10-K 1 e600285_10k-fnfg.txt FORM 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K |X| Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Fiscal Year Ended December 31, 2005 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 No. 000-23975 FIRST NIAGARA FINANCIAL GROUP, INC. ----------------------------------- (Exact name of registrant as specified in its charter) Delaware 42-1556195 ------------------------------- ---------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 6950 South Transit Road, P.O. Box 514, Lockport, NY 14095-0514 --------------------------------------------------- ---------- (Address of Principal Executive Offices) Zip Code (716) 625-7500 -------------- (Registrant's telephone number) Securities Registered Pursuant to Section 12(b) of the Act: None Securities Registered Pursuant to Section 12(g) of the Act: Common Stock, par value $0.01 per share --------------------------------------- (Title of Class) Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES |X| NO |_| Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES |_| NO |X| Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such requirements for the past 90 days. YES |X| NO |_| Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of 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. |_|. Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Large accelerated filer |X| Accelerated filer |_| Non-accelerated filer |_| Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES |_| NO |X| As of March 14, 2006, there were issued and outstanding 111,731,321 shares of the Registrant's Common Stock. The aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant, computed by reference to the last sale price on June 30, 2005, as reported by the NASDAQ National Market, was approximately $1,626,416,656. 1 DOCUMENTS INCORPORATED BY REFERENCE The following documents, in whole or in part, are specifically incorporated by reference in the indicated part of the Company's Proxy Statement:
Document Part ---------------------------------------------- ------------------------------------------------------------------- Proxy Statement for the 2006 Annual Meeting of Part III, Item 10 Stockholders "Directors and Executive Officers of the Registrant" Part III, Item 11 "Executive Compensation" Part III, Item 12 "Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters" Part III, Item 13 "Certain Relationships and Related Transactions" Part III, Item 14 "Principal Accounting Fees and Services"
2 TABLE OF CONTENTS
ITEM PAGE NUMBER NUMBER ------ ------ PART I 1 Business..................................................................................................... 4 1A Risk Factors................................................................................................. 19 1B Unresolved Staff Comments.................................................................................... 21 2 Properties................................................................................................... 21 3 Legal Proceedings............................................................................................ 21 4 Submission of Matters to a Vote of Security Holders.......................................................... 21 PART II 5 Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. 22 6 Selected Financial Data...................................................................................... 23 7 Management's Discussion and Analysis of Financial Condition and Results of Operation......................... 26 7A Quantitative and Qualitative Disclosures About Market Risk................................................... 41 8 Financial Statements and Supplementary Data.................................................................. 44 9 Changes in and Disagreements With Accountants on Accounting and Financial Disclosure......................... 85 9A Controls and Procedures...................................................................................... 85 9B Other Information............................................................................................ 86 PART III 10 Directors and Executive Officers of the Registrant........................................................... 86 11 Executive Compensation....................................................................................... 86 12 Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters............... 86 13 Certain Relationships and Related Transactions............................................................... 86 14 Principal Accounting Fees and Services....................................................................... 86 PART IV 15 Exhibits, Financial Statement Schedules...................................................................... 86 Signatures................................................................................................... 88
3 PART I ITEM 1. BUSINESS -------------------------------------------------------------------------------- GENERAL First Niagara Financial Group, Inc. First Niagara Financial Group, Inc. ("FNFG") is a Delaware corporation whose principal executive offices are located at 6950 South Transit Road, Lockport, New York. FNFG holds all of the capital stock of First Niagara Bank ("First Niagara"), a federally chartered savings bank. FNFG and First Niagara are hereinafter referred to collectively as "the Company." First Niagara is positioned as one of the leading community banks in Upstate New York, providing its customers with consumer and commercial banking services including residential and commercial real estate loans, commercial business loans and leases, consumer loans, and consumer and commercial deposit products. Additionally, First Niagara offers risk management and wealth management services. FNFG was organized in April 1998 in connection with the conversion of First Niagara from a New York State chartered mutual savings bank to a New York State chartered stock savings bank and the reorganization to a two-tiered mutual holding company (the "MHC"). In November 2002, FNFG converted First Niagara and the MHC to a federal charter subject to Office of Thrift Supervision ("OTS") regulation. On January 17, 2003, the MHC converted to stock form (the "Conversion"), with the shares of FNFG common stock owned by the MHC being sold to depositors and other investors (the "Offering"). Since 1998, the Company has deployed the proceeds from these stock offerings through its "Buy and Build" strategy, which has resulted in six whole-bank and eleven non-bank acquisitions as well as the opening of sixteen de novo branches in target market areas. This strategy coupled with the Company's organic growth initiatives, which includes an emphasis on expanding commercial operations and financial services businesses, has resulted in a successful transition from a Western New York traditional thrift to an Upstate New York community banking financial services company. On January 14, 2005, FNFG acquired Hudson River Bancorp, Inc. ("HRB"), the holding company of Hudson River Bank & Trust Company ("HRBT"), with total assets of approximately $2.8 billion and 50 branch locations. Following completion of the acquisition, HRBT locations were merged into First Niagara's branch network. The acquisition resulted in the issuance of 35.7 million shares of FNFG stock and cash payments totaling $126.8 million. On July 29, 2005, First Niagara Risk Management, Inc., the wholly owned insurance subsidiary of First Niagara, acquired Hatch Leonard Naples, Inc. ("HLN"), an insurance agency with operations across Upstate New York. Under terms of the agreement, the consideration included a combination of cash and 435,375 shares of FNFG common stock. On September 12, 2005, FNFG acquired Burke Group, Inc. ("Burke Group") an employee benefits administration and compensation consulting firm in a cash transaction. Upon acquisition, Burke Group was a subsidiary of FNFG but subsequently has become a wholly owned subsidiary of First Niagara. As of December 31, 2005, FNFG had $8.1 billion of assets and $1.4 billion of stockholders' equity. FNFG neither owns nor leases any property, but uses the premises and equipment of First Niagara. FNFG does not have any employees other than certain officers of First Niagara who also serve as officers of FNFG. First Niagara First Niagara was organized in 1870, and is a multi-market community-oriented savings bank that provides financial services to individuals, families and businesses through its branch network located across Upstate New York. As of December 31, 2005, First Niagara and all of its subsidiaries had $8.0 billion of assets, deposits of $5.5 billion, $1.3 billion of stockholders' equity, employed approximately 2,160 people and operated through 118 branches, a loan production office, 157 ATM's and several financial services subsidiaries. At December 31, 2005, the following entities operated as subsidiaries of First Niagara: First Niagara Capital, Inc. First Niagara Capital, Inc. is licensed by the Small Business Administration ("SBA") as a Small Business Investment Company and offers small business loans and makes equity investments in small businesses. At December 31, 2005, First Niagara Capital, Inc. had $4.2 million of assets. First Niagara Commercial Bank First Niagara Commercial Bank (the "Commercial Bank") is a New York State chartered bank whose primary purpose is to generate municipal deposits. Under New York State law, municipal accounts cannot otherwise be accepted directly by First Niagara, which is a federally chartered savings bank. At December 31, 2005, the Commercial Bank had $354.3 million of assets and $308.4 million of deposits. 4 First Niagara Funding, Inc. First Niagara Funding, Inc. ("FNF") is a real estate investment trust ("REIT") that holds commercial real estate loans, residential mortgages, home equity loans and commercial business loans. At December 31, 2005, FNF had $1.9 billion of assets. First Niagara Leasing, Inc. First Niagara Leasing, Inc. ("FNL") provides direct financing to the commercial small ticket lease market. At December 31, 2005, FNL had $38.8 million of assets. First Niagara Portfolio Management, Inc. First Niagara Portfolio Management, Inc. is a New York State Article 9A company, which primarily invests in U.S. government agency and Treasury obligations. At December 31, 2005, First Niagara Portfolio Management, Inc. had $66.9 million of assets. First Niagara Realty, Inc. and TSB Real Property, Inc. First Niagara Realty, Inc. and TSB Real Property, Inc. invest in real estate limited partnerships. At December 31, 2005, these subsidiaries had $6.7 million of assets. First Niagara Risk Management, Inc. First Niagara Risk Management, Inc. ("FNRM") is a full service insurance agency engaged in the sale of insurance products including business and personal insurance, surety bonds, life, disability and long-term care coverage and other risk management advisory services. FNRM serves commercial and personal clients throughout the Company's market areas. FNRM's consulting and risk management business includes alternative risk and self-insurance, claims investigation and adjusting services, as well as third party administration of self insured workers' compensation plans. As of December 31, 2005, FNRM serviced approximately $400 million of annual premium volume and had $70.1 million of assets. Effective January 1, 2006, HLN was merged into FNRM. First Niagara Securities, Inc. First Niagara Securities, Inc. acts as an agent for third-party companies to sell and service their insurance products through First Niagara's branch network. At December 31, 2005, First Niagara Securities, Inc. had $6.3 million of assets. First Niagara Centre, Inc. First Niagara Centre, Inc. owns various property locations used by First Niagara for its banking operations. At December 31, 2005, First Niagara Centre, Inc. had $9.1 million of assets. First Niagara Associates, Inc. and Premium Payment Plan LLC First Niagara Associates, Inc. ("FNA") is a wholly-owned subsidiary of First Niagara, which holds a 65% ownership interest in Premium Payment Plan LLC ("PPP"). PPP is currently licensed to provide insurance premium financing in forty-two states, but does business primarily in New York, New Jersey, Florida and Pennsylvania. On December 31, 2005, PPP had $40.5 million of assets. Burke Group, Inc. Burke Group, an employee benefits and administration and compensation consulting firm, was acquired by FNFG on September 12, 2005 and subsequently contributed to First Niagara on January 1, 2006. At December 31, 2005, the Burke Group had $5.4 million in assets. OTHER INFORMATION The Company maintains a website at www.fnfg.com. The Company makes available, free of charge, through the website, its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission ("SEC"). These forms can be accessed within the Investor Relations portion of the Company's website by clicking on "SEC Filings." Copies may also be obtained, without charge, by written request to the Investor Relations Department, 6950 South Transit Road, P.O. Box 514, Lockport, New York 14095-0514. The Company has adopted a Code of Ethics that is applicable to the senior financial officers of the Company, including the Company's Chief Executive Officer, Chief Financial Officer and Corporate Controller, among others. The Code of Ethics is available within the Investor Relations portion of the Company's website along with any amendments to or waivers from that policy. There were no amendments or waivers to the Code of Ethics for Senior Financial Officers during 2005. Additionally, the Company has adopted a general Code of Ethics that sets forth standards of ethical business conduct for all directors, officers and employees of the Company. This Code of Ethics is also available at the Company's website. 5 FORWARD LOOKING STATEMENTS This Annual Report on Form 10-K contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), that involve substantial risks and uncertainties. These forward-looking statements can be identified by the use of such words as estimate, project, believe, intend, anticipate, plan, seek, expect and other similar expressions. These forward-looking statements include: statements of the Company's goals, intentions and expectations; statements regarding the Company's business plans, prospects, growth and operating strategies; statements regarding the asset quality of the Company's loan and investment portfolios; and estimates of the Company's risks and future costs and benefits. These forward-looking statements are subject to significant risks, assumptions and uncertainties, including, among other things, the following important factors that could affect the actual outcome of future events: general economic conditions, either nationally or in the Company's market areas, that are worse than expected; significantly increased competition among depository and other financial institutions; inflation and changes in the interest rate environment that reduce the Company's margins or fair value of financial instruments; changes in laws or government regulations affecting financial institutions, including changes in regulatory fees and capital requirements; the Company's ability to enter new markets successfully and capitalize on growth opportunities; the Company's ability to successfully integrate acquired entities; changes in consumer spending, borrowing and savings habits; changes in accounting policies and practices, as may be adopted by the bank regulatory agencies, taxing authorities and the Financial Accounting Standards Board; and changes in the Company's organization, compensation and benefit plans. Because of these and other uncertainties, the Company's actual future results may be materially different from the results indicated by these forward-looking statements. MARKET AREAS AND COMPETITION The Company's primary lending and deposit gathering areas are generally concentrated in the same counties as its branches. The Company faces significant competition in both making loans and attracting deposits in its markets as the Upstate New York region has a high density of financial institutions, some of which are significantly larger and have greater financial resources than the Company. The Company's competition for loans comes principally from commercial banks, savings banks, savings and loan associations, mortgage banking companies, credit unions, insurance companies and other financial services companies. Its most direct competition for deposits has historically come from savings and loan associations, savings banks, commercial banks and credit unions. The Company faces additional competition for deposits from non-depository competitors such as the mutual fund industry, securities and brokerage firms and insurance companies. The Company offers a variety of financial services to meet the needs of the communities it serves and functions under a philosophy that includes a commitment to customer service and the community. The Company presently operates 120 branches in 24 counties that span across Upstate New York. The four largest cities in the markets the Company does business are Buffalo, Rochester, Syracuse and Albany, which have a combined total population of nearly 4 million and are the top four Metropolitan Statistical Areas in New York State outside of New York City. LENDING ACTIVITIES General. The Company's principal lending activity has been the origination of commercial real estate loans, commercial business loans and leases and residential mortgages to customers located within its primary market areas. Consistent with its long-term customer relationship focus, the Company generally retains the servicing rights on residential mortgage loans sold, which results in monthly service fee income. The Company also originates for retention in its portfolio various types of home equity and consumer loan products. Commercial Real Estate and Multi-family Lending. The Company originates real estate loans secured predominantly by first liens on apartment houses, office buildings, shopping centers, industrial and warehouse properties and to a lesser extent, by more specialized properties such as nursing homes, mobile home parks, restaurants, motels/hotels and auto dealerships. The Company's current policy with regard to such loans is to emphasize geographic distribution within its market areas, diversification of property types and minimization of credit risk. 6 As part of the Company's ongoing strategic initiative to minimize interest rate risk, commercial and multi-family real estate loans originated for the Company's portfolio are generally limited to one, three or five year adjustable-rate products which are priced at prevailing market interest rates. The initial interest rates are subsequently reset after completion of the initial one, three or five year adjustment period at new market rates that generally range between 150 and 275 basis points over the then, current one, three or five year U.S. Treasury Constant Maturity Index or Federal Home Loan Bank ("FHLB") advance rate subject to interest rate floors. The maximum term for commercial real estate loans is generally not more than 10 years, with a payment schedule based on not more than a 25-year amortization schedule for multi-family loans, and 20 years for commercial real estate loans. The Company also offers commercial real estate and multi-family construction mortgage loans. Most construction loans are made as "construction/permanent" loans, which provide for disbursement of loan funds during the construction period and conversion to a permanent loan upon the completion of construction and the attainment of either tenant lease-up provisions or prescribed debt service coverage ratios. The construction phase of the loan is made on a short-term basis, usually not exceeding 2 years, with floating interest rate levels generally indexed to either the LIBOR or prime rate. The construction loan application process includes the same criteria which are required for permanent commercial mortgage loans, as well as a submission to the Company of completed plans, specifications and cost estimates related to the proposed construction. These items are used as an additional basis to determine the appraised value of the subject property. Construction loans involve additional risks attributable to the fact that loan funds are advanced upon the security of the project under construction, which is of uncertain value prior to the completion of construction. The Company continues to emphasize commercial real estate and multi-family lending given their higher interest rates, sensitivity to interest rate changes and less susceptibility to prepayment risk. Commercial real estate and multi-family loans, however, entail significant additional risk as compared with residential mortgage lending, as they typically involve larger loan balances concentrated with a single borrower or groups of related borrowers. In addition, the payment experience on loans secured by income producing properties is typically dependent on the successful operation of the related real estate project and thus, may be subject to a greater extent to adverse conditions in the real estate market or to the general economy. To help mitigate this risk, the Company has put in place concentration limits based upon property types and maximum amounts that may be lent to an individual or group of borrowers. The Company has not experienced a significant deterioration in credit performance as a result of these higher risk loans, as the charge off rate for commercial real-estate and multi-family loans has averaged less than 5 basis points in recent years. Commercial Business Loans. The Company offers commercial business term loans, letters of credit and lines-of-credit to small and medium size companies in its market areas, some of which are secured in part by additional owner occupied real estate collateral. Additionally, secured and unsecured commercial loans and lines-of-credit are made for the purpose of financing equipment acquisition, inventory, business expansion, working capital and other general business purposes. The terms of these loans generally range from less than one year to seven years. The loans are either negotiated on a fixed-rate basis or carry variable interest rates indexed to the prime rate or LIBOR. Lines of credit expire after one year and generally carry a variable rate of interest indexed to the prime rate. The Company has a strategic emphasis on developing commercial business relationships and allocates a greater portion of available funds and personnel resources to both the commercial middle market and small business lending markets. To facilitate the Company's expansion of these areas, the Company offers additional commercial business products such as cash management, merchant services, wire transfer capabilities, business credit and debit cards, and Internet banking. The Company also dedicates resources to commercial business and real-estate loans which are 50% to 85% government guaranteed through the SBA. Terms of these loans range from one year to twenty years and generally carry a variable rate of interest indexed to the prime rate. This product allows the Company to better meet the needs of its small business customers in the market areas it serves, while protecting the Company from undue credit risk. Commercial business lending is generally considered to involve a higher degree of credit risk than secured real estate lending. The repayment of unsecured commercial business loans are wholly dependent upon the success of the borrower's business, while secured commercial business loans may be secured by collateral that is not readily marketable. Residential Real Estate Lending. The Company originates mortgage loans to enable borrowers to finance residential, owner-occupied and to some extent seasonal or vacation owner occupied properties located in its primary market areas. The Company offers conforming and non-conforming, fixed-rate and adjustable-rate, monthly and bi-weekly, residential mortgage loans with maturities generally up to 30 years and maximum loan amounts generally up to $750 thousand. The Company's bi-weekly mortgages feature an accelerated repayment structure and a linked deposit account. The Company does not offer interest-only or negative amortization residential mortgages. 7 The Company currently offers both fixed and adjustable rate conventional and government guaranteed Federal Housing Administration and Veterans Administration mortgage loans with terms of 10 to 30 years that are fully amortizing with monthly or bi-weekly loan payments. Residential loans are generally underwritten according to the Federal National Mortgage Association ("FNMA") and Federal Home Loan Mortgage Corporation ("FHLMC") uniform guidelines. The Company generally originates both fixed-rate and adjustable-rate loans in amounts up to the maximum conforming loan limits as established by FNMA and FHLMC secondary market standards. Private mortgage insurance ("PMI") and mortgage escrow accounts, from which disbursements are made for real estate taxes and insurance, are generally required for loans with loan-to-value ratios in excess of 80%. The Company generally sells newly originated conventional, conforming 20 to 30 year monthly fixed, and 25 to 30 year bi-weekly loans in the secondary market to government sponsored enterprises such as FNMA and FHLMC. The Company intends to continue to sell into the secondary market certain of its newly originated fixed rate loans to assist in asset and liability management. In addition to removing a level of interest rate risk from the balance sheet, the operation of a secondary marketing function provides cash flow to support loan growth. In an effort to provide financing for low and moderate income buyers, the Company actively participates in residential mortgage programs and products sponsored by FNMA, FHLMC, and the State of New York Mortgage Agency ("SONYMA"). The SONYMA mortgage programs provide low and moderate income households with fixed-rate loans which are generally set below prevailing conventional fixed-rate mortgage loans and which allow below-market down payments. These loans are sold by the Company to SONYMA, with the Company retaining the contractual servicing rights. The Company currently offers adjustable-rate monthly loan ("ARM") products secured by residential properties. The residential ARMs are offered with terms generally up to 30 years, with rates that adjust every one, five, seven, or ten years. After origination, the interest rate on residential ARMs is reset based upon a contractual spread or margin above a specified index (i.e. U.S. Treasury Constant Maturity Index). The appropriate index utilized at each interest rate change date corresponds to the initial one, five, seven, or ten year adjustment period of the loan. ARMs are generally subject to limitations on interest rate increases of up to 2% per adjustment period and an aggregate adjustment of up to 6% over the life of the loan. The ARMs require that any payment adjustment resulting from a change in the interest rate be sufficient to result in full amortization of the loan by the end of the loan term, and thus, do not permit any of the increased payment to be added to the principal amount of the loan, commonly referred to as negative amortization. The retention of ARMs in the Company's portfolio helps to reduce its exposure to interest rate risk. However, ARMs generally pose credit risks different from the credit risks inherent in fixed-rate loans primarily because, as interest rates rise, the underlying debt service payments of the borrowers rise, thereby increasing the potential for default. In order to minimize this risk, borrowers of residential one year adjustable-rate loans are qualified at the rate which would be in effect after the first interest rate adjustment, if that rate is higher than the initial rate. The Company believes that these risks, which have not had a material adverse effect on the Company to date, generally are less onerous than the interest rate risks associated with holding long-term fixed-rate loans. Certain of the Company's conforming ARMs can be converted at a later date to a fixed-rate mortgage loan with interest rates based upon the then-current market rates plus a predetermined margin or spread that was established at the loan closing. The Company sells ARMs, which are converted to 25 to 30 year fixed-rate term loans, to either FNMA or FHLMC. As a result of the acquisition of HRB, First Niagara now holds a 30% ownership interest in Homestead Funding Corp. ("Homestead") a mortgage banker licensed in the State of New York as well as other states. Effective with the closing of the merger, First Niagara entered into an agreement with Homestead pursuant to which First Niagara outsourced its Eastern New York residential mortgage loan origination function to Homestead. While Homestead markets their services under the First Niagara Mortgage brand, the loans are originated and closed in Homestead's name. As part of the agreement, Homestead sells selected mortgages to First Niagara as a correspondent. The Company generally purchases from Homestead for its portfolio ARMs and conventional fixed and bi-weekly loans with terms of 20 years or less at current market prices. These loans are underwritten by First Niagara prior to Homestead making the loan. Home Equity Lending. The Company offers fixed-rate, fixed-term, monthly and bi-weekly home equity loans, and prime-based home equity lines of credit ("HELOCs") in its market areas. Both fixed-rate and floating rate home equity products are offered in amounts up to 100% of the appraised value of the property (including the first mortgage) with a maximum loan amount generally up to $250 thousand. PMI is required for all fixed rate home equity loans and 8 HELOCs with combined first and second mortgage loan-to-value ratios in excess of 80%. Monthly fixed-rate home equity loans are offered with repayment terms up to 15 years and HELOCs are offered with terms up to 30 years. Bi-weekly fixed-rate home equity loans are offered with repayment terms up to 20 years, however, because the loan amortizes bi-weekly and two additional half payments are made each year, actual loan terms are significantly less. The Company offers an "Ultraflex" home equity line of credit which allows the borrower options of a 5 year interest only draw period or a 10 year draw period with principal and interest payments. Additionally, this product offers a card option to access funds and allows customers to convert their variable rate line to a fixed rate loan up to three times over the term of the line. The minimum line of credit is $10 thousand and the maximum is $250 thousand (up to $100 thousand if the loan to value exceeds 80%). Consumer Loans. The Company originates a variety of fixed-rate installment and variable rate lines-of-credit consumer loans, including indirect new and used automobile loans, mobile home loans, education loans and personal secured and unsecured loans. Mobile home loans have shorter terms to maturity and higher yields than traditional single-family residential mortgage loans. The Company generally offers mobile home loans in New York, New Jersey and Delaware with fixed-rate, fully amortizing loan terms of 10 to 20 years. Mobile home loans are originated at a higher rate of interest than residential mortgage loans. Because mobile homes may decline in value following their initial sale, the value of the collateral securing a mobile home loan may be less than the loan balance. At the time of origination, inspections are made to substantiate current market values on all mobile homes. The Company has contracted with an independent third party to generate all mobile home loan applications. However, prior to funding, all mobile home loan originations must be underwritten and approved by designated Company underwriters. As part of a negotiated servicing contract, the third party originator contacts borrowers who become delinquent in their payments and when necessary, will oversee the repossession and sale of mobile homes on the Company's behalf. For such services the Company pays the originator a fee at loan funding, of which generally 50% is deposited into a noninterest bearing escrow account, and is under the sole control of the Company to compensate for early prepayments and future losses which may be incurred on the loans. The Company originates personal secured and unsecured fixed rate installment loans and variable rate lines of credit. Terms of the loans range from 6 to 60 months and generally do not exceed $50 thousand. Secured loans are collateralized by vehicles, savings accounts or certificates of deposit. Unsecured loans are only approved for more creditworthy customers. The Company continues to be an active originator of education loans. Substantially all of the loans are originated under the auspices of the New York State Higher Education Services Corporation ("NYSHESC") or the American Student Association ("ASA"). Under the terms of these loans, no repayment is due until the student graduates, with 98% of the principal guaranteed by NYSHESC or ASA. The Company's general practice is to sell these education loans to Nelnet as the loans reach repayment status. The Company generally receives a premium of 0.50% to 1.50% on the sale of these loans. Consumer loans generally entail greater risk of loss than residential mortgage loans, particularly in the case of consumer loans that are unsecured or secured by assets that tend to depreciate, such as automobiles and mobile homes. In such cases, repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan and the remaining deficiency often does not warrant further substantial collection efforts against the borrower. In addition, consumer loan collections are dependent on the borrower's continued financial stability, which can be adversely affected by job loss, divorce, illness or personal bankruptcy. Specialized Lending. The Company's specialized lending portfolio consists of commercial leases, insurance premium finance and manufactured housing loans. The Company offers installment direct financing "small ticket" equipment leases, generally in amounts between $15 thousand and $125 thousand. Terms of these leases are up to 60 months and are guaranteed by the principals of the lessee, collateralized by the leased equipment and generally bear higher interest rates. Given the Company's strategy to shift its loan portfolio mix to higher yielding commercial loans, this product line continues to be an area of focus. The Company is engaged in the business of financing insurance premiums through PPP, a partnership which First Niagara's subsidiary FNA holds a 65% ownership interest. FNA receives 65% of the profits and absorbs 100% of any losses that are in excess of the minority owner's contributed capital. No profit distributions would be made to the minority owner until all accumulated losses have been recovered. PPP provides financing throughout the U.S. with a concentration of business in New York, New Jersey, Florida and Pennsylvania. The financed insurance policies are for various commercial lines of business and are secured against the unearned portion of the related insurance premium. The duration of the loans are generally eight to ten months. The majority of the financed premium contracts are with highly rated insurance carriers. Interest rates are based on the level of overall risk associated with the credit. 9 As a result of the HRB acquisition, the Company is party to an agreement with Tammac Corporation ("Tammac"). Previously Tammac solicited manufactured housing loan applications on behalf of HRB and received origination fees for providing those services to HRB. The Company is no longer accepting new applications from Tammac and as such is allowing this portfolio to run off. Under the agreement, Tammac continues to provide certain collection, repossession and liquidation services, at the direction of the Company, for certain delinquent loans and does not receive additional compensation for services provided to the Company. Classification of Assets. Loans are reviewed on a regular basis and are placed on nonaccrual status when, in the opinion of management, the collection of interest is doubtful. Loans are placed on nonaccrual status when payments are 90 days or more past due. At such time, interest accrued and unpaid is reversed from interest income. Consistent with regulatory guidelines, the Company provides for the classification of loans considered to be of lesser quality as "substandard," "doubtful," or "loss" assets. A loan is considered substandard if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Substandard loans include those characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. Loans classified as doubtful have all of the weaknesses inherent in those classified substandard with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Loans classified as loss are those considered uncollectible and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. Loans that do not expose the Company to risk sufficient to warrant classification in one of the aforementioned categories, but which possess some weaknesses, are designated "watch" or "special mention." When the Company classifies problem loans as either substandard or doubtful, it establishes a specific valuation allowance in an amount deemed prudent by management. General allowances represent loss allowances that have been established to recognize the risk associated with outstanding loans, but which, unlike specific allowances, have not been allocated to particular problem loans. When the Company classifies problem loans as a loss, it either establishes a specific allowance for losses equal to 100% of the amount of the loans classified, or charges-off such amount against the allowance for credit losses. The Company's determination as to the classification of its loans and the amount of its allowance is subject to ongoing review by its regulatory agencies, which can order the establishment of additional general or specific loss allowances. The Company regularly reviews its loan portfolio to determine whether any loans require classification in accordance with Company policy or applicable regulations. Allowance for Credit Losses. The allowance for credit losses is established through a provision for credit losses based on management's evaluation of losses in the loan portfolio. Such evaluation, which includes a review of all loans on which full collectibility may not be reasonably assured, considers among other matters, the estimated net realizable value or the fair value of the underlying collateral, economic conditions, historical loan loss experience and other factors that warrant recognition in determining the credit loss allowance. The Company continues to monitor and modify the level of the allowance for credit losses in order to include all losses at each reporting date that are both probable and reasonable to estimate. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for credit losses. Management's evaluation of the allowance for credit losses is based on a continuing review of the loan portfolio. The methodology for determining the amount of the allowance for credit losses consists of several elements. All individual commercial real estate and business credits and/or total loan concentrations to one borrower greater than $500 thousand are subject to a formal review process. Single credits or concentrations of $5.0 million or more are required to be reviewed every year; relationships between $1.0 million and $5.0 million are reviewed every 18 months; and relationships between $500 thousand and $1.0 million are reviewed every 36 months. Non-accruing, impaired and delinquent commercial loans are reviewed individually every month and the value of any underlying collateral is considered in determining estimates of losses on those loans and the need, if any, for a specific allowance. Another element involves estimating losses in categories of smaller balance homogeneous loans (residential, home equity, consumer) based primarily on historical loss experience, industry trends, trends in the local real estate market and the current business and economic environment in the Company's market areas. The unallocated portion of the allowance for credit losses is based on management's evaluation of various conditions, and involves a higher degree of uncertainty because this component of the allowance for credit losses is not identified with specific problem credits or portfolio segments. The conditions evaluated in connection with this element include the following: industry and regional conditions (primarily Upstate New York where the Company is subject to a high degree of concentration risk); seasoning of the loan portfolio and changes in the composition of and growth in the loan portfolio; the strength and duration of the current business cycle; existing general economic and business conditions in the lending areas; credit quality trends, including trends in nonaccruing loans; historical loan charge-off experience; and the results of regulatory examinations. 10 INVESTMENT ACTIVITIES General. The Company's investment policy provides that investment decisions will be made based on the safety of the investment, liquidity requirements, potential returns, cash flow targets, collateral for pledging purposes and desired risk parameters. In pursuing these objectives, consideration is given to the ability of an investment to provide earnings consistent with factors of quality, maturity, marketability and risk diversification. The Company limits securities investments to U.S. Government and agency securities, municipal bonds, corporate debt obligations and corporate equity securities. In addition, the policy permits investments in mortgage-backed securities, including collateralized mortgage obligations (CMO's) issued and guaranteed by FNMA, FHLMC, Government National Mortgage Association ("GNMA") or privately-issued and backed by "whole loans." Also permitted are investments in asset-backed securities ("ABS"), supported by auto loans, credit card receivables, home equity loans, student loans, and home improvement loans. The investment strategy generally utilizes a risk management approach of diversified investing to optimize investment yields while managing the overall interest rate risk position of the Company. To accomplish these objectives, the Company's focus is on investments in mortgage-related securities, including CMO's, while U.S. Government and Agency and other non-amortizing securities are utilized for call protection and liquidity purposes. The Company attempts to maintain a high degree of liquidity in its investment securities and generally does not invest in debt securities with expected average lives in excess of 5 years. At December 31, 2005, no investments in securities of a single non-U.S. Government or government agency issuer exceeded 10% of stockholders' equity. SOURCES OF FUNDS General. Deposits and borrowed funds, primarily FHLB advances and repurchase agreements, are the primary sources of the Company's funds for use in lending, investing and for other general purposes. In addition, repayments on and proceeds from sales of loans and securities, and cash flows from operations provide additional sources of funds. The Company has available lines of credit with the FHLB, Federal Reserve Bank ("FRB") and a commercial bank, which can provide liquidity if the above funding sources are not sufficient to meet the Company's short-term liquidity needs. Deposits. The Company offers a variety of deposit products with a range of interest rates and terms. Consumer deposit accounts consist of savings, negotiable order of withdrawal ("NOW"), checking, money market, and certificate of deposit accounts. Commercial account offerings include business savings and checking, money market, cash management services and a totally free checking product. The Company also accepts municipal deposits through the Commercial Bank. Borrowed Funds. Borrowings are utilized to lock-in lower cost funding, improve the maturity and match between certain assets and liabilities and leverage capital for the purpose of improving return on equity. Such borrowings primarily consist of advances and repurchase agreements with the FHLB, nationally recognized securities brokerage firms and with commercial customers. FINANCIAL SERVICES General. To complement its traditional core banking business, the Company offers a wide-range of insurance and investment products and services to help both consumer and commercial customers achieve their financial goals. These products and services are delivered through the Company's Risk Management, Wealth Management and Employee Benefits Administration businesses. The goal of these businesses is to help customers identify and achieve long- and short-range business and financial goals. Risk Management. The Company's Risk Management subsidiary provides a wide range of insurance products and services including personal, commercial and employee benefits offerings. The insurance products are complemented by claims investigation and adjusting services, third party administration of self insured workers compensation plans, alternative risk management services as well as self insurance consulting services. The Risk Management subsidiary also provides industry specific insurance programs including long-term care, moving and storage, ice rinks and municipalities. The revenue attributable to the Company's Risk Management subsidiary consists primarily of fees paid by clients as well as commissions, fees and contingent profit sharing paid by insurance carriers. These revenues are directly impacted by the fluctuation of premiums in the insurance market caused by capacity constraints and losses due to natural disasters. Other factors that affect revenue are profitability and growth of clients, continued development of new products and services, as well as access to markets. Commission rates vary dependent on the type of insurance product, the carrier represented, and the services the agent provides. During 2005, the Risk Management subsidiary grew substantially due to three strategic acquisitions. By the end of the year, the Company was servicing approximately $400 million in annual insurance premium volume. 11 Wealth Management. The Company's Wealth Management business consists of the sale of stocks, bonds, mutual funds, annuities and other investment products including IRAs, education savings plans and retirement plans to both consumer and commercial clients. Additionally, the Company offers investment advisory, trust, pension and custody services. Revenue from the sale of mutual funds and annuities consists primarily of commissions paid by clients, investment managers and third-party product providers. Revenue is affected by the development of new products, markets and services, new and lost business, the relative attractiveness of investment products offered under prevailing market conditions, changes in the investment patterns of clients, the flow of monies to and from accounts and the valuation of accounts. Mutual funds and annuities as well as other investment products are sold through First Niagara's branch network by financial consultants and appropriately licensed employees. Investment management services are performed pursuant to advisory contracts, which provide for fees payable to the Company. The amount of fees varies depending on the individual account and is usually based upon a sliding scale in relation to the level of assets under management. Assets under management and revenue levels are particularly affected by fluctuations in stock and bond market prices, the composition of assets under management and by the level of investments and withdrawals for current and new clients. Other items affecting revenue also include, but are not limited to, actual and relative investment performance, service to clients, the relative attractiveness of the investment under prevailing market conditions, changes in the investment patterns of clients and the ability to maintain investment management fees at appropriate levels. The Company also provides personal trust, employee benefit trust, and custodial services to clients in its market areas. Similar to investment management services, trust revenue is derived primarily from investment management fees, which depend largely on the total value and composition of assets under management. Assets under management and administration aggregated approximately $576.0 million as of December 31, 2005. Employee Benefits Administration. On September 12, 2005, FNFG acquired the Burke Group. Founded in 1989, Burke Group is an employee benefit-consulting firm based in Upstate New York that offers full service employee benefits consulting and plan administration. The Burke Group's primary practice areas include defined contribution plan consulting and administration, defined benefit plan consulting and actuarial valuations, compensation consulting and salary administration, and worksite benefits enrollment and on-going administration. Burke Group is paid on a flat fee basis in accordance with service agreements with its clients. Fees vary based upon the number of participants in the plans, the amount of assets under service and the amount of hours required to perform the services. The Burke Group currently operates through two offices located near Rochester and Syracuse, New York. Clients range in size from 50 to 16,000 employees. Currently, the Burke Group is the recordkeeping consultants for approximately 150,000 participants in all 50 states representing over $2 billion in plan assets. SEGMENT INFORMATION Information about the Company's business segments is included in note 17 of "Notes to Consolidated Financial Statements" filed herewith in Part II, Item 8, "Financial Statements and Supplementary Data." The Company has identified two business segments, banking and financial services. Financial services activities consist of the results of the Company's wealth and risk management operations. All other activities are considered banking. SUPERVISION AND REGULATION General. FNFG is a savings and loan holding company examined and supervised by the OTS, while First Niagara is examined and supervised by the OTS and the Federal Deposit Insurance Corporation ("FDIC"). This regulation and supervision establishes a comprehensive framework of activities in which an institution may engage and is intended primarily for the protection of the FDIC's deposit insurance funds and depositors. Under this system of federal regulation, financial institutions are periodically examined to ensure that they satisfy applicable standards with respect to their capital adequacy, assets, management, earnings, liquidity and sensitivity to market interest rates. Following completion of its examination, the federal agency critiques the institution's operations and assigns its rating (known as an institution's CAMELS rating). Under federal law, an institution may not disclose its CAMELS rating to the public. First Niagara also is a member of and owns stock in the FHLB of New York, which is one of the twelve regional banks in the FHLB System. First Niagara also is regulated to a lesser extent by the Board of Governors of the Federal Reserve System, governing reserves to be maintained against deposits and other matters. The OTS examines First Niagara and prepares reports for the consideration of its Board of Directors on any operating deficiencies. First Niagara's relationship with its depositors and borrowers also is regulated to a great extent by both federal and state laws, especially in matters concerning privacy, the ownership of deposit accounts and the form and content of loan documents. Any change in these laws or regulations, whether by the FDIC, OTS or Congress, could have a material adverse impact on the Company and its operations. 12 Federal Banking Regulation Business Activities. A federal savings bank derives its lending and investment powers from the Home Owners' Loan Act, as amended, and the regulations of the OTS. Under these laws and regulations, First Niagara may invest in mortgage loans secured by residential and commercial real estate, commercial business and consumer loans, certain types of debt securities and certain other assets. First Niagara also may establish subsidiaries that may engage in activities not otherwise permissible, including real estate investment and securities and insurance brokerage. Capital Requirements. OTS regulations require savings banks to meet three minimum capital standards: A 1.5% tangible capital ratio, a 4% leverage ratio and an 8% risk-based capital ratio. The prompt corrective action standards discussed below, in effect, establish a minimum 2% tangible capital standard. The risk-based capital standard for savings banks requires the maintenance of Tier 1 (core) and total capital (which is defined as core capital and supplementary capital) to risk-weighted assets of at least 4% and 8%, respectively. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, are multiplied by a risk-weight factor of 0% to 200%, assigned by the OTS capital regulation based on the risks believed inherent in the type of asset. Core capital is defined as common stockholders' equity (including retained earnings), certain noncumulative perpetual preferred stock and related surplus and minority interests in equity accounts of consolidated subsidiaries, less intangibles other than certain mortgage servicing rights and credit card relationships. The components of supplementary capital currently include cumulative preferred stock, long-term perpetual preferred stock, mandatory convertible securities, subordinated debt and intermediate preferred stock, the allowance for loan and lease losses limited to a maximum of 1.25% of risk-weighted assets and up to 45% of net unrealized gains on available-for-sale equity securities with readily determinable fair market values. Overall, the amount of supplementary capital included as part of total capital cannot exceed 100% of core capital. At December 31, 2005, First Niagara exceeded all minimum regulatory capital requirements. The current requirements and the actual capital levels for First Niagara are detailed in note 11 of "Notes to Consolidated Financial Statements" filed herewith in Part II, Item 8, "Financial Statements and Supplementary Data." Loans-to-One-Borrower. A federal savings bank generally may not make a loan or extend credit to a sole obligor in excess of 15% of unimpaired regulatory capital and surplus on an unsecured basis. An additional amount may be loaned, equal to 10% of unimpaired capital and surplus, if the loan is secured by readily marketable collateral, but generally does not include real estate. First Niagara is in compliance with the loans-to-one-borrower limitations. The Company's regulatory loans-to-one-borrower limit (15% of unimpaired capital and surplus) as of December 31, 2005 was $98.7 million based upon $657.8 million of unimpaired capital and surplus. However, given the Company's conservative underwriting standards and risk management philosophy, management and the Board of Directors has established an internal loans-to-one-borrower limit of approximately $65.8 million (10% of unimpaired capital and surplus) as of December 31, 2005 unless approved by the Board of Directors. Qualified Thrift Lender Test. As a federal savings bank, First Niagara is subject to a qualified thrift lender ("QTL") test. Under the QTL test, First Niagara must maintain at least 65% of its "portfolio assets" in "qualified thrift investments" in at least nine months of the most recent 12-month period. As of December 31, 2005, First Niagara had 77% of its portfolio assets in qualified thrift investments. "Portfolio assets" generally means total assets of a savings institution, less the sum of specified liquid assets up to 20% of total assets, goodwill and other intangible assets, and the value of property used in the conduct of the savings bank's business. "Qualified thrift investments" includes various types of loans made for residential and housing purposes, investments related to such purposes, including certain mortgage-backed and related securities, and loans for personal, family, household and certain other purposes up to a limit of 20% of portfolio assets. "Qualified thrift investments" also include 100% of an institution's credit card loans, education loans and small business loans. First Niagara also may satisfy the QTL test by qualifying as a "domestic building and loan association" as defined by the Internal Revenue Code of 1986, as amended. Capital Distributions. OTS regulations govern capital distributions by a federal savings bank, which include cash dividends, stock repurchases and other transactions charged to the capital account. A savings bank must file an application for approval of a capital distribution if the total capital distributions for the applicable calendar year exceed the sum of the savings bank's net income for that year to date plus the savings bank's retained net income for the preceding two years; the bank would not be at least adequately capitalized following the distribution; the distribution would violate any applicable statute, regulation, agreement or OTS-imposed condition; or the savings bank is not eligible for expedited treatment of its filings. 13 Even if an application is not otherwise required, every savings bank that is a subsidiary of a holding company must file a notice with the OTS at least 30 days before the Board of Directors declares a dividend or approves a capital distribution. The OTS may disapprove a notice or application if: the savings bank would be undercapitalized following the distribution; the proposed capital distribution raises safety and soundness concerns; or the capital distribution would violate a prohibition contained in any statute, regulation or agreement. In addition, the Federal Deposit Insurance Act provides that an insured depository institution shall not make any capital distribution, if after making such distribution, the institution would be undercapitalized. During 2005, First Niagara paid $215 million in dividends to FNFG. Community Reinvestment Act and Fair Lending Laws. All savings banks have a responsibility under the Community Reinvestment Act ("CRA") and related regulations of the OTS to help meet the credit needs of their communities, including low- and moderate-income neighborhoods. In connection with its examination of a federal savings bank, the OTS is required to assess the savings bank's record of compliance with the CRA. In addition, the Equal Credit Opportunity Act and the Fair Housing Act prohibit lenders from discriminating in their lending practices on the basis of characteristics specified in those statutes. A bank's failure to comply with the provisions of the CRA could, at a minimum, result in regulatory restrictions on its activities. The failure to comply with the Equal Credit Opportunity Act and the Fair Housing Act could result in enforcement actions by the OTS, as well as other federal regulatory agencies and the Department of Justice. First Niagara received a "Satisfactory" CRA rating on its most recent federal examination. Transactions with Related Parties. A federal savings bank's authority to engage in transactions with its "affiliates" is limited by OTS regulations and by Sections 23A and 23B of the Federal Reserve Act (the "FRA"). The term "affiliates" for these purposes generally means any company that controls or is under common control with an institution. FNFG is an affiliate of First Niagara. In general, transactions with affiliates must be on terms that are as favorable to the savings bank as comparable transactions with non-affiliates. In addition, certain types of these transactions are restricted to an aggregate percentage of the savings bank's capital. Collateral in specified amounts must usually be provided by affiliates in order to receive loans from the savings bank. In addition, OTS regulations prohibit a savings bank from lending to any of its affiliates that are engaged in activities that are not permissible for bank holding companies and from purchasing the securities of any affiliate, other than a subsidiary. Regulation W, issued by the Federal Reserve, comprehensively implements Sections 23A and 23B. The regulation unifies and updates staff interpretations issued over the years, incorporates several new interpretative proposals (such as to clarify when transactions with an unrelated third party will be attributed to an affiliate) and addresses new issues arising as a result of the expanded scope of non-banking activities engaged in by banks and bank holding companies in recent years and authorized for financial holding companies under the Gramm-Leach-Bliley ("GLB") Act. First Niagara's authority to extend credit to its directors, executive officers and 10% stockholders, as well as to entities controlled by such persons, is currently governed by the requirements of Sections 22(g) and 22(h) of the FRA and Regulation O of the FRB. Among other things, these provisions require that extensions of credit to insiders (i) be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with unaffiliated persons and that do not involve more than the normal risk of repayment or present other unfavorable features, and (ii) do not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of First Niagara's capital. In addition, extensions of credit in excess of certain limits must be approved by First Niagara's Board of Directors. Loans due from certain officers and directors of the Company and affiliates amounted to $3.4 million and $2.5 million at December 31, 2005 and 2004, respectively. Enforcement. The OTS has primary enforcement responsibility over federal savings institutions and has the authority to bring enforcement action against all "institution-affiliated parties," including stockholders, and attorneys, appraisers and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on an insured institution. Formal enforcement action may range from the issuance of a capital directive or a cease and desist order for the removal of officers and/or directors of the institution, receivership, conservatorship or the termination of deposit insurance. Civil penalties cover a wide range of violations and actions, and range up to $25 thousand per day, unless a finding of reckless disregard is made, in which case penalties may be as high as $1.1 million per day. The FDIC also has the authority to recommend to the Director of the OTS that enforcement action be taken with respect to a particular savings institution. If action is not taken by the OTS Director, the FDIC has authority to take action under specified circumstances. Standards for Safety and Soundness. Federal law requires each federal banking agency to prescribe certain standards for all insured depository institutions. These standards relate to, among other things, internal controls, information and audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, compensation, and other operational and managerial standards as the agency deems appropriate. The federal banking agencies adopted 14 Interagency Guidelines Prescribing Standards for Safety and Soundness to implement the safety and soundness standards required under federal law. The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. If the 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. If an institution fails to meet these standards, the appropriate federal banking agency may require the institution to submit a compliance plan. Prompt Corrective Action Regulations. Under the prompt corrective action regulations, the OTS is required and authorized to take supervisory actions against undercapitalized savings banks. For this purpose, a savings bank is placed in one of the following five categories based on the bank's capital: well-capitalized (at least 5% leverage capital, 6% tier 1 risk-based capital and 10% total risk-based capital); adequately capitalized (at least 3% leverage capital, 4% tier 1 risk-based capital and 8% total risk-based capital); undercapitalized (less than 8% total risk-based capital, 4% tier 1 risk-based capital or 3% leverage capital); significantly undercapitalized (less than 6% total risk-based capital, 3% tier 1 risk-based capital or 3% leverage capital); and critically undercapitalized (less than 2% tangible capital). Generally, the banking regulator is required to appoint a receiver or conservator for a bank that is "critically undercapitalized." The regulation also provides that a capital restoration plan must be filed with the OTS within 45 days of the date a bank receives notice that it is "undercapitalized," "significantly undercapitalized," or "critically undercapitalized." A capital restoration plan must disclose, among other things, the steps an insured institution will take to become adequately capitalized without appreciably increasing the risk to which the institution is exposed. In addition, each company that controls the institution must guarantee that the institution will comply with the plan until the institution has been adequately capitalized on average during each of four consecutive calendar quarters. Such guarantee could have a material adverse affect on the financial condition of such guarantor. In addition, numerous mandatory supervisory actions become immediately applicable to the bank, including, but not limited to, restrictions on growth, investment activities, capital distributions and affiliate transactions. The OTS may also take any one of a number of discretionary supervisory actions against undercapitalized banks, including the issuance of a capital directive and the replacement of senior executive officers and directors. At December 31, 2005, First Niagara met the criteria for being considered "well-capitalized." The current requirements and the actual levels for First Niagara are detailed in note 11 of "Notes to Consolidated Financial Statements" filed herewith in Part II, Item 8, "Financial Statements and Supplementary Data." Insurance of Deposit Accounts. Deposit accounts in First Niagara are insured by the FDIC up to applicable legal limits. On February 8, 2006, federal legislation to reform federal deposit insurance was signed into law. The new legislation requires, among other things, the merger of the Savings Association Insurance Fund and the Bank Insurance Fund into a unified Deposit Insurance Fund; indexing the current $100,000 deposit insurance limit to inflation beginning in 2010 and in every succeeding five years, and requiring the FDIC to consider raising the standard maximum insurance limit if warranted; increasing the deposit insurance limit for certain retirement accounts to $250,000 and indexing that limit to inflation; and eliminating the current 1.25% Designated Reserve Ratio ("DRR") and providing the FDIC with discretion to set the DRR within a range of 1.15%-1.50% for any given year. The legislation requires the FDIC to issue regulations no later than November 5, 2006, with such regulations to take effect no later than 90 days following publication. Prohibitions Against Tying Arrangements. Federal savings banks are prohibited, subject to some exceptions, from extending credit to or offering any other service, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or its affiliates or not obtain services from a competitor of the institution. Federal Home Loan Bank System. First Niagara is a member of the FHLB System, which consists of 12 regional Federal Home Loan Banks. The FHLB System provides a central credit facility primarily for member institutions. As a member of the FHLB of New York, First Niagara is required to acquire and hold shares of capital stock in the FHLB in an amount equal to 0.2% of the aggregate principal amount of its unpaid residential mortgage loans, commercial real estate loans, home equity loans, CMO's and other similar obligations at the beginning of each year, and 4.5% of its borrowings from the FHLB. First Niagara is in compliance with this requirement. Federal Reserve System. The Federal Reserve Board regulations require savings banks to maintain non-interest-earning reserves against their transaction accounts, such as NOW and regular checking accounts. First Niagara is in compliance with these reserve requirements. The balances maintained to meet the reserve requirements imposed by the Federal Reserve Board may be used to satisfy liquidity requirements imposed by the OTS. 15 Privacy Standards. Federal regulations require financial institutions, such as First Niagara, to disclose their privacy policy, including identifying with whom they share "non-public personal information," to customers at the time of establishing the customer relationship and annually thereafter. In addition, First Niagara is required to provide its customers with the ability to "opt-out" of having First Niagara share their non-public personal information with nonaffiliated third parties before it can disclose such information, subject to certain exceptions. The federal banking agencies adopted guidelines establishing standards for safeguarding customer information. The guidelines describe the agencies' expectations for the creation, implementation and maintenance of an information security program, which would include administrative, technical and physical safeguards appropriate to the size and complexity of the institution and the nature and scope of its activities. The standards set forth in the guidelines are intended to ensure the security and confidentiality of customer records and information, protect against any anticipated threats or hazards to the security or integrity of such records, and protect against unauthorized access to records or information that could result in substantial harm or inconvenience to customers. On March 29, 2005, the federal banking regulators jointly issued guidance stating that financial institutions, such as First Niagara, should develop and implement a response program to address security breaches involving customer information, including customer notification procedures. First Niagara has developed such a program. Holding Company Regulation FNFG is a savings and loan holding company, subject to regulation and supervision by the OTS, which has enforcement authority over FNFG. Among other things, this authority permits the OTS to restrict or prohibit activities that are determined to be a risk to First Niagara. The GLB Act of 1999 restricts unitary savings and loan holding companies, not existing or applied for before May 4, 1999, to those activities permissible for financial holding companies or for multiple savings and loan holding companies. FNFG is not a grandfathered unitary savings and loan holding company and, therefore, is limited to the activities permissible for financial holding companies or for multiple savings and loan holding companies. A financial holding company may engage in activities that are financial in nature, including underwriting equity securities and insurance, incidental to financial activities or complementary to a financial activity. A multiple savings and loan holding company is generally limited to activities permissible for bank holding companies under Section 4(c)(8) of the Bank Holding Company Act, subject to the prior approval of the OTS, and certain additional activities authorized by OTS regulations. Federal law prohibits a savings and loan holding company, directly or indirectly, or through one or more subsidiaries, from acquiring control of another savings institution or holding company thereof, without prior written approval of the OTS. It also prohibits the acquisition or retention of, with specified exceptions, more than 5% of the equity securities of a company engaged in activities that are not closely related to banking or financial in nature or acquiring or retaining control of an institution that is not federally insured. In evaluating applications by holding companies to acquire savings institutions, the OTS must consider the financial and managerial resources, future prospects of the savings institution involved, the effect of the acquisition on the risk to the insurance fund, the convenience and needs of the community and competitive factors. Commercial Bank Regulation The Commercial Bank is subject to extensive regulation by the New York State Banking Department ("NYSBD") as its chartering agency and by the FDIC as its deposit insurer. The Commercial Bank must file reports with the NYSBD and the FDIC concerning its activities and financial condition, and it must obtain regulatory approval prior to entering into certain transactions, such as mergers with, or acquisitions of, other depository institutions and opening or acquiring branch offices. The NYSBD and the FDIC conduct periodic examinations to assess the Commercial Bank's compliance with various regulatory requirements. This regulation and supervision is intended primarily for the protection of the deposit insurance funds and depositors. The regulatory authorities have extensive discretion in connection with the exercise of their supervisory and enforcement activities. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease and desist orders and to remove directors and officers. These enforcement actions may be initiated in response to violations of laws, regulations or unsafe or unsound practices. The Commercial Bank derives its powers primarily from the applicable provisions of the New York Banking Law and the regulations adopted thereunder. State banks are limited in their investments and the activities they may engage in as principal to those permissible under applicable state law and those permissible for national banks and their subsidiaries, unless such investments and activities are specifically permitted by the Federal Deposit Insurance Act or the FDIC determines that such activity or investment would pose no significant risk to the deposit insurance funds. The Commercial Bank limits its activities to accepting municipal deposits and acquiring municipal and other securities. 16 Under New York Banking Law, the Commercial Bank is not permitted to declare, credit or pay any dividends if its capital stock is impaired or would be impaired as a result of the dividend. In addition, the New York Banking Law provides that the Commercial Bank can not declare nor pay dividends in any calendar year in excess of its "net profits" for such year combined with its "retained net profits" of the two preceding years, less any required transfer to surplus or a fund for the retirement of preferred stock, without prior regulatory approval. The Commercial Bank is subject to minimum capital requirements imposed by the FDIC that are substantially similar to the capital requirements imposed on First Niagara. The FDIC regulations require that each bank maintain a minimum ratio of qualifying total capital to risk-weighted assets of 8.0%, and a minimum ratio of tier 1 capital to risk-weighted assets of 4.0%. In addition, under the minimum leverage-based capital requirement adopted by the FDIC, the Commercial Bank must maintain a ratio of tier 1 capital to average total assets (leverage ratio) of at least 3% to 5%, depending on the Bank's CAMELS composite examination rating. Capital requirements higher than the generally applicable minimum requirements may be established for a particular bank if the FDIC determines that a bank's capital is, or may become, inadequate in view of the bank's particular circumstances. Failure to meet capital guidelines could subject a bank to a variety of enforcement actions, including actions under the FDIC's prompt corrective action regulations. At December 31, 2005, the Commercial Bank met the criteria for being considered "well-capitalized." The current requirements and the actual levels for the Commercial Bank are detailed in note 11 of "Notes to Consolidated Financial Statements" filed herewith in Part II, Item 8, "Financial Statements and Supplementary Data." Other Legislation USA Patriot Act of 2001. The USA Patriot Act of 2001 (the "Patriot Act") was enacted in response to the terrorist attacks, which occurred on September 11, 2001. The Patriot Act is intended to strengthen U.S. law enforcement's and the intelligence communities' abilities to work cohesively to combat terrorism on a variety of fronts. The potential impact of the Patriot Act on financial institutions of all kinds is significant and wide ranging. The Patriot Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations that promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. Financial Services Modernization Legislation. The GLB Act of 1999 repealed provisions of the Glass-Steagall Act which restricted the affiliation of Federal Reserve member banks with firms "engaged principally" in specified securities activities, and which restricted officer, director, or employee interlocks between a member bank and any company or person "primarily engaged" in specified securities activities. In addition, the GLB Act contains provisions that expressly preempt any state law restricting the establishment of financial affiliations, primarily related to insurance. The general effect of the law is to establish a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms, and other financial service providers by revising and expanding the Bank Holding Company Act framework to permit a holding company to engage in a full range of financial activities through a new entity known as a "financial holding company." "Financial activities" is broadly defined to include not only banking, insurance and securities activities, but also merchant banking and additional activities that the Federal Reserve Board, in consultation with the Secretary of the Treasury, determines to be financial in nature, incidental to such financial activities, or complementary activities that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system. The GLB Act provides that no company may acquire control of an insured savings association unless that company engages, and continues to engage, only in the financial activities permissible for a financial holding company, unless the company is grandfathered as a unitary savings and loan holding company on May 4, 1999 or became a unitary savings and loan holding company pursuant to an application pending on that date. The GLB Act also permits national banks to engage in expanded activities through the formation of financial subsidiaries. A national bank may have a subsidiary engaged in any activity authorized for national banks directly or any financial activity, except for insurance underwriting, insurance investments, real estate investment or development, or merchant banking, which may only be conducted through a subsidiary of a financial holding company. Financial activities include all activities permitted under new sections of the Bank Holding Company Act or permitted by regulation. 17 The Fair and Accurate Credit Transactions ("FACT") Act of 2003. The FACT Act includes many provisions concerning national credit reporting standards, and permits consumers, including the customers of the Company, to opt out of information sharing among affiliated companies for marketing purposes. The FACT Act also requires financial institutions, including banks, to notify their customers if they report negative information about them to credit bureaus or if the credit that is granted to them is on less favorable terms than are generally available. Banks also must comply with guidelines to be established by their federal banking regulators to help detect identity theft. Sarbanes-Oxley Act. The stated goals of the Sarbanes-Oxley Act of 2002 ("SOX") are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. SOX includes very specific additional disclosure requirements and new corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules and mandates further studies of certain issues by the SEC and the Comptroller General. SOX represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees. SOX addresses, among other matters, audit committees; certification of financial statements and internal controls by the Chief Executive Officer and Chief Financial Officer; the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer's securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement; a prohibition on insider trading during pension plan black out periods; disclosure of off-balance sheet transactions; a prohibition on certain loans to directors and officers; expedited filing requirements for Forms 4; disclosure of a code of ethics and filing a Form 8-K for a change or waiver of such code; "real time" filing of periodic reports; the formation of a public accounting oversight board; auditor independence; and various increased criminal penalties for violations of securities laws. The SEC has enacted rules to implement various provisions of SOX. TAXATION General. FNFG and First Niagara are subject to federal income taxation in the same general manner as other corporations, with some exceptions discussed below. The following discussion of federal taxation is intended only to summarize certain pertinent federal and state income tax matters and is not a comprehensive description of the tax rules applicable to FNFG and First Niagara. Method of Accounting. For federal income tax purposes, FNFG and First Niagara report their income and expenses on the accrual method of accounting and use a tax year ending December 31st for filing its consolidated federal income tax returns. Net Operating Loss Carryovers. A financial institution may carry back net operating losses to the preceding two taxable years for federal income tax purposes and forward to the succeeding 20 taxable years for federal and New York State income tax purposes, subject to certain limitations. At December 31, 2005, First Niagara had $16.1 million of net operating loss carryforwards for federal income tax purposes and $16.0 million for New York State income tax purposes obtained through its recent bank acquisitions. The usage of these losses is subject to an annual limitation. Corporate Dividends. FNFG may exclude from its income 100% of dividends received from First Niagara as a member of the same affiliated group of corporations. Taxable Distributions and Recapture. Prior to the Small Business Protection Act of 1996, bad debt reserves created prior to January 1, 1988 were subject to recapture into taxable income should First Niagara fail to meet certain thrift asset and definitional tests. New federal legislation eliminated these thrift related recapture rules. However, under current law, pre-1988 reserves remain subject to recapture should First Niagara make certain nondividend distributions or cease to maintain a bank charter. At December 31, 2005, First Niagara's federal pre-1988 reserve, which no federal income tax provision has been made, was approximately $42.0 million. State of New York. FNFG reports income on a consolidated calendar year basis to New York State. New York State franchise tax on corporations is imposed in an amount equal to the greater of (a) 7.5% of "entire net income" allocable to New York State, (b) 3% of "alternative entire net income" allocable to New York State, (c) 0.01% of the average value of assets allocable to New York State, or (d) nominal minimum tax. Entire net income is based on Federal taxable income, subject to certain modifications. Alternative entire net income is based on entire net income with certain modifications. 18 The 2006 New York State budget bill proposed by the Governor currently contains a provision that would reduce the statutory tax rate on the taxable income base from 7.5% to 6.75%, phased in over a multi-year period, and would disallow the exclusion of dividends paid by a REIT. The bill, if enacted as proposed, would be effective beginning in 2006, and the Company would lose the tax benefit associated with its REIT. Without the REIT dividend exclusion, the Company's 2005 effective tax rate would have been approximately 38.2%. Status of Audits by Taxing Authorities. FNFG and First Niagara are subject to routine audits of their tax returns by the Internal Revenue Service and New York State Department of Taxation. There are no indications of any material adjustments noted for any examination currently being conducted by these taxing authorities. ITEM 1A. RISK FACTORS -------------------------------------------------------------------------------- Commercial Real Estate and Business Loans Expose the Company to Increased Credit Risks. At December 31, 2005, the Company's portfolio of commercial real estate and business loans totaled $2.3 billion, or 44.5% of total loans. The Company plans to continue to emphasize the origination of these types of loans, which generally expose the Company to a greater risk of non-payment and loss than residential real estate loans because repayment of the loans often depends on the successful operations and income stream of the borrowers. Additionally, such loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to residential real estate loans. Also, many borrowers have more than one commercial loan outstanding. Consequently, an adverse development with respect to one loan or one credit relationship can expose the Company to a significantly greater risk of loss compared to an adverse development with respect to a residential real estate loan. The Company targets its business lending and marketing strategy towards small- to medium-sized businesses. These small- to medium-sized businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities. If general economic conditions negatively impact these businesses, the Company's results of operations and financial condition may be adversely affected. Increases to the Allowance for Credit Losses to Cover Loan Losses May Cause the Company's Earnings to Decrease. The Company's customers may not repay their loans according to the original terms, and the collateral securing the payment of those loans may be insufficient to pay any remaining loan balance. The Company may experience significant loan losses, which could have a material adverse effect on operating results. The Company makes various assumptions and judgments about the collectibility of the 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 amount of the allowance for credit losses, the Company relies on loan quality reviews, past experience and an evaluation of economic conditions, among other factors. If the assumptions prove to be incorrect, the allowance for credit losses may not be sufficient to cover losses inherent in the loan portfolio, resulting in additions to the allowance. Material additions to the allowance would materially decrease net income. The Company's emphasis on the origination of commercial real estate and business loans is one of the more significant factors in evaluating the allowance for credit losses. As the Company continues to increase the amount of such loans, additional or increased provisions for credit losses may be necessary and as a result would decrease earnings. Bank regulators periodically review the Company's allowance for credit losses and may require an increase to the provision for credit losses or further loan charge-offs. Any increase in the Company's allowance for credit losses or loan charge-offs as required by these regulatory authorities could have a material adverse effect on the Company's results of operations and/or financial condition. The Concentration of Loans in the Company's Primary Market Area May Increase Risk. The Company's success depends primarily on the general economic conditions in Upstate New York. Accordingly, the local economic conditions in Upstate New York have a significant impact on the ability of borrowers to repay loans and the value of the collateral securing those loans. A significant decline in general economic conditions caused by inflation, recession, unemployment or other factors beyond the Company's control would impact these local economic conditions and could negatively affect financial results. 19 Changes in Interest Rates Could Adversely Affect the Company's Results of Operations and Financial Condition. The Company's results of operations and financial condition are significantly affected by changes in interest rates. Results of operations depend substantially on net interest income, which is the difference between the interest income earned on interest-earning assets and the interest expense paid on interest-bearing liabilities. Because the Company's interest-bearing liabilities generally reprice or mature more quickly than its interest-earning assets, an increase in interest rates generally would tend to result in a decrease in net interest income. The Company has taken steps to mitigate this risk such as holding fewer longer-term residential mortgages as well as investing excess funds in shorter-term investments. Changes in interest rates also affect the value of interest-earning assets, and in particular investment securities available for sale. Generally, the value of investment securities fluctuate inversely with changes in interest rates. At December 31, 2005, investment securities available for sale totaled $1.6 billion. Unrealized losses on securities available for sale, net of tax, amounted to $18.1 million and are reported as a separate component of stockholders' equity. Decreases in the fair value of securities available for sale, therefore, could have an adverse effect on stockholders' equity. Changes in interest rates may also affect the average life of loans and mortgage-related securities. Decreases in interest rates can result in increased prepayments of loans and mortgage-related securities, as borrowers refinance to reduce borrowing costs. Under these circumstances, the Company is subject to reinvestment risk to the extent that it is unable to reinvest the cash received from such prepayments at rates that are comparable to the rates on existing loans and securities. Additionally, increases in interest rates may decrease loan demand and make it more difficult for borrowers to repay adjustable rate loans. The Company's Ability to Grow May Be Limited if it Cannot Make Acquisitions. In an effort to fully deploy excess capital and to increase loans and deposits, the Company intends to continue to acquire other financial institutions, financial services companies or branches. The Company competes with other financial institutions with respect to proposed acquisitions. The Company cannot assure that it will be able to identify and attractive acquisition candidates or make acquisitions on favorable terms. In addition, the Company cannot assure that it will be able to successfully integrate acquired institutions in a timely and efficient manner, that it will be successful in retaining existing customer relationships or that it will be successful in achieving anticipated operating efficiencies. The Company's Expanding Branch Network May Affect Financial Performance. Since 1998, the Company has expanded its branch network by both acquiring financial institutions and establishing de novo branches. At December 31, 2001, the Company had 37 branches, compared with 118 at December 31, 2005. In addition, during 2006, the Company expects to open up to six new branches. There can be no assurance that the Company's ongoing branch expansion strategy will be accretive to earnings, or that it will be accretive to earnings within a reasonable period of time. Numerous factors contribute to the performance of a new branch, such as a suitable location, qualified personnel and an effective marketing strategy. Additionally, it takes time for a new branch to gather sufficient loans and deposits to generate enough income to offset its expenses, some of which, like salaries and occupancy expense, are relatively fixed costs. Strong Competition May Limit Growth and Profitability. Competition in the banking and financial services industry is intense. The Company competes with commercial banks, savings institutions, mortgage brokerage firms, credit unions, finance companies, mutual funds, insurance companies, and brokerage and investment banking firms operating locally and elsewhere. Many of these competitors (whether regional or national institutions) have substantially greater resources and lending limits than the Company and may offer certain services that the Company does not or cannot provide. The Company's profitability depends upon its ability to successfully compete in its market area. The Company Operates in a Highly Regulated Environment and May Be Adversely Affected by Changes in Laws and Regulations. The Company is subject to extensive regulation, supervision and examination by the OTS and the FDIC. Such regulators govern the activities in which the Company may engage, primarily for the protection of depositors. These regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the imposition of restrictions on the operation of a bank, the classification of assets by a bank and the adequacy of a bank's allowance for loan losses. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, or legislation, could have a material impact on the Company and its operations. The Company believes that it is in substantial compliance with applicable federal, state and local laws, rules and regulations. Because the Company's business is highly regulated, the laws, rules and applicable regulations are subject to regular modification and change. There can be no assurance that proposed laws, rules and regulations, or any other laws rule or regulation, will not be adopted in the future, which could make compliance more difficult or expensive or otherwise adversely affect the Company's business, financial condition or prospects. 20 ITEM 1B. UNRESOLVED STAFF COMMENTS -------------------------------------------------------------------------------- Not applicable. ITEM 2. PROPERTIES -------------------------------------------------------------------------------- Both FNFG and First Niagara maintain their executive offices at an administrative center located at 6950 South Transit Road, Lockport, New York. The administrative center, built in 1997, has 76 thousand square feet of space and is owned by First Niagara. As of December 31, 2005, First Niagara conducted its business through 118 full-service branches, a loan production office, 158 ATMs and several financial services subsidiaries. Of the 118 branches, 17 are located in Albany County, 16 in Erie County, 10 in Rensselaer County, 8 in Saratoga County, 7 each in Columbia and Monroe Counties, 6 each in Niagara and Schenectady Counties, 5 each in Cayuga, Greene, Oneida and Montgomery Counties, 3 each in Cortland, Ontario and Tompkins Counties, 2 each in Orleans, Fulton and Warren Counties and 1 each in Dutchess, Genesee, Onondaga, Schoharie, Seneca and Washington Counties. Additionally, 56 of the branches are owned and 62 are leased. The loan production office is leased and located in Monroe County. In addition to its branch network, First Niagara leases 13 offices and owns 7 buildings that it utilizes for its financial services subsidiaries, back office operations, training, tenant rental and storage. The total square footage for these facilities is approximately 252 thousand square feet, and are located in Albany, Cayuga, Clinton, Erie, Monroe, Niagara, Onondaga, and Tompkins Counties. At December 31, 2005, the Company's premises and equipment had a net book value of $92.1 million. See note 5 of the "Notes to Consolidated Financial Statements" filed herewith in Part II, Item 8, "Financial Statements and Supplementary Data" for further detail on the Company's premises and equipment. All of these properties are generally in good condition and are appropriate for their intended use. The Company has announced the leasing of 60,000 square feet of office space in downtown Buffalo, beginning in July 2006, to establish a Western New York "Market Center" that will house approximately 200 employees of its commercial lending, insurance, trust and related groups. This lease is expected to incrementally add approximately $474 thousand to annual rent expense. ITEM 3. LEGAL PROCEEDINGS -------------------------------------------------------------------------------- The Company is not involved in any legal proceedings other than proceedings occurring in the ordinary course of business. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS -------------------------------------------------------------------------------- No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 2005. 21 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES -------------------------------------------------------------------------------- The common stock of FNFG is traded under the symbol of FNFG on the NASDAQ National Market. During 2005, the high and low sales price of the common stock was $15.16 and $12.05, respectively. FNFG paid dividends of $0.38 per common share during the year ended December 31, 2005. See additional information regarding the market price and dividends paid filed herewith in Part II, Item 6, "Selected Financial Data." The Company does not have any equity compensation plan that was not approved by stockholders, other than its employee stock ownership plan. Set forth below is certain information as of December 31, 2005 regarding equity compensation to directors and employees of the Company that has been approved by stockholders.
Number of securities to be Number of securities Equity compensation plans approved by issued upon exercise of Weighted average remaining available for stockholders outstanding options and rights exercise price issuance under the plan ---------------------------------------- ------------------------------ ---------------- ----------------------- First Niagara Financial Group, Inc. 1999 Stock Option Plan................ 1,696,920 $4.71 10,868 First Niagara Financial Group, Inc. 1999 Recognition and Retention Plan... 368,599(1) Not Applicable 13,789 First Niagara Financial Group, Inc. Amended and Restated 2002 Long-term Incentive Stock Benefit Plan.......... 2,711,903 $13.13 5,212,613 ----------------- ----------------- Total............................ 4,777,422 5,237,270 ================= =================
(1) Represents shares that have been granted but have not yet vested. FNFG's ability to pay dividends to its stockholders is substantially dependent upon the ability of First Niagara to pay dividends to FNFG. The payment of dividends by First Niagara is subject to continued compliance with minimum regulatory capital requirements. The OTS may disapprove a dividend if: First Niagara would be undercapitalized following the distribution; the proposed capital distribution raises safety and soundness concerns; or the capital distribution would violate a prohibition contained in any statute, regulation or agreement. Management does not believe these regulatory requirements will affect First Niagara's ability to pay dividends in the future given its well capitalized position. The following table discloses information regarding the purchases of FNFG stock made by the Company during the fourth quarter of 2005:
Total number of shares purchased as Maximum number part of publicly of shares yet Total number of Average price paid announced repurchase to be purchased Date shares purchased per share plans (1) sunder the plans ------------------ ---------------- ------------------ -------------------- ---------------- October 636,500 $14.29 2,298,739 3,501,261 November 325,000 $14.73 2,623,739 3,176,261 December 205,000 $14.84 2,828,739 2,971,261 ---------------- =================== ================ Fourth quarter 2005 1,166,500 $14.51 ================ ==================
(1) On May 18, 2005, the Company announced that its Board of Directors had approved a 5,800,000 share repurchase program. As of December 31, 2005, the average cost of the 2,828,739 shares repurchased under the current program was $14.18 per share. The extent to which shares are repurchased depend on a number of factors including market trends and prices, economic conditions, and alternative uses for capital. 22 ITEM 6. SELECTED FINANCIAL DATA --------------------------------------------------------------------------------
At or for the year ended December 31, ------------------------------------------------------------------ 2005 2004 2003 2002 2001 ---------- ---------- ---------- ---------- ---------- (Dollar and share amounts in thousands, except per share amounts) Selected financial condition data: Total assets .......................... $8,064,832 $5,078,374 $3,589,507 $2,934,795 $2,857,946 Loans and leases, net ................. 5,216,299 3,215,255 2,269,203 1,974,560 1,853,141 Securities available for sale: Mortgage-backed ..................... 867,037 618,156 499,611 340,319 339,881 Other ............................... 737,851 551,973 346,272 292,045 354,016 Deposits .............................. 5,479,412 3,337,682 2,355,216 2,205,421 1,990,830 Borrowings ............................ 1,096,427 750,686 457,966 397,135 559,040 Stockholders' equity .................. $1,374,423 $ 928,162 $ 728,174 $ 283,696 $ 260,617 Common shares outstanding(1) .......... 108,656 78,277 66,326 64,681 64,158 Selected operations data: Interest income ....................... $ 375,217 $ 224,578 $ 169,959 $ 167,637 $ 178,368 Interest expense ...................... 125,067 68,476 62,544 76,107 99,352 ---------- ---------- ---------- ---------- ---------- Net interest income ................. 250,150 156,102 107,415 91,530 79,016 Provision for credit losses ........... 7,348 8,442 7,929 6,824 4,160 ---------- ---------- ---------- ---------- ---------- Net interest income after provision for credit losses ................ 242,802 147,660 99,486 84,706 74,856 Noninterest income .................... 90,663 51,866 43,379 41,787 34,625 Noninterest expense ................... 188,206 120,850 88,277 77,331 71,147 ---------- ---------- ---------- ---------- ---------- Income from continuing operations before income taxes .............. 145,259 78,676 54,588 49,162 38,334 Income taxes from continuing operations 52,400 26,859 18,646 18,752 12,427 ---------- ---------- ---------- ---------- ---------- Income from continuing operations ... 92,859 51,817 35,942 30,410 25,907 Income from discontinued operations, net of tax(2) ........... -- -- 164 385 55 ---------- ---------- ---------- ---------- ---------- Net income(3) ....................... $ 92,859 $ 51,817 $ 36,106 $ 30,795 $ 25,962 ========== ========== ========== ========== ========== Stock and related per share data(1): Earnings per common share(3): Basic .............................. $ 0.85 $ 0.66 $ 0.55 $ 0.48 $ 0.41 Diluted ............................ 0.84 0.65 0.53 0.47 0.40 Cash dividends ....................... 0.38 0.30 0.22 0.17 0.14 Book value ........................... 12.65 11.86 10.98 4.39 4.06 Market Price (NASDAQ: FNFG): High ............................... 15.16 15.78 16.55 12.41 6.92 Low ................................ 12.05 11.49 10.11 6.07 4.16 Close .............................. $ 14.47 $ 13.95 $ 14.97 $ 10.10 $ 6.51
23
At or for the year ended December 31, ---------------------------------------------------------------------- 2005 2004 2003 2002 2001 ---------- ---------- ---------- ---------- ---------- (Dollars in thousands) Selected financial ratios and other data: Performance ratios(4): Return on average assets(3) ................. 1.18% 1.05% 1.02% 1.08% 0.97% Return on average equity(3) ................. 6.76 5.59 5.19 11.22 10.16 Return on average tangible equity(3)(5) ..... 14.41 8.75 6.15 15.90 15.09 Net interest rate spread .................... 3.40 3.32 2.89 3.30 2.99 Net interest rate margin .................... 3.70 3.60 3.33 3.52 3.25 Efficiency ratio(3) ......................... 55.22 58.11 58.54 58.01 62.61 Dividend payout ratio ....................... 44.71% 45.45% 40.00% 35.42% 41.86% Capital Ratios(6): Total risk-based capital .................... 12.26% 17.65% 19.04% 11.34% 11.36% Tier 1 risk-based capital ................... 11.01 16.40 17.94 10.27 10.27 Tier 1 (core) capital ....................... 7.56 11.40 11.92 6.54 6.71 Tangible capital ............................ 7.56 11.40 11.87 6.54 N/A Ratio of stockholders' equity to total assets 17.04% 18.28% 20.29% 9.67% 9.12% Asset quality ratios: Total non-accruing loans .................... $ 21,930 $ 12,028 $ 12,305 $ 7,478 $ 11,480 Other non-performing assets ................. 843 740 543 1,423 665 Allowance for credit losses ................. 72,340 41,422 25,420 20,873 18,727 Net loan charge-offs ........................ $ 7,114 $ 7,090 $ 5,383 $ 4,678 $ 3,179 Total non-accruing loans to total loans ..... 0.41% 0.37% 0.54% 0.37% 0.61% Total non-performing assets to total assets . 0.28 0.25 0.36 0.30 0.42 Allowance for credit losses to non-accruing loans ..................................... 329.87 344.38 206.58 279.13 163.13 Allowance for credit losses to total loans .. 1.37 1.27 1.11 1.05 1.00 Net charge-offs to average loans ............ 0.14% 0.23% 0.24% 0.24% 0.17% Other data: Number of branches .......................... 118 71 47 38 37 Full time equivalent employees .............. 1,984 1,200 944 945 919
24
2005 2004 ---------------------------------------- ---------------------------------------- Fourth Third Second First Fourth Third Second First quarter quarter quarter quarter quarter quarter quarter quarter ------- ------- ------- ------- ------- ------- ------- ------- Selected Quarterly Data: (In thousands except per share amounts) Interest income .................. $98,475 $96,297 $93,930 $86,515 $58,954 $56,818 $55,750 $53,056 Interest expense ................. 35,613 32,801 30,368 26,285 18,028 17,180 16,815 16,453 ------- ------- ------- ------- ------- ------- ------- ------- Net interest income ......... 62,862 63,496 63,562 60,230 40,926 39,638 38,935 36,603 Provision for credit losses ...... 2,500 1,647 900 2,301 1,846 1,742 3,104 1,750 ------- ------- ------- ------- ------- ------- ------- ------- Net interest income after provision for credit losses 60,362 61,849 62,662 57,929 39,080 37,896 35,831 34,853 Noninterest income ............... 26,211 25,640 20,401 18,411 13,521 13,107 13,387 11,851 Noninterest expense .............. 50,384 47,808 46,161 43,853 32,044 30,378 29,849 28,579 ------- ------- ------- ------- ------- ------- ------- ------- Income before income taxes ... 36,189 39,681 36,902 32,487 20,557 20,625 19,369 18,125 Income taxes ..................... 12,689 15,508 12,811 11,392 6,998 7,295 6,356 6,210 ------- ------- ------- ------- ------- ------- ------- ------- Net Income ....................... $23,500 $24,173 $24,091 $21,095 $13,559 $13,330 $13,013 $11,915 ======= ======= ======= ======= ======= ======= ======= ======= Earnings per share: Basic ....................... $ 0.22 $ 0.22 $ 0.22 $ 0.19 $ 0.17 $ 0.17 $ 0.16 $ 0.15 Diluted ..................... 0.21 0.22 0.22 0.19 0.17 0.17 0.16 0.15 Market price (NASDAQ:FNFG): High ........................ 15.15 15.16 14.65 14.16 14.85 14.00 14.13 15.78 Low ......................... 13.35 13.78 12.05 12.80 13.18 11.84 11.49 13.32 Close ....................... 14.47 14.44 14.58 13.21 13.95 13.38 12.00 13.64 Cash Dividends ................... $ 0.10 $ 0.10 $ 0.09 $ 0.09 $ 0.08 $ 0.08 $ 0.07 $ 0.07
---------- (1) All per share data and references to the number of shares outstanding for purposes of calculating per share amounts prior to January 17, 2003 are adjusted to give recognition to the 2.58681 exchange ratio applied in the Conversion. (2) Effective February 18, 2003, First Niagara sold NOVA Healthcare Administrators, Inc. its wholly- owned third-party benefit plan administrator subsidiary. For the periods presented, the Company has reported the results of operations from NOVA as "Discontinued Operations." 2003 amounts include the net gain realized on the sale of $208 thousand. (3) With the adoption of SFAS No. 142 "Goodwill and Other Intangibles" on January 1, 2002, the Company is no longer required to amortize goodwill. Goodwill amortization of $4.7 million has been excluded from 2001 amounts for consistency purposes. The 2001 efficiency ratio excludes $4.6 million of goodwill amortization from continuing operations. Without excluding this amount the 2001 efficiency ratio would have been 66.78%. (4) Computed using daily averages. (5) Excludes average goodwill and other intangibles of $729.8 million, $335.8 million, $109.2 million, $80.9 million and $83.6 million for 2005, 2004, 2003, 2002 and 2001, respectively. (6) Effective November 8, 2002, First Niagara converted to a federal charter subject to OTS capital requirements. These capital requirements apply only to First Niagara and do not consider additional capital retained by FNFG. Prior to converting to federal charters, FNFG and First Niagara were required to maintain minimum capital ratios calculated in a similar manner to, but not entirely the same as, the framework of the OTS. Amounts prior to 2002 have not been recomputed to reflect OTS requirements. 25 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION -------------------------------------------------------------------------------- GENERAL The following is an analysis of the financial condition and results of operations of First Niagara Financial Group, Inc. This item should be read in conjunction with the consolidated financial statements and related notes filed herewith in Part II, Item 8, "Financial Statements and Supplementary Data" and the description of First Niagara Financial Group, Inc.'s business filed here within Part I, Item I, "Business." OVERVIEW First Niagara Financial Group, Inc. ("FNFG") holds all of the capital stock of First Niagara Bank ("First Niagara"), a federally chartered savings bank subject to Office of Thrift Supervision ("OTS") regulation. FNFG and First Niagara are hereinafter referred to collectively as "the Company." The Company is positioned as one of the leading community banks in Upstate New York with $8.1 billion of assets, $5.5 billion of deposits and 118 branch locations as of December 31, 2005. FNFG was organized in April 1998 in connection with the conversion of First Niagara from a mutual savings bank to a stock savings bank. Since that time the Company has strategically deployed capital through its "Buy and Build" strategy, which included the acquisition of six banks and eleven financial services companies. As a result, First Niagara is now a multi market community banking and financial services company that provides its customers with a full range of products and services delivered through four customer focused business units: consumer; commercial; business services; and wealth management. This includes residential and commercial real estate loans, commercial business loans and leases, home equity and other consumer loans, as well as various consumer and commercial deposit products. Additionally, the Company offers risk management (insurance) and wealth management products and services. The "Build" portion of the Company's strategy includes steady organic growth, including the opening of sixteen de novo locations since its initial public offering. These branches were primarily centered around the Western end of New York State where acquisition opportunities have been more limited. The Company has recently committed to an even more aggressive de novo strategy to continue to expand its service area in that region and fill coverage gaps. Since its initial public offering the Company has also significantly expanded its commercial loan operations, which includes a full product suite of cash management and merchant banking services. The Company's objective is to redirect its lending focus so that its loan portfolio will become more like that of a commercial bank. This strategy has also been effective in reducing interest rate sensitivity and is a source of non-interest bearing deposits. In 2004, the Company launched a strategic initiative to better leverage the businesses acquired, position the Company for future growth and improve overall performance. The outcome was a three to five year strategic plan that focuses on deepening relationships with both commercial and retail customers and providing superior customer service that will lead to improved performance and profitability. During 2005 the Company made significant enhancements to its infrastructure in order to support this relationship based strategy. The Company entered the higher growth Capital Region of New York State through its acquisitions of Hudson River Bancorp, Inc. ("HRB") on January 14, 2005 and Troy Financial Corporation ("TFC") on January 16, 2004. HRB was the holding company of the former Hudson River Bank & Trust Company, which had total assets of approximately $2.8 billion, deposits of $1.8 billion and fifty branch locations. The acquisition resulted in the issuance of 35.7 million shares of FNFG stock and cash payments totaling $126.8 million. The results of operations of HRB were included in the 2005 consolidated statement of income from the date of acquisition. TFC was the holding company of the former Troy Savings Bank and Troy Commercial Bank, and through those subsidiaries operated twenty-one branch locations with $1.4 billion of assets and $923.7 million of deposits. The acquisition resulted in the issuance of 13.3 million shares of FNFG stock and cash payments totaling $151.9 million. The results of operations of TFC were included in the consolidated statements of income from the date of acquisition. 26 The following table summarizes the estimated fair values of the assets acquired and liabilities assumed in the HRB and TFC acquisitions as of the effective date of the acquisitions (in thousands): Hudson River Troy Financial January 14, 2005 January 16, 2004 ---------------- ---------------- Assets Cash and securities available for sale $ 615,006 $ 345,059 Loans and leases Commercial: Real estate ................... 414,135 306,780 Business ...................... 104,525 178,607 ----------- ----------- Total commercial loans ... 518,660 485,387 Residential real estate ............ 984,215 226,066 Home equity ........................ 97,165 40,239 Other consumer ..................... 18,720 8,357 Specialized lending ................ 74,849 -- ----------- ----------- Total loans and leases ...... 1,693,609 760,049 Allowance for credit losses ....... (30,684) (14,650) ----------- ----------- Total loans and leases, net . 1,662,925 745,399 Goodwill .............................. 352,528 217,389 Other intangibles ..................... 35,817 17,247 Other assets .......................... 117,129 97,440 ----------- ----------- Total assets ................. $ 2,783,405 $ 1,422,534 =========== =========== Liabilities Deposits: Core: Savings .......................... $ 602,610 $ 273,579 Interest-bearing checking ........ 371,214 331,029 Noninterest-bearing .............. 234,927 86,765 ----------- ----------- Total core deposits ......... 1,208,751 691,373 Certificates ....................... 570,207 232,292 ----------- ----------- Total deposits .............. 1,778,958 923,665 Borrowings ............................ 371,556 124,723 Other liabilities ..................... 17,080 17,597 ----------- ----------- Total liabilities ........... 2,167,594 1,065,985 ----------- ----------- Net assets acquired $ 615,811 $ 356,549 =========== =========== Financial Overview Total assets increased to $8.1 billion at December 31, 2005 from $5.1 billion at December 31, 2004. While the impact of the HRB acquisition was significant, balance sheet growth also reflects a $327.5 million, or 7%, organic increase in loans. That includes a 10% increase in commercial real-estate and business loans as well as a 17% increase in home equity loans. This loan growth was funded by a $362.8 million, or 7%, organic increase in deposits. Profitable loan and core deposit growth continued to be a challenge during 2005 given the interest rate environment and competitive market conditions. That combination of factors resulted in a significant change in the Company's deposit mix as consumer preferences shifted towards higher rate money market and certificate accounts. Net income for the year ended December 31, 2005 increased to $92.9 million, or $0.84 per diluted share from $51.8 million, or $0.65 per diluted share for 2004. While the 2005 results include a 10 basis point improvement in net interest rate margin as a result of the net earning assets acquired from HRB, the flat yield curve and change in deposit mix resulted in a decline in margin throughout the year. The effects of this margin pressure on net interest income have been lessened through continuing loan and deposit growth, as well as effective asset-liability management. As a result of a favorable credit environment in 2005, the provision for credit losses was reduced to $7.3 million versus $8.4 million for 2004. Increases in both noninterest income and expense reflect the impact of the acquisition of HRB and four financial services companies, continued expansion of existing operations, the addition of three new branches and initial implementation of the Company's strategic plan. Net income for the year ended December 31, 2004 increased 44% from $36.1 million, or $0.53 per diluted share for 2003. These results reflect the benefits of the acquisition of TFC, as well as increased commercial lending and deposit growth, which contributed to the 45% increase in net interest income and a 27 basis point improvement in the net interest margin. Similar to 2005 results, increases in both noninterest income and expense during 2004 reflect the impact of whole bank and financial services acquisitions as well as expansion of existing operations. 27 CRITICAL ACCOUNTING ESTIMATES Management of the Company evaluates those accounting estimates that are judged to be critical - those most important to the presentation of the Company's financial condition and results of operations, and that require management's most subjective and complex judgements. Accordingly, the accounting estimates relating to the adequacy of the allowance for credit losses and the analysis of the carrying value of goodwill for impairment are deemed to be critical, as the judgments could have a material effect on the results of operations of the Company. A detailed description of the Company's methodology for calculating the allowance for credit losses and assumptions made is included within the "Lending Activities" section filed herewith in Part I, Item 1, "Business." Although goodwill is not subject to amortization, the carrying value must be tested for impairment at least annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. Impairment testing requires that the fair value of each reporting unit be compared to the carrying amount of its net assets, including goodwill. Reporting units were identified based upon an analysis of each of the Company's individual operating segments. A reporting unit is defined as any distinct, separately identifiable component of an operating segment for which complete, discrete financial information is available that management regularly reviews. Goodwill was allocated to each reporting unit based on its relative fair value at the time of the related acquisition. Determining the fair value of a reporting unit requires a high degree of subjective management judgment. Discounted cash flow valuation models are utilized that incorporate such variables as revenue growth rates, expense trends, interest rates and terminal values. Based upon an evaluation of key data and market factors, management selects the specific variables to be incorporated into the valuation model. Future changes in the economic environment or operations of reporting units could cause changes to these variables, which could result in impairment being identified. During 2005, the Company did not identify any individual reporting unit where fair value was less than carrying value, including goodwill. ANALYSIS OF FINANCIAL CONDITION Lending Activities Loan Portfolio Composition. Set forth below is selected information concerning the composition of the Company's loan and lease portfolios in dollar amounts and in percentages as of the dates indicated:
At December 31, ----------------------------------------------------------------------- 2005 2004 2003 --------------------- --------------------- --------------------- Amount Percent Amount Percent Amount Percent ---------- ------- ---------- ------- ---------- ------- (Dollars in thousands) Commercial: Real estate ................. $1,647,576 31.27% $1,081,709 33.31% $ 653,976 28.61% Construction ................ 222,907 4.23 187,149 5.76 86,154 3.77 Business .................... 473,571 8.99 345,520 10.64 136,869 5.99 ---------- ------ ---------- ------ ---------- ------ Total commercial .......... 2,344,054 44.49 1,614,378 49.71 876,999 38.37 Residential real estate ........ 2,182,907 41.43 1,132,471 34.87 948,877 41.51 Home equity .................... 403,340 7.66 247,190 7.61 179,282 7.84 Other consumer ................. 178,732 3.39 174,309 5.37 202,630 8.86 Specialized lending ............ 159,759 3.03 79,358 2.44 78,131 3.42 ---------- ------ ---------- ------ ---------- ------ Total loans and leases ...... 5,268,792 100.00% 3,247,706 100.00% 2,285,919 100.00% ---------- ====== ---------- ====== ---------- ====== Net deferred costs and unearned discounts.................... 19,847 8,971 8,704 Allowance for credit losses..... (72,340) (41,422) (25,420) ---------- ---------- ---------- Total loans and leases, net.. $5,216,299 $3,215,255 $2,269,203 ========== ========== ========== At December 31, ---------------------------------------------- 2002 2001 --------------------- --------------------- Amount Percent Amount Percent ---------- ------- ---------- ------- (Dollars in thousands) Commercial: Real estate ................. $ 473,493 23.80% $ 392,896 21.06% Construction ................ 101,633 5.11 56,394 3.02 Business .................... 137,091 6.89 117,209 6.28 ---------- ------ ---------- ------ Total commercial .......... 712,217 35.80 566,499 30.36 Residential real estate ........ 929,524 46.73 983,947 52.75 Home equity .................... 136,986 6.89 114,443 6.14 Other consumer ................. 169,155 8.50 182,126 9.76 Specialized lending ............ 41,464 2.08 18,412 0.99 ---------- ------ ---------- ------ Total loans and leases ...... 1,989,346 100.00% 1,865,427 100.00% ---------- ====== ---------- ====== Net deferred costs and unearned discounts.................... 6,087 6,441 Allowance for credit losses..... (20,873) (18,727) ---------- ---------- Total loans and leases, net.. $1,974,560 $1,853,141 ========== ==========
Total loans and leases outstanding increased $2.0 billion from December 31, 2004 to December 31, 2005, including $1.7 billion attributable to the acquisition of HRB, 58% of which were residential mortgage loans. Excluding the loans acquired with HRB, commercial real estate and business loans increased $211.0 million, or 10% This met the Company's growth target for the year despite competitive market conditions. At December 31, 2005, commercial loans comprised 44% of the loan portfolio. 28 Another highlight for 2005 was the 17% organic increase in home equity loans, which was a direct result of the Company's active marketing of this lower credit risk, relationship building product. Growth in the residential real estate portfolio was a challenge during the year given the interest rate environment, which has caused consumers to move away from the short-term, variable rate loan products the Company typically holds in portfolio. Nonetheless, organic residential real estate loan growth was 3% for the year. Allowance for Credit Losses. The following table sets forth the allocation of the allowance for credit losses by loan category as of the dates indicated:
At December 31, --------------------------------------------------------------------------------- 2005 2004 2003 ----------------------- ----------------------- ----------------------- Amount of Percent Amount of Percent Amount of Percent allowance of loans allowance of loans allowance of loans for credit to total for credit to total for credit to total losses loans losses loans losses loans ---------- -------- ---------- -------- ---------- -------- (Dollars in thousands) Commercial: Real estate ........ $26,751 36% $12,117 39% $ 7,137 32% Business ........... 15,644 9 10,010 11 5,168 6 ------- ------- ------- ------- ------- ------- Total commercial 42,395 45 22,127 50 12,305 38 Residential real estate 4,036 41 2,196 35 1,763 42 Home equity ........... 1,667 8 703 8 509 8 Other consumer ........ 5,299 3 3,254 5 3,781 9 Specialized lending ... 7,892 3 2,609 2 2,497 3 Unallocated ........... 11,051 -- 10,533 -- 4,565 -- ------- ------- ------- ------- ------- ------- Total ................ $72,340 100% $41,422 100% $25,420 100% ======= ======= ======= ======= ======= ======= At December 31, ---------------------------------------------------- 2002 2001 ----------------------- ----------------------- Amount of Percent Amount of Percent allowance of loans allowance of loans for credit to total for credit to total losses loans losses loans ------- ------- ------- ------- (Dollars in thousands) Commercial: Real estate ........ $ 4,917 29% $ 4,824 24% Business ........... 6,025 7 4,526 6 ------- ------- ------- ------- Total commercial 10,942 36 9,350 30 Residential real estate 1,828 47 1,996 53 Home equity ........... 524 7 614 6 Other consumer ........ 3,811 8 3,379 10 Specialized lending ... 1,304 2 357 1 Unallocated ........... 2,464 -- 3,031 -- ------- ------- ------- ------- Total ................ $20,873 100% $18,727 100% ======= ======= ======= =======
The allowance for credit losses increased to $72.3 million at December 31, 2005 from $41.4 million at December 31, 2004. That is primarily due to the addition of HRB's $30.7 million allowance. During 2005 the unallocated portion of the allowance for credit losses declined as a percentage of the total allowance. This decrease reflects the application of Statement of Position 03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer," to the loans acquired from HRB as well as the continuing enhancement and refinement of the Company's allowance allocation methodology. During 2005, the Company benefited from a favorable credit environment with annualized net loan charge-offs totaling 0.14% of average loans, compared to the 0.24% average experienced over the last three years. Non-performing assets amounted to 0.28% of total assets at December 31, 2005 and remained consistent with 2004 but still below historical levels. The allowance for credit losses to total loans ratio was 1.37% at the end of 2005 compared to 1.43% following the HRB acquisition in January. This decrease reflects the impact of portfolio growth and the favorable credit experience. The ratio of the allowance to non-accruing loans of 330% at December 31, 2005, compares to 344% at December 31, 2004. 29 While management uses currently available information to recognize losses on loans, future credit loss provisions will be necessary based on numerous factors, including changes in economic conditions. To the best of management's knowledge, the allowance for credit losses includes all losses at each reporting date that are both probable and reasonable to estimate. However, there can be no assurance that the allowance for credit losses will be adequate to cover all losses that may in fact be realized in the future or that a higher level of provision for credit losses will not be required. Non-Accruing Loans and Non-Performing Assets. The following table sets forth information regarding non-accruing loans and other non-performing assets as of the dates indicated:
At December 31, ------------------------------------------------------------------- 2005 2004 2003 2002 2001 ------- ------- ------- ------- ------- (Dollars in thousands) Non-accruing loans (1): Commercial: Real estate ................... $ 6,755 $ 3,416 $ 3,878 $ 1,225 $ 2,402 Business ...................... 3,171 1,564 1,964 400 1,309 ------- ------- ------- ------- ------- Total commercial ..... 9,926 4,980 5,842 1,625 3,711 Residential real estate .......... 5,911 4,276 3,905 4,071 4,833 Home equity ...................... 567 519 401 332 491 Other consumer ................... 953 801 538 652 510 Specialized lending .............. 4,573 1,452 1,619 798 1,935 ------- ------- ------- ------- ------- Total non-accruing loans ...... 21,930 12,028 12,305 7,478 11,480 Real estate owned .................. 843 740 543 1,423 665 ------- ------- ------- ------- ------- Total non-performing assets (2) $22,773 $12,768 $12,848 $ 8,901 $12,145 ======= ======= ======= ======= ======= Total non-performing assets as a percentage of total assets ....... 0.28% 0.25% 0.36% 0.30% 0.42% ======= ======= ======= ======= ======= Total non-accruing loans as a percentage of total loans ........ 0.41% 0.37% 0.54% 0.37% 0.61% ======= ======= ======= ======= =======
(1) Loans are placed on non-accrual status when they become 90 days past due or if they have been identified by the Company as presenting uncertainty with respect to the collectibility of interest or principal. Non-accruing loans do not include loans that were 90 days or more past due but still accruing interest of $510 thousand at December 31, 2001. There were no such loans at December 31, 2005, 2004, 2003 or 2002. (2) Non-performing assets do not include $3.1 million, $2.7 million and $259 thousand of performing renegotiated loans that are accruing interest at December 31, 2005, 2004 and 2003 respectively. There were no such loans at December 31, 2002, or 2001. Investing Activities Securities Portfolio. Investment securities available for sale decreased $170.2 million since the end of January 2005, just subsequent to the acquisition of HRB. This reflects the Company's decision to de-leverage the balance sheet given the flattening yield curve and narrow spreads between investment yields and rates paid on wholesale borrowings. However, the Company's investment portfolio remains well positioned to provide a stable source of cash flow with limited earnings volatility, as the weighted average life of securities available for sale at December 31, 2005 was 2.2 years. 30 At December 31, 2005, all of the Company's investment securities were classified as available for sale. The following table sets forth certain information with respect to the amortized cost and fair values of the Company's portfolio as of the dates indicated:
At December 31, -------------------------------------------------------------------------------- 2005 2004 2003 ------------------------ ------------------------ ------------------------ Amortized Fair Amortized Fair Amortized Fair cost value cost value cost value ---------- ---------- ---------- ---------- ---------- ---------- Investment securities: (Dollars in thousands) Debt securities: States and political ......... $ 392,298 $ 390,890 $ 277,599 $ 277,573 $ 36,766 $ 38,189 subdivisions U.S. Government Agencies ..... 258,206 254,274 249,045 246,483 287,604 287,058 Corporate .................... 39,051 39,483 21,424 21,420 13,708 13,610 ---------- ---------- ---------- ---------- ---------- ---------- Total debt securities ..... 689,555 684,647 548,068 545,476 338,078 338,857 Other ............................ 6,307 6,377 6,308 6,447 7,298 7,341 ---------- ---------- ---------- ---------- ---------- ---------- Total investment securities $ 695,862 $ 691,024 $ 554,376 $ 551,923 $ 345,376 $ 346,198 ========== ========== ========== ========== ========== ========== Average remaining life of debt securities(1)................ 1.16 years 1.54 years 2.53 years ========== ========== ========== Mortgage-backed securities: FNMA ......................... $ 229,534 $ 222,560 $ 190,406 $ 188,224 $ 207,480 $ 206,798 FHLMC ........................ 125,831 121,668 135,971 134,093 121,639 121,219 GNMA ......................... 5,812 5,890 5,951 6,187 9,959 10,304 CMOs ......................... 530,891 516,919 291,871 289,652 161,922 161,290 ---------- ---------- ---------- ---------- ---------- ---------- Total mortgage-backed securities ............ $ 892,068 $ 867,037 $ 624,199 $ 618,156 $ 501,000 $ 499,611 ========== ========== ========== ========== ========== ========== Average remaining life of mortgage-backed securities(1)... 3.09 years 3.59 years 3.65 years ========== ========== ========== Asset-backed securities(2) ....... $ 47,048 $ 46,827 $ 50 $ 50 $ 74 $ 74 ========== ========== ========== ========== ========== ========== Average remaining life of asset-backed securities(1)...... 2.07 years 1.50 years 0.83 years ========== ========== ========== Total securities available for sale .............. $1,634,978 $1,604,888 $1,178,625 $1,170,129 $ 846,450 $ 845,883 ========== ========== ========== ========== ========== ========== Average remaining life of investment securities available for sale(1) 2.23 years 2.63 years 3.20 years ========== ========== ==========
(1) Average remaining life does not include other investment securities and is computed utilizing estimated maturities and prepayment assumptions. (2) Asset-backed securities are backed by fixed-rate home equity loans. Funding Activities Deposits. Total deposits increased $2.1 billion from December 31, 2004 to December 31, 2005, including $1.8 billion acquired with HRB. During 2005, organic deposit growth was $362.8 million, or 7%, and was primarily driven by an increase in relationship money market and CD accounts. Deposit growth also benefited from expansion of the Company's municipal banking business and de novo branch expansion strategy, which contributed $123.8 million and $31.6 million of funds, respectively, during 2005. The Company continues to prioritize deposit gathering and retention efforts given its relationship based strategy and the importance of lower cost funding to support loan growth. 31 Set forth below is selected information concerning the composition of the Company's deposits:
At December 31, ---------------------------------------------------------------------------------------------------- 2005 2004 2003 -------------------------------- -------------------------------- -------------------------------- Weighted Weighted Weighted average average average Amount Percent rate Amount Percent rate Amount Percent rate ---------- ------- -------- ---------- ------- -------- ---------- ------- -------- (Dollars in thousands) Core deposits: Savings ................. $1,619,187 29.55% 1.31% $1,086,769 32.56% 1.02% $ 654,320 27.78% 0.78% Interest-bearing checking 1,182,995 21.59 1.46 912,598 27.34 1.06 538,967 22.88 0.80 Noninterest-bearing ..... 592,076 10.81 -- 291,491 8.74 -- 170,384 7.24 -- ---------- ------ ---------- ------ ---------- ------ Total core deposits ... 3,394,258 61.95 1.14 2,290,858 68.64 0.91 1,363,671 57.90 0.69 Certificates .............. 2,085,154 38.05 3.38 1,046,824 31.36 2.37 991,545 42.10 2.58 ---------- ------ ---------- ------ ---------- ------ Total deposits ........ $5,479,412 100.00% 1.99% $3,337,682 100.00% 1.37% $2,355,216 100.00% 1.49% ========== ====== ========== ====== ========== ======
Borrowings. The following table sets forth certain information as to the Company's borrowings for the years indicated:
At or for the year ended December 31, ---------------------------------------- 2005 2004 2003 ---------- ---------- ---------- (Dollars in thousands) Period-end balance: FHLB advances ............................ $ 520,760 $ 336,671 $ 214,501 Repurchase agreements .................... 575,667 400,930 243,465 Other borrowings ......................... -- 13,085 -- ---------- ---------- ---------- Total borrowings .................... $1,096,427 $ 750,686 $ 457,966 ========== ========== ========== Maximum balance: FHLB advances ............................ $ 704,995 $ 367,300 $ 256,820 Repurchase agreements .................... 627,271 400,930 243,465 Other borrowings ......................... 22,907 13,453 6,000 Average balance: FHLB advances ............................ $ 576,099 $ 321,398 $ 231,729 Repurchase agreements .................... 588,918 343,813 199,248 Other borrowings ......................... 11,693 12,573 322 Period-end weighted average interest rate: FHLB advances ............................ 5.00% 4.31% 5.37% Repurchase agreements .................... 3.80 3.83 4.58 Other borrowings ......................... -- 5.34 --
Borrowings at the end of 2005 were $1.10 billion compared to $1.26 billion following the HRB acquisition in January. This $158.1 million decrease reflects the Company's deleveraging strategy. As the flat yield curve does not create any leverage opportunity, the Company will continue to evaluate the benefits of further reducing its leverage position in 2006. Equity Activities Stockholders' equity increased to $1.4 billion at December 31, 2005 compared to $928.2 million at December 31, 2004. The HRB and Hatch Leonard Naples ("HLN") acquisitions included the issuance of a total of 36.2 million shares of common stock with an aggregate value of $490.5 million. During 2005, common stock dividends declared of $0.38 per share totaled $42.4 million, which represents a 27% increase over the prior year $0.30 per share and a 45% payout ratio. In 2005, the Company completed its 4.2 million share repurchase program announced in August 2004 and made additional buybacks under a 5.8 million share repurchase program announced in May 2005. In total, the Company repurchased 6.5 million of its shares at an average cost of $13.62 per share. While treasury stock repurchases are an important component of the Company's capital management strategy, the extent to which shares are repurchased in the future will depend on a number of factors including market trends and prices and alternative uses for capital. 32 RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2005 AND DECEMBER 31, 2004 Net Interest Income When compared to the prior year, the net interest rate margin improved 10 basis points during 2005 and reflects the benefits of the higher yielding net earning assets acquired from HRB as well as loan and noninterest bearing deposit growth. However, pressure on the Company's net interest rate margin was persistent throughout the year due to the flat yield curve, competitive loan pricing and shift in deposit mix. As a result, the average net interest rate margin declined 13 basis points from the first to the fourth quarter of 2005. The 67% increase in interest income during 2005 reflects the earnings assets acquired from HRB as well as home equity and commercial loan growth. Those initiatives, coupled with the benefit of a 200 basis point rise in short-term rates, were the primary drivers behind the 37 basis point increase in yield on the Company's interest-earning assets during 2005. The increase in interest expense was also primarily due to the rise in short-term rates as well as the shift in deposit mix towards higher rate certificate, money market and municipal accounts across an expanded deposit base, which included the accounts acquired from HRB. Average Balance Sheet. The following table sets forth certain information relating to the consolidated statements of condition and reflects the average yields earned on interest-earning assets, as well as the average rates paid on interest-bearing liabilities for the years indicated. All average balances are average daily balances:
For the year ended December 31, --------------------------------------------------------------------------------------- 2005 2004 ----------------------------------------- ----------------------------------------- Average Interest Average Interest outstanding earned/ outstanding earned/ balance paid Yield/rate balance paid Yield/rate ----------- ---------- ---------- ----------- ---------- ---------- (Dollars in thousands) Interest-earning assets: Loans(1) ........................... $4,992,673 $ 313,813 6.28% $3,094,203 $ 190,100 6.14% Mortgage-backed securities(2) ...... 948,750 38,131 4.02 613,888 22,598 3.68 Other investment securities(2) ..... 739,500 20,264 2.74 563,315 11,023 1.96 Money market and other investments . 76,724 3,009 3.92 61,259 857 1.39 ---------- ---------- ---- ---------- ---------- ---- Total interest-earning assets .... 6,757,647 $ 375,217 5.55% 4,332,665 $ 224,578 5.18% ---------- ---------- ---- ---------- ---------- ---- Allowance for credit losses ........... (73,230) (40,228) Noninterest-earning assets(3)(4) ...... 1,168,171 657,280 ---------- ---------- Total assets ..................... $7,852,588 $4,949,717 ========== ========== Interest-bearing liabilities: Savings deposits ................... $1,643,758 $ 17,987 1.09% $1,033,983 $ 9,768 0.94% Checking accounts .................. 1,174,366 13,476 1.15 889,372 8,258 0.93 Certificates of deposit ............ 1,831,418 50,670 2.77 1,081,034 23,924 2.21 Borrowings ......................... 1,176,710 42,934 3.65 677,784 26,526 3.91 ---------- ---------- ---- ---------- ---------- ---- Total interest-bearing liabilities 5,826,252 $ 125,067 2.15% 3,682,173 $ 68,476 1.86% ---------- ---------- ---- ---------- ---------- ---- Noninterest-bearing deposits .......... 547,599 275,227 Other noninterest-bearing liabilities . 104,323 64,560 ---------- ---------- Total liabilities ................ 6,478,174 4,021,960 Stockholders' equity(3) ............... 1,374,414 927,757 ---------- ---------- Total liabilities and stockholders' equity...... $7,852,588 $4,949,717 ========== ========== Net interest income.................... $ 250,150 $ 156,102 ========== ========== Net interest rate spread............... 3.40% 3.32% ==== ==== Net earning assets..................... $ 931,395 $ 650,492 ========== ========== Net interest rate margin............... 3.70% 3.60% ========== ========== Ratio of average interest-earning assets to average interest-bearing liabilities....................... 115.99% 117.67% ========== ========== For the year ended December 31, ----------------------------------------- 2003 ----------------------------------------- Average Interest outstanding earned/ balance paid Yield/rate ----------- ---------- ---------- (Dollars in thousands) Interest-earning assets: Loans(1) ........................... $2,245,055 $ 148,995 6.64% Mortgage-backed securities(2) ...... 425,253 10,397 2.44 Other investment securities(2) ..... 312,450 6,939 2.22 Money market and other investments . 243,450 3,628 1.49 ---------- ---------- ---- Total interest-earning assets .... 3,226,208 $ 169,959 5.27% ---------- ---------- ---- Allowance for credit losses ........... (24,328) Noninterest-earning assets(3)(4) ...... 329,817 ---------- Total assets ..................... $3,531,697 ========== Interest-bearing liabilities: Savings deposits ................... $ 670,785 $ 6,809 1.01% Checking accounts .................. 525,346 4,767 0.91 Certificates of deposit ............ 998,428 29,232 2.93 Borrowings ......................... 431,299 21,736 5.04 ---------- ---------- ---- Total interest-bearing liabilities 2,625,858 $ 62,544 2.38% ---------- ---------- ---- Noninterest-bearing deposits .......... 155,546 Other noninterest-bearing liabilities . 54,379 ---------- Total liabilities ................ 2,835,783 Stockholders' equity(3) ............... 695,914 ---------- Total liabilities and stockholders' equity...... $3,531,697 ========== Net interest income.................... $ 107,415 ========== Net interest rate spread............... 2.89% ==== Net earning assets..................... $ 600,350 ========== Net interest rate margin............... 3.33% ========== Ratio of average interest-earning assets to average interest-bearing liabilities....................... 122.86% ==========
(1) Net of deferred costs, unearned discounts and non-accruing loans. (2) Amounts shown are at amortized cost. Interest earned amounts have not been adjusted for tax benefits on municipal investment securities. (3) Includes unrealized gains/losses on securities available for sale. (4) Includes non-accruing loans and the cash surrender value of bank-owned life insurance, earnings from which are reflected in noninterest income. 33 Rate/Volume Analysis. The following table presents the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected the Company's net interest income during the years indicated. Information is provided in each category with respect to: (i) changes attributable to changes in volume (changes in volume multiplied by prior rate); (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume); and (iii) the net change. The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate:
For the year ended December 31, ----------------------------------------------------------------------------- 2005 vs. 2004 2004 vs. 2003 ----------------------------------- ------------------------------------- Increase/(decrease) Increase/(decrease) due to Total due to Total --------------------- increase ---------------------- increase Volume Rate (decrease) Volume Rate (decrease) -------- -------- ---------- -------- -------- ---------- (In thousands) Interest-earning assets: Loans ................................ $119,948 $ 3,765 $123,713 $ 52,854 $(11,749) $ 41,105 Mortgage-backed securities ........... 13,295 2,238 15,533 5,702 6,499 12,201 Other investment securities .......... 4,053 5,188 9,241 4,995 (911) 4,084 Money market and other investments ... 404 1,748 2,152 (1,923) (848) (2,771) -------- -------- -------- -------- -------- -------- Total interest-earning assets .... $137,700 $ 12,939 $150,639 $ 61,628 $ (7,009) $ 54,619 ======== ======== ======== ======== ======== ======== Interest-bearing liabilities: Savings deposits ..................... $ 6,479 $ 1,740 $ 8,219 $ 3,461 $ (502) $ 2,959 Checking accounts .................... 2,823 2,395 5,218 3,378 113 3,491 Certificates of deposit .............. 19,778 6,968 26,746 2,269 (7,577) (5,308) Borrowings ........................... 18,102 (1,694) 16,408 10,427 (5,637) 4,790 -------- -------- -------- -------- -------- -------- Total interest-bearing liabilities $ 47,182 $ 9,409 $ 56,591 $ 19,535 $(13,603) $ 5,932 ======== ======== ======== ======== ======== ======== Net interest income.............. $ 94,048 $ 48,687 ======== ========
Provision for Credit Losses During 2005, the Company benefited from a favorable credit environment and strong asset quality. As a result, the provision for credit losses was $7.3 million, or 0.15% of average loans, compared to $8.4 million or 0.27% for 2004. During the second half of 2005, the Company did increase provision levels compared to the first two quarters, as net charge-offs and non-performing loans began to move towards more normalized levels. The provision is based upon management's assessment of the adequacy of the allowance for credit losses with consideration given to such interrelated factors as the composition and risk in the loan portfolio, the level of non-accruing and delinquent loans and related collateral or government guarantees, charge-offs and economic conditions. The Company establishes provisions for credit losses, which are charged to operations, in order to maintain the allowance for credit losses at a level to absorb credit losses in the existing loan portfolio. 34 The following table sets forth the analysis of the allowance for credit losses, including charge-off and recovery data, for the years indicated:
For the year ended December 31, ------------------------------------------------------- 2005 2004 2003 2002 2001 ------- ------- ------- ------- ------- (Dollars in thousands) Balance at beginning of year ............ $41,422 $25,420 $20,873 $18,727 $17,746 Charge-offs: Commercial: Real estate ........................ 1,285 669 416 390 901 Business ........................... 2,402 1,504 2,072 1,449 847 ------- ------- ------- ------- ------- Total commercial ............... 3,687 2,173 2,488 1,839 1,748 Residential real estate ............... 192 49 518 370 382 Home equity ........................... 34 -- -- -- 158 Other consumer ........................ 3,926 4,272 2,547 2,572 1,571 Specialized lending ................... 2,785 1,732 1,207 1,023 212 ------- ------- ------- ------- ------- Total ............................ 10,624 8,226 6,760 5,804 4,071 ------- ------- ------- ------- ------- Recoveries: Commercial: Real estate ........................ 864 86 154 270 268 Business ........................... 1,283 231 333 163 89 ------- ------- ------- ------- ------- Total commercial ............... 2,147 317 487 433 357 Residential real estate ............... 61 83 74 107 30 Home equity ........................... -- -- -- -- -- Other consumer ........................ 777 638 621 536 425 Specialized lending ................... 525 98 195 50 80 ------- ------- ------- ------- ------- Total ............................ 3,510 1,136 1,377 1,126 892 ------- ------- ------- ------- ------- Net charge-offs ......................... 7,114 7,090 5,383 4,678 3,179 Provision for credit losses ............. 7,348 8,442 7,929 6,824 4,160 Allowance obtained through acquisitions . 30,684 14,650 2,001 -- -- ------- ------- ------- ------- ------- Balance at end of year .................. $72,340 $41,422 $25,420 $20,873 $18,727 ======= ======= ======= ======= ======= Ratio of net charge-offs to average loans outstanding .................... 0.14% 0.23% 0.24% 0.24% 0.17% ======= ======= ======= ======= ======= Ratio of allowance for credit losses to total loans ....................... 1.37% 1.27% 1.11% 1.05% 1.00% ======= ======= ======= ======= ======= Ratio of allowance for credit losses to non-accruing loans ................ 329.87% 344.38% 206.58% 279.13% 163.13% ======= ======= ======= ======= =======
Noninterest Income For 2005, noninterest income totaled $90.7 million compared to $51.9 million for 2004. This increase reflects the benefit of the HRB acquisition as well as the purchase of four financial services companies during the year. Most notably were the acquisitions of HLN and The Burke Group during the third quarter of 2005 which added $10.0 million to risk management revenue from the dates of acquisition. Banking services revenue increased $17.5 million from 2004 to 2005, reflecting the growth in the Company's customer base as well as implementation of its relationship based sales strategy. While wealth management revenues for the year increased 18% over 2004, revenue from that business unit was flat throughout 2005 as the benefits of the added customer base in Eastern New York were mitigated by lower annuity sales due to the unfavorable interest rate environment for these products. Noninterest income also included a $1.4 million pre-tax gain from the sale of a real-estate joint partnership during the third quarter of the year. For 2005, noninterest income represented 27% of total net revenues versus 25% for the prior year. However, this percentage was almost 30% for the fourth quarter of 2005, reflecting the benefits of the financial services acquisitions in the second half of the year. 35 Noninterest Expenses Noninterest expenses for 2005 increased $67.4 million over 2004. This was mainly the result of operating costs associated with the former HRB operations, as well as ongoing expenses from the four financial services companies acquired, three de novo locations opened and initial implementation of the Company's strategic plan. Non-recurring marketing, training and other expenses associated with the HRB acquisition totaled $2.5 million, primarily incurred during the first quarter of 2005, which is comparable to the $2.2 million incurred during 2004 related to the TFC and HRB transactions. Even with these increases, as well as the higher level of revenue from lower margin financial services businesses, the Company's efficiency ratio improved to 55% for 2005 compared to 58% for 2004. This improvement is a direct result of the Company's focus on expense management as well as synergies attained with the HRB transaction. Income Taxes The effective tax rate of 36.1% for 2005 included a $1.3 million tax charge relating to the surrender of $40 million of bank owned life insurance obtained in the TFC and HRB acquisitions. Excluding this charge, the effective tax rate was 35.1% compared to 34.1% for 2004 as the assets acquired from HRB generated less tax advantaged income. Additionally, the results for 2004 include nonrecurring tax-exempt payments from bank owned life insurance proceeds. The 2006 New York State budget bill proposed by the Governor currently contains a provision that would reduce the statutory tax rate on the taxable income base from 7.5% to 6.75%, phased in over a multi-year period, and would disallow the exclusion of dividends paid by a real estate investment trust subsidiary ("REIT"). The bill, if enacted as proposed, would be effective beginning in 2006, and the Company would lose the tax benefit associated with its REIT. Without the REIT dividend exclusion, the Company's 2005 effective tax rate would have been approximately 38.2%. RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2004 AND DECEMBER 31, 2003 Net Interest Income Net interest income increased to $156.1 million and the net interest rate margin improved to 3.60% from 3.33% when comparing 2004 to 2003. Contributing to these increases was a 43 basis point improvement in the net interest rate spread due to the Company's active asset and liability management initiatives and lower mortgage-backed security premium amortization. Additionally, net interest income benefited from a $50.1 million increase in average net earning assets from 2003 to 2004 primarily due to a $32.9 million organic increase in average noninterest-bearing deposits and the acquisition of TFC. The 32% increase in interest income in 2004 compared to 2003 reflects the impact of a $1.1 billion increase in average interest earning assets due primarily to the acquisition of TFC, and increased commercial real estate and business loans. The benefits of those increases were partially offset by a 9 basis point decrease in the yield on those assets when compared to 2003, which was attributable to the generally lower interest rate environment. This was partially mitigated by the shift in the Company's loan portfolio mix to higher yielding commercial real estate and business loans, as well as the rise in short-term rates during the second half of the year which caused the yield on the Company's variable-rate assets and short-term investment securities portfolio to increase. Additionally, the Company's yield on interest earning assets benefited from lower mortgage-backed security premium amortization, which amounted to $1.8 million for 2004 compared to $8.2 million for 2003. The increase in interest expense during 2004 resulted from a $1.1 billion increase in average interest bearing liabilities, due to the deposits and borrowings assumed in the TFC acquisition and core deposit growth. However, a 72 basis point reduction in the rate paid on certificates of deposits resulted from the Company's strategy to replace higher-rate time accounts with lower cost core deposits and borrowings. Additionally, the Company benefited from the run-off of higher rate borrowings, which contributed to the rate paid on borrowed funds declining from 5.04% in 2003 to 3.91% in 2004. Provision for Credit Losses As a percentage of average loans outstanding, net charge-offs for 2004 were comparable to the 2003 level. During 2004, the Company continued to experience a low level of charge-offs in its residential, home equity and commercial real estate loan portfolios. Commercial business loan charge-offs decreased to 0.71% of average loans outstanding from 1.28% in 2003. The increase in consumer loan net charge-offs was entirely the result of $1.4 million of charge-offs incurred 36 during the second quarter of 2004 related to an indirect auto relationship. In consideration of the higher amount of charge-offs, as well as an increase in higher-risk commercial real estate and business loans outstanding, the Company raised its provision for credit losses to $8.4 million in 2004 from $7.9 million in 2003. Noninterest Income Noninterest income continues to be a strong diversified source of revenue for the Company and amounted to 25% of net revenue for 2004. The Company earned $51.9 million of noninterest income in 2004, compared to $43.4 million for 2003. This reflects the impact of the acquisition of TFC, which added approximately $6.9 million of noninterest income, as well as the Company's efforts to further implement its financial services business model across it market areas, which resulted in core growth in bank services, lending and leasing and mutual fund and annuity revenue. Additionally, leasing revenue benefited from the acquisition of a leasing company in September 2004. Also contributing to the increase was the full year benefit of two insurance agencies acquired in July 2003, which added $1.7 million to fee income. Core risk management revenue for 2004 was higher than 2003 as increased plan administration and agency commissions more than offset the impact of lower contingent profit sharing commissions received. Contingent commission income amounted to $1.3 million for 2004. Partially offsetting these increases was the impact of lower gains from the sale of mortgage loans from 2003 record levels. Noninterest Expenses Noninterest expenses for 2004 increased $32.6 million over 2003. This was mainly the result of operating costs associated with the 21 TFC branches and lending operations acquired, as well as costs related to the insurance agencies and leasing company. Additionally, 2004 results include $2.2 million of non-recurring marketing, training and other expenses associated with the TFC and HRB acquisitions. Professional services include fees incurred in connection with the Company's strategic planning initiative and implementation of section 404 of the Sarbanes-Oxley Act of 2002. The remainder of the increase in noninterest expense is attributable to the addition of three branches, growth in commercial operations, which included the hiring of seasoned commercial loan officers, as well as other costs and investments in the Company's systems to support future growth. Given the revenue growth during the year, even with these increases, the Company's efficiency ratio of 58% for 2004 improved from the 59% for 2003. Income Taxes The effective tax rate from continuing operations of 34.1% for 2004 remained consistent with the 2003 effective rate of 34.2%. LIQUIDITY AND CAPITAL RESOURCES In addition to cash flow from operations, deposits and borrowings, funding is provided from the principal and interest payments received on loans and investment securities. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit balances and loan prepayments are greatly influenced by the level of interest rates, economic environment and local competitive conditions. The Company's primary investing activities are the origination of loans and the purchase of investment securities. During 2005 loan originations totaled $2.0 billion compared to $1.1 billion for 2004, while purchases of investment securities totaled $453.3 million during 2005 compared to $553.4 million for 2004. The increase in loan originations is a result of increased lending capacity due to the HRB acquisition as well as the on-going implementation of the Company's strategic plan. The lower level of investment security purchases in 2005 primarily relates to the Company's decision to de-leverage the balance sheet given the narrow spreads between investments and wholesale borrowings. During 2005, cash flows provided by securities available for sale amounted to $590.2 million compared to $466.5 million for 2004. Deposit growth and borrowings, excluding those acquired from HRB, provided $355.5 million of additional funding for 2005. The Company has a total of $1.1 billion available under existing lines of credit with the Federal Home Loan Bank, Federal Reserve Bank and commercial banks that may be used to fund lending activities, liquidity needs and/or to adjust and manage the asset and liability position of the Company. 37 Contractual Obligations and Other Commitments. The following table indicates certain funding obligations of the Company by time remaining until maturity as follows:
At December 31, 2005 ------------------------------------------------------------------ Less than 1 Over 1 to 3 Over 3 to 5 Over 5 year years years years Total ----------- ----------- ----------- ---------- ---------- (In thousands) Certificates of deposit (1) ..................... $1,690,835 $ 363,067 $ 29,093 $ 2,159 $2,085,154 Borrowings ...................................... 440,695 480,060 58,436 117,236 1,096,427 Commitments to extend credit (2) ................ 885,433 -- -- -- 885,433 Standby letters of credit (2) ................... 60,335 -- -- -- 60,335 Commitments to sell residential real estate loans 9,395 -- -- -- 9,395 Operating leases (3) ............................ 4,908 8,271 5,819 14,946 33,944 Purchase obligations ............................ 2,400 4,575 2,000 833 9,808 Investment partnership commitments .............. 815 575 -- 1,262 2,652 ---------- ---------- ---------- ---------- ---------- Total contractual obligations ............. $3,094,816 $ 856,548 $ 95,348 $ 136,436 $4,183,148 ========== ========== ========== ========== ==========
(1) Includes the maturity of certificates of deposit greater than $100 thousand as follows: $167.1 million in three months or less; $114.5 million between three months and six months; $179.6 million between six months and one year; and $64.3 million over one year. (2) The Company does not expect all of the commitments to extend credit and standby letters of credit to be funded. Thus, the total commitment amounts do not necessarily represent future cash requirements. Commitments to extend credit includes $576.1 million available under lines of credit, which generally expire unfunded one year from the date of origination. (3) The Company has announced the leasing of office space in downtown Buffalo, beginning in July 2006, to establish a Western New York "Market Center." This lease is expected to incrementally add approximately $474 thousand to annual rent expense. Included in the borrowing amounts in the preceding table are advances and reverse repurchase agreements that have call provisions that could accelerate their maturity if interest rates were to rise significantly from current levels as follows: $191.9 million in 2006 and $5.3 million in 2008. Loan Commitments. In the ordinary course of business the Company extends commitments to originate commercial and consumer loans. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since the Company does not expect all of the commitments to be funded, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's creditworthiness on a case-by-case basis. Collateral may be obtained based upon management's assessment of the customers' creditworthiness. Commitments to extend credit may be written on a fixed rate basis exposing the Company to interest rate risk given the possibility that market rates may change between the commitment date and the actual extension of credit. The Company had outstanding commitments to originate loans of approximately $309.3 million and $139.3 million at December 31, 2005 and 2004, respectively. To assist with asset and liability management and to provide cash flow to support loan growth, the Company generally sells newly originated conventional, conforming 20 to 30 year monthly fixed, and 25 to 30 year bi-weekly loans in the secondary market to government sponsored enterprises such as the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. In line with its customer relationship focus, the Company generally retains the servicing rights on residential mortgage loans sold, which results in monthly service fee income. Commitments to sell residential mortgages amounted to $9.4 million and $7.6 million at December 31, 2005 and 2004, respectively. The Company also extends credit to consumer and commercial customers, up to a specified amount, through lines of credit. The borrower is able to draw on these lines as needed, thus the funding requirements are generally more difficult to predict. Unused commercial lines of credit amounted to $389.9 million at December 31, 2005 and generally have an expiration period of less than one year. Home equity and other consumer lines of credit totaled $186.2 million and have an expiration period of up to ten years. In addition to the above, the Company issues standby letters of credit to third parties that guarantee payments on behalf of commercial customers in the event the customer fails to perform under the terms of the contract between the customer and the third-party. Standby letters of credit amounted to $60.3 million at December 31, 2005 and generally have an expiration period of less than two years. Since the majority of unused lines of credit and outstanding standby letters of credit expire without being funded, the Company's obligation under the above commitment amounts is substantially less than the amounts reported. It is anticipated that there will be sufficient funds available to meet the current loan commitments and other obligations through the sources described above. The credit risk involved in issuing these commitments is essentially the same as that involved in extending loans to customers and is limited to the contractual notional amount of those instruments. 38 Security Yields, Maturities and Repricing Schedule. The following table sets forth certain information regarding the carrying value, weighted average yields and contractual maturities of the Company's available for sale securities portfolio as of December 31, 2005. Adjustable-rate securities are included in the period in which interest rates are next scheduled to adjust and fixed-rate securities are included in the period in which the final contractual repayment is due. No adjustments have been made for prepayment of principal. Actual maturities are expected to be significantly shorter as a result of loan repayments underlying mortgage-backed securities. The tax benefits of the Company's investment securities have not been factored into the yield calculations in this table. Amounts are shown at fair value:
At December 31, 2005 ------------------------------------------------------------------ More than one More than five One year or less year to five years years to ten years ------------------- ------------------- -------------------- Weighted Weighted Weighted carrying Average carrying Average carrying Average value yield value yield value yield ------------------- ------------------- -------------------- (Dollars in thousands) Debt securities: States and political subdivisions ............ $ 252,644 2.73% $ 135,940 3.08% $ 2,306 3.93% U.S. Government agencies .. 148,721 3.46 105,553 3.25 -- -- Corporate ................. 7,847 6.57 28,744 7.30 -- -- ---------- ---------- ---------- Total debt securities .... 409,212 3.07 270,237 3.60 2,306 3.93 ---------- ---------- ---------- Mortgage-backed securities: CMO's ..................... -- -- 266 4.47 31,837 3.98 FNMA ...................... -- -- 10,072 3.55 167,777 3.93 FHLMC ..................... 114 4.12 62,743 3.18 35,348 4.32 GNMA ...................... 4 8.02 293 6.34 -- -- ---------- ---------- ---------- Total mortgage-backed securities ........... 118 4.25 73,374 3.25 234,962 4.00 ---------- ---------- ---------- Asset-backed securities ... -- -- -- -- -- -- Other (1) ................. -- -- -- -- -- -- ---------- ---------- ---------- Total securities available for sale ..... $ 409,330 3.07% $ 343,611 3.52% $ 237,268 4.00% ========== ========== ========== At December 31, 2005 ------------------------------------------ After ten years Total ------------------- ------------------- Weighted Weighted carrying Average carrying Average value yield value yield ------------------- ------------------- (Dollars in thousands) Debt securities: States and political subdivisions ............ $ -- -- % $ 390,890 2.86% U.S. Government agencies .. -- -- 254,274 3.37 Corporate ................. 2,892 4.84 39,483 6.97 ---------- ---------- Total debt securities .... 2,892 4.84 684,647 3.29 ---------- ---------- Mortgage-backed securities: CMO's ..................... 484,816 4.19 516,919 4.18 FNMA ...................... 44,711 4.59 222,560 4.05 FHLMC ..................... 23,463 4.47 121,668 3.76 GNMA ...................... 5,593 5.16 5,890 5.22 ---------- ---------- Total mortgage-backed securities ........... 558,583 4.25 867,037 4.09 ---------- ---------- Asset-backed securities ... 46,827 3.87 46,827 3.87 Other (1) ................. -- -- 6,377 1.73 ---------- ---------- Total securities available for sale ..... $ 608,302 4.22% $1,604,888 3.73% ========== ==========
(1) Estimated maturities do not include other securities available for sale. Loan Maturity and Repricing Schedule. The following table sets forth certain information as of December 31, 2005, regarding the amount of loans maturing or repricing in the Company's portfolio. Demand loans having no stated schedule of repayment and no stated maturity are reported as due in one year or less. Adjustable-rate loans are included in the period in which interest rates are next scheduled to adjust rather than the period in which they contractually mature, and fixed-rate loans (including bi-weekly loans) are included in the period in which contractual payments are due. No adjustments have been made for prepayment of principal:
One Within through After one five five year years years Total ---------- ---------- ---------- ---------- (In thousands) Commercial: Real estate ............. $ 617,400 $ 792,852 $ 460,231 $1,870,483 Business ................ 350,375 95,027 28,169 473,571 ---------- ---------- ---------- ---------- Total commercial ..... 967,775 887,879 488,400 2,344,054 Residential real estate ..... 251,229 627,390 1,304,288 2,182,907 Home equity ................. 219,868 71,526 111,946 403,340 Other consumer .............. 77,442 71,110 30,180 178,732 Specialized lending ......... 75,914 62,752 21,093 159,759 ---------- ---------- ---------- ---------- Total loans and leases $1,592,228 $1,720,657 $1,955,907 $5,268,792 ========== ========== ========== ==========
39 For the loans reported in the preceding table, the following sets forth at December 31, 2005, the dollar amount of all fixed-rate and adjustable-rate loans due after December 31, 2006: Due after December 31, 2006 ---------------------------------------- Fixed Adjustable Total ---------- ---------- ---------- (In thousands) Commercial: Real estate ................... $ 714,345 $ 538,738 $1,253,083 Business ...................... 123,196 -- 123,196 ---------- ---------- ---------- Total commercial ............ 837,541 538,738 1,376,279 Residential real estate ........... 1,679,977 251,701 1,931,678 Home equity ....................... 183,472 -- 183,472 Other consumer .................... 101,290 -- 101,290 Specialized lending ............... 81,872 1,973 83,845 ---------- ---------- ---------- Total loans and leases ..... $2,884,152 $ 792,412 $3,676,564 ========== ========== ========== FNFG's ability to pay dividends to its shareholders and make acquisitions are primarily dependent upon the ability of First Niagara to pay dividends to FNFG. The OTS may disapprove a dividend if: First Niagara would be undercapitalized following the distribution; the proposed capital distribution raises safety and soundness concerns; or the capital distribution would violate a prohibition contained in any statute, regulation or agreement. Management does not believe these regulatory requirements will affect First Niagara's ability to pay dividends in the future given its well capitalized position. Cash, interest-bearing demand accounts at correspondent banks, federal funds sold, and other short-term investments are the Company's most liquid assets. The level of these assets is monitored daily and are dependent on operating, financing, lending and investing activities during any given period. Excess short-term liquidity is usually invested in overnight federal funds sold. In the event that funds beyond those generated internally are required due to higher than expected loan commitment fundings, deposit outflows or the amount of debt being called, additional sources of funds are available through the use of repurchase agreements, the sale of loans or investments or the Company's various lines of credit. As of December 31, 2005, the total of cash, interest-bearing demand accounts, federal funds sold and other short-term investments was $140.1 million, or 1.7% of total assets. FOURTH QUARTER RESULTS Net income for the quarter ended December 31, 2005 increased to $23.5 million, or $0.21 per diluted share from $13.6 million, or $0.17 per diluted share for the same period of 2004. Net interest income was $62.9 million for the fourth quarter of 2005, reflecting a 6 basis point decrease in the Company's net interest rate margin. That was a result of a combination of tightening of loan spreads and the continuing shift in deposit mix towards higher cost accounts partially offset by 9% annualized average net earning asset growth. A $2.5 million provision for credit losses was recognized during the quarter ended December 31, 2005 as credit quality remained stable and loan loss experience continued at low levels. Total non-performing assets decreased to $22.8 million at December 31, 2005. For the three months ended December 31, 2005, noninterest income increased to $26.2 million and benefited from a full quarter of revenues from the HLN and Burke Group businesses. Noninterest income as a percentage of total revenue continues to steadily increase and now represents 29.4% of total net revenues. The HLN and Burke Group acquisitions also accounted for the fourth quarter increase in noninterest expense to $50.4 million. These lower margin businesses increased the Company's efficiency ratio to 56.6%. However, given the Company's continuing focus on process improvement and expense management, the efficiency ratio for the Company's banking segment was 50.1%. Total loans increased to $5.29 billion at December 31, 2005, driven by an 8% annualized increase in commercial real estate and business loans and a 21% annualized increase in home equity loans during the quarter. Total deposits increased to $5.48 billion at December 31, 2005. That includes 18% annualized growth in higher cost relationship based certificate and money market accounts as well as a temporary inflow of direct deposits given the impact of the New Year's holiday falling on a weekend. 40 IMPACT OF NEW ACCOUNTING STANDARDS On January 1, 2006 the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 123R, "Share Based Payment" which revised SFAS No. 123 and superseded Accounting Principles Board Opinion No. 25. More specifically, this Statement requires companies to recognize in the income statement over the required service period the grant-date fair value of stock options and other equity-based compensation issued to employees and directors estimated using option pricing models. The Company has chosen to apply the modified prospective approach. Accordingly, awards that are granted, modified or settled after January 1, 2006 will be accounted for in accordance with SFAS No. 123R and any unvested equity awards granted prior to that date will be recognized in the income statement as service is rendered based on their grant-date fair value calculated in accordance with SFAS No. 123. The Company estimates that the adoption of SFAS No. 123R will increase 2006 compensation expense by approximately $1.3 million. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK -------------------------------------------------------------------------------- The principal objective of the Company's interest rate risk management is to evaluate the interest rate risk inherent in certain assets and liabilities, determine the appropriate level of risk given the Company's business strategy, operating environment, capital and liquidity requirements and performance objectives, and manage the risk consistent with Board approved guidelines. The Asset and Liability Committee ("ALCO") is comprised of senior management who are responsible for reviewing the Company's activities and strategies, the effect of those strategies on the net interest rate margin, the fair value of the portfolio and the effect that changes in interest rates will have on the portfolio and exposure limits. The Company utilizes the following strategies to manage interest rate risk: (1) emphasizing the origination and retention of residential and commercial adjustable-rate loans, home equity loans, and residential fixed-rate mortgage loans having terms to maturity of less than twenty years; (2) selling a significant portion of newly originated 20-30 year fixed-rate, residential mortgage loans into the secondary market without recourse; (3) investing in shorter term securities which generally bear lower yields as compared to longer term investments, but which better position the Company for increases in market interest rates; (4) growing core deposits; and (5) utilizing wholesale borrowings to support cash flow needs and help match asset repricing. Additionally, the Company intends to continue to analyze the future utilization of derivative instruments such as interest rate swaps, caps and collars as part of its overall asset and liability management process as permitted by the Company's ALCO Policy. Gap Analysis. The matching of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are "interest rate sensitive" and by monitoring a Company's interest rate sensitivity "gap." An asset or liability is said to be interest rate sensitive within a specific time period if it will mature or reprice within that time period. The interest rate sensitivity gap is defined as the difference between the amount of interest-earning assets maturing or repricing within a specific time period and the amount of interest-bearing liabilities maturing or repricing within that same time period. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. A gap is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets. Accordingly, during a period of rising interest rates, an institution with a negative gap position is likely to experience a decline in net interest income as the cost of its interest-bearing liabilities increase at a rate faster than its yield on interest-earning assets. Conversely, an institution with a positive gap is likely to realize an increase in net interest income in a rising interest rate environment. Management believes that the Company's net interest income simulation modeling analysis is a better indicator of the Company's interest rate risk exposure than gap analysis. 41 The following table sets forth the amount of interest-earning assets and interest-bearing liabilities outstanding at December 31, 2005, which are anticipated by the Company, based upon certain assumptions, to reprice or mature in each of the future time periods shown. Except as stated below, the amount of assets and liabilities shown which reprice or mature during a particular period were determined in accordance with the earlier of the repricing date or the contractual maturity of the asset or liability. The table sets forth an approximation of the projected repricing of assets and liabilities at December 31, 2005, on the basis of contractual maturities, anticipated prepayments, and scheduled rate adjustments within the selected time intervals. Residential and commercial real estate loans were projected to repay at rates between 10% and 28% annually, while mortgage-backed securities were projected to prepay at rates between 12% and 31% annually. Savings and interest bearing checking accounts were assumed to decay, or run-off, between 6% and 48% annually. While the Company believes such assumptions to be reasonable, there can be no assurance that assumed prepayment rates and decay rates will approximate actual future loan prepayment and deposit withdrawal activity:
Amounts maturing or repricing at December 31, 2005 ---------------------------------------------------------- Less than 3-6 6 months 1-3 3 months months To 1 year years ----------- ----------- ----------- ----------- (Dollars in thousands) Interest-earning assets: Loans (1) ................................. $ 1,256,530 $ 253,754 $ 489,043 $ 1,436,321 Mortgage-backed securities (2) ............ 47,410 46,092 88,940 341,741 Other investment securities (2) ........... 122,795 138,854 190,815 225,991 Other interest-earning assets ............. 17,044 -- -- -- ----------- ----------- ----------- ----------- Total interest-earning assets .... 1,443,779 438,700 768,798 2,004,053 ----------- ----------- ----------- ----------- Interest-bearing liabilities: Savings deposits .......................... 86,139 82,571 157,387 513,446 Checking accounts ......................... 61,003 61,003 122,006 444,487 Certificate accounts ...................... 488,507 477,444 724,884 363,067 Borrowings ................................ 203,535 55,065 182,095 480,060 ----------- ----------- ----------- ----------- Total interest-bearing liabilities 839,184 676,083 1,186,372 1,801,060 ----------- ----------- ----------- ----------- Interest rate sensitivity gap ................ $ 604,595 $ (237,383) $ (417,574) $ 202,993 =========== =========== =========== =========== Cumulative interest rate sensitivity gap ..... $ 604,595 $ 367,212 $ (50,362) $ 152,631 =========== =========== =========== =========== Ratio of interest-earning assets to interest-bearing liabilities .............. 172.05% 64.89% 64.80% 111.27% Ratio of cumulative gap to interest-earning assets .................................... 8.72% 5.29% (0.73%) 2.20% Amounts maturing or repricing at December 31, 2005 --------------------------------------------------------- 3-5 5-10 Over 10 years years years Total ----------- ----------- ----------- ----------- (Dollars in thousands) Interest-earning assets: Loans (1) ................................. $ 999,701 $ 779,751 $ 21,695 $ 5,236,795 Mortgage-backed securities (2) ............ 181,637 158,589 27,659 892,068 Other investment securities (2) ........... 44,599 4,403 15,453 742,910 Other interest-earning assets ............. -- -- 47,269 64,313 ----------- ----------- ----------- ----------- Total interest-earning assets .... 1,225,937 942,743 112,076 6,936,086 ----------- ----------- ----------- ----------- Interest-bearing liabilities: Savings deposits .......................... 390,869 272,560 116,215 1,619,187 Checking accounts ......................... 142,688 163,546 188,262 1,182,995 Certificate accounts ...................... 29,093 1,407 752 2,085,154 Borrowings ................................ 58,436 117,236 -- 1,096,427 ----------- ----------- ----------- ----------- Total interest-bearing liabilities 621,086 554,749 305,229 5,983,763 ----------- ----------- ----------- ----------- Interest rate sensitivity gap ................ $ 604,851 $ 387,994 $ (193,153) $ 952,323 =========== =========== =========== =========== Cumulative interest rate sensitivity gap ..... $ 757,482 $ 1,145,476 $ 952,323 =========== =========== =========== Ratio of interest-earning assets to interest-bearing liabilities .............. 197.39% 169.94% 36.72% 115.92% Ratio of cumulative gap to interest-earning assets .................................... 10.92% 16.51% 13.73%
(1) Amounts shown are principal balances net of non-accruing loans. (2) Amounts shown are at amortized cost. Net Interest Income Analysis. Certain shortcomings are inherent in the method of analysis presented in the gap table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as adjustable-rate loans, have features, which restrict changes in interest rates, both on a short-term basis and over the life of the asset. Further, in the event of changes in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the table. Finally, the ability of many borrowers to service their adjustable-rate loans may decrease in the event of an interest rate increase. As a result of these shortcomings, the Company focuses more attention on simulation modeling, such as the net interest income analysis discussed below, rather than gap analysis. The net interest income simulation modeling is considered by Management to be more informative in forecasting future income. 42 The accompanying table sets forth as of December 31, 2005 and 2004 the estimated impact on the Company's net interest income for the next twelve months resulting from potential changes in interest rates over that time period and assumes a parallel shift across the yield curve. The effects of a "flattening" or "steepening" of the yield curve are not considered in the analysis. The estimates are predicated on certain assumptions including loan and mortgage-related investment prepayment speeds, reinvestment rates, and deposit maturities and decay rates similar to the gap analysis. These assumptions are inherently uncertain and, as a result, the Company cannot precisely predict the impact of changes in interest rates on net interest income. Actual results may differ significantly due to timing, magnitude and frequency of interest rate changes and changes in market conditions: Calculated increase (decrease) at December 31, ------------------------------------------------------ 2005 2004 ------------------------ ------------------------ Net Net Changes in interest interest interest rates income % Change income % Change ----------------- --------- --------- ---------- -------- (Dollars in thousands) +200 basis points $ (2,420) (1.0) % $ 1,811 1.1 % +100 basis points (952) (0.4) 1,049 0.6 -100 basis points (430) (0.2) (1,674) (1.0) -200 basis points (2,622) (1.1) N/A N/A As is the case with the gap table, certain shortcomings are inherent in the methodology used in the above interest rate risk measurements. Modeling changes in net interest income requires the making of certain assumptions that may or may not reflect the manner in which actual yields respond to changes in market interest rates. In this regard, the net interest income table presented assumes that the change in interest rates is reflected uniformly across the yield curve regardless of the duration to maturity or repricing of specific assets and liabilities. Accordingly, although the net interest income table provides an indication of the Company's interest rate risk exposure at a particular point in time, such measurements are not intended to and do not provide a precise forecast of the effect of changes in market interest rates on the Company's net interest income and will differ from actual results. 43 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA -------------------------------------------------------------------------------- Management's Report on Internal Control Over Financial Reporting Management is responsible for establishing and maintaining adequate internal control over financial reporting for First Niagara Financial Group, Inc. and its subsidiary (the "Company"), as such term is defined in Exchange Act Rules 13a-15(f). Management conducted an evaluation of the effectiveness of the Company's internal control over financial reporting as of December 31, 2005 based on the framework in "Internal Control-Integrated Framework" issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on that evaluation, Management concluded that the Company's internal control over financial reporting is effective as of December 31, 2005. KPMG LLP, an independent registered public accounting firm, has audited the consolidated financial statements included in this Annual Report and has issued an attestation report on management's assessment of the Company's internal control over financial reporting. Their reports follow this statement. /s/ Paul J. Kolkmeyer /s/ John R. Koelmel Paul J. Kolkmeyer John R. Koelmel President and Chief Executive Officer Executive Vice President, Chief Financial Officer 44 Report of Independent Registered Public Accounting Firm The Board of Directors and Stockholders First Niagara Financial Group, Inc.: We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that First Niagara Financial Group, Inc. and subsidiary (the Company) maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. 45 In our opinion, management's assessment that the Company maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of condition of First Niagara Financial Group, Inc. and subsidiary as of December 31, 2005 and 2004, and the related consolidated statements of income, comprehensive income, changes in stockholders' equity, and cash flows for each of the years in the threeyear period ended December 31, 2005, and our report dated March 13, 2006 expressed an unqualified opinion on those consolidated financial statements. /s/ KPMG LLP Buffalo, New York March 13, 2006 46 Report of Independent Registered Public Accounting Firm The Board of Directors and Stockholders First Niagara Financial Group, Inc.: We have audited the accompanying consolidated statements of condition of First Niagara Financial Group, Inc. and subsidiary (the Company) as of December 31, 2005 and 2004, and the related consolidated statements of income, comprehensive income, changes in stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2005. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of First Niagara Financial Group, Inc. and subsidiary as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the threeyear period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company's internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 13, 2006 expressed an unqualified opinion on management's assessment of, and the effective operation of, internal control over financial reporting. /s/ KPMG LLP Buffalo, New York March 13, 2006 47 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Consolidated Statements of Condition December 31, 2005 and 2004 (In thousands, except share and per share amounts)
2005 2004 ----------- ----------- Assets Cash and due from banks $ 125,171 64,342 Money market investments 14,957 3,300 Securities available for sale 1,604,888 1,170,129 Loans and leases, net 5,216,299 3,215,255 Bank-owned life insurance 76,667 86,464 Premises and equipment, net 92,118 61,760 Goodwill 698,636 323,782 Core deposit and other intangibles 62,071 21,878 Other assets 174,025 131,464 ----------- ----------- Total assets $ 8,064,832 5,078,374 =========== =========== Liabilities and Stockholders' Equity Liabilities: Deposits $ 5,479,412 3,337,682 Short-term borrowings 440,695 209,236 Long-term borrowings 655,732 541,450 Other 114,570 61,844 ----------- ----------- Total liabilities 6,690,409 4,150,212 ----------- ----------- Commitments and contingent liabilities (note 10) -- -- Stockholders' equity: Preferred stock, $0.01 par value, 50,000,000 shares authorized; none issued -- -- Common stock, $0.01 par value, 250,000,000 shares authorized; 120,046,007 shares issued in 2005 and 84,298,473 shares issued in 2004 1,200 843 Additional paid-in capital 1,237,530 751,175 Retained earnings 285,242 238,048 Accumulated other comprehensive loss (18,330) (5,437) Common stock held by ESOP, 3,740,659 shares in 2005 and 3,895,159 shares in 2004 (28,150) (29,275) Unearned compensation - restricted stock awards, 410,999 shares in 2005 and 345,410 shares in 2004 (4,276) (3,173) Treasury stock, at cost, 7,238,304 shares in 2005 and 1,781,029 shares in 2004 (98,793) (24,019) ----------- ----------- Total stockholders' equity 1,374,423 928,162 ----------- ----------- Total liabilities and stockholders' equity $ 8,064,832 5,078,374 =========== ===========
See accompanying notes to consolidated financial statements. 48 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Consolidated Statements of Income Years ended December 31, 2005, 2004 and 2003 (In thousands, except per share amounts)
2005 2004 2003 -------- -------- -------- Interest income: Loans and leases $313,813 190,100 148,995 Securities available for sale 58,395 33,621 17,336 Money market and other investments 3,009 857 3,628 -------- -------- -------- Total interest income 375,217 224,578 169,959 Interest expense: Deposits 82,133 41,950 40,808 Borrowings 42,934 26,526 21,736 -------- -------- -------- Total interest expense 125,067 68,476 62,544 -------- -------- -------- Net interest income 250,150 156,102 107,415 Provision for credit losses 7,348 8,442 7,929 -------- -------- -------- Net interest income after provision for credit losses 242,802 147,660 99,486 -------- -------- -------- Noninterest income: Banking services 37,327 19,818 16,445 Risk management services 32,541 17,391 14,765 Lending and leasing 7,204 4,676 4,941 Wealth management services 5,638 4,764 3,525 Bank-owned life insurance 3,837 3,761 3,502 Other 4,116 1,456 201 -------- -------- -------- Total noninterest income 90,663 51,866 43,379 -------- -------- -------- Noninterest expense: Salaries and employee benefits 99,522 65,264 50,377 Occupancy and equipment 18,823 12,513 9,315 Technology and communications 19,555 11,499 9,839 Professional services 7,784 5,117 2,219 Marketing and advertising 6,994 4,738 3,205 Amortization of core deposit and other intangibles 12,083 4,605 1,384 Other 23,445 17,114 11,938 -------- -------- -------- Total noninterest expense 188,206 120,850 88,277 -------- -------- -------- Income from continuing operations before income taxes 145,259 78,676 54,588 Income taxes from continuing operations 52,400 26,859 18,646 -------- -------- -------- Income from continuing operations 92,859 51,817 35,942 Income from discontinued operations, net of income taxes of $1,868 in 2003 -- -- 164 -------- -------- -------- Net income $ 92,859 51,817 36,106 ======== ======== ======== Earnings per common share: Basic $ 0.85 0.66 0.55 Diluted 0.84 0.65 0.53 Weighted average common shares outstanding: Basic 109,646 78,750 66,111 Diluted 110,658 79,970 67,754
See accompanying notes to consolidated financial statements. 49 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Consolidated Statements of Comprehensive Income Years ended December 31, 2005, 2004 and 2003 (In thousands)
2005 2004 2003 -------- -------- -------- Net income $ 92,859 51,817 36,106 -------- -------- -------- Other comprehensive loss, net of income taxes: Securities available for sale: Net unrealized losses arising during the year (12,977) (4,729) (4,566) Reclassification adjustment for realized gains included in net income (1) (36) (5) -------- -------- -------- (12,978) (4,765) (4,571) -------- -------- -------- Minimum pension liability adjustment, net of income taxes 85 68 1,757 -------- -------- -------- Total other comprehensive loss (12,893) (4,697) (2,814) -------- -------- -------- Total comprehensive income $ 79,966 47,120 33,292 ======== ======== ========
See accompanying notes to consolidated financial statements. 50 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Consolidated Statements of Changes in Stockholders' Equity Years ended December 31, 2005, 2004 and 2003 (In thousands, except per share amounts)
Accumulated Common Additional other stock Common paid-in Retained comprehensive held by stock capital earnings income (loss) ESOP ---------- ---------- ---------- ------------- ---------- Balances at January 1, 2003 $ 298 137,624 196,074 2,074 (11,024) Net income -- -- 36,106 -- -- Total other comprehensive loss, net -- -- -- (2,814) -- Corporate reorganization: Merger of First Niagara Financial Group, MHC (158) 19,607 -- -- -- Treasury stock retired (37) (38,860) -- -- -- Exchange of common stock 161 (197) -- -- -- Proceeds from stock offering, net of related expenses 410 390,535 -- -- -- Purchase of shares by ESOP -- -- -- -- (20,500) Common stock issued for the acquisition of Finger Lakes Bancorp, Inc. 34 33,527 -- -- -- Purchase of treasury stock -- -- -- -- -- Exercise of stock options -- 165 -- -- -- ESOP shares released -- 966 -- -- 1,125 Restricted stock awards, net -- 1,251 -- -- -- Common stock dividends of $0.22 per share -- -- (14,642) -- -- ---------- ---------- ---------- ---------- ---------- Balances at December 31, 2003 $ 708 544,618 217,538 (740) (30,399) Net income -- -- 51,817 -- -- Total other comprehensive loss, net -- -- -- (4,697) -- Common stock issued for the acquisition of Troy Financial Corporation 133 201,147 -- -- -- Purchase of treasury stock -- -- -- -- -- Exercise of stock options 2 3,847 (7,387) -- -- ESOP shares released -- 952 -- -- 1,124 Restricted stock awards, net -- 611 -- -- -- Common stock dividends of $0.30 per share -- -- (23,920) -- -- ---------- ---------- ---------- ---------- ---------- Balances at December 31, 2004 $ 843 751,175 238,048 (5,437) (29,275) Net income -- -- 92,859 -- -- Total other comprehensive loss, net -- -- -- (12,893) -- Common stock issued for the acquisition of Hudson River Bancorp 357 484,093 -- -- -- Treasury stock issued for the acquisition of Hatch Leonard Naples, Inc. -- 215 -- -- -- Purchase of treasury stock -- -- -- -- -- Exercise of stock options -- 640 (3,305) -- -- ESOP shares released -- 1,025 -- -- 1,125 Restricted stock awards, net -- 382 -- -- -- Common stock dividends of $0.38 per share -- -- (42,360) -- -- ---------- ---------- ---------- ---------- ---------- Balances at December 31, 2005 $ 1,200 1,237,530 285,242 (18,330) (28,150) ========== ========== ========== ========== ========== Unearned compensation - restricted stock Treasury awards stock Total ---------------- ---------- ---------- Balances at January 1, 2003 (2,453) (38,897) 283,696 Net income -- -- 36,106 Total other comprehensive loss, net -- -- (2,814) Corporate reorganization: Merger of First Niagara Financial Group, MHC -- -- 19,449 Treasury stock retired -- 38,897 -- Exchange of common stock -- -- (36) Proceeds from stock offering, net of related expenses -- -- 390,945 Purchase of shares by ESOP -- -- (20,500) Common stock issued for the acquisition of Finger Lakes Bancorp, Inc. -- -- 33,561 Purchase of treasury stock -- (1,604) (1,604) Exercise of stock options -- 570 735 ESOP shares released -- -- 2,091 Restricted stock awards, net 77 (141) 1,187 Common stock dividends of $0.22 per share -- -- (14,642) ---------- ---------- ---------- Balances at December 31, 2003 (2,376) (1,175) 728,174 Net income -- -- 51,817 Total other comprehensive loss, net -- -- (4,697) Common stock issued for the acquisition of Troy Financial Corporation -- -- 201,280 Purchase of treasury stock -- (34,961) (34,961) Exercise of stock options -- 10,612 7,074 ESOP shares released -- -- 2,076 Restricted stock awards, net (797) 1,505 1,319 Common stock dividends of $0.30 per share -- -- (23,920) ---------- ---------- ---------- Balances at December 31, 2004 (3,173) (24,019) 928,162 Net income -- -- 92,859 Total other comprehensive loss, net -- -- (12,893) Common stock issued for the acquisition of Hudson River Bancorp -- -- 484,450 Treasury stock issued for the acquisition of Hatch Leonard Naples, Inc. -- 5,785 6,000 Purchase of treasury stock -- (87,964) (87,964) Exercise of stock options -- 5,206 2,541 ESOP shares released -- -- 2,150 Restricted stock awards, net (1,103) 2,199 1,478 Common stock dividends of $0.38 per share -- -- (42,360) ---------- ---------- ---------- Balances at December 31, 2005 (4,276) (98,793) 1,374,423 ========== ========== ==========
See accompanying notes to consolidated financial statements. 51 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Consolidated Statements of Cash Flows Years ended December 31, 2005, 2004 and 2003 (In thousands)
2005 2004 2003 ----------- ----------- ----------- Cash flows from operating activities: Net income $ 92,859 51,817 36,106 Adjustments to reconcile net income to net cash provided by operating activities: Amortization of fees and discounts, net 4,000 9,738 14,082 Provision for credit losses 7,348 8,442 7,929 Depreciation of premises and equipment 11,359 8,206 6,187 Amortization of core deposit and other intangibles 12,083 4,605 1,417 Gain on sale of real estate partnership (1,377) -- -- ESOP and stock based compensation expense 3,715 3,175 3,592 Deferred income tax expense 8,937 7,340 2,857 Net (increase) decrease in loans held for sale 80 (1,144) 1,602 Net (increase) decrease in other assets 1,291 (2,516) (5,414) Net increase (decrease) in other liabilities 12,050 4,099 (5,951) ----------- ----------- ----------- Net cash provided by operating activities 152,345 93,762 62,407 ----------- ----------- ----------- Cash flows from investing activities: Proceeds from sales of securities available for sale 3,002 66,837 64,734 Proceeds from maturities of securities available for sale 344,456 244,050 381,559 Principal payments received on securities available for sale 242,752 155,624 393,707 Purchases of securities available for sale (453,317) (553,427) (928,709) Net increase in loans (343,688) (211,539) (100,900) Proceeds from redemption of (purchase of) bank-owned life insurance 42,254 -- (5,000) Acquisitions and dispositions, net of cash and cash equivalents (118,739) (51,724) (27,307) Other, net (23,398) (13,332) (7,591) ----------- ----------- ----------- Net cash used in investing activities (306,678) (363,511) (229,507) ----------- ----------- ----------- Cash flows from financing activities: Net increase (decrease) in deposits 362,772 47,609 (33,773) Repayments of short-term borrowings, net (200,217) (22,024) (36,458) Proceeds from long-term borrowings 235,000 211,500 39,890 Repayments of long-term borrowings (42,070) (19,114) (16,951) Proceeds from exercise of stock options 1,658 4,049 459 Purchase of treasury stock (87,964) (34,961) (1,604) Dividends paid on common stock (42,360) (23,920) (14,642) Net proceeds from Conversion and Offering -- -- 313,906 ----------- ----------- ----------- Net cash provided by financing activities 226,819 163,139 250,827 ----------- ----------- ----------- Net increase (decrease) in cash and cash equivalents 72,486 (106,610) 83,727 Cash and cash equivalents at beginning of year 67,642 174,252 90,525 ----------- ----------- ----------- Cash and cash equivalents at end of year $ 140,128 67,642 174,252 =========== =========== =========== Cash paid during the year for: Income taxes $ 36,643 19,231 14,782 Interest expense 122,244 67,591 62,552 Acquisitions and dispositions of noncash assets and liabilities: Assets acquired, net of dispositions $ 2,787,373 1,330,282 375,820 Liabilities assumed, net of dispositions 2,166,333 1,077,177 343,455
See accompanying notes to consolidated financial statements. 52 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 (1) Summary of Significant Accounting Policies First Niagara Financial Group, Inc. ("FNFG"), a Delaware corporation, and its subsidiary bank (the "Company") provide financial services to individuals and businesses in Upstate New York. The Company provides a full range of products and services through its consumer, commercial, business services and wealth management business units, including consumer banking, residential and commercial lending, leasing, cash management, risk and wealth management services as well as employee benefits administration and consulting services. FNFG owns all of the capital stock of First Niagara Bank ("First Niagara"), a federally chartered savings bank. First Niagara Commercial Bank (the "Commercial Bank"), a wholly-owned subsidiary of First Niagara, is a New York State chartered commercial bank whose primary purpose is to accept municipal deposits, which under New York State law cannot be accepted by federally chartered savings banks. The accounting and reporting policies of the Company conform to general practices within the banking industry and to U.S. generally accepted accounting principles ("GAAP"). Certain reclassification adjustments were made to the 2004 and 2003 financial statements to conform them to the 2005 presentation. The following is a description of the Company's significant accounting policies: (a) Principles of Consolidation The consolidated financial statements include the accounts of FNFG and First Niagara and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. (b) Cash and Cash Equivalents For purposes of the consolidated statement of cash flows, cash and cash equivalents include cash and due from banks, federal funds sold, and other money market investments which have a term of less than three months at the time of purchase. (c) Investment Securities All investment securities are classified as available for sale and are carried at fair value, with unrealized gains and losses, net of the related deferred income tax effect, reported as a component of stockholders' equity (accumulated other comprehensive income (loss)). Realized gains and losses are included in the consolidated statements of income using the specific identification method. A decline in the fair value of any available for sale security below cost that is deemed other than temporary is charged to operations, resulting in the establishment of a new cost basis. Premiums and discounts on investment securities are amortized/accreted to interest income utilizing the interest method. (d) Loans and Leases Loans are stated at the principal amount outstanding, adjusted for unamortized deferred fees and costs as well as discounts and premiums, all of which are amortized to income using the interest method. Accrual of interest income on loans is discontinued after payments become more than ninety days delinquent, unless the status of a particular loan clearly indicates earlier discontinuance is more appropriate. Delinquency status is based upon the contractual terms of the loans. All uncollected interest income previously recognized on non-accrual loans is reversed and subsequently recognized only to the extent payments are received. When there is doubt as to the collectibility of loan principal, interest payments are applied to principal. Loans are generally returned to accrual status when principal and interest payments are current, full collectibility of principal and interest is reasonably assured and a consistent repayment record, generally six months, has been demonstrated. Loans are charged off against the allowance for credit losses when it becomes evident that such balances are not fully collectible. 53 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts of principal and interest under the original terms of the agreement. Such loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, the loan's observable market price or the fair value of the underlying collateral if the loan is collateral dependent. The Company enters into direct financing equipment lease transactions with certain commercial customers. At lease inception, the present value of future rentals and the estimated lease residual value are recorded as commercial business loans. Unearned interest income and sales commissions and other direct costs incurred are capitalized and are amortized to interest income over the lease term utilizing the interest method. (e) Allowance for Credit Losses The allowance for credit losses is established through charges to the provision for credit losses. Management's evaluation of the allowance is based on a continuing review of the loan portfolio. Larger balance nonaccruing, impaired and delinquent loans are reviewed individually and the value of any underlying collateral is considered in determining estimates of losses associated with those loans. Losses in smaller balance, homogeneous loans are estimated based on historical experience, industry trends and current trends in the real estate market and the current economic environment in the Company's market areas. The adequacy of the allowance for credit losses is based on management's evaluation of various conditions including the following: changes in the composition of and growth in the loan portfolio; industry and regional conditions; the strength and duration of the current business cycle; existing general economic and business conditions in lending areas; credit quality trends, including trends in nonaccruing loans; historical loan charge-off experience; and the results of bank regulatory examinations. (f) Premises and Equipment Premises and equipment are carried at cost, net of accumulated depreciation and amortization. Depreciation is computed on the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized on the straight-line method over the lesser of the life of the improvements or the lease term. The Company generally amortizes buildings over a period of 20 to 39 years, furniture and equipment over a period of 3 to 10 years, and capital leases over the respective lease term. (g) Goodwill and Intangible Assets The excess of the cost of acquired entities over the fair value of identifiable tangible and intangible assets acquired, less liabilities assumed, is recorded as goodwill. Acquired intangible assets with definite useful economic lives are amortized over their useful economic life utilizing an accelerated amortization method. On a periodic basis, the Company assess whether events or changes in circumstances indicate that the carrying amounts of core deposit and other intangible assets may be impaired. Goodwill and any acquired intangible assets with an indefinite useful economic life are not amortized, but are reviewed for impairment annually at the reporting unit level. A reporting unit is defined as any distinct, separately identifiable component of an operating segment for which complete, discrete financial information is available and reviewed regularly by segment management. Discounted cash flow valuation models that incorporate such variables as revenue growth rates, expense trends, discount rates and terminal values are utilized to determine the fair value of the Company's reporting units. (h) Employee Benefits Contributions due under the Company's defined contribution plans are accrued as earned by employees. The Company also maintains a non-contributory, qualified, defined benefit pension plan (the "Pension Plan") that covers substantially all employees who meet certain age and service requirements. All benefit accruals and participation in the Pension Plan have been frozen. Pension plans 54 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 acquired in connection with the Company's previous whole-bank acquisitions were frozen prior to or shortly after the completion of the transactions. The actuarially determined pension benefit in the form of a life annuity is based on the employee's combined years of service, age and compensation. The Company's policy is to at least fund the minimum amount required by government regulations. The cost of the Pension Plan is based on actuarial computations of current and future benefits for employees, and is charged to current operating expenses. The Company provides post-retirement benefits, principally health care and group life insurance (the "Post-retirement Plan"), to employees who met certain age and service requirements by December 31, 2001. The expected costs of providing these post-retirement benefits are accrued during an employee's active years of service. (i) Stock-Based Compensation The Company maintains various long-term incentive stock benefit plans under which fixed award stock options and restricted stock may be granted to certain directors and key employees. The Company has continued to apply the intrinsic value-based method of accounting prescribed by Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and has only adopted the disclosure requirements of Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation," as amended by SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - An Amendment of FASB Statement No. 123." As such, compensation expense is recorded on the date the options are granted only if the current market price of the underlying stock exceeded the exercise price. Compensation expense related to restricted stock awards is based upon the market value of FNFG's stock on the grant date and is accrued ratably over the required service period. Had the Company determined compensation cost based on the fair value method under SFAS No. 123, net income would have been reduced to the pro forma amounts indicated below. These amounts may not be representative of the effects on reported net income for future years due to changes in market conditions and the number of options outstanding:
2005 2004 2003 ---------- ---------- ---------- (In thousands, except per share amounts) Net Income: As reported $ 92,859 51,817 36,106 Add: Stock-based employee compensation expense included in net income, net of related income tax effects 939 659 900 Deduct: Stock-based employee compensation expense determined under the fair-value based method, net of related income tax effects (2,983) (1,788) (1,997) ---------- ---------- ---------- Pro forma $ 90,815 50,688 35,009 ========== ========== ========== Basic earnings per share: As reported $ 0.85 0.66 0.55 Pro forma 0.83 0.64 0.53 Diluted earnings per share: As reported $ 0.84 0.65 0.53 Pro forma 0.82 0.63 0.52
The per share weighted-average fair value of stock options granted for 2005, 2004 and 2003 were $3.50, $4.12 and $4.46 on the date of grant, respectively, using the Black Scholes option-pricing model and were based upon the grant date fair value of FNFG stock of $13.05, $13.15 and $13.73, respectively. The Company deducted 10% in each year to reflect an estimate of forfeitures prior to vesting. 55 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 The following weighted-average assumptions were utilized to compute the fair value of options granted for the respective years: 2005 2004 2003 ----------- ----------- ----------- Expected dividend yield 2.75% 2.11% 1.55% Risk-free interest rate 4.04% 3.98% 3.02% Expected life 6.5 years 6.5 years 6.5 years Expected volatility 29.30% 32.13% 33.14% =========== =========== =========== On December 28, 2005, the Company's Board of Directors approved the acceleration of the vesting of all unvested stock options held by directors and employees of the Company that were otherwise scheduled to vest by December 31, 2006. As a result of this acceleration, options to purchase 779,897 shares of the Company's common stock, or 35% of all unvested options outstanding, became exercisable immediately. All but 60,016 of the accelerated options had an exercise price below the Company's current stock price. All other terms of the affected options, as well as the terms of all other options scheduled to vest after December 31, 2006, remain unchanged. On January 1, 2006 the Company adopted SFAS No. 123R, "Share Based Payment," which revised SFAS No. 123 and superseded APB Opinion No. 25. More specifically, this Statement requires companies to recognize in the statement of income over the required service period the grant-date fair value of stock options and other equity-based compensation issued to employees and directors estimated using option pricing models. The Company has chosen to apply the modified prospective approach. Accordingly, awards that are granted, modified or settled after January 1, 2006 will be accounted for in accordance with SFAS No. 123R and any unvested equity awards granted prior to that date will be recognized in the income statement as service is rendered based on their grant-date fair value calculated in accordance with SFAS No. 123. The Company estimates that the adoption of SFAS No. 123R will increase 2006 compensation expense by approximately $1.3 million. (j) Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the periods in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through income tax expense. (k) Earnings per Share Basic earnings per share ("EPS") is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company. (l) Investment and Fiduciary Services Assets held in fiduciary or agency capacity for customers are not included in the accompanying consolidated statements of condition, since such assets are not assets of the Company. Fee income is recognized on the accrual method based on the fair value of assets administered. (m) Use of Estimates Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and disclosure of contingent assets and liabilities to prepare these financial statements in conformity with U.S. generally accepted accounting principles. Actual results could differ from those estimates. 56 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 (2) Acquisitions Hudson River Bancorp, Inc. On January 14, 2005, FNFG acquired all of the outstanding common shares of Hudson River Bancorp, Inc. ("HRB"), and its wholly owned subsidiary Hudson River Bank & Trust Company. The aggregate purchase price of $615.8 million included the issuance of 35.7 million shares of FNFG stock (valued at $13.552 per share), cash payments totaling $126.8 million and capitalized costs related to the acquisition, primarily investment banking and professional fees, of $4.5 million. The results of HRB's operations are included in the 2005 consolidated statement of income from the date of acquisition. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition (in thousands): January 14, 2005 ----------- Cash and cash equivalents $ 23,396 Securities available for sale 591,610 Loans, net 1,662,925 Goodwill 352,528 Core deposit and other intangibles 35,817 Other assets 117,129 ---------- Total assets acquired 2,783,405 ---------- Deposits 1,778,958 Borrowings 371,556 Other liabilities 17,080 ---------- Total liabilities assumed 2,167,594 ---------- Net assets acquired $ 615,811 ========== As a result of the implementation of Statement of Position ("SOP") 03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer," effective January 1, 2005, loans acquired from HRB with evidence of deterioration of credit quality since origination such that the Company estimates all contractually required payments will not be collected, are being carried at estimated net realizable value. At the date of acquisition those loans had an outstanding contractual balance and carrying value of approximately $25.1 million and $15.1 million, respectively. As of December 31, 2005, principal payments on the loans had reduced those amounts to approximately $14.9 million and $6.8 million, respectively. No allowance for loan losses has been allocated to those loans as of December 31, 2005. 57 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 The core deposit and other intangible assets acquired are being amortized using the double declining balance method over their estimated useful-life of 10 years. The goodwill was primarily assigned to the Company's banking segment of which none is deductible for tax purposes. The following table presents unaudited pro forma information as if the acquisition of HRB had been consummated as of the beginning of 2004. Pro forma information for 2005 is not presented since such results were not materially different from actual results due to the timing of the acquisition. This pro forma information gives effect to certain adjustments, including purchase accounting fair value adjustments, amortization of core deposits and other intangibles and related income tax effects. The pro forma information does not represent the actual results of operations that would have occurred had the Company acquired HRB at the beginning of 2004. Among other items, operational efficiencies, revenue enhancements and $2.5 million of indirect merger and integration costs incurred by FNFG in 2005 are not reflected in the pro forma amounts (in thousands, except per share amounts): Pro forma 2004 --------- Net interest income $253,750 Noninterest income 74,182 Noninterest expense 184,432 Net income 83,699 Basic earnings per common share $ 0.73 Diluted earnings per common share $ 0.72 ======== Hatch Leonard Naples, Inc. and Burke Group, Inc. On July 29, 2005, First Niagara Risk Management, Inc., a wholly owned insurance subsidiary of First Niagara, acquired Hatch Leonard Naples, Inc. ("HLN"), an insurance agency with operations across Upstate New York. Under terms of the agreement, the consideration included a combination of cash and 435,375 shares of FNFG common stock (valued at $13.781 per share). On September 12, 2005, FNFG acquired Burke Group, Inc. ("Burke Group"), an employee benefits administration and compensation consulting firm in a cash transaction. The results of HLN and Burke Group have been included in the 2005 consolidated statement of income from the respective dates of acquisition. Additionally, the Company recorded a total of $23.8 million of goodwill and $15.1 million in customer list intangibles in connection with the transactions. The customer lists are being amortized on an accelerated basis over 18 years. The goodwill was assigned to the Company's financial services segment of which $2.1 million is deductible for tax purposes. 58 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 (3) Investment Securities The amortized cost, gross unrealized gains and losses and approximate fair value of securities available for sale at December 31, 2005 and 2004 are summarized as follows (in thousands):
Amortized Unrealized Unrealized Fair At December 31, 2005: cost gains losses value ---------- ---------- ---------- ---------- Debt securities: States and political subdivisions $ 392,298 584 (1,992) 390,890 U.S. Government agencies 258,206 8 (3,940) 254,274 Corporate 39,051 489 (57) 39,483 ---------- ---------- ---------- ---------- Total debt securities 689,555 1,081 (5,989) 684,647 ---------- ---------- ---------- ---------- Mortgage-backed securities: Federal National Mortgage Association 229,534 107 (7,081) 222,560 Federal Home Loan Mortgage Corporation 125,831 203 (4,366) 121,668 Government National Mortgage Association 5,812 121 (43) 5,890 Collateralized mortgage obligations: Federal Home Loan Mortgage Corporation 294,329 -- (7,210) 287,119 Federal National Mortgage Association 111,885 3 (3,365) 108,523 Privately issued 112,512 -- (3,127) 109,385 Government National Mortgage Association 12,165 -- (273) 11,892 ---------- ---------- ---------- ---------- Total collateralized mortgage obligations 530,891 3 (13,975) 516,919 ---------- ---------- ---------- ---------- Total mortgage-backed securities 892,068 434 (25,465) 867,037 ---------- ---------- ---------- ---------- Asset-backed securities 47,048 3 (224) 46,827 Other 6,307 211 (141) 6,377 ---------- ---------- ---------- ---------- Total securities available for sale $1,634,978 1,729 (31,819) 1,604,888 ========== ========== ========== ========== At December 31, 2004: Debt securities: States and political subdivisions $ 277,599 1,031 (1,057) 277,573 U.S. Government agencies 249,045 12 (2,574) 246,483 Corporate 21,424 100 (104) 21,420 ---------- ---------- ---------- ---------- Total debt securities 548,068 1,143 (3,735) 545,476 ---------- ---------- ---------- ---------- Mortgage-backed securities: Federal National Mortgage Association 190,406 307 (2,489) 188,224 Federal Home Loan Mortgage Corporation 135,971 544 (2,422) 134,093 Government National Mortgage Association 5,951 239 (3) 6,187 Collateralized mortgage obligations: Federal Home Loan Mortgage Corporation 145,797 119 (1,116) 144,800 Federal National Mortgage Association 84,508 93 (752) 83,849 Privately issued 48,830 40 (446) 48,424 Government National Mortgage Association 12,736 -- (157) 12,579 ---------- ---------- ---------- ---------- Total collateralized mortgage obligations 291,871 252 (2,471) 289,652 ---------- ---------- ---------- ---------- Total mortgage-backed securities 624,199 1,342 (7,385) 618,156 ---------- ---------- ---------- ---------- Asset-backed securities 50 -- -- 50 Other 6,308 183 (44) 6,447 ---------- ---------- ---------- ---------- Total securities available for sale $1,178,625 2,668 (11,164) 1,170,129 ========== ========== ========== ==========
59 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 The following tables set forth certain information regarding the Company's securities available for sale that were in an unrealized loss position at December 31, 2005 and 2004 by the length of time those securities were in a continuous loss position as follows (in thousands):
Less than 12 months 12 months or longer Total ----------------------- ----------------------- ----------------------- Fair Unrealized Fair Unrealized Fair Unrealized At December 31, 2005: value losses value losses value losses --------- ---------- --------- ---------- --------- ---------- Debt securities: States and political subdivisions $ 223,236 927 79,936 1,065 303,172 1,992 U.S. Government agencies 133,593 1,944 116,766 1,996 250,359 3,940 Corporate 5,701 47 474 10 6,175 57 --------- --------- --------- --------- --------- --------- Total debt securities 362,530 2,918 197,176 3,071 559,706 5,989 --------- --------- --------- --------- --------- --------- Mortgage-backed securities: Federal National Mortgage Association 94,004 1,784 124,861 5,297 218,865 7,081 Federal Home Loan Mortgage Corporation 31,856 711 84,013 3,655 115,869 4,366 Government National Mortgage Association 3,057 35 470 8 3,527 43 Collateralized mortgage obligations: Federal Home Loan Mortgage Corporation 188,862 3,724 98,257 3,486 287,119 7,210 Federal National Mortgage Association 49,520 1,068 58,690 2,297 108,210 3,365 Privately issued 77,928 2,120 31,457 1,007 109,385 3,127 Government National Mortgage Association 4,544 100 7,348 173 11,892 273 --------- --------- --------- --------- --------- --------- Total collateralized mortgage obligations 320,854 7,012 195,752 6,963 516,606 13,975 --------- --------- --------- --------- --------- --------- Total mortgage-backed securities 449,771 9,542 405,096 15,923 854,867 25,465 --------- --------- --------- --------- --------- --------- Asset-backed securities 44,608 224 -- -- 44,608 224 Other 4,665 141 -- -- 4,665 141 --------- --------- --------- --------- --------- --------- Total securities available for sale $ 861,574 12,825 602,272 18,994 1,463,846 31,819 ========= ========= ========= ========= ========= ========= At December 31, 2004: Debt securities: States and political subdivisions $ 221,725 1,030 4,104 27 225,829 1,057 U.S. Government agencies 190,586 1,648 45,910 926 236,496 2,574 Corporate 8,794 93 474 11 9,268 104 --------- --------- --------- --------- --------- --------- Total debt securities 421,105 2,771 50,488 964 471,593 3,735 --------- --------- --------- --------- --------- --------- Mortgage-backed securities: Federal National Mortgage Association 122,069 1,384 39,042 1,105 161,111 2,489 Federal Home Loan Mortgage Corporation 47,994 676 62,882 1,746 110,876 2,422 Government National Mortgage Association 765 3 -- -- 765 3 Collateralized mortgage obligations: Federal Home Loan Mortgage Corporation 118,465 937 7,795 179 126,260 1,116 Federal National Mortgage Association 56,546 752 -- -- 56,546 752 Privately issued 35,627 446 -- -- 35,627 446 Government National Mortgage Association 12,579 157 -- -- 12,579 157 --------- --------- --------- --------- --------- --------- Total collateralized mortgage obligations 223,217 2,292 7,795 179 231,012 2,471 --------- --------- --------- --------- --------- --------- Total mortgage-backed securities 394,045 4,355 109,719 3,030 503,764 7,385 --------- --------- --------- --------- --------- --------- Other 4,462 44 -- -- 4,462 44 --------- --------- --------- --------- --------- --------- Total securities available for sale $ 819,612 7,170 160,207 3,994 979,819 11,164 ========= ========= ========= ========= ========= =========
60 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 Management has assessed the securities available for sale that were in an unrealized loss position at December 31, 2005 and 2004 and determined that the decline in fair value was temporary. In making this determination management considered the period of time the securities were in a loss position, the percentage decline in comparison to the securities' amortized cost, the financial condition of the issuer (primarily government or government agencies) and the Company's ability and intent to hold these securities until their fair value recovers to their amortized cost. Management believes the decline in fair value was caused by the increase in interest rates and not the credit deterioration of the individual issuer. More specifically, the $19.0 million of unrealized losses on investment securities that have been in a continuous loss position for twelve months or longer at December 31, 2005 were determined to be temporary as nearly all of the investment securities are guaranteed by U.S. Government or government agencies which have minimal credit risk, if any, and all of the investment securities are investment grade. Gross realized gains and losses on securities available for sale are summarized as follows (in thousands): 2005 2004 2003 ------ ------ ------ Gross realized gains $ 5 774 1,208 Gross realized losses (3) (714) (1,199) ------ ------ ------ Net realized gains $ 2 60 9 ====== ====== ====== Scheduled contractual maturities of certain investment securities owned by the Company at December 31, 2005 are as follows (in thousands): Amortized Fair cost value ---------- ---------- Debt Securities: Within one year $ 381,718 $ 379,915 After one year through five years 268,616 265,026 After five years through ten years 3,028 3,002 After ten years 36,193 36,704 ---------- ---------- Total debt securities 689,555 684,647 Asset-backed securities 47,048 46,827 Mortgage-backed securities 892,068 867,037 ---------- ---------- $1,628,671 $1,598,511 ========== ========== While the contractual maturities of mortgage-backed securities ("MBS") and asset-backed securities ("ABS") generally exceed ten years, the effective lives are expected to be significantly shorter due to prepayments of the underlying loans and the nature of the MBS and ABS structures owned. At December 31, 2005 and 2004, $923.7 million and $620.5 million, respectively, of investment securities were pledged to secure borrowings and lines of credit from the Federal Home Loan Bank ("FHLB") and Federal Reserve Bank ("FRB"), as well as repurchase agreements and certain deposits. At December 31, 2005, the Company's investment portfolio included securities issued by the Federal Home Loan Mortgage Corporation ("FHLMC"), the Federal National Mortgage Association ("FNMA") and the FHLB with a fair value of $443.4 million, $385.2 million and $156.7 million, respectively. No other investments in securities of a single issuer exceeded 10% of stockholders' equity. 61 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 (4) Loans and Leases Loans and leases receivable at December 31, 2005 and 2004 consist of the following (in thousands): 2005 2004 ----------- ----------- Commercial: Real estate $ 1,647,576 1,081,709 Construction 222,907 187,149 Business 473,571 345,520 ----------- ----------- Total commercial 2,344,054 1,614,378 Residential real estate 2,182,907 1,132,471 Home equity 403,340 247,190 Other consumer 178,732 174,309 Specialized lending 159,759 79,358 ----------- ----------- Total loans and leases 5,268,792 3,247,706 Net deferred costs and unearned discounts 19,847 8,971 Allowance for credit losses (72,340) (41,422) ----------- ----------- Total loans and leases, net $ 5,216,299 3,215,255 =========== =========== Non-accrual loans amounted to $21.9 million, $12.0 million and $12.3 million at December 31, 2005, 2004 and 2003, respectively. Interest income that would have been recorded if the loans had been performing in accordance with their original terms amounted to $431 thousand, $393 thousand and $295 thousand in 2005, 2004 and 2003, respectively. There were no loans past due 90 days or more that were still accruing interest at December 31, 2005 and 2004. The balance of impaired loans at December 31, 2005 and 2004 amounted to $20.7 million and $10.4 million, respectively. The allowance for credit losses includes valuation allowances relating to those loans of $4.2 million and $1.9 million, respectively. The aggregate recorded investment of loans whose terms have been modified through a troubled debt restructuring amounted to $5.2 million at December 31, 2005 and $4.2 million at December 31, 2004. Residential mortgage loans include loans held for sale of $3.8 million and $3.9 million at December 31, 2005 and December 31, 2004, respectively. Loans sold amounted to $69.4 million, $48.6 million and $56.4 million in 2005, 2004 and 2003, respectively. Gains on the sale of loans were $374 thousand, $612 thousand and $1.3 million in 2005, 2004 and 2003, respectively. Mortgages serviced for others by the Company totaled $378.3 million, $325.1 million and $246.1 million at December 31, 2005, 2004 and 2003, respectively. The mortgage servicing assets recorded as a result of those loans amounted to $2.3 million, $2.0 million and $1.7 million at December 31, 2005, 2004 and 2003, respectively. Nearly all of the Company's loans are to customers in Upstate New York. The ultimate collectibility of these loans is susceptible to changes in market conditions in this market area. Loans due from certain officers and directors of the Company and affiliates amounted to $3.4 million and $2.5 million at December 31, 2005 and 2004, respectively. 62 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 Changes in the allowance for credit losses are summarized as follows (in thousands):
2005 2004 2003 -------- -------- -------- Balance at beginning of year $ 41,422 25,420 20,873 Recorded in connection with acquisitions 30,684 14,650 2,001 Provision for credit losses 7,348 8,442 7,929 Charge-offs (10,624) (8,226) (6,760) Recoveries 3,510 1,136 1,377 -------- -------- -------- Balance at end of year $ 72,340 41,422 25,420 ======== ======== ========
(5) Premises and Equipment A summary of premises and equipment at December 31, 2005 and 2004 follows (in thousands): 2005 2004 --------- --------- Land $ 10,566 7,130 Buildings and improvements 76,466 53,856 Furniture and equipment 67,479 53,074 --------- --------- 154,511 114,060 Accumulated depreciation (62,393) (52,300) --------- --------- Premises and equipment, net $ 92,118 61,760 ========= ========= Rent expense was $4.5 million, $2.8 million and $2.1 million for 2005, 2004 and 2003, respectively. (6) Goodwill and Other Intangible Assets The following table sets forth information regarding the Company's goodwill for 2005 and 2004 (in thousands): Financial Banking services Consolidated segment segment total --------- --------- ------------ Balances at January 1, 2004 $ 95,540 10,441 105,981 Acquired 217,735 -- 217,735 Contingent earn-out -- 66 66 --------- --------- --------- Balances at December 31, 2004 313,275 10,507 323,782 Acquired 349,425 27,577 377,002 Tax settlements (2,148) -- (2,148) --------- --------- --------- Balances at December 31, 2005 $ 660,552 38,084 698,636 ========= ========= ========= The Company has performed the required annual goodwill impairment tests and as such has determined that goodwill was not impaired as of December 31, 2005 and 2004. 63 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 The following table sets forth information regarding the Company's amortizing intangible assets at December 31, 2005 and 2004 (in thousands): 2005 2004 -------- -------- Customer lists $ 28,503 10,458 Accumulated amortization (7,988) (4,873) -------- -------- Net carrying amount 20,515 5,585 -------- -------- Core deposit intangible 54,388 20,157 Accumulated amortization (12,832) (3,864) -------- -------- Net carrying amount 41,556 16,293 -------- -------- Total amortizing intangible assets, net $ 62,071 21,878 ======== ======== Estimated future amortization expense over the next five years for intangible assets outstanding at December 31, 2005 is as follows (in thousands): 2006 $ 11,823 2007 9,807 2008 8,148 2009 6,718 2010 5,665 (7) Other Assets A summary of other assets at December 31, 2005 and 2004 follows (in thousands): 2005 2004 -------- -------- FHLB stock $ 47,269 28,485 Accrued interest receivable 32,185 20,016 Other receivables and prepaid assets 33,078 18,801 Net deferred tax assets (see note 13) 32,020 26,836 Real estate and other investments 16,941 27,873 Other 12,532 9,453 -------- -------- $174,025 131,464 ======== ======== Included in real estate and other investments at December 31, 2004 is a $17.3 million, 90% ownership, multi-tenant retail shopping plaza located in the Company's market area. The Company sold this investment during 2005, which resulted in a $1.4 million gain. Also included in real estate and other investments are $12.2 million and $10.6 million of limited partnership investments at December 31, 2005 and 2004, respectively, that the Company has determined to be variable interest entities for which the Company is not the primary beneficiary. These investments were made primarily to support the Company's community reinvestment initiatives and are accounted for under the equity method. The Company's exposure related to these entities is limited to its recorded investment. At December 31, 2005, the Company has committed to invest an additional $2.7 million in these partnerships. 64 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 (8) Deposits Deposits consist of the following at December 31, 2005 and 2004 (dollars in thousands):
2005 2004 ------------------------ ------------------------ Weighted Weighted average average Balance rate Balance rate ------------------------ ------------------------ Core deposits: Savings $ 1,619,187 1.31 % $ 1,086,769 1.02 % Interest-bearing checking 1,182,995 1.46 912,598 1.06 Noninterest-bearing 592,076 -- 291,491 -- ----------- ----------- Total core deposits 3,394,258 1.14 2,290,858 0.91 Certificates maturing: Within one year 1,690,835 3.36 768,608 2.15 After one year, through two years 273,038 3.54 207,467 2.90 After two years, through three years 90,029 3.34 39,642 3.35 After three years, through four years 19,389 3.27 23,022 3.18 After four years, through five years 9,704 3.54 6,111 3.26 After five years 2,159 3.66 1,974 3.97 ----------- ----------- Total certificates 2,085,154 3.38 1,046,824 2.37 ----------- ----------- Total deposits $ 5,479,412 1.99 % $ 3,337,682 1.37 % =========== ===========
Interest expense on deposits is summarized as follows (in thousands): 2005 2004 2003 ------- ------- ------- Certificates $50,670 23,924 29,232 Savings 17,987 9,768 6,809 Interest-bearing checking 13,476 8,258 4,767 ------- ------- ------- $82,133 41,950 40,808 ======= ======= ======= Certificates of deposit issued in amounts over $100 thousand amounted to $525.5 million, $234.6 million and $198.0 million at December 31, 2005, 2004 and 2003, respectively. Interest expense thereon totaled $12.3 million, $5.3 million and $5.8 million in 2005, 2004 and 2003, respectively. Interest rates on all certificates range from 1.00% to 7.50% at December 31, 2005. 65 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 (9) Borrowings Outstanding borrowings at December 31, 2005 and 2004 are summarized as follows (in thousands): 2005 2004 -------- -------- Short-term borrowings: FHLB advances $211,786 105,597 Repurchase agreements 228,909 103,639 -------- -------- $440,695 209,236 ======== ======== Long-term borrowings: FHLB advances $308,974 231,074 Repurchase agreements 346,758 297,291 Other -- 13,085 -------- -------- $655,732 541,450 ======== ======== FHLB advances bear fixed interest rates ranging from 2.04% to 6.83% and had a weighted average rate of 5.00% at December 31, 2005. Repurchase agreements bear fixed interest rates ranging from 1.59% to 6.32% and had a weighted average rate of 3.80% at December 31, 2005. Interest expense on borrowings is summarized as follows (in thousands): 2005 2004 2003 ------- ------- ------- FHLB advances $22,121 13,132 11,328 Repurchase agreements 20,237 12,767 10,408 Other 576 627 -- ------- ------- ------- $42,934 26,526 21,736 ======= ======= ======= The Company has lines of credit with the FHLB, FRB and a commercial bank that provide a secondary funding source for lending, liquidity and asset and liability management. At December 31, 2005, the FHLB facility totaled $1.2 billion with $520.8 million outstanding that was secured by approximately $612.0 million of residential mortgage and multifamily loans. The FRB and commercial bank lines of credit totaled $53.9 million and $50.0 million, respectively, with no borrowings outstanding on either line as of December 31, 2005. Under the commercial bank line of credit agreement, FNFG is required to pledge shares of First Niagara common stock equal to two times the borrowings outstanding and maintain certain standard financial covenants. The interest rate on outstanding borrowings under this line of credit is equal to the LIBOR rate plus 150 basis points that resets every 30, 60 or 90 days or the Prime Rate less 25 basis points, at the election of FNFG. As of December 31, 2005, the Company had entered into repurchase agreements with the FHLB and various broker-dealers, whereby securities available for sale with a carrying value of $616.4 million were pledged to collateralize the borrowings. These are treated as financing transactions and the obligations to repurchase are reflected as a liability in the consolidated financial statements. The dollar amount of securities underlying the agreements are included in securities available for sale in the consolidated statements of condition. However, the securities are delivered to the dealer with whom each transaction is executed. The dealers may sell, loan or otherwise dispose of such securities to other parties in the normal course of their business, but agree to resell to the Company the same securities at the maturity of the agreements. The Company also retains the right of substitution of collateral throughout the terms of the agreements. At December 31, 2005, there were no amounts at risk under reverse repurchase agreements with any individual counterparty or group of related counterparties that exceeded 10% of stockholders' equity. The amount at risk is equal to the excess of the carrying value (or market value if greater) of the securities sold under agreements to repurchase over the amount of the repurchase liability. 66 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 The aggregate maturities of long-term borrowings at December 31, 2005 are as follows (in thousands): 2007 $ 230,399 2008 249,661 2009 34,678 2010 23,758 Thereafter 117,236 ---------- $ 655,732 ========== Included in the borrowing amounts in the preceding table are advances and reverse repurchase agreements that have call provisions that could accelerate their maturity if interest rates were to rise significantly from current levels as follows: $191.9 million in 2006 and $5.3 million in 2008. (10) Commitments and Contingent Liabilities Loan Commitments In the ordinary course of business, the Company extends commitments to originate residential mortgages, commercial loans and other consumer loans. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since the Company does not expect all of the commitments to be funded, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's creditworthiness on a case-by-case basis. Collateral may be obtained based upon management's assessment of the customers' creditworthiness. Commitments to extend credit may be written on a fixed rate basis exposing the Company to interest rate risk given the possibility that market rates may change between commitment and actual extension of credit. The Company had outstanding commitments to originate loans of approximately $309.3 million and $139.3 million at December 31, 2005 and 2004, respectively. The Company also extends credit to consumer and commercial customers, up to a specified amount, through lines of credit. As the borrower is able to draw on these lines as needed, the funding requirements are generally unpredictable. Unused lines of credit amounted to $576.1 million and $367.7 million at December 31, 2005 and 2004, respectively. The Company also issues standby letters of credit to third parties, which guarantee payments on behalf of commercial customers in the event the customer fails to perform under the terms of the contract with the third-party. Standby letters of credit amounted to $60.3 million and $31.1 million at December 31, 2005 and 2004, respectively. Since a significant portion of unused commercial lines of credit and the majority of outstanding standby letters of credit expire without being funded, the Company's expectation is that its obligation to fund the above commitment amounts is substantially less than the amounts reported. The credit risk involved in issuing these commitments is essentially the same as that involved in extending loans to customers and is limited to the contractual notional amount of those instruments. To assist with asset and liability management and to provide cash flow to support loan growth, the Company generally sells newly originated conventional, conforming 20 to 30 year monthly fixed, and 25 to 30 year bi-weekly loans in the secondary market to government sponsored enterprises such as FNMA and FHLMC. The Company generally retains the servicing rights on residential mortgage loans sold, which results in monthly service fee income. Commitments to sell residential mortgages amounted to $9.4 million and $7.6 million at December 31, 2005 and 2004, respectively. Lease Obligations Future minimum rental commitments for premises and equipment under noncancellable operating leases at December 31, 2005 were $4.9 million in 2006; $4.3 million in 2007; $4.0 million in 2008; $3.4 million in 2009; $2.4 million in 2010 and a total of $14.9 million thereafter through 2029. Real estate taxes, insurance and maintenance expenses related to these leases are obligations of the Company. 67 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 Contingent Liabilities In the ordinary course of business there are various threatened and pending legal proceedings against the Company. Based on consultation with outside legal counsel, management believes that the aggregate liability, if any, arising from such litigation would not have a material adverse effect on the Company's consolidated financial statements at December 31, 2005. (11) Capital Office of Thrift Supervision ("OTS") regulations require savings institutions such as First Niagara to maintain a minimum ratio of tangible capital to total adjusted assets of 1.5%, a minimum ratio of Tier 1 (core) capital to total adjusted assets of 4.0% and a minimum ratio of total (core and supplementary) capital to risk-weighted assets of 8.0%. The Commercial Bank, as a New York State chartered commercial bank, is also subject to minimum capital requirements imposed by the Federal Deposit Insurance Corporation ("FDIC") that are substantially similar to the capital requirements imposed on First Niagara. The FDIC regulations require the Commercial Bank to maintain a minimum ratio of total capital to risk-weighted assets of 8.0% and a minimum ratio of Tier 1 capital to risk-weighted assets of 4.0%. In addition, under the minimum leverage-based capital requirement adopted by the FDIC, the Commercial Bank must maintain a ratio of Tier 1 capital to average total assets (leverage ratio) of at least 3% to 5%, depending on its CAMELS composite examination rating. Under prompt corrective action regulations, an institution's respective regulatory authority is required to take certain supervisory actions (and may take additional discretionary actions) with respect to an undercapitalized institution. Such actions could have a direct material effect on the institution's financial statements. The regulations establish a framework for the classification of banks into five categories -- well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. Generally, an institution is considered well capitalized if it has a Tier 1 (core) capital ratio of at least 5.0%, a Tier 1 risk-based capital ratio of at least 6.0% and a total risk-based capital ratio of at least 10.0%. 68 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 The actual capital amounts and ratios for First Niagara and the Commercial Bank at December 31, 2005 and 2004 are presented in the following table (dollars in thousands):
To be well capitalized Minimum under prompt corrective Actual capital adequacy action provisions ---------------------- ------------------------ ------------------------ Amount Ratio Amount Ratio Amount Ratio --------- -------- ---------- -------- ---------- -------- First Niagara Bank: December 31, 2005: Tangible capital $ 554,009 7.56 % $ 109,874 1.50 % $ N/A N/A % Tier 1 (core) capital 554,009 7.56 292,998 4.00 366,248 5.00 Tier 1 risk-based capital 554,009 11.01 N/A N/A 301,952 6.00 Total risk-based capital 616,916 12.26 402,602 8.00 503,253 10.00 December 31, 2004: Tangible capital $ 537,161 11.40 % $ 70,699 1.50 % $ N/A N/A % Tier 1 (core) capital 537,161 11.40 188,531 4.00 235,663 5.00 Tier 1 risk-based capital 537,161 16.40 N/A N/A 196,545 6.00 Total risk-based capital 578,108 17.65 262,060 8.00 327,575 10.00 First Niagara Commercial Bank: December 31, 2005: Leverage Ratio $ 17,031 5.20 % $ 9,833 3.00 % $ 16,388 5.00 % Tier 1 risk-based capital 17,031 22.64 3,009 4.00 4,513 6.00 Total risk-based capital 17,031 22.64 6,018 8.00 7,522 10.00 December 31, 2004: Leverage Ratio $ 11,968 6.74 % $ 5,330 3.00 % $ 8,883 5.00 % Tier 1 risk-based capital 11,968 26.03 1,839 4.00 2,758 6.00 Total risk-based capital 11,968 26.03 3,678 8.00 4,597 10.00
The foregoing capital ratios are based in part on specific quantitative measures of assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by the OTS and FDIC about capital components, risk weightings and other factors. These capital requirements apply only to First Niagara and the Commercial Bank, and do not consider additional capital retained by FNFG. As of December 31, 2005, First Niagara and the Commercial Bank met all capital adequacy requirements to which they were subject. The most recent FDIC notification categorized First Niagara and the Commercial Bank as well-capitalized institutions under the prompt corrective action regulations. Management is unaware of any conditions or events since the latest notification from federal regulators that have changed the capital adequacy category of First Niagara or the Commercial Bank. FNFG's ability to pay dividends to its stockholders is substantially dependent upon the ability of First Niagara to pay dividends to FNFG. The payment of dividends by First Niagara is subject to continued compliance with minimum regulatory capital requirements. The OTS may disapprove a dividend if: First Niagara would be undercapitalized following the distribution; the proposed capital distribution raises safety and soundness concerns; or the capital distribution would violate a prohibition contained in any statute, regulation or agreement. Management does not believe these regulatory requirements will affect First Niagara's ability to pay dividends in the future given its well capitalized position. 69 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 During 2005, FNFG repurchased 3.6 million shares of its common stock, completing the 4.2 million (5%) share repurchase program approved by its Board of Directors in August 2004. The average cost of total shares repurchased under this program was $13.34 per share. In May 2005 the Board of Directors approved an additional program to repurchase up to 5.8 million (5%) of FNFG's outstanding common stock. As of December 31, 2005, 2.8 million shares have been repurchased under this program at an average cost of $14.18 per share. Mutual to Stock Conversion On January 17, 2003, FNFG converted from mutual to stock form (the "Conversion"). In connection with the Conversion, the 61% of outstanding shares of FNFG common stock owned by First Niagara Financial Group, MHC (the "MHC") was sold to depositors of First Niagara and other public investors (the "Offering"). Completion of the Conversion and Offering resulted in the issuance of 67.4 million shares of common stock. A total of 41.0 million shares were sold in subscription, community and syndicated offerings, at $10.00 per share. An additional 26.4 million shares were issued to the former public stockholders of FNFG based upon an exchange ratio of 2.58681 new shares for each share of FNFG held as of the close of business on January 17, 2003. In connection with the Conversion, the amount of authorized but unissued preferred stock was increased from 5.0 million shares to 50.0 million shares. The Conversion was accounted for as a reorganization in corporate form with no change in the historical basis of the Company's assets, liabilities or equity. Costs related to the Offering, primarily marketing fees paid to the Company's investment banking firm, professional fees, registration fees, printing and mailing costs were $19.1 million and accordingly, net offering proceeds were $390.9 million. As a result of the Conversion and Offering, FNFG was succeeded by a new, fully public, Delaware corporation with the same name and the MHC ceased to exist. First Niagara established a liquidation account at the time Conversion. The liquidation account was established in an amount equal to First Niagara's net worth as of the date of the latest consolidated statement of financial condition appearing in the final prospectus for the Conversion (September 30, 2002). In the event of a complete liquidation of First Niagara, each eligible account holder will be entitled, under New York State Law, to receive a distribution from the liquidation accounts in an amount equal to their current adjusted account balance for all such depositors then holding qualifying deposits in First Niagara. Accordingly, retained earnings of the Company are deemed to be restricted up to the balances of the liquidation account at December 31, 2005 and 2004. The liquidation account, which is reduced annually to the extent that eligible account holders have reduced their qualifying deposits as of each anniversary date, totaled $97.0 million at December 31, 2005 and $129.6 million at December 31, 2004. 70 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 (12) Stock Based Compensation The Company has two stock based compensation plans pursuant to which options may be granted to directors and key employees. The 1999 Stock Option Plan authorizes grants of options to purchase up to 3,597,373 shares of common stock. The Amended and Restated 2002 Long-Term Incentive Stock Benefit Plan authorizes the issuance of up to 8,020,454 shares of common stock pursuant to grants of stock options, stock appreciation rights, accelerated ownership option rights or stock awards. As of December 31, 2005, only stock options have been granted under this plan. Under both plans, stock options are granted with an exercise price equal to the stock's market value on the date of grant. All options have a 10-year term and become fully vested and exercisable over a period of 3 to 5 years from the grant date. At December 31, 2005, there were a total of 5,223,481 shares available for grant under both plans. The reduction of income taxes paid as a result of the exercise of stock options was $881 thousand, $3.0 million and $203 thousand for 2005, 2004 and 2003, respectively. All stock options and restricted stock awards outstanding and available for grant on January 17, 2003 were adjusted for the 2.58681 exchange ratio applied in the Conversion. The following is a summary of stock option activity for 2005, 2004 and 2003: Weighted Number of average shares exercise price ---------- -------------- Outstanding at January 1, 2003 1,326,743 $12.86 January 17, 2003 Conversion 2,105,289 4.97 Granted 667,900 13.73 Exercised (104,823) 4.38 Forfeited (65,858) 7.13 ---------- Outstanding at December 31, 2003 3,929,251 6.44 Granted 780,660 13.15 Exercised (981,738) 4.41 Forfeited (79,219) 12.98 ---------- Outstanding at December 31, 2004 3,648,954 8.28 Granted 1,343,970 13.05 Exercised (431,278) 5.21 Forfeited (152,823) 12.57 ---------- Outstanding at December 31, 2005 4,408,823 $ 9.89 ========== 71 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 The following is a summary of stock options outstanding at December 31, 2005, 2004 and 2003:
Weighted Weighted Weighted average average average Options exercise remaining Options exercise Exercise price outstanding price life (years) exercisable price ------------------------- ----------- -------- ------------ ----------- -------- December 31, 2005: $3.49 - $4.16 1,270,503 $ 3.86 3.88 1,270,503 $ 3.86 $4.87 - $12.87 1,215,545 10.65 7.20 914,145 9.93 $12.91 - $13.28 1,531,115 13.02 8.88 574,139 13.10 $13.52 - $16.21 391,660 14.79 8.27 222,907 14.84 ----------- ----------- Total 4,408,823 9.89 6.92 2,981,694 8.32 =========== =========== December 31, 2004: $3.49 - $3.65 687,430 $ 3.51 5.46 540,562 $ 3.51 $4.16 916,280 4.16 4.38 916,280 4.16 $4.87 - $12.87 1,355,884 10.58 8.17 385,734 8.27 $13.28 - $16.21 689,360 14.00 8.59 156,175 13.78 ----------- ----------- Total 3,648,954 8.28 6.79 1,998,751 5.53 =========== =========== December 31, 2003: $3.49 - $3.65 965,510 $ 3.51 6.44 668,152 $ 3.51 $4.16 - $5.93 1,859,766 4.30 5.74 1,454,209 4.24 $6.52 - $9.80 109,939 8.83 8.26 35,569 8.31 $11.25 - $16.21 994,036 13.03 9.21 151,854 12.06 ----------- ----------- Total 3,929,251 6.44 6.86 2,309,784 4.60 =========== ===========
The 1999 Reward and Recognition Plan (the "RRP Plan") authorizes the issuance of up to 1,438,949 shares of restricted stock to executive management, members of the Board of Directors and key employees. The restricted stock generally vests over 3 to 5 years from the grant date. Compensation expense equal to the market value of FNFG's stock on the grant date is accrued ratably over the service period for shares granted. At December 31, 2005, there were 368,599 unvested shares outstanding and 13,789 additional shares available for grant under the RRP Plan. Shares granted under the RRP Plan during 2005, 2004 and 2003 totaled 176,657, 140,100 and 97,100, respectively, and had a weighted average market value on the date of grant of $13.15, $13.36 and $13.49, respectively. Compensation expense related to the RRP Plan amounted to $1.5 million, $1.1 million and $1.4 million for 2005, 2004 and 2003, respectively. In September 2005, the Board of Directors approved the 2005 Long-Term Performance Plan (the "LTP Plan"). The purpose of the LTP Plan is to advance the interests of the Company and to increase shareholder value by providing key executives of the Company with long term incentives as a reward for performance, as a motivation for future performance and as a retention tool for continued employment. The LTP Plan is a multi-vehicle, multi-year performance plan, with incentive award opportunities defined based upon the Company attaining specific performance measures and targets. For the three year performance period beginning in 2005 these performance metrics include the achievement of revenue, earnings per share growth, return on assets and total shareholder return targets, as well as Strategic Plan initiatives, specified by the Board of Directors. Shares awarded under the LTP Plan will be funded by shares authorized under the Company's existing stock-based compensation plans that were previously approved by shareholders of the Company. For 2005, 42,400 shares were allocated under the LTP Plan and compensation expense amounted to $175 thousand. 72 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 (13) Income Taxes Total income taxes were allocated as follows (in thousands):
2005 2004 2003 -------- -------- -------- Income taxes from continuing operations $ 52,400 26,859 18,646 Income taxes from discontinued operations -- -- 1,868 Stockholders' equity (9,796) (6,751) (2,877) ======== ======== ========
The components of income taxes attributable to income from continuing and discontinued operations are as follows (in thousands):
2005 2004 2003 ------- ------- ------- Continuing Operations: Current: Federal $39,986 17,760 14,888 State 3,477 1,759 901 ------- ------- ------- 43,463 19,519 15,789 ------- ------- ------- Deferred: Federal 7,655 6,680 2,447 State 1,282 660 410 ------- ------- ------- 8,937 7,340 2,857 ------- ------- ------- Income taxes from continuing operations 52,400 26,859 18,646 Income taxes from discontinued operations -- -- 1,868 ------- ------- ------- Total income taxes $52,400 26,859 20,514 ======= ======= =======
The Company's effective tax rate from continuing operations for 2005, 2004 and 2003 was 36.1%, 34.1% and 34.2%, respectively. Income tax expense attributable to income from continuing operations differs from the expected tax expense (computed by applying the Federal corporate tax rate of 35% to income before income taxes) as follows (in thousands):
2005 2004 2003 -------- -------- -------- Expected tax expense from continuing operations $ 50,841 27,537 19,106 Increase (decrease) attributable to: State income taxes, net of Federal benefit 3,782 1,876 757 Bank-owned life insurance income (1,343) (1,287) (1,202) Surrender of bank-owned life insurance 1,185 -- -- Municipal interest (2,520) (1,677) (499) Nondeductible ESOP expense 436 416 450 Amortization of nondeductible intangibles 186 186 186 Other (167) (192) (152) -------- -------- -------- Income taxes from continuing operations $ 52,400 26,859 18,646 ======== ======== ========
73 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2005 and 2004 are presented below (in thousands):
2005 2004 -------- -------- Deferred tax assets: Financial statement allowance for credit losses $ 27,553 16,527 SOP 03-3 adjustment (see note 2) 3,259 -- Net purchase discount on acquired companies 2,337 157 Deferred compensation 5,183 3,459 Post-retirement benefit obligation 3,215 3,081 Unrealized loss on securities available for sale 12,005 3,390 Net operating loss carryforwards acquired 6,425 11,466 Other 2,432 853 -------- -------- Total gross deferred tax assets 62,409 38,933 Valuation allowance -- -- -------- -------- Net deferred tax assets 62,409 38,933 -------- -------- Deferred tax liabilities: Tax return allowance for credit losses, in excess of base year amount (2,864) (1,575) Excess of tax return depreciation over financial statement depreciation (419) (1,237) Acquired intangibles (20,789) (6,154) Pension obligation (5,425) (2,300) Other (892) (831) -------- -------- Total gross deferred tax liabilities (30,389) (12,097) -------- -------- Net deferred tax asset $ 32,020 26,836 ======== ========
A financial institution may carry net operating losses back to the preceding two taxable years and forward to the succeeding twenty taxable years, subject to certain limitations. At December 31, 2005, First Niagara had net operating loss carry forwards of $16.1 million for Federal income tax purposes and $16.0 million for New York State income tax purposes, which will expire in 2023. These losses, subject to an annual limitation, were obtained through the acquisition of Troy Financial Corporation and HRB. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, availability of operating loss carry backs, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income, the opportunity for net operating loss carry backs, and projections for future taxable income over the periods which deferred tax assets are deductible, management believes it is more likely than not the Company will realize the benefits of these deductible differences at December 31, 2005. During 2003, the Company sold its wholly-owned subsidiary, NOVA Healthcare Administrators, Inc., which generated a pre-tax gain of $2.1 million. For income tax purposes, this sale was treated as an asset sale, which resulted in approximately $1.9 million in Federal and state tax expense. 74 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 Prior to the Small Business Protection Act of 1996, bad debt reserves created prior to January 1, 1988 were subject to recapture into taxable income should First Niagara fail to meet certain thrift asset and definitional tests. Subsequent Federal legislation eliminated these thrift related recapture rules. However, under current law, pre-1988 reserves remain subject to recapture should First Niagara make certain non-dividend distributions or cease to maintain a bank charter. At December 31, 2005, First Niagara's Federal pre-1988 reserve, for which no Federal income tax provision has been made, was approximately $42.0 million. First Niagara is subject to routine audits of its tax returns by the Internal Revenue Service and New York State Department of Taxation and Finance. There are no indications of any material adjustments for any examination currently being conducted by these taxing authorities. (14) Earnings Per Share The following is the computation of basic and diluted earnings per share for the periods indicated (in thousands except per share amounts):
2005 2004 2003 --------- --------- --------- Net income available to common stockholders $ 92,859 51,817 36,106 ========= ========= ========= Basic and diluted weighted average shares outstanding: Total shares issued 118,773 83,703 71,069 Unallocated ESOP shares (3,836) (3,991) (4,050) Unvested restricted stock awards (404) (385) (433) Treasury shares (4,887) (577) (475) --------- --------- --------- Total basic weighted average shares outstanding 109,646 78,750 66,111 Incremental shares from assumed exercise of stock options 904 1,103 1,436 Incremental shares from assumed vesting of restricted stock awards 108 117 207 --------- --------- --------- Total diluted weighted average shares outstanding 110,658 79,970 67,754 ========= ========= ========= Basic earnings per share $ 0.85 0.66 0.55 ========= ========= ========= Diluted earnings per share $ 0.84 0.65 0.53 ========= ========= =========
The above diluted weighted average share calculations do not include 329,000, 347,000 and 60,000 of stock option and restricted stock awards for 2005, 2004 and 2003, respectively, that were not dilutive to the earnings per share calculations. (15) Benefit Plans 401(k) Plan Employees of the Company that meet certain age and service requirements are eligible to participate in the Company sponsored 401(k) plan. Under the plan, participants may make contributions, in the form of salary reductions, up to the maximum Internal Revenue Code limit. The Company contributes an amount to the plan equal to 100% of the first 2% of employee contributions plus 75% of employee contributions between 3% and 6%. The Company's contribution to these plans amounted to $2.4 million, $1.6 million and $1.4 million for 2005, 2004 and 2003, respectively. 75 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 Employee Stock Ownership Plan ("ESOP") Employees of the Company that meet certain age and service requirements are eligible to participate in the Company's ESOP. The ESOP holds shares of FNFG common stock that were purchased in the 1998 initial public offering, the Offering and in the open market. The 2,050,000 shares purchased in the Offering were purchased at the $10 per share offering price. The purchased shares were funded by loans in 1998 and 2003 from FNFG payable in equal annual installments over 30 years bearing a fixed interest rate. Loan payments are funded by cash contributions from First Niagara and dividends on allocated and unallocated FNFG stock held by the ESOP. The loan can be prepaid without penalty. Shares purchased by the ESOP are maintained in a suspense account and held for allocation among the participants. As annual loan payments are made, shares are released and allocated to employee accounts. Compensation expense is recognized in an amount equal to the average market price of the shares released during the respective year. Compensation expense of $1.8 million, $1.9 million and $2.0 million was recognized for 2005, 2004 and 2003, respectively, in connection with the 154,499 shares allocated to participants during each of those respective years. The amount of unallocated and allocated FNFG shares held by the ESOP were 3,740,659 and 916,745, respectively, at December 31, 2005 and 3,895,159 and 822,201, respectively, at December 31, 2004. The fair value of unallocated ESOP shares was $54.1 million and $54.3 million at December 31, 2005 and 2004, respectively. Pension Plans In 2002, the Company froze all benefit accruals and participation in the Pension Plan. Accordingly, subsequent to that date, no employees are permitted to commence participation in the Pension Plan and future salary increases and years of credited service will not be considered when computing an employee's benefits under the Pension Plan. Additionally, all pension plans acquired by the Company in connection with its previous whole-bank acquisitions were frozen prior to or shortly after completion of the transactions. On January 14, 2005, in connection with its acquisition of HRB, the Company became the sponsor of HRB's retirement plan, which was frozen on December 31, 2004. This plan had an accumulated benefit obligation of $26.1 million and a fair value of plan assets of $24.2 million at the time of acquisition. During 2005 the Company contributed $6.4 million to the Pension Plan. As of December 31, 2005, the Company has met all minimum ERISA funding requirements. As of October 1, 2005 and 2004 the accumulated benefit obligation of one of First Niagara's unfunded pension plans exceeded the fair value of its assets. Accordingly, the Company has recorded within stockholders' equity a $411 thousand additional minimum pension liability less taxes of $165 thousand for 2005 and a $552 thousand additional minimum pension liability less taxes of $221 thousand for 2004. The projected benefit obligation for this plan was $2.0 million at October 1, 2005 and 2004. 76 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 Information regarding the Company's pension plans at December 31, 2005 and 2004 are as follows (in thousands):
2005 2004 -------- -------- Change in projected benefit obligation: Projected benefit obligation at beginning of year $ 41,901 16,818 Projected benefit obligation assumed in acquisition 26,084 22,380 Interest cost 3,855 2,115 Actuarial loss 4,300 2,178 Benefits paid (3,193) (1,724) Settlements -- (69) Plan amendments -- 203 -------- -------- Projected benefit obligation at end of year 72,947 41,901 -------- -------- Change in fair value of plan assets: Fair value of plan assets at beginning of year 40,328 14,675 Plan assets acquired 24,182 23,067 Employer contributions 6,381 2,945 Actual gain on plan assets 4,491 1,434 Benefits paid (3,193) (1,724) Settlements -- (69) -------- -------- Fair value of plan assets at end of year 72,189 40,328 -------- -------- Projected benefit obligation in excess of plan assets at end of year (758) (1,573) Unrecognized actuarial loss 12,945 8,087 -------- -------- Prepaid pension costs $ 12,187 6,514 ======== ======== Accumulated benefit obligation $ 72,947 41,901 ======== ========
Net pension (income) cost is comprised of the following (in thousands): 2005 2004 2003 ------- ------- ------- Interest cost $ 3,855 2,115 868 Expected return on plan assets (5,448) (2,934) (871) Amortization of unrecognized loss 381 275 207 Amortization of unrecognized prior service liability 16 -- -- ------- ------- ------- Net periodic pension (income) cost $(1,196) (544) 204 ======= ======= ======= The principal actuarial assumptions used were as follows:
Projected benefit obligation 2005 2004 2003 ------- ------- ------- Discount rate 5.25% 5.75% 6.00% Expected long-term rate of return on plan assets 8.00% 9.00% 9.00% ======= ======= ======= Net periodic pension (income) cost Discount rate 5.75% 6.00% 6.50% Expected long-term rate of return on plan assets 9.00% 9.00% 8.50% ======= ======= =======
77 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 The discount rate used in the measurement of the pension obligation is based on the Moody's Seasoned Aaa and Aa corporate bond rates as of the measurement date. The expected long-term rate of return on plan assets reflects long-term earnings expectations on existing plan assets and those contributions expected to be received during the current plan year. In estimating that rate, appropriate consideration was given to historical returns earned by plan assets in the fund and the rates of return expected to be available for reinvestment. Rates of return were adjusted to reflect current capital market assumptions and changes in investment allocations. Equities and fixed income securities were assumed to earn a return in the range of 7% to 8% and 5% to 6%, respectively. The long-term inflation rate was estimated to be 2.6%. When these overall return expectations are applied to the Pension Plan's target allocation, the expected rate of return is determined to be 8.0%. The weighted average asset allocation of the Company's Pension Plan at October 1, 2005 and 2004, the plans measurement date, were as follows (in thousands): 2005 2004 ------ ------ Asset Category: Equity mutual funds 43% 69% Bond mutual funds 49% 31% Cash 8% -- ------ ------ 100% 100% ====== ====== The Company's target allocation for investment in equity mutual funds is 40% - 60% with a mix between large cap core and value, small cap and international companies. The target allocation for bond mutual fund investments is 40% - 60% with a mix between actively managed and intermediate bond funds. This allocation is consistent with the Company's goal of diversifying the Pension Plans assets in order to preserve capital while achieving investment results that will contribute to the proper funding of pension obligations and cash flow requirements. Asset rebalancing is performed at least annually, with interim adjustments made when the investment mix varies by more than 5% from the target. Estimated benefit payments under the Company's Pension Plan over the next ten years at December 31, 2005 are as follows (in thousands): 2006 $ 3,256 2007 3,229 2008 3,230 2009 3,272 2010 3,271 2011-2015 18,489 ========= 78 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 Other Post-retirement Benefits The Company has modified the Post-retirement Plan so that participation is closed to those employees who did not meet the retirement eligibility requirements by December 31, 2001. A reconciliation of the benefit obligation and accrued benefit cost of the Post-retirement Plan at December 31, 2005 and 2004 are as follows (in thousands):
2005 2004 ------- ------- Change in accumulated post-retirement benefit obligation: Accumulated post-retirement benefit obligation at beginning of year $ 8,615 4,987 Post-retirement benefit obligation assumed in acquisitions 304 3,576 Interest cost 501 434 Actuarial loss 665 5 Benefits paid (507) (387) ------- ------- Accumulated post-retirement benefit obligation at end of year 9,578 8,615 Fair value of plan assets at end of year -- -- ------- ------- Post-retirement benefit obligation in excess of plan assets at end of year (9,578) (8,615) Unrecognized actuarial loss 2,146 1,583 Unrecognized prior service cost (626) (691) ------- ------- Accrued post-retirement benefit cost at end of year $(8,058) (7,723) ======= ======= Accumulated post-retirement benefit obligation $ 9,578 8,615 ======= =======
The components of net periodic post-retirement benefit cost are as follows (in thousands):
2005 2004 2003 ----- ----- ----- Interest cost $ 501 434 277 Amortization of unrecognized loss 100 90 53 Amortization of unrecognized prior service cost (64) (64) (64) ----- ----- ----- Total periodic cost $ 537 460 266 ===== ===== =====
The principal actuarial assumptions used were as follows:
Accumulated post-retirement benefit obligation 2005 2004 2003 ------- ------- ------- Discount rate 5.25% 5.75% 6.00% Assumed rate of future compensation increase 4.00% 4.00% 4.00% ======= ======= ======= Total periodic cost Discount rate 5.75% 6.00% 6.50% Assumed rate of future compensation increase 4.00% 4.00% 4.00% ======= ======= =======
79 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 The Company uses an October 1st measurement date for the Post-retirement Plan. The discount rate used in the measurement of the post-retirement obligation is based on the Moody's Seasoned Aaa and Aa corporate bond rates as of the measurement date. The assumed health care cost trend rate used in measuring the accumulated post-retirement benefit obligation was 8.0% for 2006, and gradually decreased to 5.0% by 2009 and thereafter. This assumption can have a significant effect on the amounts reported. If the rate were increased one percent, the accumulated post-retirement benefit obligation as of December 31, 2005 would have increased by 13% and total periodic cost would have increased by 10%. If the rate were decreased one percent, the accumulated post-retirement benefit obligation as of December 31, 2005 would have decreased by 11% and the total periodic cost would have decreased by 8%. The Company does not anticipate making any contributions to the Post-retirement Plan in 2006. The Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the "Medicare Act") introduced prescription drug benefits under Medicare Part D as well as a Federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. As permitted, the Company has elected to defer recognizing the effects of the Medicare Act from the calculation of its accumulated post-retirement benefit obligation and cost. In January 2005, the Centers for Medicare and Medicaid Services released final regulations implementing the Medicare Act. The Medicare Act's effect on the Company's post-retirement benefit obligation and cost is not expected to be significant to the Company's consolidated statement of condition or results of operations. Estimated benefit payments under the Post-retirement Plan over the next ten years at December 31, 2005 is as follows (in thousands): 2006 $ 631,582 2007 637,380 2008 633,537 2009 628,307 2010 620,290 2011-2015 3,200,024 Other Plans The Company also sponsors various non-qualified compensation plans for officers and employees. Awards are payable if certain earnings and performance objectives are met. Awards under these plans amounted to $5.9 million, $4.5 million and $3.7 million for 2005, 2004 and 2003, respectively. The Company also maintains various unfunded supplemental benefit plans for certain former and present executive officers. The accrued benefit liability under these plans was $1.6 million and $1.1 million at December 31, 2005 and 2004, respectively. 80 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 (16) Fair Value of Financial Instruments The carrying value and estimated fair value of the Company's financial instruments at December 31, 2005 and 2004 are as follows (in thousands): Carrying Estimated fair value value ---------- -------------- December 31, 2005: Financial assets: Cash and cash equivalents $ 140,128 $ 140,128 Securities available for sale 1,604,888 1,604,888 Loans and leases, net 5,216,299 5,245,380 FHLB stock 47,269 47,269 Financial liabilities: Deposits $5,479,412 $5,460,811 Borrowings 1,096,427 1,094,909 December 31, 2004: Financial assets: Cash and cash equivalents $ 67,642 $ 67,642 Securities available for sale 1,170,129 1,170,129 Loans and leases, net 3,215,255 3,262,380 FHLB stock 28,485 28,485 Financial liabilities: Deposits $3,337,682 $3,331,553 Borrowings 750,686 769,257 Fair value estimates are based on existing on and off balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in these estimates. Fair value estimates are made as of the dates indicated, based on relevant market information and information about the financial instruments, including judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Fair value estimates, methods, and assumptions are set forth below for each type of financial instrument. Cash and Cash Equivalents The carrying value approximates the fair value because the instruments have original maturities of three months or less. 81 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 Securities Available for Sale The carrying value and fair value are estimated based on year-end quoted market prices. Loans and Leases Variable-rate loans reprice as the rate they are indexed to changes. Therefore, the carrying value of such loans approximates their fair value. The fair value of fixed-rate loans and leases are calculated by discounting scheduled cash flows through estimated maturity using year-end origination rates. The estimate of maturity is based on the contractual cash flows adjusted for prepayment estimates based on current economic and lending conditions. FHLB Stock FHLB stock carrying value approximates fair value. Deposits The fair value of deposits with no stated maturity, such as savings and checking, as well as mortgagors' payments held in escrow, is equal to the amount payable on demand. The fair value of certificates of deposit is based on the discounted value of contractual cash flows, using rates currently offered for deposits of similar remaining maturities. Borrowings The fair value of borrowings is calculated by discounting scheduled cash flows through the estimated maturity using current market rates. Commitments The fair value of commitments to extend credit, standby letters of credit and financial guarantees are not included in the above table as the carrying value generally approximates fair value. These instruments generate fees that approximate those currently charged to originate similar commitments. Additional information about these instruments is included in note 10. (17) Segment Information The Company has two business segments, banking and financial services. The financial services segment includes the Company's insurance, investment advisory, trust and employee benefits administration and consulting businesses. The banking segment includes the results of First Niagara excluding financial services. The results of operations from NOVA Healthcare Administrators, Inc., the third-party benefit plan administrator subsidiary sold in February 2003, are included as discontinued operations in the financial services segment. Transactions between the banking and financial services segments are primarily related to interest income and expense on intercompany deposit accounts, and are eliminated in consolidation. 82 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 Information for the Company's segments for the years ended December 31, 2005, 2004 and 2003 is presented in the following table (in thousands):
Financial Consolidated Banking services Eliminations total -------- -------- ------------ ------------ 2005 Net interest income $250,104 46 -- 250,150 Provision for credit losses 7,348 -- -- 7,348 -------- -------- -------- -------- Net interest income after provision for credit losses 242,756 46 -- 242,802 Noninterest income 52,387 38,372 (96) 90,663 Amortization of core deposit and other intangibles 9,000 3,083 -- 12,083 Other noninterest expense 145,414 30,805 (96) 176,123 -------- -------- -------- -------- Income before income taxes 140,729 4,530 -- 145,259 Income tax expense 50,588 1,812 -- 52,400 -------- -------- -------- -------- Net income $ 90,141 2,718 -- 92,859 ======== ======== ======== ======== 2004 Net interest income $156,071 31 -- 156,102 Provision for credit losses 8,442 -- -- 8,442 -------- -------- -------- -------- Net interest income after provision for credit losses 147,629 31 -- 147,660 Noninterest income 29,705 22,227 (66) 51,866 Amortization of core deposit and other intangibles 3,435 1,170 -- 4,605 Other noninterest expense 98,961 17,350 (66) 116,245 -------- -------- -------- -------- Income before income taxes 74,938 3,738 -- 78,676 Income tax expense 25,364 1,495 -- 26,859 -------- -------- -------- -------- Net income $ 49,574 2,243 -- 51,817 ======== ======== ======== ======== 2003 Net interest income $107,354 61 -- 107,415 Provision for credit losses 7,929 -- -- 7,929 -------- -------- -------- -------- Net interest income after provision for credit losses 99,425 61 -- 99,486 Noninterest income 25,070 18,346 (37) 43,379 Amortization of core deposit and other intangibles 439 945 -- 1,384 Other noninterest expense 72,420 14,510 (37) 86,893 -------- -------- -------- -------- Income from continuing operations before income taxes 51,636 2,952 -- 54,588 Income taxes from continuing operations 17,465 1,181 -- 18,646 -------- -------- -------- -------- Income from continuing operations 34,171 1,771 -- 35,942 Income from discontinued operations -- 164 -- 164 -------- -------- -------- -------- Net income $ 34,171 1,935 -- 36,106 ======== ======== ======== ========
83 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003 (18) Condensed Parent Company Only Financial Statements The following condensed statements of condition of FNFG as of December 31, 2005 and 2004 and the related condensed statements of income and cash flows for 2005, 2004 and 2003 should be read in conjunction with the consolidated financial statements and related notes (in thousands):
2005 2004 ---------- ---------- Condensed Statements of Condition Assets: Cash and cash equivalents $ 46,722 4,230 Investment securities available for sale 1,205 2,565 Loan receivable from ESOP 30,810 31,410 Investment in subsidiary 1,282,603 883,249 Other assets 16,108 7,275 ---------- ---------- Total assets $1,377,448 928,729 ========== ========== Liabilities and Stockholders' Equity: Accounts payable and other liabilities $ 3,025 567 Stockholders' equity 1,374,423 928,162 ---------- ---------- Total liabilities and stockholders' equity $1,377,448 928,729 ========== ==========
2005 2004 2003 --------- --------- --------- Condensed Statements of Income Interest income $ 1,702 1,815 2,958 Dividends received from subsidiary 215,000 38,600 32,500 --------- --------- --------- Total interest income 216,702 40,415 35,458 Interest expense 109 -- -- --------- --------- --------- Net interest income 216,593 40,415 35,458 Net realized losses on securities available for sale -- -- (79) Noninterest income 1,905 -- -- Noninterest expense 5,569 3,575 2,770 --------- --------- --------- Income before income taxes and undistributed income of subsidiary 212,929 36,840 32,609 Income tax benefit (1,073) (808) (101) --------- --------- --------- Income before undistributed income of subsidiary 214,002 37,648 32,710 Undistributed income of subsidiary (121,143) 14,169 3,396 --------- --------- --------- Net income $ 92,859 51,817 36,106 ========= ========= =========
84 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2004 and 2003
Condensed Statements of Cash Flows 2005 2004 2003 --------- --------- --------- Cash flows from operating activities: Net income $ 92,859 51,817 36,106 Adjustments to reconcile net income to net cash provided by operating activities: Undistributed income of subsidiary 121,143 (14,169) (3,396) Net realized losses on securities available for sale -- -- 79 Stock based compensation expense 1,565 1,099 1,501 Deferred income tax expense (benefit) 95 (207) (130) (Increase) decrease in other assets 3,956 267 (4,201) Increase (decrease) in other liabilities 392 (760) (1,169) --------- --------- --------- Net cash provided by operating activities 220,010 38,047 38,28,790 --------- --------- --------- Cash flows from investing activities: Proceeds from sales of securities available for sale 1,400 206 3,543 Purchases of securities available for sale -- (1,000) -- Acquisitions, net of cash and cash equivalents (50,852) (146,538) (28,128) Repayment of ESOP loan receivable 600 570 681 --------- --------- --------- Net cash used in investing activities (48,852) (146,762) (23,904) --------- --------- --------- Cash flows from financing activities: Purchase of treasury stock (87,964) (34,961) (1,604) Proceeds from exercise of stock options 1,658 4,049 459 Dividends paid on common stock (42,360) (23,920) (14,642) Net proceeds from Conversion and Offering -- -- 195,454 Purchase of common stock by ESOP -- -- (20,500) --------- --------- --------- Net cash provided by (used in) financing activities (128,666) (54,832) 159,167 --------- --------- --------- Net increase (decrease) in cash and cash equivalents 42,492 (163,547) 164,053 Cash and cash equivalents at beginning of year 4,230 167,777 3,724 --------- --------- --------- Cash and cash equivalents at end of year $ 46,722 4,230 167,777 ========= ========= =========
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE -------------------------------------------------------------------------------- Not applicable. ITEM 9A. CONTROLS AND PROCEDURES -------------------------------------------------------------------------------- Management's Report on Internal Control Over Financial Reporting - Filed herewith under Part II, Item 8, "Financial Statements and Supplementary Data." 85 ITEM 9A. CONTROLS AND PROCEDURES (Continued) -------------------------------------------------------------------------------- Evaluation of Disclosure Controls and Procedures - With the participation of management, the Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of December 31, 2005. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of that date, the Company's disclosure controls and procedures are effective to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms. There has been no change in the Company's internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. ITEM 9B. OTHER INFORMATION -------------------------------------------------------------------------------- Not applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT -------------------------------------------------------------------------------- Information regarding directors and executive officers of FNFG in the Proxy Statement for the 2006 Annual Meeting of Stockholders is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION -------------------------------------------------------------------------------- Information regarding executive compensation in the Proxy Statement for the 2006 Annual Meeting of Stockholders is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS -------------------------------------------------------------------------------- Information regarding security ownership of certain beneficial owners of FNFG management in the Proxy Statement for the 2006 Annual Meeting of Stockholders is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS -------------------------------------------------------------------------------- Information regarding certain relationships and related transactions in the Proxy Statement for the 2006 Annual Meeting of Stockholders is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES -------------------------------------------------------------------------------- Information regarding the fees paid to and services provided by KPMG LLP, the Company's independent registered public accounting firm in the Proxy Statement for the 2006 Annual Meeting of Stockholders is incorporated herein by reference. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES -------------------------------------------------------------------------------- (a) Financial statements are filed as part of this Annual Report on Form 10-K. See Part II, Item 8. "Financial Statements and Supplementary Data." 86 ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES (Continued) -------------------------------------------------------------------------------- (b) Exhibits The exhibits listed below are filed herewith or are incorporated by reference to other filings. Exhibit Index to Form 10-K Exhibit 3.3 Certificate of Incorporation (1) Exhibit 3.4 Amended and Restated Bylaws (2) Exhibit 10.1 Form of Employment Agreement with the Named Executive Officers (3) Exhibit 10.2 First Niagara Bank Deferred Compensation Plan (4) Exhibit 10.3 First Niagara Financial Group, Inc. 1999 Stock Option Plan Exhibit 10.4 First Niagara Financial Group, Inc. 1999 Recognition and Retention Plan(5) Exhibit 10.5 First Niagara Financial Group, Inc. Amended and Restated 2002 Long-Term Incentive Stock Benefit Plan Exhibit 10.6 First Amended and Restated Revolving Credit Promissory Note with Fifth Third Bank (6) Exhibit 10.7 Residential Mortgage Program Agreement with Homestead Funding Corp. (7) Exhibit 10.8 First Niagara Financial Group, Inc. 2005 Long-Term Performance Plan(8) Exhibit 11 Calculations of Basic Earnings Per Share and Diluted Earnings Per Share (See Note 14 to Notes to Consolidated Financial Statements) Exhibit 14 Code of Ethics for Senior Financial Officers (9) Exhibit 21 Subsidiary of First Niagara Financial Group, Inc. (See Part I, Item 1 of Form 10-K) Exhibit 23 Consent of Independent Registered Public Accounting Firm Exhibit 31.1 Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Exhibit 31.2 Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Exhibit 32 Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (1) Incorporated by reference to the Company's Registration Statement on Form S-1, originally filed with the Securities and Exchange Commission on September 18, 2002. (2) Incorporated by reference to the Company's Current Report on Form 8-K filed with the Securities and Exchange Commission on January 3, 2006. (3) Incorporated by reference to the Company's Pre-effective Amendment No. 1 to the Registration Statement on Form S-1, filed with the Securities and Exchange Commission on November 14, 2002. (4) Incorporated by reference to the Company's Registration Statement on Form S-1, originally filed with the Securities and Exchange Commission on December 22, 1997. (5) Incorporated by reference to the Company's Proxy Statement for the 1999 Annual Meeting of Stockholders filed with the Securities and Exchange Commission on March 31, 1999. (6) Incorporated by reference to the Company's Current Report on Form 8-K filed with the Securities and Exchange Commission on December 7, 2004. (7) Incorporated by reference to the Company's 2004 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 15, 2005. (8) Incorporated by reference to the Company's Current Report on Form 8-K filed with the Securities and Exchange Commission on September 23, 2005. (9) Incorporated by reference to the Company's 2003 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 12, 2004. 87 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FIRST NIAGARA FINANCIAL GROUP, INC. Date: March 14, 2006 By: /s/ Paul J. Kolkmeyer ------------------------------------- Paul J. Kolkmeyer President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signatures Title Date ---------- ----- ---- /s/ Paul J. Kolkmeyer President and Chief Executive March 14, 2006 ---------------------------- Officer Paul J. Kolkmeyer /s/ John R. Koelmel Executive Vice President, March 14, 2006 ---------------------------- Chief Financial Officer John R. Koelmel /s/ Gordon P. Assad Director March 14, 2006 ---------------------------- Gordon P. Assad /s/ John J. Bisgrove, Jr. Director March 14, 2006 ---------------------------- John J. Bisgrove, Jr. /s/ G. Thomas Bowers Director March 14, 2006 ---------------------------- G. Thomas Bowers /s/ James W. Currie Director March 14, 2006 ---------------------------- James W. Currie /s/ Daniel J. Hogarty, Jr. Vice Chairman March 14, 2006 ---------------------------- Daniel J. Hogarty, Jr. /s/ William H. Jones Vice Chairman March 14, 2006 ---------------------------- William H. Jones /s/ Daniel W. Judge Director March 14, 2006 ---------------------------- Daniel W. Judge /s/ Richard P. Koskey Director March 14, 2006 ---------------------------- Richard P. Koskey /s/ B. Thomas Mancuso Director March 14, 2006 ---------------------------- B. Thomas Mancuso /s/ James Miklinski Director March 14, 2006 ---------------------------- James Miklinski /s/ Sharon D. Randaccio Director March 14, 2006 ---------------------------- Sharon D. Randaccio /s/ Robert G. Weber Chairman March 14, 2006 ---------------------------- Robert G. Weber /s/ Louise Woerner Director March 14, 2006 ---------------------------- Louise Woerner /s/ David M. Zebro Director March 14, 2006 ---------------------------- David M. Zebro 88