debt restructurings.

Allowance for Loan Losses

The allowance for loan losses is maintained at levels considered adequate by management to provide for probable loan losses inherent in the loan portfolio as of the consolidated balance sheet reporting dates. The allowance for loan losses is based on management’s assessment of various factors affecting the loan portfolio, including portfolio composition, delinquent and non-accrual loans, national and local business conditions and loss experience and an overall evaluation of the quality of the underlying collateral.

Changes in the allowance for loan losses during the periods indicated were as follows:

 

                                                                                                                            
       Years Ended December 31,  

(Dollars in thousands)

     2012     2011     2010     2009     2008  

Beginning balance

     $ 13,053      $ 10,155      $ 9,242      $ 6,912      $ 3,637   

Provision for loan losses

       8,581        3,663        3,181        4,082        5,638   

Charge offs:

            

Real estate

       1,840        1,334        2,719        1,938        2,265   

Commercial business

              72        93               98   

Consumer

       164        96        199        87        3   
    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total charge-offs

       2,004        1,502        3,011        2,025        2,366   

Recoveries:

            

Real estate

       823        690        646        250          

Commercial business

       11               8                 

Consumer

       40        47        89        23        3   
    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total recoveries

       874        737        743        273        3   
    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net charge-offs

       (1,130     (765     (2,268     (1,752     (2,363
    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Ending balance

     $ 20,504      $ 13,053      $ 10,155      $ 9,242      $ 6,912   
    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Allowance to non-accrual loans

       51.81     24.31     23.54     42.59     48.57

Allowance to total loans outstanding

       1.13     0.96     0.86     1.12     0.97

Net charge-offs to average loans outstanding

       0.07     0.06     0.19     0.23     0.38

The Company’s provision for loan losses was $8.6 million for the year ended December 31, 2012 compared to $3.7 million for the year ended December 31, 2011. The increase in the provision for loan losses was primarily due to increases in the commercial real estate, construction and commercial business loan categories for the year ended December 31, 2012 compared to the year ended December 31, 2011, as such loans have higher inherent credit risk than loans in our residential real estate loan categories. The provision for loan losses was also based on management’s assessment of loan portfolio growth and composition changes, an ongoing evaluation of credit quality and current economic conditions. The allowance for loan losses was $20.5 million or 1.13% of total loans outstanding at December 31, 2012, compared to $13.1 million or 0.96% of total loans outstanding at December 31, 2011. The Company continues to assess the adequacy of its allowance for loan losses in accordance with established policies.

 

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

 

     At December 31,  
     2012     2011     2010  

(Dollars in thousands)

  Amount     % of
Allowance
to Total
Allowance
    % of
Loans in
Category
of Total
Loans
    Amount     % of
Allowance
to Total
Allowance
    % of
Loans in
Category
of Total
Loans
    Amount     % of
Allowance
to Total
Allowance
    % of
Loans in
Category
of Total
Loans
 

Real estate loans:

                 

Residential real estate:

                 

One-to four-family

  $ 2,507        12.2     24.5   $ 1,861        14.3     30.9   $ 1,130        11.1     34.0

Multi-family

    1,431        7.0        9.9        1,361        10.4        13.0        1,038        10.2        11.4   

Home equity lines of credit

    226        1.1        3.4        245        1.9        4.5        227        2.2        5.3   

Commercial real estate

    10,405        50.8        44.0        6,980        53.4        39.0        5,238        51.7        36.6   

Construction

    3,656        17.8        9.6        1,430        11.0        6.9        2,042        20.1        9.6   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total real estate loans

    18,225        88.9        91.4        11,877        91.0        94.3        9,675        95.3        96.9   

Commercial business loans

    2,174        10.6        8.2        1,061        8.1        5.3        448        4.4        2.6   

Consumer

    105        0.5        0.4        115        0.9        0.4        32        0.3        0.5   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans

  $ 20,504        100.0     100.0   $ 13,053        100.0     100.0   $ 10,155        100.0     100.0
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The allowance consists of general and allocated components. The general component relates to pools of non-impaired loans and is based on historical loss experience adjusted for qualitative factors. The allocated component relates to loans that are classified as impaired, whereby an allowance is established when the discounted cash flows, collateral value or observable market price of the impaired loan is lower than the carrying value of that loan.

The Company had impaired loans totaling $41.2 million and $58.9 million as of December 31, 2012 and 2011, respectively. At December 31, 2012, impaired loans totaling $6.7 million had a valuation allowance of $649,000. Impaired loans totaling $9.1 million had a valuation allowance of $490,000 at December 31, 2011. The Company’s average investment in impaired loans was $51.7 million and $49.7 million for the years ended December 31, 2012 and 2011, respectively.

A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Impairment is measured on a loan by loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, we do not separately identify individual one-to four-family residential and consumer loans for impairment disclosures, unless such loans are subject to a troubled debt restructuring. The Company periodically may agree to modify the contractual terms of loans. When a loan is modified and a concession is made to a borrower experiencing financial difficulty, the modification is considered a TDR. All TDRs are initially classified as impaired.

We review residential and commercial loans for impairment based on the fair value of collateral, if collateral-dependent, or the present value of expected cash flows. Management has reviewed the collateral value for all impaired and non-accrual loans that were collateral-dependent as of December 31, 2012 and considered any probable loss in determining the allowance for loan losses.

 

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For residential loans measured for impairment based on the collateral value, we will do the following:

 

   

When a loan becomes seriously delinquent, generally 60 days past due, internal valuations are completed by our in-house appraiser who is a Massachusetts certified residential appraiser. We obtain third party appraisals, which are generally the basis for charge-offs when a loss is indicated, prior to the foreclosure sale. We generally are able to complete the foreclosure process within nine to 12 months from receipt of the internal valuation.

 

   

We make adjustments to appraisals based on updated economic information, if necessary, prior to the foreclosure sale. We review current market factors to determine whether, in management’s opinion, downward adjustments to the most recent appraised values may be warranted. If so, we use our best estimate to apply an estimated discount rate to the appraised values to reflect current market factors.

 

   

Appraisals we receive are based on comparable property sales.

For commercial loans measured for impairment based on the collateral value, we will do the following:

 

   

We obtain a third party appraisal at the time a loan is deemed to be in a workout situation and there is no indication that the loan will return to performing status, generally when the loan is 90 days or more past due. One or more updated third party appraisals are obtained prior to foreclosure depending on the foreclosure timeline. In general we order new appraisals every 180 days on loans in the process of foreclosure.

 

   

We make downward adjustments to appraisals when conditions warrant. Adjustments are made by applying a discount to the appraised value based on occupancy, recent changes in condition to the property and certain other factors. Adjustments are also made to appraisals for construction projects involving residential properties based on recent sales of units. Losses are recognized if the appraised value less estimated costs to sell is less than our carrying value of the loan.

 

   

Appraisals we receive are generally based on a reconciliation of comparable property sales and income capitalization approaches. For loans on construction projects involving residential properties, appraisals are generally based on a discounted cash flow analysis assuming a bulk sale to a single buyer.

Loans that are partially charged off generally remain on non-accrual status until foreclosure or such time that they are performing in accordance with the terms of the loan and have a sustained payment history of at least six months. The accrual of interest is generally discontinued when the contractual payment of principal or interest has become 90 days past due or management has serious doubts about further collectability of principal or interest, even though the loan is currently performing. Loan losses are charged against the allowance when we believe the uncollectability of a loan balance is confirmed, generally when appraised values (as adjusted values, if applicable) less estimated costs to sell, are less than the Company’s carrying values.

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 our 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 in the United States of America, there can be no assurance that regulators, in reviewing our loan portfolio, will not require us to increase our allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above. Any material increase in the allowance for loan losses may adversely affect our financial condition and results of operations.

Securities Portfolio

At December 31, 2012, the securities portfolio was $262.8 million, or 11.5% of total assets. At that date, 46.2% of the securities portfolio, or $121.4 million, was invested in corporate bonds. The amortized cost and fair value of corporate bonds in the financial services sector was $76.0 million, and $78.5 million, respectively. The remainder of the corporate bond portfolio includes companies from a variety of industries. Refer to Note 3 Securities Available for Sale in Notes to the Consolidated Financial Statements included in Item 8 Financial Statements and Supplementary

 

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Data within this report for more detail regarding industry concentrations in the Company’s corporate bond portfolio. The portfolio also includes debt securities issued by government-sponsored enterprises, municipal bonds, mortgage-backed securities issued by government-sponsored enterprises and private companies and marketable equity securities. Included in marketable equity securities are money market mutual funds and common stocks. The following table sets forth the amortized cost and fair value of our securities, all of which at the dates indicated were available for sale.

 

                                                                                                                                                     
    At December 31,  
    2012     2011     2010  

(In thousands)

  Amortized
Cost
    Fair
Value
    Amortized
Cost
    Fair
Value
    Amortized
Cost
    Fair
Value
 

Debt securities:

           

Corporate bonds

  $ 117,714      $ 121,420      $ 163,746      $ 165,704      $ 214,625      $ 222,038   

Government-sponsored enterprises

    53,084        53,149        82,898        83,195        36,062        35,900   

Municipal bonds

    7,236        7,461        7,401        7,574        6,583        6,493   

Residential mortgage-backed securities:

           

Government-sponsored enterprises

    16,280        17,298        25,296        26,664        33,625        34,542   

Private label

    3,169        3,309        7,322        7,055        9,737        10,334   

Other debt securities

                                641        641   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total debt securities

    197,483        202,637        286,663        290,192        301,273        309,948   

Marketable equity securities:

           

Common stocks

    42,406        46,334        31,820        36,007        31,344        36,765   

Money market mutual funds

    13,833        13,814        9,049        9,031        13,904        13,889   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total marketable equity securities

    56,239        60,148        40,869        45,038        45,248        50,654   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 253,722      $ 262,785      $ 327,532      $ 335,230      $ 346,521      $ 360,602   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

At December 31, 2012, we had no investments in a single company or entity, other than Government-sponsored enterprises, that had an aggregate book value in excess of 10% of our equity.

The following table sets forth the stated maturities and weighted average yields of the securities at December 31, 2012.

 

    One Year
or Less
    More than
One Year to
Five
Years
    More than
Five Years
to Ten
Years
    More than
Ten Years
    Total  

(Dollars in thousands)

  Amortized
Cost
    Weighted
Average
Yield
    Amortized
Cost
    Weighted
Average
Yield
    Amortized
Cost
    Weighted
Average
Yield
    Amortized
Cost
    Weighted
Average
Yield
    Amortized
Cost
    Weighted
Average
Yield
 

Debt securities:

                   

Corporate bonds

  $ 5,290        4.69   $ 105,845        2.80   $ 6,579        4.07   $        %      $ 117,714        2.96

Government-sponsored enterprises

                  97        4.06        52,987        1.30                      53,084        1.30   

Municipal bonds

    1,460        2.18        4,377        2.98        1,399        3.61                      7,236        2.94   

Residential mortgage-backed securities:

                   

Government-sponsored enterprises

                  4        12.46        18        9.34        16,258        4.38        16,280        4.39   

Private label

                                256        5.00        2,913        5.67        3,169        5.62   
 

 

 

     

 

 

     

 

 

     

 

 

     

 

 

   

Total debt securities

  $ 6,750        4.14   $ 110,323        2.81   $ 61,239        1.67   $ 19,171        4.58   $ 197,483        2.67
 

 

 

     

 

 

     

 

 

     

 

 

     

 

 

   

The available-for-sale securities portfolio decreased $72.4 million, or 21.6% to $262.8 million at December 31, 2012 from $335.2 million at December 31, 2011. Money market mutual funds included in the marketable equity securities portfolio totaled $13.8 million and $9.0 million at December 31, 2012 and 2011, respectively.

Each reporting period, the Company evaluates all securities with a decline in fair value below the amortized cost of the investment to determine whether or not the impairment is deemed to be other-than-temporary. OTTI is required to be recognized if (1) the Company intends to sell the security; (2) it is “more likely than not” that the Company will be required to sell the security before recovery of its amortized cost basis; or (3) for debt securities, the present value of expected cash flows is not sufficient to recover the entire amortized cost basis.

 

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Marketable equity securities are evaluated for OTTI based on the severity and duration of the impairment and, if deemed to be other than temporary, the declines in fair value are reflected in earnings as realized losses. For impaired debt securities that the Company intends to sell, or more likely than not will be required to sell, the full amount of the depreciation is recognized as OTTI through earnings. For all other impaired debt securities, credit-related OTTI is recognized through earnings and non-credit related OTTI is recognized in other comprehensive income/loss, net of applicable taxes. At December 31, 2012, unrealized losses in our debt portfolio ranged from 0% to 6.6%, and unrealized losses in our equity portfolio ranged from 0% to 23.5%.

As of December 31, 2012, the net unrealized gain on the total debt securities portfolio was $5.2 million. The Company has no indication that the issuer will be unable to continue to service the obligations, and management does intend not to sell, and more likely than not will not be required to sell, such bond before the earlier of recovery or maturity. As a result, management considers the decline in market value to be temporary. No other debt securities had a market decline greater than 5.0% of amortized cost.

As of December 31, 2012, the net unrealized gain on the total marketable equity securities portfolio was $3.9 million. Two equity securities had fair value declines of 15.0% or more, with net unrealized losses of $116,000. The most significant market valuation decrease related to any one equity security within the portfolio at December 31, 2012 is $72,000. Although the issuers have shown declines in earnings as a result of the weakened economy, no credit issues have been identified that cause management to believe the decline in market value is other than temporary, and the Company has the ability and intent to hold these investments until a recovery of fair value. In analyzing an equity issuer’s financial condition, management considers industry analysts’ reports, financial performance and projected target prices of investment analysts within a one-year time frame.

Refer to Note 3 Securities Available for Sale in Notes to the Consolidated Financial Statements included in Item 8 Financial Statements and Supplementary Data within this report for more detail regarding the Company’s assessment of other-than-temporary impairment.

Deposits

Deposits are a major source of our funds for lending and other investment purposes. Deposit inflows and outflows are significantly influenced by general interest rates and money market conditions. Our deposit base is comprised of demand, NOW, money market, regular savings and other deposits, and certificates of deposit. We consider demand, NOW, money market, and regular and other deposits to be core deposits. Total deposits increased $260.9 million, or 16.3%, to $1.865 billion at December 31, 2012 from $1.604 billion at December 31, 2011. Our continuing focus on the acquisition and expansion of core deposit relationships resulted in net growth in those non-term deposits of $279.1 million, or 29.1%, to $1.237 billion, or 66.3% of total deposits. The net deposit growth also reflects $156.3 million of new deposits from the five branches opened during the last two years.

The following table sets forth the average balances of deposits for the periods indicated.

 

                                                                                                                             
    Years Ended December 31,  
    2012     2011     2010  

(Dollars in thousands)

  Average
Balance
    Average
Rate
    Percent
of Total
Deposits
    Average
Balance
    Average
Rate
    Percent
of Total
Deposits
    Average
Balance
    Average
Rate
    Percent
of Total
Deposits
 

Demand deposits

  $ 172,258            10.9   $ 126,737            9.1   $ 106,549            7.7

NOW deposits

    154,375        0.48        9.7        134,557        0.46        9.6        117,584        0.46        9.3   

Money market deposits

    523,133        0.86        32.5        376,546        0.93        27.8        308,756        1.12        22.2   

Regular and other deposits

    231,274        0.38        13.2        205,664        0.49        13.3        184,287        0.55        12.9   

Certificates of deposit

    630,349        1.53        33.7        692,638        1.82        40.2        644,181        1.93        47.9   
 

 

 

     

 

 

   

 

 

     

 

 

   

 

 

     

 

 

 

Total

  $ 1,711,389        0.92     100.0   $ 1,536,142        1.15     100.0   $ 1,361,357        1.28     100.0
 

 

 

     

 

 

   

 

 

     

 

 

   

 

 

     

 

 

 

 

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Table of Contents

The following table indicates the amount of certificates of deposit of $100,000 or more by time remaining until maturity as of December 31, 2012.

 

                        

(In thousands)

     Certificates
of Deposit
 

Maturity Period:

    

Three months or less

     $ 36,992   

Over three through six months

       58,447   

Over six through twelve months

       84,077   

Over twelve months

       148,066   
    

 

 

 

Total

     $ 327,582   
    

 

 

 

Borrowings

We use borrowings from the Federal Home Loan Bank of Boston to supplement our supply of funds for loans and investments. In addition, we may also purchase federal funds from local banking institutions as an additional short-term funding source for the Bank. Total borrowings increased $29.8 million, or 22.7%, to $161.3 million at December 31, 2012 from $131.5 million at December 31, 2011, reflecting a $46.3 million increase in Federal Home Loan Bank of Boston advances partially offset by a $16.5 million decrease in short-term borrowings. The Bank entered into new advances with the Federal Home Loan Bank of Boston totaling $90.0 million with terms of five to seven years and fixed interest rates of 0.99% to 1.57% during the year ended December 31, 2012. At December 31, 2012 and 2011, Federal Home Loan Bank of Boston advances totaled $161.3 million and $114.9 million, respectively, with a weighted average rate of 2.05% and 2.61%, respectively. At December 31, 2012 and 2011, federal funds purchased totaled $0 and $16.5 million, respectively, with a weighted average rate of 0.15%. At December 31, 2012, we also had an available line of credit of $9.4 million with the Federal Home Loan Bank of Boston at an interest rate that adjusts daily, none of which was outstanding at that date.

Information relating to borrowings, including the federal funds purchased, is detailed in the following table.

 

                                                                          
       Years Ended December 31,  

(Dollars in thousands)

     2012     2011     2010  

Balance outstanding at end of year

     $ 161,254      $ 131,450      $ 148,683   

Average amount outstanding during the year

     $ 152,730      $ 143,346      $ 154,123   

Weighted average interest rate during the year

       2.10     2.26     2.33

Maximum outstanding at any month end

     $ 182,061      $ 157,848      $ 163,336   

Weighted average interest rate at end of year

       2.05     2.29     2.43

Stockholders’ Equity

Total stockholders’ equity increased $14.0 million, or 6.4%, to $233.9 million at December 31, 2012, from $219.9 million at December 31, 2011. The increase for the year ended December 31, 2012 was due primarily to $12.4 million in net income and a $930,000 increase in accumulated other comprehensive income primarily reflecting an increase in the fair value of available for sale securities, net of tax, partially offset by a $1.0 million increase in treasury stock resulting from the Company’s repurchase of 87,504 shares. Stockholders’ equity to assets was 10.27% at December 31, 2012, compared to 11.14% at December 31, 2011. Book value per share increased to $10.57 at December 31, 2012 from $9.93 at December 31, 2011. Tangible book value per share increased to $9.95 at December 31, 2012 from $9.31 at December 31, 2011. Market price per share increased $4.33, or 34.8%, to $16.78 at December 31, 2012 from $12.45 at December 31, 2011. At December 31, 2012, the Company and the Bank continued to exceed all regulatory capital requirements.

 

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Table of Contents

Average Balance Sheets and Related Yields and Rates

The following table presents information regarding average balances of assets and liabilities, the total dollar amounts of interest income and dividends from average interest-earning assets, the total dollar amounts of interest expense on average interest-bearing liabilities and the resulting annualized 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 daily average balances, and non-accrual loans are included in average balances but are not deemed material. Loan fees are included in interest income on loans but are not material.

 

                                                                                                                                                                                                                                
    Years Ended December 31,  
    2012     2011     2010  

(Dollars in thousands)

  Average
Balance
    Interest     Yield/
Cost
    Average
Balance
    Interest     Yield/
Cost
    Average
Balance
    Interest     Yield/
Cost
 

Assets:

                 

Interest-earning assets:

                 

Loans(1)

  $ 1,550,707      $ 76,050        4.90   $ 1,230,294      $ 66,157        5.38   $ 1,184,816      $ 67,459        5.69

Securities and certificates of deposits

    298,918        8,587        2.87        364,199        12,153        3.34        350,038        14,432        4.12   

Other interest-earning assets(2)

    135,183        332        0.25        190,634        502        0.26        72,136        168        0.23   
 

 

 

   

 

 

     

 

 

   

 

 

     

 

 

   

 

 

   

Total interest-earning assets

    1,984,808        84,969        4.28        1,785,127        78,812        4.41        1,606,990        82,059        5.11   
   

 

 

       

 

 

       

 

 

   

Noninterest-earning assets

    124,727            128,955            131,756       
 

 

 

       

 

 

       

 

 

     

Total assets

  $ 2,109,535          $ 1,914,082          $ 1,738,746       
 

 

 

       

 

 

       

 

 

     

Liabilities and stockholders’ equity:

                 

Interest-bearing liabilities:

                 

NOW deposits

  $ 154,375        741        0.48      $ 134,557        613        0.46      $ 117,584        540        0.46   

Money market deposits

    523,133        4,484        0.86        376,546        3,515        0.93        308,756        3,447        1.12   

Regular and other deposits

    231,274        887        0.38        205,664        1,003        0.49        184,287        1,011        0.55   

Certificates of deposit

    630,349        9,627        1.53        692,638        12,607        1.82        644,181        12,446        1.93   
 

 

 

   

 

 

     

 

 

   

 

 

     

 

 

   

 

 

   

Total interest-bearing deposits

    1,539,131        15,739        1.02        1,409,405        17,738        1.26        1,254,808        17,444        1.39   

Borrowings

    152,730        3,206        2.10        143,346        3,234        2.26        154,123        3,596        2.33   
 

 

 

   

 

 

     

 

 

   

 

 

     

 

 

   

 

 

   

Total interest-bearing liabilities

    1,691,861        18,945        1.12        1,552,751        20,972        1.35        1,408,931        21,040        1.49   
   

 

 

       

 

 

       

 

 

   

Noninterest-bearing demand deposits

    172,258            126,737            106,549       

Other noninterest-bearing liabilities

    16,166            15,138            13,798       
 

 

 

       

 

 

       

 

 

     

Total liabilities

    1,880,285            1,694,626            1,529,278       

Total stockholders’ equity

    229,250            219,456            209,468       
 

 

 

       

 

 

       

 

 

     

Total liabilities and stockholders’ equity

  $ 2,109,535          $ 1,914,082          $ 1,738,746       
 

 

 

       

 

 

       

 

 

     

Net interest-earning assets

  $ 292,947          $ 232,376          $ 198,059       
 

 

 

       

 

 

       

 

 

     

Net interest income

    $ 66,024          $ 57,840          $ 61,019     
   

 

 

       

 

 

       

 

 

   

Interest rate spread(3)

        3.16         3.06         3.62

Net interest margin(4)

        3.33         3.24         3.80

Average interest-earning assets to average interest-bearing liabilities

      117.32         114.97         114.06  

Supplemental Information:

                 

Total deposits, including noninterest-bearing demand deposits

  $ 1,711,389      $ 15,739        0.92   $ 1,536,142      $ 17,738        1.15   $ 1,361,357      $ 17,444        1.28

Total deposits and borrowings, including noninterest-bearing demand deposits

  $ 1,864,119      $ 18,945        1.02   $ 1,679,488      $ 20,972        1.25   $ 1,515,480      $ 21,040        1.39

 

 

 

(1)

Loans on non-accrual status are included in average balances.

 

(2)

Includes Federal Home Loan Bank stock and associated dividends.

 

(3)

Interest rate spread represents the difference between the yield on interest-earning assets and the cost of interest-bearing liabilities.

 

(4)

Net interest margin represents net interest income divided by average interest-earning assets.

 

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Table of Contents

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). The net column represents the sum of the prior columns. For purposes of this table, changes attributable to changes in both rate and volume that cannot be segregated have been allocated proportionally based on the changes due to rate and the changes due to volume.

 

                                                                                                                                                     
     Years Ended December 31,
2012 Compared to 2011
Increase (Decrease) Due to
    Years Ended December 31,
2011 Compared to 2010
Increase (Decrease) Due to
 

(In thousands)

   Volume     Rate     Net     Volume     Rate     Net  

Interest Income:

            

Loans

   $ 16,097      $ (6,204   $ 9,893      $ 2,531      $ (3,833   $ (1,302

Securities and certificates of deposits

     (2,008     (1,558     (3,566     564        (2,843     (2,279

Other interest-earning assets

     (138     (32     (170     309        25        334   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

     13,951        (7,794     6,157        3,404        (6,651     (3,247

Interest Expense:

            

Deposits

     416        (2,415     (1,999     1,779        (1,485     294   

Borrowings

     205        (233     (28     (246     (116     (362
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

     621        (2,648     (2,027     1,533        (1,601     (68
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Change in net interest income

   $ 13,330      $ (5,146   $ 8,184      $ 1,871      $ (5,050   $ (3,179
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Results of Operations for the Years Ended December 31, 2012, 2011 and 2010

Net Income

Our primary source of income is net interest income. Net interest income is the difference between interest income, which is the income that we earn on our loans and investments, and interest expense, which is the interest that we pay on our deposits and borrowings. Changes in levels of interest rates affect our net interest income. A secondary source of income is non-interest income, which includes revenue that we receive from providing products and services. The majority of our non-interest income generally comes from customer service fees, loan fees, bank-owned life insurance, mortgage banking gains and gains on sales of securities.

Net income information is as follows:

 

                                                                                                                                                                              
     Years Ended December 31,     Change 2012/2011     Change 2011/2010  

(Dollars in thousands)

   2012     2011     2010     Amount     Percent     Amount     Percent  

Net interest income

   $ 66,024      $ 57,840      $ 61,019      $ 8,184        14.1   $ (3,179     (5.2 )% 

Provision for loan losses

     8,581        3,663        3,181        4,918        134.3        482        15.2   

Non-interest income

     21,261        15,388        11,721        5,873        38.2        3,667        31.3   

Non-interest expenses

     59,948        50,994        48,804        8,954        17.6        2,190        4.5   

Net income

     12,426        11,970        13,374        456        3.8        (1,404     (10.5

Return on average assets

     0.59     0.63     0.77     (0.04     (6.3 )%      (0.14     (18.2 )% 

Return on average equity

     5.42     5.45     6.38     (0.03     (0.6 )%      (0.93     (14.6 )% 

The Company recorded a pre-tax gain of $4.8 million on June 8, 2012 due to the sale of Hampshire First Bank, which was 43% owned by the Company, to NBT Bancorp, Inc. and NBT Bank, N.A. On an after-tax basis, this gain increased net income by $2.9 million, or $0.13 per diluted share, for the year ended December 31, 2012.

 

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Table of Contents

Net Interest Income

Net interest income increased $8.2 million, or 14.1%, to $66.0 million for the year ended December 31, 2012 from $57.8 million for the year ended December 31, 2011. The net interest rate spread and net interest margin were 3.16% and 3.33%, respectively, for the year ended December 31, 2012 compared to 3.06% and 3.24%, respectively, for the year ended December 31, 2011. The increase in net interest income was due primarily to strong loan growth along with a decline in the cost of funds for the year ended December 31, 2012 compared to 2011.

The average balance of the Company’s loan portfolio increased $320.4 million, or 26.0%, to $1.551 billion, which was partially offset by the decline in the yield on loans of 48 basis points to 4.90% for the year ended December 31, 2012 compared to the year ended December 31, 2011. The Company’s cost of total deposits declined 23 basis points to 0.92%, which was partially offset by the increase in the average balance of total deposits of $175.2 million, or 11.4%, to $1.711 billion for the year ended December 31, 2012 compared to the year ended December 31, 2011. The Company’s yield on interest-earning assets declined 13 basis points to 4.28% for the year ended December 31, 2012 compared to 4.41% for the year ended December 31, 2011, while the cost of funds declined 23 basis points to 1.02% for the year ended December 31, 2012 compared to 1.25% for the year ended December 31, 2011.

For the year ended December 31, 2011, net interest income decreased $3.2 million, or 5.2%, to $57.8 million from $61.0 million for the year ended December 31, 2010. The net interest rate spread and net interest margin were 3.06% and 3.24%, respectively, for the year ended December 31, 2011 compared to 3.62% and 3.80%, respectively, for the year ended December 31, 2010. The decrease in net interest income was due primarily to declines in yields on loans and securities for the year ended December 31, 2011 compared to 2010.

The Company’s yield on loans declined 31 basis points to 5.38%, which was partially offset by an increase in the average balance of the loan portfolio of $45.5 million, or 3.8%, to $1.230 billion for the year ended December 31, 2011 compared to the year ended December 31, 2010. For the year ended December 31, 2011, the average balance of total deposits increased $174.8 million, or 12.8%, to $1.536 billion, which was partially offset by a decline in the cost of total deposits of 13 basis points to 1.15% compared to the year ended December 31, 2010. The Company’s yield on interest-earning assets declined 70 basis points to 4.41% for the year ended December 31, 2011 compared to 5.11% for the year ended December 31, 2010, while the cost of funds declined 14 basis points to 1.25% for the year ended December 31, 2011 compared to 1.39% for the year ended December 31, 2010.

Provision for Loan Losses

The Company’s provision for loan losses was $8.6 million for the year ended December 31, 2012 compared to $3.7 million and $3.2 million for the years ended December 31, 2011 and 2010, respectively. For further discussion of the changes in the provision and allowance for loan losses, refer to “Management’s Discussion and Analysis of Results of Operations and Financial Condition - Allowance for Loan Losses.”

 

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Table of Contents

Non-Interest Income

 

                                                                                                                                                                              
     Years Ended December 31,      Change 2012/2011     Change 2011/2010  

(Dollars in thousands)

   2012      2011      2010      Amount     Percent     Amount     Percent  

Customer service fees

   $ 6,645       $ 5,867       $ 5,823       $ 778        13.3   $ 44        0.8

Loan fees

     339         584         636         (245     (42.0     (52     (8.2

Mortgage banking gains, net

     2,371         2,125         1,811         246        11.6        314        17.3   

Gain on sales of securities, net

     5,568         4,464         1,790         1,104        24.7        2,674        149.4   

Income from bank-owned life insurance

     1,201         1,221         1,169         (20     (1.6     52        4.4   

Equity income on investment in affiliate bank

     310         1,110         492         (800     (72.1     618        125.6   

Gain on sales of investment in affiliate bank

     4,819                         4,819                        

Other income

     8         17                 (9     (52.9     17          
  

 

 

    

 

 

    

 

 

    

 

 

     

 

 

   

Total non-interest income

   $ 21,261       $ 15,388       $ 11,721       $ 5,873        38.2   $ 3,667        31.3
  

 

 

    

 

 

    

 

 

    

 

 

     

 

 

   

Non-interest income increased $5.9 million, or 38.2%, to $21.3 million for the year ended December 31, 2012 from $15.4 million for the year ended December 31, 2011, primarily due to a $4.8 million gain on sale of the Hampshire First Bank affiliate and increases of $1.1 million in gain on sales of securities, net, $778,000 in customer service fees and $246,000 in mortgage banking gains, net, partially offset by decreases of $800,000 in equity income from the Hampshire First Bank affiliate and $245,000 in loan fees.

For the year ended December 31, 2011, non-interest income increased $3.7 million, or 31.3%, to $15.4 million from $11.7 million for the year ended December 31, 2010 primarily due to increases of $2.7 million in gain on sales of securities, net, $314,000 in mortgage banking gains, net, and $618,000 in equity income from Hampshire First Bank.

Non-Interest Expense