EX-13 2 exh13.htm PORTIONS OF 2009 ANNUAL REPORT TO SHAREHOLDERS exh13.htm
 
EXHIBIT 13

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

The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and the notes relating thereto included herein. When necessary, reclassifications have been made to prior period’s data for purposes of comparability with current period presentation without impacting earnings.

Overview
 
Unity Bancorp, Inc. (the “Parent Company”) is a bank holding company incorporated in New Jersey and registered under the Bank Holding Company Act of 1956, as amended. Its wholly-owned subsidiary, Unity Bank (the “Bank,” or when consolidated with the Parent Company, the “Company”) is chartered by the New Jersey Department of Banking and Insurance. The Bank provides a full range of commercial and retail banking services through the Internet and its sixteen branch offices located in Hunterdon, Middlesex, Somerset, Union and Warren counties in New Jersey and Northampton County in Pennsylvania. These services include the acceptance of demand, savings and time deposits and the extension of consumer, real estate, Small Business Administration (“SBA”) and other commercial credits.

Results of Operations

Beginning in 2008 and continuing through 2009, there has been unprecedented financial, credit and capital market stress.  Factors such as lack of liquidity in the credit markets, financial institution failures, asset “fair market value” write-downs, and capital adequacy and credit quality concerns resulted in a lack of confidence by the markets in the financial industry.  Consumer sentiment remained low, consumer spending contracted, housing values declined, the stock market remained volatile, and unemployment remained at approximately 10 percent.   
       Corporate layoffs, hiring freezes and bankruptcies persist and capital spending plans have been postponed.  Individual’s uncertainties regarding the labor market have re-prioritized spending habits and have curbed discretionary spending.  The majority of the financial sector continues to trade at a discount to book value due to credit concerns and negative publicity in the news media.  Secondary markets for many types of financial assets remain very restrictive.  
The Company’s 2009 results were impacted by the magnitude of the recession and its subsequent impact on our customers and our loan and securities portfolios.  Items which materially impacted earnings for the year included:
·  
A $3.5 million increase year over year in the provision for loan losses due to the inherent credit risk within the loan portfolio,
·  
$2.6 million in other-than-temporary impairment charges (“OTTI”) on two bank pooled trust preferred securities due to the deterioration of the underlying collateral for the issues,
·  
A $1.1 million increase in FDIC insurance premiums due to an increase in assessment rates and a $408 thousand special assessment, and
·  
An $824 thousand decrease in gains on the sale of SBA loans.

Despite this challenging operating environment, the Company’s performance included the following accomplishments:
·  
Controlled operating expenses, which remained flat when the increased FDIC insurance premiums and special assessment are excluded,
·  
Continued market share expansion as total deposits increased 7.2 percent from one year ago, and
·  
The Company remained well-capitalized.
  
For the year ended December 31, 2009, the Company reported a net loss attributable to common shareholders of $2.6 million compared to net income available to common shareholders of $1.8 million for 2008.  Performance ratios included:

   
2009
   
2008
 
Net income (loss) per common share - Basic (1)
  $ (0.36 )   $ 0.26  
Net income (loss) per common share - Diluted (1)
  $ (0.36 )   $ 0.25  
Return (loss) on average assets
    (0.12 )%     0.24 %
Return (loss) on average equity (2)
    (5.29 )%     3.83 %
Efficiency ratio
    75.49  %     71.90 %

(1) Defined as net income adjusted for dividends accrued and accretion of discount on perpetual preferred stock divided by weighted average shares outstanding.
(2) Defined as net income adjusted for dividends accrued and accretion of discount on perpetual preferred stock divided by average shareholders’ equity (excluding preferred stock).

Net Interest Income
 
The primary source of income for the Company is net interest income, the difference between the interest earned on earning assets such as investments and loans, and the interest paid on deposits and borrowings.  Factors that impact the Company’s net interest income include the interest rate environment, the volume and mix of interest-earning assets and interest-bearing liabilities, and the competitive nature of the Company’s marketplace.
In 2008, the Federal Open Market Committee lowered interest rates 400 basis points in an attempt to stimulate economic activity.  By year-end 2008, the Fed Funds target
 
 
Annual Report Page 5 
19

 
rate had fallen to 0.25 percent and the Prime rate to 3.25 percent.  During 2009, interest rates remained stable at this low level.  Consequently, the Company realized lower yields on earning assets and lower funding costs.
During 2009, tax-equivalent interest income decreased $1.4 million or 2.7 percent to $49.5 million.  This decrease was driven by the lower average yield on earning assets and a shift in the mix of earning assets:
·  
Of the $1.4 million decrease in interest income on a tax-equivalent basis, a $5.5 million decrease is attributed to reduced yields on interest-earning assets, which was partially offset by a $4.2 million increase due to the increase in average interest-earning assets.
·  
The average volume of interest-earning assets increased $85.7 million to $866.9 million in 2009 compared to $781.2 million in 2008. This was due primarily to a $61.9 million increase in average investment securities and a $22.6 million increase in average loans.
·  
The mix of asset growth was concentrated in investment securities due to attractive pricing opportunities as the stressed economic environment tapered creditworthy lending opportunities.
·  
The yield on interest-earning assets decreased 81 basis points to 5.71 percent in 2009 due to the lower overall interest rate environment compared to 2008.  Yields on all earning assets, particularly those with variable rates, fell due to these lower market rates.  For example, the yield on SBA 7(a) loans fell 219 basis points to 6.06 percent from 8.25 percent in 2008.
 
Total interest expense was $21.6 million in 2009, a decrease of $1.9 million or 8.1 percent compared to 2008.  This decrease was driven by the lower overall interest rate environment in 2009 combined with the shift in deposit mix from higher priced products:
·  
Of the $1.9 million decrease in interest expense in 2009, $3.5 million was attributed to a decrease in the rates paid on interest-bearing liabilities, partially offset by a $1.6 million increase due to a higher volume of these liabilities.
·  
Interest-bearing liabilities averaged $757.4 million in 2009, an increase of $65.9 million, or 9.5 percent, compared to 2008.  The increase in interest-bearing liabilities was a result of increases in all deposit categories and borrowed funds.
·  
The average cost of interest-bearing liabilities decreased 55 basis points to 2.84 percent, primarily due to the repricing of deposits and borrowings in a lower interest rate environment.  The cost of interest-bearing deposits decreased 59 basis points to 2.66 percent in 2009 and the cost of borrowed funds and subordinated debentures decreased 30 basis points to 3.88 percent.
·  
The lower cost of funding was also attributed to a shift in the mix of deposits from higher cost time deposits to lower cost savings deposits.
 
Tax-equivalent net interest income amounted to $28.0 million in 2009, an increase of $503 thousand, or 1.8 percent, compared to 2008. Net interest margin decreased 29 basis points to 3.22 percent for 2009, compared to 3.51 percent in 2008.  The net interest spread was 2.87 percent, a 26 basis point decrease from 3.13 percent in 2008.
The table on pages 8 and 9 reflects the components of net interest income, setting forth for the periods presented herein: (1) average assets, liabilities and shareholders’ equity, (2) interest income earned on interest-earning assets and interest expense paid on interest-bearing liabilities, (3) average yields earned on interest-earning assets and average rates paid on interest-bearing liabilities, (4) net interest spread (which is the average yield on interest-earning assets less the average rate on interest-bearing liabilities), and (5) net interest income/margin on average earning assets. Rates/Yields are computed on a fully tax-equivalent basis, assuming a federal income tax rate of 34 percent.

 
Annual Report Page 6 
20

 
This page left intentionally blank.
 
 
Annual Report Page 7 
21

 
Consolidated Average Balance Sheets

(Dollar amounts in thousands - interest amounts and interest rates/yields on a fully tax-equivalent basis.)
For the years ended December 31,

   
2009
   
2008
 
    Average          
Rate/
   
Average
         
Rate/
 
   
Balance
   
Interest
   
Yield
   
Balance
   
Interest
   
Yield
 
ASSETS
                                   
                                     
Interest-earning assets:
                                   
Federal funds sold and interest-bearing deposits
  $ 27,163     $ 117       0.43 %   $ 26,686     $ 471       1.76 %
Federal Home Loan Bank stock
    5,061       277       5.47       4,353       240       5.51  
Securities:
                                               
Available for sale
    135,537       6,189       4.57       74,243       3,761       5.07  
Held to maturity
    32,292       1,593       4.93       31,710       1,654       5.22  
Total securities (A)
    167,829       7,782       4.64       105,953       5,415       5.11  
Loans, net of unearned discount:
                                               
SBA
    103,031       6,246       6.06       101,430       8,370       8.25  
SBA 504
    73,517       4,821       6.56       74,617       5,572       7.47  
Commercial
    301,340       19,881       6.60       308,751       21,424       6.94  
Residential mortgage
    126,474       7,252       5.73       100,110       5,971       5.96  
Consumer
    62,481       3,160       5.06       59,291       3,462       5.84  
Total loans (A),(B)
    666,843       41,360       6.20       644,199       44,799       6.95  
Total interest-earning assets
  $ 866,896     $ 49,536       5.71 %   $ 781,191     $ 50,925       6.52 %
Noninterest-earning assets:
                                               
Cash and due from banks
    18,948                       17,529                  
Allowance for loan losses
    (11,721                     (9,179                
Other assets
    33,913                       31,667                  
Total noninterest-earning assets
    41,140                       40,017                  
Total Assets
  $ 908,036                     $ 821,208  
                                                 
                                                 
LIABILITIES AND SHAREHOLDERS’ EQUITY
                                               
Interest-bearing liabilities:
                                               
Interest-bearing demand deposits
  $ 89,500     $ 1,063       1.19 %   $ 84,336     $ 1,468       1.74 %
Savings deposits
    214,274       3,574       1.67       168,784       3,644       2.16  
Time deposits
    341,233       12,523       3.67       330,174       13,836       4.19  
Total interest-bearing deposits
    645,007       17,160       2.66       583,294       18,948       3.25  
Borrowed funds and subordinated debentures
    112,403       4,422       3.88       108,214       4,526       4.18  
Total interest-bearing liabilities
  $ 757,410     $ 21,582       2.84 %   $ 691,508     $ 23,474       3.39 %
Noninterest-bearing liabilities:
                                               
Demand deposits
    79,252                       78,282                  
Other liabilities
    4,313                       2,531                  
Total noninterest-bearing liabilities
    83,565                       80,813                  
Shareholders’ equity
    67,061                       48,887                  
Total Liabilities and Shareholders’ Equity
  $ 908,036                     $ 821,208  
Net interest spread
          $ 27,954       2.87 %           $ 27,451       3.13 %
Tax-equivalent basis adjustment
            (126                     (160        
Net interest income
          $ 27,828                            27,291
Net interest margin
                    3.22 %                     3.51 %
 
(A) Yields related to securities and loans exempt from federal and state income taxes are stated on a fully tax-equivalent basis.  They are reduced by the nondeductible portion of interest expense, assuming a federal tax rate of 34 percent and applicable state tax rates.
(B) The loan averages are stated net of unearned income, and the averages include loans on which the accrual of interest has been discontinued.
 

Annual Report Page 8
 
22

 
 
 
2007
   
2006
   
2005
 
Average
Balance
   
Interest
   
Rate/
Yield
   
Average
Balance
   
Interest
   
Rate/
Yield
   
Average
Balance
   
Interest
   
Rate/
Yield
 
                                                   
                                                   
$ 22,290     $ 1,068       4.79 %   $ 21,606     $ 1,042       4.82 %   $ 17,160     $ 572       3.33 %
  3,336       258       7.73       2,340       139       5.94       1,513       76       5.02  
                                                                     
  65,853       3,253       4.94       64,134       2,964       4.62       72,695       3,076       4.23  
  37,724       1,986       5.26       41,156       2,069       5.03       31,139       1,477       4.74  
  103,577       5,239       5.06       105,290       5,033       4.78       103,834       4,553       4.38  
                                                                     
  84,185       9,039       10.74       84,113       8,615       10.24       74,369       6,558       8.82  
  66,393       5,345       8.05       54,462       4,514       8.29       40,655       3,010       7.40  
  275,448       20,393       7.40       240,311       17,400       7.24       189,384       13,154       6.95  
  68,443       3,995       5.84       59,933       3,305       5.51       62,103       3,318       5.34  
  54,789       3,722       6.79       47,652       3,208       6.73       45,707       2,648       5.79  
  549,258       42,494       7.74       486,471       37,042       7.61       412,218       28,688       6.96  
$ 678,461     $ 49,059       7.23 %   $ 615,707     $ 43,256       7.02 %   $ 534,725     $ 33,889       6.34 %
                                                                     
  13,467                       12,439                       12,661                  
  (8,184 )                     (7,493 )                     (6,398 )                
  29,304                       29,302                       24,399                  
  34,587                       34,248                       30,662                  
$ 713,048                     $ 649,955                     $ 565,387                  
                                                                     
                                                                     
                                                                     
                                                                     
$ 85,750     $ 1,928       2.25 %   $ 117,730     $ 2,648       2.25 %   $ 150,420     $ 2,605       1.73 %
  204,214       8,064       3.95       183,815       6,948       3.78       130,911       3,164       2.42  
  213,407       10,206       4.78       169,572       7,101       4.19       118,174       3,820       3.23  
  503,371       20,198       4.01       471,117       16,697       3.54       399,505       9,589       2.40  
  84,962       4,276       5.03       55,756       2,735       4.91       46,604       2,014       4.32  
$ 588,333     $ 24,474       4.16 %   $ 526,873     $ 19,432       3.69 %   $ 446,109     $ 11,603       2.60 %
                                                                     
  75,581                       77,747                       78,519                  
  2,416                       2,218                       2,634                  
  77,997                       79,965                       81,153                  
  46,718                       43,117                       38,125                  
$ 713,048                     $ 649,955                     $ 565,387                  
        $ 24,585       3.07 %           $ 23,824       3.33 %           $ 22,286       3.74 %
          (159 )                     (79 )                     (52 )        
        $ 24,426                     $ 23,745                     $ 22,234          
                  3.62 %                     3.87 %                     4.17 %

 
Annual Report Page 9
23

 
   The rate volume table below presents an analysis of the impact on interest income and expense resulting from changes in average volume and rates over the periods presented. Changes that are not due to volume or rate variances have been allocated proportionally to both, based on their relative absolute values. Amounts have been computed on a tax-equivalent basis, assuming a federal income tax rate of 34 percent.

   
2009 versus 2008
   
2008 versus 2007
 
Year ended December 31,
 
Increase (Decrease)
Due to change in
   
Increase (Decrease)
Due to change in
 
(In thousands on a tax-equivalent basis)
 
Volume
   
Rate
   
Net
   
Volume
   
Rate
   
Net
 
Interest Income:
                                   
Federal funds sold and interest-bearing deposits
  $ 8     $ (362 )   $ (354 )   $ 179     $ (776 )   $ (597 )
Federal Home Loan Bank stock
    39       (2 )     37       67       (85 )     (18 )
Investment securities
    2,862       (495 )     2,367       104       72       176  
Net loans
    1,242       (4,681 )     (3,439 )     6,818       (4,513 )     2,305  
Total interest income
  $ 4,151     $ (5,540 )   $ (1,389 )   $ 7,168     $ (5,302 )   $ 1,866  
Interest Expense:
                                               
Interest-bearing demand deposits
  $ 85     $ (490 )   $ (405 )   $ (31 )   $ (429 )   $ (460 )
Savings deposits
    861       (931 )     (70 )     (1,224 )     (3,196 )     (4,420 )
Time deposits
    451       (1,764 )     (1,313 )     5,016       (1,386 )     3,630  
Total deposits
  $ 1,397     $ (3,185 )   $ (1,788 )   $ 3,761     $ (5,011 )   $ (1,250 )
Borrowed funds and subordinated debentures
    192       (296 )     (104 )     1,048       (798 )     250  
Total interest expense
  $ 1,589     $ (3,481 )   $ (1,892 )   $ 4,809     $ (5,809 )   $ (1,000 )
Net interest income – fully tax-equivalent
  $ 2,562     $ (2,059 )   $ 503     $ 2,359     $ 507     $ 2,866  
Decrease (increase) in tax-equivalent adjustment
                    34                       (1 )
Net interest income
                  $ 537                     $ 2,865  

Provision for Loan Losses
The provision for loan losses totaled $8.0 million for 2009, an increase of $3.5 million compared to $4.5 million for 2008.  The increase is directly related to the increase in nonperforming loans and net charge-offs experienced as a result of the continued weakness in the economy both nationally and in our trade area. Additional information may be found under the caption, “Financial Condition-Asset Quality.”
Each period’s loan loss provision is the result of management’s analysis of the loan portfolio and reflects changes in the size and composition of the portfolio, the level of net charge-offs, delinquencies, current economic conditions and other internal and external factors impacting the risk within the loan portfolio. Additional information may be found under the caption, “Financial Condition - Allowance for Loan Losses and Unfunded Loan Commitments.” The current provision is considered appropriate under management’s assessment of the adequacy of the allowance for loan losses.

Noninterest Income
Historically, Unity has had a strong source of noninterest income in the form of gains on the sale of the guaranteed portion of its SBA loans.  Under the SBA 7(a) program, the SBA guarantees up to 90 percent of the principal of a qualifying loan. In the past, the Company would sell the guaranteed portion of the loan into the secondary market and retain the unguaranteed portion.  However, beginning in 2008, pricing in the secondary market for SBA loans began to deteriorate in response to the credit crisis.  Consequently, Unity has held a significant portion of its current production of SBA loans in its portfolio. This decision has resulted in lower levels of noninterest income in 2009 that will likely continue in the foreseeable future. In addition, other-than-temporary impairment (“OTTI”) charges have significantly reduced noninterest income during 2009.
Noninterest income was $2.1 million for 2009, a $554 thousand, or 20.6 percent decrease compared to $2.7 million for 2008.  The following table shows the components of noninterest income for 2009 and 2008:

(In thousands)
 
2009
   
2008
 
Service charges on deposit accounts
  $ 1,418     $ 1,393  
Service and loan fee income
    1,214       1,271  
Gain on sale of SBA loans held for sale, net
    393       1,217  
Gain on sale of mortgage loans
    217       40  
Bank owned life insurance
    222       210  
Other-than-temporary impairment charges on securities
    (2,611 )     (1,540 )
Net security gains (losses)
    855       (378 )
Other income
    432       481  
Total noninterest income
  $ 2,140     $ 2,694  
 
Changes in our noninterest income reflect:
·  
Service charges on deposit accounts increased 1.8 percent.  During this period, increased analysis fees on commercial accounts were partially offset by lower levels of overdraft fees.
 
 
Annual Report Page 10
24

 
·  
Service and loan fee income decreased 4.5 percent as a result of lower loan origination volume and SBA servicing income, offset in part by higher prepayment fees.
·  
Net gains on SBA loan sales decreased $824 thousand or 67.7 percent compared to 2008 as a result of a significantly lower volume of loans sold.  SBA loan sales totaled $5.2 million for the twelve months ended December 31, 2009, compared to $24.8 million for 2008.  As a result of the significantly reduced premiums and the absence of liquidity in the secondary market for SBA loans due to the credit crisis, the Company closed all SBA production offices outside of its New Jersey, Pennsylvania and New York footprint late in the third quarter of 2008. Consequently, management believes that net gains on SBA loan sales will remain at lower levels or continue to decline for the foreseeable future.
·  
Gains on the sale of mortgage loans increased $177 thousand due to a higher volume of loans sold.  Sales of mortgage loans totaled $17.7 million and $2.6 million for 2009 and 2008, respectively.
·  
In December 2004, the Company purchased $5.0 million of bank owned life insurance (“BOLI”) to offset the rising costs of employee benefits.  In 2009, the increase in the cash surrender value of the BOLI was $222 thousand compared to $210 thousand the prior year.
·  
During 2009, the Company recognized $2.6 million in OTTI charges on two bank pooled trust preferred securities due to deterioration in the value of the underlying collateral.  These two securities, which had a cost basis of $3.0 million, had been previously written down $306 thousand in December of 2008.  In addition during 2008, OTTI charges of approximately $1.2 million were taken on three callable FHLMC perpetual preferred securities due to the decline in market value of these securities and the eventual placement of FHLMC in conservatorship in September 2008.  
·  
The Company realized net security gains of $855 thousand on the sale of securities in 2009 compared to a net loss of $378 thousand on sales in 2008.  In 2009, the Company sold approximately $31.5 million in book value of mortgage related products as well as the remaining portion of callable Freddie Mac perpetual preferred securities on its books.  In 2008, the Company sold approximately $2.1 million in book value of callable Freddie Mac perpetual preferred securities, resulting in a pre-tax loss of $469 thousand.  This loss was partially offset by other sales during the year which yielded a gain of $91 thousand.
·  
Other income totaled $432 thousand and $481 thousand in 2009 and 2008, respectively.  The decline was due primarily to reduced annuity commission income.
 
Noninterest Expense
In response to the challenging economic environment which began in 2008 and continued throughout 2009, the Company took several steps to reduce its operating expenses.  The primary cost reduction mechanism was the significant reduction in staffing related to closing our SBA loan production offices outside of our primary trade areas in the fourth quarter of 2008.  The effect of this reduction in head-count can be seen in the 6.2 percent decrease in compensation and benefits expense year over year.  Unfortunately, this and other cost cutting strategies were offset by the large increase in FDIC insurance premiums during the year, as well as a special assessment designed to recapitalize the Deposit Insurance Fund.  
Total noninterest expense was $23.9 million for 2009, an increase of $1.0 million or 4.4 percent over 2008. The following table presents a breakdown of noninterest expense for the years ended December 31, 2009 and 2008:

(In thousands)
 
2009
   
2008
 
Compensation and benefits
  $ 11,243     $ 11,985  
Occupancy
    2,552       2,773  
Processing and communications
    2,077       2,251  
Furniture and equipment
    1,829       1,675  
Professional services
    1,042       898  
Loan collection costs
    1,023       662  
Deposit insurance
    1,707       589  
Advertising
    530       451  
Other expenses
    1,944       1,655  
Total noninterest expense
  $ 23,947     $ 22,939  

Changes in noninterest expense reflect:
·  
Compensation and benefits expense, the largest component of noninterest expense, decreased $742 thousand or 6.2 percent year over year, for the reason noted above. This reduction in payroll expense was partially offset by increased retail commissions.   At December 31, 2009 and 2008 there were 165 and 169 full-time equivalent employees, respectively.
·  
Occupancy expense declined $221 thousand or 8.0 percent this past year due primarily to the renegotiation of the lease on our corporate headquarters.
·  
Processing and communications expenses decreased $174 thousand or 7.7 percent.  This was the result of renegotiated communications and ATM processing contracts, bringing items processing in-house and reduced capital expenditures, partially offset by increased volume driven and service module data processing expenses.
·  
Furniture and equipment expense increased $154 thousand or 9.2 percent due to depreciation expense on new equipment and software as well as increased software and network maintenance costs.
·  
Professional service fees increased $144 thousand or 16.0 percent in 2009 in response to higher legal and audit costs.
 
 
Annual Report Page 11
25

 
·  
Loan collection costs increased $361 thousand or 54.5 percent as the Company addressed the collection of a higher volume of delinquent loans.
·  
Deposit insurance expense increased $1.1 million in 2009 due to higher premium rates and a $408 thousand special assessment as the FDIC recapitalizes the Deposit Insurance Fund.
·  
Advertising expense increased $79 thousand or 17.5 percent in 2009 in support of the Company’s sales initiative.
·  
Other expenses increased $289 thousand or 17.5 percent compared to the prior year.  This increase was due primarily to other real estate owned (“OREO”) expenses.
 
Income Tax Expense
For 2009, the Company reported an income tax benefit of $898 thousand for a 45.4 percent effective tax rate compared to income tax expense of $616 thousand or a 24.2 percent effective tax rate in 2008.  The benefit in 2009 was due to a net loss.  The Company anticipates a lower effective tax rate in 2010.

Financial Condition

Total assets increased $32.0 million, or 3.6 percent, to $930.4 million at December 31, 2009, compared to $898.3 million at December 31, 2008. This increase was due to a $39.2 million increase in cash and cash equivalents and a $19.5 million increase in total securities funded by a $51.1 million increase in total deposits.  Total loans and total borrowed funds decreased $28.9 million and $20.0 million, respectively.  Total shareholders’ equity remained flat from the prior year.
Average total assets for 2009 were $908.0 million, an $86.8 million increase from the prior year’s $821.2 million average balance. The increase in average assets was due primarily to growth in the securities portfolio funded by increased deposits.

Investment Securities Portfolio
The Company’s securities portfolio consists of available for sale (“AFS”) and held to maturity (“HTM”) investments. Management determines the appropriate security classification of available for sale or held to maturity at the time of purchase. The investment securities portfolio is maintained for asset-liability management purposes, as well as for liquidity and earnings purposes.
AFS securities are investments carried at fair value that may be sold in response to changing market and interest rate conditions or for other business purposes. Activity in this portfolio is undertaken primarily to manage liquidity and interest rate risk, to take advantage of market conditions that create economically attractive returns and as an additional source of earnings. AFS securities consist primarily of U.S. Government sponsored entities, obligations of state and political subdivisions, mortgage-backed securities, trust preferred securities and equity securities.
HTM securities, which are carried at amortized cost, are investments for which there is the positive intent and ability to hold to maturity. The portfolio is comprised of U.S. Government sponsored entities, obligations of state and political subdivisions, mortgage-backed securities and trust preferred securities.
AFS securities totaled $140.8 million at December 31, 2009, an increase of $23.4 million or 20.0 percent, compared to $117.3 million at December 31, 2008.  This net increase was the result of the following:
·  
$104.8 million in purchases, which consisted of $89.6 million of mortgage-backed securities and collateralized mortgage obligations (“CMOs”) and $15.2 million of U.S. Government sponsored entities.
·  
$50.3 million in principal payments, maturities and called bonds,
·  
$31.5 million in sales net of gains, which consisted primarily of mortgage-backed securities and CMOs, and
·  
$965 thousand of appreciation in the market value of the portfolio.  At December 31, 2009, the portfolio had a net unrealized loss of $8 thousand compared to a net unrealized loss of $974 thousand at the end of the prior year. These unrealized losses are reflected net of tax in shareholders’ equity as other comprehensive loss.
 
The average balance of securities available for sale amounted to $135.5 million in 2009 compared to $74.2 million in 2008. The average yield earned on the available for sale portfolio decreased 50 basis points, to 4.57 percent in 2009 from 5.07 percent in 2008. The weighted average repricing of securities available for sale, adjusted for prepayments, amounted to 2.5 years at December 31, 2009, compared to 2.1 years in 2008.
At December 31, 2009, the Company’s available for sale portfolio included one bank trust preferred security with a book value of $976 thousand and a market value of $390 thousand. The Company monitors the credit worthiness of the issuer of this security quarterly. At December 31, 2009, the Company had not taken any OTTI adjustments on this security. Management will continue to monitor the performance of the security and the underlying institution for impairment. Changes in the credit worthiness of the underlying issuer may result in OTTI charges and realized losses in the future.
HTM securities were $28.3 million at December 31, 2009, a decrease of $3.9 million or 12.2 percent, from year-end 2008.  This net decrease was the result of:
·  
$4.0 million in purchases,
·  
$6.4 million in principal payments, maturities and called bonds, and
·  
A $1.5 million decrease related to other-than-temporary impairment charges on two pooled trust preferred securities.
 
As of December 31, 2009 and 2008, the market value of held to maturity securities was $28.4 million and $30.1
 
 
Annual Report Page 12
26

 
million, respectively. The average balance of securities held to maturity amounted to $32.3 million in 2009 compared to $31.7 million in 2008. The average yield earned on held to maturity securities decreased 29 basis points, from 5.22 percent in 2008 to 4.93 percent in 2009. The weighted average repricing of held to maturity securities, adjusted for prepayments, amounted to 2.7 years and 3.7 years at December 31, 2009 and December 31, 2008, respectively.
During 2009, the Company recognized $2.6 million of credit related other-than-temporary impairment losses on two held to maturity securities due to the deterioration in the underlying collateral. These two securities were transferred from the AFS portfolio to the HTM portfolio during 2008 at fair market value with the adjustment being posted to other comprehensive income in shareholders’ equity.  Consequently, the $2.6 million OTTI charge resulted in a $1.5 million net decrease to HTM securities and a $1.1 million increase to other comprehensive income in shareholders’ equity. These two pooled trust preferred securities, which had a cost basis of $3.0 million, had been previously written down $306 thousand in December of 2008.  The remaining book value of the trust preferred securities was approximately $50 thousand at December 31, 2009. 
Securities with a carrying value of $71.4 million and $69.9 million at December 31, 2009 and 2008, respectively, were pledged to secure Government deposits, secure other borrowings and for other purposes required or permitted by law.
Approximately 82 percent of the total investment portfolio had a fixed rate of interest at December 31, 2009.

Loan Portfolio
The loan portfolio, which represents the Company’s largest asset group, is a significant source of both interest and fee income. The portfolio consists of SBA, SBA 504, commercial, residential mortgage and consumer loans. Different segments of the loan portfolio are subject to differing levels of credit and interest rate risk.
Total loans decreased $28.9 million or 4.2 percent to $657.0 million at December 31, 2009, compared to $685.9 million at year-end 2008. The declines occurred in all loan types, are a direct result of the economic downturn and low consumer and business confidence levels, and reflect the impact of loan sales and reduced loan demand.  Creditworthy borrowers are cutting back on capital expenditures or postponing their purchases in hopes that the economy will improve.  In general, banks are lending less because consumers and businesses are demanding less credit. 
Average loans increased $22.6 million or 3.5 percent from $644.2 million in 2008, to $666.8 million in 2009.  The increase in average loans was due to growth in the SBA, residential mortgage and consumer portfolios, partially offset by decreases in the SBA 504 and commercial portfolios.  The largest increase was in the residential mortgage portfolio, totaling $26.4 million.  The yield on the overall loan portfolio fell 75 basis points to 6.20 percent in 2009 compared to 6.95 percent in 2008. This decrease was the result of variable rate, prime-based loan products such as SBA loans and home equity lines of credit repricing lower as rates remained low in 2009.  The prime rate has remained at 3.25 percent since December 2008.
SBA loans, on which the SBA provides guarantees of up to 90 percent of the principal balance, are considered a higher risk loan product for the Company than its other loan products.  The Company’s SBA loans were historically sold in the secondary market with the nonguaranteed portion held in the portfolio as a loan held for investment.  During the third and fourth quarters of 2008, as a result of the significantly reduced premiums on sale and the ongoing credit crisis, the Company closed all SBA production offices outside of its New Jersey, Pennsylvania and New York primary trade area.  Consequently, the volume of new SBA loans and gains on SBA loans declined in 2009. 
SBA 7(a) loans held for sale, carried at the lower of cost or market, amounted to $21.4 million at December 31, 2009, a decrease of $775 thousand from $22.2 million at December 31, 2008.  SBA 7(a) loans held to maturity amounted to $77.8 million at December 31, 2009, a decrease of $5.3 million from $83.1 million at December 31, 2008. The yield on SBA loans, which are generally floating and adjust quarterly to the Prime rate, was 6.06 percent for 2009, compared to 8.25 percent for the prior year due to the continued low interest rate environment.
At December 31, 2009, SBA 504 loans totaled $70.7 million, a decrease of $6.1 million from $76.8 million at December 31, 2008. The SBA 504 program consists of real estate backed commercial mortgages where the Company has the first mortgage and the SBA has the second mortgage on the property. Generally, the Company has a 50 percent loan to value ratio on SBA 504 program loans.  The yield on SBA 504 loans dropped 91 basis points to 6.56 percent for 2009 compared to 7.47 percent for 2008.
Commercial loans are generally made in the Company’s market place for the purpose of providing working capital, financing the purchase of equipment, inventory or commercial real estate and for other business purposes. These loans amounted to $293.7 million at December 31, 2009, a decrease of $14.4 million from year-end 2008. This decrease can be attributed to principal paydowns on these loans with minimal new loan volume.  The yield on commercial loans was 6.60 percent for 2009, compared to 6.94 percent for the prior year.
Residential mortgage loans consist of loans secured by 1 to 4 family residential properties. These loans amounted to $133.1 million at December 31, 2009, flat from year-end 2008. New loan volume during the year was offset by the sale of mortgage loans totaling $17.7 million.  The yield on residential mortgages was 5.73 percent for the twelve-months ended December 31, 2009, compared to 5.96 percent for the same period in 2008.
Consumer loans consist of home equity loans and loans for the purpose of financing the purchase of consumer goods, home improvements, and other personal needs, and are generally secured by the personal property being purchased. These loans amounted to $60.3 million at December 31, 2009, a decrease of $2.3 million from December 31, 2008.  The yield on consumer loans was 5.06 percent for 2009, compared to 5.84 percent for the prior year.
 
 
Annual Report Page 13
27

 
The following table sets forth the classification of loans by major category, including unearned fees, deferred costs and excluding the allowance for loan losses for the past five years at December 31:

   
2009
   
2008
   
2007
   
2006
   
2005
 
(In thousands)
 
Amount
   
% of Total
   
Amount
   
% of Total
   
Amount
   
% of Total
   
Amount
   
% of Total
   
Amount
   
% of Total
 
SBA held for sale
  $ 21,406       3.3 %   $ 22,181       3.2 %   $ 24,640       4.2 %   $ 12,273       2.4 %   $ 14,001       3.1 %
SBA held to maturity
    77,844       11.8       83,127       12.1       68,875       11.7       66,802       13.2       64,660       14.4  
SBA 504
    70,683       10.8       76,802       11.2       72,145       12.2       58,067       11.4       48,639       10.9  
Commercial
    293,739       44.6       308,165       44.9       293,641       49.7       254,128       50.1       211,942       47.2  
Residential mortgage
    133,059       20.3       133,110       19.5       73,697       12.5       63,493       12.5       62,039       13.8  
Consumer
    60,285       9.2       62,561       9.1       57,134       9.7       52,927       10.4       47,286       10.6  
Total loans
  $ 657,016       100.0     $ 685,946       100.0     $ 590,132       100.0     $ 507,690       100.0     $ 448,567       100.0  

As of December 31, 2009, approximately 12 percent of the Company’s total loan portfolio consists of loans to various unrelated and unaffiliated borrowers in the Hotel/Motel industry.  Such loans are collateralized by the underlying real property financed and/or partially guaranteed by the SBA.  There are no other concentrations of loans to any borrowers or group of borrowers exceeding 10 percent of the total loan portfolio. There are no foreign loans in the portfolio.  As a preferred SBA lender, a portion of the SBA portfolio is to borrowers outside the Company’s lending area.
The following table shows the maturity distribution or repricing of the loan portfolio and the allocation of floating and fixed interest rates at December 31, 2009:

(In thousands)
 
Within
1 Year
   
1-5
Years
   
After 5 Years
   
Total
 
SBA
  $ 75,810     $ 16,009     $ 7,431     $ 99,250  
SBA 504
    9,069       53,289       8,325       70,683  
Commercial
    123,830       143,165       26,744       293,739  
Residential mortgage
    39,016       52,919       41,124       133,059  
Consumer
    39,127       13,547       7,611       60,285  
    Total
  $ 286,852     $ 278,929     $ 91,235     $ 657,016  
Amount of loans with maturities or repricing dates greater than
one year:
 
Fixed interest rates
                    $ 166,446  
Floating or adjustable interest rates
      203,718  
Total
                          $ 370,164  
 
Asset Quality
Inherent in the lending function is credit risk, which is the possibility a borrower may not perform in accordance with the contractual terms of their loan.  A borrower’s inability to pay their obligations according to the contractual terms can create the risk of past due loans and, ultimately, credit losses, especially on collateral deficient loans.  The Company minimizes its credit risk by loan diversification and adhering to strict credit administration policies and procedures.  Due diligence on loans begins when we initiate contact regarding a loan with a borrower.  Documentation, including a borrower’s credit history, materials establishing the value and liquidity of potential collateral, the purpose of the loan, the source of funds for repayment of the loan, and other factors, are analyzed before a loan is submitted for approval.  The loan portfolio is then subject to on-going internal reviews for credit quality, as well as independent credit reviews by an outside firm. 
          The risk of loss is difficult to quantify and is subject to fluctuations in collateral values, general economic conditions and other factors. The current state of the economy and the downturn in the real estate market have resulted in increased loan delinquencies and defaults.  In some cases, these factors have also resulted in significant impairment to the value of loan collateral.  The Company values its collateral through the use of appraisals, broker price opinions, and knowledge of its local market.  In response to the credit risk in its portfolio, the Company has increased staffing in its credit monitoring department and increased efforts in the collection and analysis of borrower’s financial statements and tax returns.   
          Nonperforming loans consist of loans that are not accruing interest (nonaccrual loans) as a result of principal or interest being in default for a period of 90 days or more or when the ability to collect principal and interest according to the contractual terms is in doubt.  When a loan is classified as nonaccrual, interest accruals discontinue and all past due interest previously recognized as income is reversed and charged against current period income.  Generally, until the loan becomes current, any payments received from the borrower are applied to outstanding principal, until such time as management determines that the financial condition of the borrower and other factors merit recognition of a portion of such payments as interest income.  Loans past due 90 days or more and still accruing interest are not included in nonperforming loans.  Loans past due 90 days or more generally represent loans that are well collateralized and in a continuing process that are expected to result in repayment or restoration to current status.
 
 
Annual Report Page 14
28

 
The following table sets forth information concerning nonperforming loans and nonperforming assets at December 31 for the past five years:
 
(In thousands)
 
2009
   
2008
   
2007
   
2006
   
2005
 
Nonperforming by category:
                             
SBA (1)
  $ 6,559     $ 4,228     $ 2,110     $ 5,212     $ 1,391  
SBA 504
    5,575       4,600       -       -       757  
Commercial
    7,397       5,247       1,630       3,172       493  
Residential mortgage
    5,578       1,808       1,192       322       1,510  
Consumer
    387       237       529       203       210  
Total nonperforming loans
    25,496     $ 16,120     $ 5,461     $ 8,909     $ 4,361  
OREO
    1,530       710       106       211       178  
Total nonperforming assets
  $ 27,026     $ 16,830     $ 5,567     $ 9,120     $ 4,539  
Past due 90 days or more and still accruing interest:
                                       
SBA
  $ 592     $ 332     $ 114     $ -     $ -  
SBA 504
    -       -       -       -       -  
Commercial
    469       146       41       -       -  
Residential mortgage
    1,196       2,058       -       78       -  
Consumer
    29       -       -       -       -  
Total
  $ 2,286     $ 2,536     $ 155     $ 78     $ -  
Nonperforming loans to total loans
    3.88 %     2.35 %     0.93 %     1.75 %     0.97 %
Nonperforming assets to total loans and OREO
    4.10       2.45       0.94       1.80       1.01  
Nonperforming assets to total assets
    2.90       1.87       0.74       1.31       0.74  
(1) SBA loans guaranteed
  $ 1,931     $ 1,983     $ 714     $ 2,953     $ 758  

The current state of the economy largely impacts the Company’s level of delinquent and nonperforming loans.  The recession that began in 2008 continues to put a strain on the Company’s borrowers and their ability to pay their loan obligations.  Unemployment rates are at the highest level in 25 years and businesses are reluctant to hire.  Unemployment and flat wages have caused consumer spending and demand for goods to decline, impacting the profitability of small businesses.  Consequently, the Company’s nonperforming loans increased over the past two years.
Nonperforming loans were $25.5 million at December 31, 2009, a $9.4 million increase from $16.1 million at year-end 2008.  Nonperforming loans increased in all loan categories, with the biggest increase of $3.8 million in the residential mortgage portfolio. Included in nonperforming loans at December 31, 2009, are approximately $1.9 million of loans guaranteed by the SBA, compared to $2.0 million at December 31, 2008.  In addition, there were $2.3 million and $2.5 million in loans past due 90 days or more and still accruing interest at December 31, 2009 and December 31, 2008, respectively.  
Other real estate owned (“OREO”) properties totaled $1.5 million at December 31, 2009, an increase of $820 thousand from $710 thousand at year-end 2008.  The Company took title to two commercial properties totaling $1.3 million during the third quarter of 2009, as well as one SBA property and one residential property totaling $253 thousand.  All OREO properties held by the Company as of December 31, 2008 were sold during 2009.
Potential problem loans are those where information about possible credit problems of borrowers causes management to have doubt as to the ability of such borrowers to comply with loan repayment terms.  These loans are not included in nonperforming loans as they continue to perform.  Potential problem loans totaled $1.6 million at December 31, 2009, a decrease of $1.2 million from $2.7 million at December 31, 2008.
Troubled debt restructurings (“TDRs”) occur when a creditor, for economic or legal reasons related to a debtor’s financial condition, grants a concession to the debtor that it would not otherwise consider, such as a below market interest rate, extending the maturity of a loan, or a combination of both.  At December 31, 2009, there were four loans totaling $6.6 million that were classified as TDRs by the Company and are deemed impaired.  These loans are not included in the nonperforming or potential problem loan figures listed above, as they continue to perform under their modified terms.  In addition, the Company modified loans during the course of the year that were not considered TDRs.  These loan modifications were predominantly done in the Company’s higher risk SBA portfolio.  Modifications were made to SBA and commercial loans totaling $26.6 million and to residential mortgages totaling $2.7 million.  The types of modifications include changing from a fixed rate of interest to a floating market rate, extending the term of the loan, or allowing interest only payments for a specified period of time.  The majority of loans modified during the year are performing according to their new terms.
 
 
Annual Report Page 15
29


Allowance for Loan Losses and Unfunded Loan Commitments
Management reviews the level of the allowance for loan losses on a quarterly basis.  The standardized methodology used to assess the adequacy of the allowance includes the allocation of specific and general reserves.  Specific reserves are made to significant individual impaired loans, which have been defined to include all nonaccrual loans and troubled debt restructurings.  The general reserve is set based upon a representative average historical net charge-off rate adjusted for certain environmental factors such as: delinquency and impairment trends, charge-off and recovery trends, volume and loan term trends, risk and underwriting policy trends, staffing and experience changes, national and local economic trends, industry conditions and credit concentration changes. 
Beginning in the third quarter of 2009, when calculating the five-year historical net charge-off rate, the Company weights the past three years more heavily due to the higher amount of charge-offs experienced during those years.  All of the environmental factors are ranked and assigned a basis points value based on the following scale: low, low moderate, moderate, high moderate, and high risk.  The factors are evaluated separately for each type of loan.  For example, commercial loans are broken down further into commercial and industrial loans, commercial mortgages, construction loans, etc.  Each type of loan is risk weighted for each environmental factor based on its individual characteristics. 
According to the Company’s policy, a loss (“charge-off”) is to be recognized and charged to the reserve for loan losses as soon as a loan is recognized as uncollectable.  All credits which are 90 days past due must be analyzed for their ability to collect. Once a loss is known to exist, the loss approval process is immediately expedited.
During 2009, the Company significantly increased its loan loss provision in response to the inherent credit risk within its loan portfolio and changes to some of the environmental factors noted above.  The inherent credit risk was evidenced by the increase in delinquent and nonperforming loans during the year, as the downturn in the economy impacted borrowers’ abilities to pay and factors, such as a weakened housing market, eroded the value of underlying collateral.  In addition, net charge-offs increased during the year as the Company proactively addressed these issues.
The allowance for loan losses totaled $13.8 million and $10.3 million at December 31, 2009 and December 31, 2008, respectively, with a resulting allowance to total loan ratios of 2.11 percent and 1.51 percent, respectively.  Net charge-offs amounted to $4.5 million in 2009, compared to $2.6 million in 2008.  The increase in net charge-offs was primarily related to the SBA 7(a) and commercial loan portfolios, most of which are secured by real estate.  Net charge-offs to average loan ratios are shown in the table below for each major loan category.  In 2009, the highest net charge-off ratio can be seen in the Company’s higher risk SBA portfolio.
 
 
Annual Report Page 16
30

 
The following is a summary of the allowance for loan losses for the past five years:

(In thousands)
 
2009
   
2008
   
2007
   
2006
   
2005
 
Balance, beginning of year
  $ 10,326     $ 8,383     $ 7,624     $ 6,892     $ 5,856  
Provision charged to expense
    8,000       4,500       1,550       1,550       1,850  
Charge-offs:
                                       
SBA
    1,874       1,246       770       573       301  
SBA 504
    812       1,000       -       -       18  
Commercial
    1,845       408       155       298       282  
Residential mortgage
    216       25       -       -       49  
Consumer
    27       145       50       62       523  
Total charge-offs
    4,774       2,824       975       933       1,173  
Recoveries:
                                       
SBA
    123       177       147       20       204  
SBA 504
    27       -       -       -       -  
Commercial
    134       39       18       75       84  
Residential mortgage
    -       -       -       -       -  
Consumer
    6       51       19       20       71  
Total recoveries
    290       267       184       115       359  
Total net charge-offs
  $ 4,484     $ 2,557     $ 791     $ 818     $ 814  
Balance, end of year
  $ 13,842     $ 10,326     $ 8,383     $ 7,624     $ 6,892  
Selected loan quality ratios:
                                       
Net charge-offs to average loans:
                                       
SBA
    1.70 %     1.05 %     0.74 %     0.66 %     0.13 %
SBA 504
    1.07       1.34       0.00       0.00       0.04  
Commercial
    0.57       0.12       0.05       0.09       0.10  
Residential mortgage
    0.17       0.02       0.00       0.00       0.08  
Consumer
    0.03       0.16       0.06       0.09       0.99  
Total loans
    0.67       0.40       0.14       0.17       0.20  
Allowance to total loans
    2.11       1.51       1.42       1.50       1.54  
Allowance to nonperforming loans
    54.29       64.06       153.49       85.58       158.04  
 
The following table sets forth, for each of the major lending categories, the amount of the allowance for loan losses allocated to each category and the percentage of total loans represented by such category, as of December 31st  of each year.  The allocated allowance is the total of identified specific and general reserves by loan category.  The allocation is made for analytical purposes and is not necessarily indicative of the categories in which future losses may occur.  The total allowance is available to absorb losses from any segment of the portfolio.

   
2009
   
2008
   
2007
   
2006
   
2005
 
(In thousands)
 
Amount
   
% of Total
   
Amount
   
% of Total
   
Amount
   
% of Total
   
Amount
   
% of Total
   
Amount
   
% of Total
 
Balance applicable to:
                                                           
SBA
  $ 3,320       15.1 %   $ 2,603       15.3 %   $ 2,188       15.9 %   $ 2,066       15.6 %   $ 1,712       17.5 %
SBA 504
    1,906       10.8       1,083       11.2       907       12.2       802       11.4       661       10.9  
Commercial
    6,228       44.6       4,486       44.9       4,208       49.7       4,063       50.1       3,756       47.2  
Residential mortgage
    1,712       20.3       1,494       19.5       570       12.5       305       12.5       444       13.8  
Consumer
    676       9.2       660       9.1       510       9.7       388       10.4       319       10.6  
Total
  $ 13,842       100.0     $ 10,326       100.0     $ 8,383       100.0     $ 7,624       100.0     $ 6,892       100.0  
 
In addition to the allowance for loan losses, the Company maintains an allowance for unfunded loan commitments.  Commitments to extend credit represent arrangements to lend funds or provide liquidity subject to specified contractual conditions.  At December 31, 2009, a $76 thousand commitment reserve was reported on the balance sheet as an “other liability” compared to $105 thousand at December 31, 2008.  Management determines this amount using estimates of future loan funding and losses related to those credit exposures.
 
 
Annual Report Page 17
31

 
Deposits
Deposits, which include noninterest-bearing demand deposits, interest-bearing demand deposits, savings deposits and time deposits, are the primary source of the Company’s funds.  The Company offers a variety of products designed to attract and retain customers, with primary focus on building and expanding relationships.  For 2009, the Company experienced continued growth in deposits.  This growth was achieved through an emphasis on customer service, competitive rate structures and selective marketing through the Company’s branch network.  The Company continues to focus on establishing a comprehensive relationship with business borrowers, seeking deposits as well as lending relationships.
The following are period-end deposit balances for each of the last three years:

At December 31,
 
2009
   
2008
   
2007
 
(In thousands)
 
Amount
   
%
   
Amount
   
%
   
Amount
   
%
 
Ending balance:
                                   
Noninterest-bearing demand deposits
  $ 80,100       10.6 %   $ 74,090       10.5 %   $ 70,600       11.7 %
Interest-bearing demand deposits
    100,046       13.2       87,046       12.3       78,019       13.0  
Savings deposits
    286,334       37.7       134,875       19.1       196,390       32.7  
Time deposits
    291,759       38.5       411,106       58.1