10-Q 1 penseco10qjune302008.txt 1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ------------------ FORM 10-Q ------------------ /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2008 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 ------------------ Commission file number 000-23777 PENSECO FINANCIAL SERVICES CORPORATION Incorporated pursuant to the laws of Pennsylvania ------------------ Internal Revenue Service -- Employer Identification No. 23-2939222 150 North Washington Avenue, Scranton, Pennsylvania 18503-1848 (570) 346-7741 ------------------ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /X/ No /_/ Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer /_/ Accelerated filer /X/ Non-accelerated filer /_/ Smaller reporting company /_/ (Do not check if a smaller reporting company) Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes /_/ No /X/ The total number of shares of the registrant's Common Stock, $0.01 par value, outstanding on July 25, 2008 was 2,148,000. ================================================================================ 2 PENSECO FINANCIAL SERVICES CORPORATION Page Part I -- FINANCIAL INFORMATION Item 1. Unaudited Financial Statements - Consolidated Balance Sheets: June 30, 2008................................................ 3 December 31, 2007............................................ 3 Statements of Income: Three Months Ended June 30, 2008............................. 4 Three Months Ended June 30, 2007............................. 4 Six Months Ended June 30, 2008............................... 5 Six Months Ended June 30, 2007............................... 5 Statements of Cash Flows: Six Months Ended June 30, 2008............................... 6 Six Months Ended June 30, 2007............................... 6 Notes to Unaudited Consolidated Financial Statements........... 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................................... 15 Item 3. Quantitative and Qualitative Disclosures About Market Risk..... 28 Item 4. Controls and Procedures........................................ 29 Part II -- OTHER INFORMATION Item 1. Legal Proceedings.............................................. 30 Item 1A. Risk Factors................................................... 30 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds..... 32 Item 3. Defaults Upon Senior Securities................................. 32 Item 4. Submission of Matters to a Vote of Security Holders............. 32 Item 5. Other Information............................................... 33 Item 6. Exhibits........................................................ 33 Signatures................................................................... 33 2 3 PART I. FINANCIAL INFORMATION, ITEM 1 -- FINANCIAL STATEMENTS PENSECO FINANCIAL SERVICES CORPORATION CONSOLIDATED BALANCE SHEETS (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
June 30, December 31, 2008 2007 ------------- ------------ ASSETS Cash and due from banks $ 15,054 $ 10,677 Interest bearing balances with banks 4,171 967 Federal funds sold - - ------------- ------------ Cash and Cash Equivalents 19,225 11,644 Investment securities: Available-for-sale, at fair value 103,154 77,328 Held-to-maturity (fair value of $65,685 and $69,491, respectively) 64,670 68,120 ------------- ------------ Total Investment Securities 167,824 145,448 Loans, net of unearned income 422,293 404,639 Less: Allowance for loan losses 5,140 4,700 ------------- ------------ Loans, Net 417,153 399,939 Bank premises and equipment 9,092 9,323 Other real estate owned - - Accrued interest receivable 3,641 3,558 Cash surrender value of life insurance 7,525 7,368 Other assets 4,436 3,513 ------------- ------------ Total Assets $628,896 $580,793 ============= ============ LIABILITIES Deposits: Non-interest bearing $ 75,049 $ 73,926 Interest bearing 361,980 342,607 ------------- ------------ Total Deposits 437,029 416,533 Other borrowed funds: Repurchase agreements 38,376 20,492 Short-term borrowings 454 13,201 Long-term borrowings 77,807 55,966 Accrued interest payable 1,423 1,498 Other liabilities 1,416 3,388 ------------- ------------ Total Liabilities 556,505 511,078 ------------- ------------ STOCKHOLDERS' EQUITY Common stock ($ .01 par value, 15,000,000 shares authorized, 2,148,000 shares issued and outstanding) 21 21 Surplus 10,819 10,819 Retained earnings 62,820 59,697 Accumulated other comprehensive income (1,269) (822) ------------- ------------ Total Stockholders' Equity 72,391 69,715 ------------- ------------ Total Liabilities and Stockholders' Equity $628,896 $580,793 ============= ============
(See accompanying Notes to Unaudited Consolidated Financial Statements) 3 4 PENSECO FINANCIAL SERVICES CORPORATION CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Three Months Ended Three Months Ended Ended Ended June 30, 2008 June 30, 2007 ------------------ ------------------ INTEREST INCOME Interest and fees on loans $ 6,436 $ 6,559 Interest and dividends on investments: U.S. Treasury securities and U.S. Agency obligations 1,100 952 States & political subdivisions 836 724 Other securities 69 97 Interest on Federal funds sold - 219 Interest on balances with banks 23 102 ------------------ ------------------ Total Interest Income 8,464 8,653 ------------------ ------------------ INTEREST EXPENSE Interest on time deposits of $100,000 or more 355 527 Interest on other deposits 1,424 1,915 Interest on other borrowed funds 1,018 869 ------------------ ------------------ Total Interest Expense 2,797 3,311 ------------------ ------------------ Net Interest Income 5,667 5,342 Provision for loan losses 216 124 ------------------ ------------------ Net Interest Income After Provision for Loan Losses 5,451 5,218 ------------------ ------------------ NON-INTEREST INCOME Trust department income 382 367 Service charges on deposit accounts 396 260 Merchant transaction income 935 873 Other fee income 489 373 Bank-owned life insurance income 80 77 Other operating income 82 30 VISA mandatory share redemption - - Realized gains (losses) on securities, net - - ------------------ ------------------ Total Non-Interest Income 2,364 1,980 ------------------ ------------------ NON-INTEREST EXPENSES Salaries and employee benefits 2,509 2,330 Expense of premises and fixed assets 667 725 Merchant transaction expenses 703 671 Other operating expenses 1,578 1,385 ------------------ ------------------ Total Non-Interest Expenses 5,457 5,111 ------------------ ------------------ Income before income taxes 2,358 2,087 Applicable income taxes 430 387 ------------------ ------------------ Net Income 1,928 1,700 Other comprehensive income, net of taxes: Unrealized securities (losses) gains (1,299) (222) Unrealized gains on employee benefit plans 445 - ------------------ ------------------ Comprehensive Income $ 1,074 $ 1,478 ================== ================== Earnings per Common Share (Based on 2,148,000 shares outstanding) $ 0.89 $ 0.79 Cash Dividends Declared Per Common Share $ 0.41 $ 0.37
(See accompanying Notes to Unaudited Consolidated Financial Statements) 4 5 PENSECO FINANCIAL SERVICES CORPORATION CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Six Months Ended Six Months Ended Ended Ended June 30, 2008 June 30, 2007 ------------------ ------------------ INTEREST INCOME Interest and fees on loans $ 13,097 $ 12,852 Interest and dividends on investments: U.S. Treasury securities and U.S. Agency obligations 2,005 1,963 States & political subdivisions 1,672 1,445 Other securities 143 238 Interest on Federal funds sold - 304 Interest on balances with banks 34 193 ------------------ ------------------ Total Interest Income 16,951 16,995 ------------------ ------------------ INTEREST EXPENSE Interest on time deposits of $100,000 or more 806 1,036 Interest on other deposits 2,957 3,727 Interest on other borrowed funds 1,944 1,645 ------------------ ------------------ Total Interest Expense 5,707 6,408 ------------------ ------------------ Net Interest Income 11,244 10,587 Provision for loan losses 451 220 ------------------ ------------------ Net Interest Income After Provision for Loan Losses 10,793 10,367 ------------------ ------------------ NON-INTEREST INCOME Trust department income 747 739 Service charges on deposit accounts 659 511 Merchant transaction income 2,119 1,920 Other fee income 968 654 Bank-owned life insurance income 158 155 Other operating income 118 46 VISA mandatory share redemption 1,213 - Realized gains (losses) on securities, net - 51 ------------------ ------------------ Total Non-Interest Income 5,982 4,076 ------------------ ------------------ NON-INTEREST EXPENSES Salaries and employee benefits 4,924 4,705 Expense of premises and fixed assets 1,435 1,350 Merchant transaction expenses 1,605 1,495 Other operating expenses 2,551 2,793 ------------------ ------------------ Total Non-Interest Expenses 10,515 10,343 ------------------ ------------------ Income before income taxes 6,260 4,100 Applicable income taxes 1,375 730 ------------------ ------------------ Net Income 4,885 3,370 Other comprehensive income, net of taxes: Unrealized securities (losses) gains (892) (200) Unrealized gains on employee benefit plans 445 - ------------------ ------------------ Comprehensive Income $ 4,438 $ 3,170 ================== ================== Earnings per Common Share (Based on 2,148,000 shares outstanding) $ 2.27 $ 1.57 Cash Dividends Declared Per Common Share $ 0.82 $ 0.74
(See accompanying Notes to Unaudited Consolidated Financial Statements) 5 6 PENSECO FINANCIAL SERVICES CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (IN THOUSANDS)
Six Months Ended Six Months Ended Ended Ended June 30, 2008 June 30, 2007 ------------------ ------------------ OPERATING ACTIVITIES Net Income $ 4,885 $ 3,370 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 417 418 Provision for loan losses 451 220 Deferred income tax provision (benefit) 13 7 Amortization of securities, (net of accretion) 148 196 Gain on VISA mandatory share redemption (1,213) - Net realized (gains) losses on securities - (51) (Gain) loss on other real estate - (20) (Increase) decrease in interest receivable (83) (35) (Increase) decrease in cash surrender value of life insurance (157) (155) (Increase) decrease in other assets (936) (602) Increase (decrease) in income taxes payable 1,386 96 (Decrease) increase in interest payable (75) 89 (Decrease) increase in other liabilities (800) (313) ------------------ ------------------ Net cash provided (used) by operating activities 4,036 3,220 ------------------ ------------------ INVESTING ACTIVITIES Purchase of investment securities available-for-sale (38,465) (10,922) Proceeds from sales and maturities of investment securities available-for-sale 6,282 21,366 Purchase of investment securities to be held-to-maturity - - Proceeds from repayments of investment securities available-for-sale 5,000 5,941 Proceeds from repayments of investment securities held-to-maturity 3,306 3,097 Net loans (originated) repaid (18,105) (16,122) Proceeds from other real estate - 65 Investment in premises and equipment (186) (742) ------------------ ------------------ Net cash (used) provided by investing activities (42,168) 2,683 ------------------ ------------------ FINANCING ACTIVITIES Net increase (decrease) in demand and savings deposits 15,864 9,290 Net proceeds (payments) on time deposits 4,632 1,060 Increase (decrease) in federal funds purchased - - Increase (decrease) in repurchase agreements 17,884 15,119 Net (decrease) increase in short-term borrowings (12,747) (5,068) Increase in long-term borrowings 27,000 - Repayments of long-term borrowings (5,159) (4,900) Cash dividends paid (1,761) (1,590) ------------------ ------------------ Net cash provided (used) by financing activities 45,713 13,911 ------------------ ------------------ Net increase (decrease) in cash and cash equivalents 7,581 19,814 Cash and cash equivalents at January 1 11,644 14,778 ------------------ ------------------ Cash and cash equivalents at June 30 $ 19,225 $ 34,592 ================== ==================
The Company paid interest and income taxes of $5,782 and $1,928 and $6,319 and $640, for the six month period ended June 30, 2008 and 2007, respectively. (See accompanying Notes to Unaudited Consolidated Financial Statements) 6 7 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS FOR THE QUARTER ENDED JUNE 30, 2008 (UNAUDITED) These Notes to Unaudited Consolidated Financial Statements reflect events subsequent to December 31, 2007, the date of the most recent Report of Independent Registered Public Accounting Firm, through the date of this Quarterly Report on Form 10-Q. These Notes to Unaudited Consolidated Financial Statements should be read in conjunction with Parts I and II of this Report, in particular, (1) Part I, Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations for the three and six month periods ended June 30, 2008 and June 30, 2007, with respect to the Company's net interest income, capital requirements and liquidity, (2) Part II, Item 6, Exhibits and (3) the Company's Annual Report on Form 10-K for the year ended December 31, 2007, which was filed with the Securities and Exchange Commission on March 17, 2008 and is incorporated herein by reference. FORWARD LOOKING INFORMATION This Quarterly Report on Form 10-Q contains forward-looking statements that are based on assumptions and may describe future plans, strategies and expectations of Penseco Financial Services Corporation. These forward-looking statements are generally identified by use of the words "believe," "expect," "intend," "anticipate," "estimate," "project" or similar expressions. Penseco Financial Services Corporation's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations of Penseco Financial Services Corporation and its subsidiary include, but are not limited to, changes in interest rates, national and regional economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in Penseco Financial Services Corporation's market area, changes in real estate market values in Penseco Financial Services Corporation's market area, changes in relevant accounting principles and guidelines and inability of third party service providers to perform. Additional factors that may affect our results are discussed in Item 1A to this Quarterly Report on Form 10-Q titled "Risk Factors". These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, Penseco Financial Services Corporation does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events. Unless the context indicates otherwise, all references in this Quarterly Report to "Company," "we," "us" and "our" refer to Penseco Financial Services Corporation and its subsidiary. NOTE 1 -- PRINCIPLES OF CONSOLIDATION Penseco Financial Services Corporation is a financial holding company incorporated under the laws of Pennsylvania. It is the parent company of Penn Security Bank and Trust Company (Bank), a Pennsylvania state chartered bank. Intercompany transactions have been eliminated in preparing the consolidated financial statements. The accounting policies of the Company conform with accounting principles generally accepted in the United States of America and with general practices within the banking industry. NOTE 2 -- BASIS OF PRESENTATION The unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information. In the opinion of management, all adjustments that are of a normal recurring nature and are considered necessary for a fair presentation have been included. They are not, however, necessarily indicative of the results of consolidated operations for a full year. All information is presented in thousands of dollars, except per share amounts. For further information, refer to the consolidated financial statements and accompanying notes included in the Company's Annual Report on Form 10-K for the year ended December 31, 2007. 7 8 NOTE 3 -- USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for losses on loans and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowances for losses on loans and foreclosed real estate, management obtains independent appraisals for significant properties. NOTE 4 -- INVESTMENT SECURITIES Investments in securities are classified in two categories and accounted for as follows: Securities Held-to-Maturity Bonds, notes, debentures and mortgage-backed --------------------------- securities for which the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for amortization of premiums and accretion of discounts computed on the straight-line basis, which approximates the interest method, over the remaining period to maturity. Securities Available-for-Sale Bonds, notes, debentures, mortgage-backed ----------------------------- securities and certain equity securities not classified as securities to be held to maturity are carried at fair value with unrealized holding gains and losses, net of tax, reported as a net amount in a separate component of stockholders' equity until realized. The amortization of premiums on mortgage-backed securities is done based on management's estimate of the lives of the securities, adjusted, when necessary, for advanced prepayments in excess of those estimates. Realized gains and losses on the sale of securities available-for-sale are determined using the specific identification method and are reported as a separate component of other income in the Statements of Income. Unrealized gains and losses are included as a separate item in computing comprehensive income. The amortized cost and fair value of investment securities at June 30, 2008 and December 31, 2007 are as follows: AVAILABLE-FOR-SALE
Gross Gross Amortized Unrealized Unrealized Fair June 30, 2008 Cost Gains Losses Value ------------------------------------------------------------------------------------ U.S. Agency securities $ 20,224 $ 154 $ 77 $ 20,301 Mortgage-backed securities 35,190 161 641 34,710 States & political subdivisions 40,398 507 234 40,671 ------------------------------------------------------------------------------------ Total Debt Securities 95,812 822 952 95,682 Equity securities 7,249 1,048 825 7,472 ------------------------------------------------------------------------------------ Total Available-for-Sale $103,061 $ 1,870 $ 1,777 $103,154 ------------------------------------------------------------------------------------
AVAILABLE-FOR-SALE Gross Gross Amortized Unrealized Unrealized Fair June 30, 2008 Cost Gains Losses Value ------------------------------------------------------------------------------------ U.S. Agency securities $ 14,929 $ 144 $ - $ 15,073 Mortgage-backed securities 15,402 161 - 15,563 States & political subdivisions 38,740 830 96 39,474 ------------------------------------------------------------------------------------ Total Debt Securities 69,071 1,135 96 70,110 Equity securities 6,812 921 515 7,218 ------------------------------------------------------------------------------------ Total Available-for-Sale $ 75,883 $ 2,056 $ 611 $ 77,328 ------------------------------------------------------------------------------------
8 9
HELD-TO-MATURITY Gross Gross Amortized Unrealized Unrealized Fair June 30, 2008 Cost Gains Losses Value ------------------------------------------------------------------------------------ Mortgage-backed securities $ 35,434 $ 1 $ 441 $ 34,994 States & political subdivisions 29,236 1,455 - 30,691 ------------------------------------------------------------------------------------ Total Held-to-Maturity $ 64,670 $1,456 $ 441 $ 65,685 ------------------------------------------------------------------------------------
HELD-TO-MATURITY
Gross Gross Amortized Unrealized Unrealized Fair June 30, 2008 Cost Gains Losses Value ------------------------------------------------------------------------------------ Mortgage-backed securities $ 38,880 $ 3 $ 341 $ 38,542 States & political subdivisions 29,240 1,709 - 30,949 ------------------------------------------------------------------------------------ Total Held-to-Maturity $ 68,120 $1,712 $ 341 $ 69,491 ------------------------------------------------------------------------------------
The amortized cost and fair value of debt securities at June 30, 2008 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
June 30, 2008 Available-for-Sale Held-to-Maturity ------------------------------------------------------------------------------------------------- Amortized Fair Amortized Fair Cost Value Cost Value ------------------------------------------------------------------------------------------------- Due in one year or less: U.S. Agency securities $ 4,990 $ 5,019 $ - $ - After one year through five years: U.S. Agency securities 15,234 15,282 - - After five year through ten years: States & political subdivisions 460 484 3,043 3,170 After ten years: States & political subdivisions 39,938 40,187 26,193 27,521 ------------------------------------------------------------------------------------------------- Subtotal 60,622 60,972 29,236 30,691 Mortgage-backed securities 35,190 34,710 35,434 34,994 ------------------------------------------------------------------------------------------------- Total Debt Securities $ 95,812 $ 95,682 $ 64,670 $65,685 -------------------------------------------------------------------------------------------------
The gross fair value and unrealized losses of the Company's investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2008 and December 31, 2007 are as follows:
Less than twelve Twelve months or months more Totals -------------------- --------------------- --------------------- Fair Unrealized Fair Unrealized Fair Unrealized June 30, 2008 Value Losses Value Losses Value Losses ------------------------------------------------------ --------------------- --------------------- U.S. Agency securities $10,154 $ 77 $ - $ - $10,154 $ 77 Mortgage-backed securities 58,058 1,082 - - 58,058 1,082 States & political subdivisions 16,036 234 - - 16,036 234 Equities 90 33 1,140 792 1,230 825 ---------------------- --------------------- --------------------- Total $84,338 $1,426 $1,140 $ 792 $85,478 $2,218 ====================== ===================== =====================
The table above at June 30, 2008, includes thirty-one (31) securities that have unrealized losses for less than twelve months and fifteen (15) securities that have been in an unrealized loss position for twelve or more months. 9 10
Less than twelve Twelve months or months more Totals -------------------- --------------------- --------------------- Fair Unrealized Fair Unrealized Fair Unrealized June 30, 2008 Value Losses Value Losses Value Losses ------------------------------------------------------ --------------------- --------------------- Mortgage-backed securities $ - $ - $38,285 $ 341 $38,285 $ 341 States & political subdivisions 8,817 96 - - 8,817 96 Equities 1,075 285 464 230 1,539 515 ---------------------- --------------------- --------------------- Total $9,892 $ 381 $38,749 $ 571 $48,641 $ 952 ====================== ===================== =====================
U.S. AGENCY SECURITIES The unrealized losses on the Company's investments in these obligations were caused by interest rate fluctuations. The contractual terms of these investments do not permit the issuer to settle the securities at price less than the par value of the investment. Because the Company has the ability to hold these investments until a recovery of fair value, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at June 30, 2008. MORTGAGE-BACKED SECURITIES The unrealized losses on the Company's investments in mortgage-backed securities were caused by interest rate fluctuations. The contractual cash flows of these investments are guaranteed by an agency of the U.S. government. Accordingly, it is expected that these securities would not be settled at a price less than the amortized cost of the Company's investment. Because the decline in market value is attributable to changes in interest rates and not credit quality and because the Company has the ability to hold these investments until a recovery of fair value, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at June 30, 2008. STATE AND POLITICAL SUBDIVISIONS The unrealized losses on the Company's investments in these obligations were caused by interest rate fluctuations. The contractual terms of these investments do not permit the issuer to settle the securities at price less than the par value of the investment. Because the Company has the ability to hold these investments until a recovery of fair value, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at June 30, 2008. MARKETABLE EQUITY SECURITIES The unrealized losses on the Company's investments in marketable equity securities were caused primarily by interest rate fluctuations and other market conditions. The Company's investments in marketable equity securities consist primarily of investments in common stock of companies in the financial services industry. Because the Company has the ability and intent to hold these investments for a reasonable period of time sufficient for a forecasted recovery of fair value, the Company does not consider these investments to be other-than-temporarily impaired at June 30, 2008. 10 11 NOTE 5 -- LOAN PORTFOLIO Details regarding the Company's loan portfolio are as follows:
June 30, December 31, As of: 2008 2007 ------------------------------------------------------------------------------- Real estate - construction and land development $ 24,657 $ 25,858 Real estate mortgages 337,936 318,437 Commercial 24,583 24,505 Credit card and related plans 3,114 3,324 Installment and other 27,363 26,542 Obligations of states & political subdivisions 4,640 5,973 ------------------------------------------------------------------------------- Loans, net of unearned income 422,293 404,639 Less: Allowance for loan losses 5,140 4,700 ------------------------------------------------------------------------------- Loans, net $417,153 $399,939 -------------------------------------------------------------------------------
The Company does not engage in any sub-prime or Alt-A credit lending. Therefore, the Company is not subject to any credit risks associated with such loans. NOTE 6 -- LOAN SERVICING The Company generally retains the right to service mortgage loans sold to others. The cost allocated to the mortgage servicing rights retained has been recognized as a separate asset and is being amortized in proportion to and over the period of estimated net servicing income. Mortgage servicing rights are evaluated for impairment based on the fair value of those rights. Fair values are estimated using discounted cash flows based on current market rates of interest and expected future prepayment rates. For purposes of measuring impairment, the rights must be stratified by one or more predominant risk characteristics of the underlying loans. The Company stratifies its capitalized mortgage servicing rights based on the product type, interest rate and term of the underlying loans. The amount of impairment recognized is the amount, if any, by which the amortized cost of the rights for each stratum exceed the fair value. NOTE 7 -- LONG-TERM DEBT A summary of the long-term debt at June 30, 2008 are as follows:
Monthly Installment Fixed Rate Maturity Date Balance ------------------------------------------------------------------------------- Amortizing loans $ 253 3.22% 03/15/10 $ 5,158 90 3.10% 02/28/13 4,690 430 3.74% 03/13/13 22,427 67 3.44% 03/02/15 4,788 13 3.48% 03/31/15 969 10 3.83% 04/02/18 986 186 4.69% 03/13/23 23,789 ------------------------------------------------------------------------------- Total amortizing 62,807 ------------------------------------------------------------------------------- Non-amortizing loans 2.61% 03/02/09 1,000 2.62% 08/31/09 1,000 2.61% 03/01/10 1,000 2.61% 08/30/10 1,000 2.88% 02/28/11 2,000 3.27% 02/29/12 2,000 3.49% 02/28/13 7,000 ------------------------------------------------------------------------------- Total non-amortizing 15,000 ------------------------------------------------------------------------------- Total long term debt $ 77,807 -------------------------------------------------------------------------------
The loans are secured by a general collateral pledge of the Company. The Company has agreed to maintain sufficient qualifying collateral to fully secure the above borrowings. 11 12 Aggregate maturities of long-term debt at June 30, 2008 are as follows:
June 30, Principal -------- --------- 2009 $ 11,268 2010 11,885 2011 10,932 2012 10,237 2013 13,898 Thereafter 19,587 --------- $ 77,807 =========
NOTE 8 -- EMPLOYEE BENEFIT PLANS The Company provides a post-retirement benefit plan for eligible employees. The components of the post-retirement benefit costs are as follows:
Post-retirement Benefits ------------------------ Six months ended June 30, 2008 2007 ------------------------------------------------------------ Service cost $ 2 $ 2 Interest cost 9 8 Expected return on plan assets - - Amortization of prior service cost 4 4 Amortization of net loss (gain) - - ------------------------------------------------------------ Net periodic pension cost $ 15 $ 14 ------------------------------------------------------------
Contributions ------------- The Company previously disclosed in its financial statements for the year ended December 31, 2007 that it expected to contribute $290 to its pension plan and $14 to its postretirement plan for 2008. The final actuarial calculation for 2008 was revised to $400 and $32, respectively. As of June 30, 2008, $100 has been contributed to the pension plan for 2008. Readers should refer to the Annual Report on Form 10-K for further details on the Company's defined benefit pension plan. Effective June 21, 2008 the Company has frozen its defined benefit pension plan. The following information as of June 30, 2008 reflects the curtailment of the pension plan. Obligations and funded status:
Pension Benefits ---------------------------------- As of: June 30, 2008 December 31, 2007 ----------------------------------------------------------------------------------- Change in benefit obligation Benefit obligation, beginning $ 13,558 $ 12,600 Service cost 201 438 Interest cost 409 738 Amendments (1,941) - Change in assumptions 354 (154) Actuarial (gain) loss - 559 Benefits paid (301) (623) ----------------------------------------------------------------------------------- Benefit obligation, ending 12,280 13,558 ----------------------------------------------------------------------------------- Change in plan assets Fair value of plan assets, beginning 12,255 11,548 Actual return on plan assets (523) 1,051 Employer contributions 173 279 Benefits paid (301) (623) ----------------------------------------------------------------------------------- Fair value of plan assets, ending 11,604 12,255 ----------------------------------------------------------------------------------- Funded status at end of year $ (676) $ (1,303) -----------------------------------------------------------------------------------
12 13 Amounts recognized in the balance sheet consist of:
Pension Benefits ---------------------------------- As of: June 30, 2008 December 31, 2007 ----------------------------------------------------------------------------------- Noncurrent assets $ 443 $ 230 Noncurrent liabilities $ 676 $1,303 -----------------------------------------------------------------------------------
Amounts recognized in accumulated other comprehensive income consist of:
Pension Benefits ---------------------------------- As of: June 30, 2008 December 31, 2007 ----------------------------------------------------------------------------------- Prior service cost $ - $ 52 Net actuarial loss (gain) 2,033 2,656 Deferred taxes (691) (921) ----------------------------------------------------------------------------------- Net amount recognized $1,342 $1,787 -----------------------------------------------------------------------------------
Components of net periodic pension and other amounts recognized in other comprehensive income:
Pension Benefits ---------------------------------- As of: June 30, 2008 December 31, 2007 ----------------------------------------------------------------------------------- Net periodic benefit cost Service cost $ 201 $ 438 Interest cost 409 738 Expected return on plan assets (510) (962) Amortization of prior service cost - 1 Amortization of unrecognized net loss 69 141 Curtailment loss 52 - ----------------------------------------------------------------------------------- Net periodic pension cost $ 221 $ 356 -----------------------------------------------------------------------------------
Effective July 1, 2008, the Company is sponsoring a new 401(k) pension plan for all eligible employees. NOTE 9 -- REGULATORY MATTERS The Company and the Bank are subject to various regulatory capital requirements administered by the Federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory--and possibly additional discretionary--actions by regulators that, if undertaken, could have a direct material effect on the Company and the Bank's Consolidated Financial Statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company's and the Bank's capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the Capital Adequacy table on the following page) of Tier I and Total Capital to risk-weighted assets and of Tier I Capital to average assets (Leverage ratio). The table also presents the Company's actual capital amounts and ratios. Management believes, as of June 30, 2008, that the Company and the Bank meet all capital adequacy requirements to which they are subject. As of June 30, 2008, the most recent notification from the Federal Deposit Insurance Corporation (FDIC) categorized the Company as "well capitalized" under the regulatory framework for prompt corrective action. To be categorized as "well capitalized", the Company must maintain minimum Tier I Capital, Total Capital and Leverage ratios as set forth in the following Capital Adequacy table. There are no conditions or events since that notification that management believes have changed the Company's categorization by the FDIC. The Company and Bank are also subject to minimum capital levels, which could limit the payment of dividends, although the Company and Bank currently have capital levels which are in excess of minimum capital level ratios required. 13 14 The Pennsylvania Banking Code restricts capital funds available for payment of dividends to the Retained Earnings of the Bank. Accordingly, at June 30, 2008, the balances in the capital stock and surplus accounts totaling $10,840 are unavailable for dividends. In addition, the Bank is subject to restrictions imposed by Federal law on certain transactions with the Company's affiliates. These transactions include extensions of credit, purchases of or investments in stock issued by the affiliate, purchases of assets subject to certain exceptions, acceptance of securities issued by an affiliate as collateral for loans, and the issuance of guarantees, acceptances, and letters of credit on behalf of affiliates. These restrictions prevent the Company's affiliates from borrowing from the Bank unless the loans are secured by obligations of designated amounts. Further, the aggregate of such transactions by the Bank with a single affiliate is limited in amount to 10 percent of the Bank's Capital Stock and Surplus, and the aggregate of such transactions with all affiliates is limited to 20 percent of the Bank's Capital Stock and Surplus. The Federal Reserve System has interpreted "Capital Stock and Surplus" to include undivided profits.
Actual Regulatory Requirements ------------------------------------------- ------------------------------------------------- For Capital To Be Adequacy Purposes "Well Capitalized" ------------------ ------------------- As of June 30, 2008 Amount Ratio Amount Ratio Amount Ratio ------------------------------------------------------------------------------------------------------------------ Total Capital (to Risk Weighted Assets) PFSC (Company) $78,588 19.67% > $31,934 > 8.0% > $39,918 > 10.0% - - - - PSB (Bank) $75,224 18.92% > $31,788 > 8.0% > $39,735 > 10.0% - - - - Tier 1 Capital (to Risk Weighted Assets) PFSC $73,600 18.42% > $15,967 > 4.0% > $23,951 > 6.0% - - - - PSB $70,255 17.67% > $15,894 > 4.0% > $23,841 > 6.0% - - - - Tier 1 Capital (to Average Assets) PFSC $73,600 12.19% > $ * > * > $30,198 > 5.0% - - - - PSB $70,255 11.97% > $ * > * > $29,347 > 5.0% - - - -
PFSC - *3.0% ($18,119), 4.0% ($24,158) or 5.0% ($30,198) depending on the bank's CAMELS Rating and other regulatory risk factors PSB - *3.0% ($17,608), 4.0% ($23,478) or 5.0% ($29,347) depending on the bank's CAMELS Rating and other regulatory risk factors.
Actual Regulatory Requirements ------------------------------------------- ------------------------------------------------- For Capital To Be Adequacy Purposes "Well Capitalized" ------------------ ------------------- As of December 31, 2007 Amount Ratio Amount Ratio Amount Ratio ------------------------------------------------------------------------------------------------------------------ Total Capital (to Risk Weighted Assets) PFSC $75,145 19.89% > $30,222 > 8.0% > $37,777 > 10.0% - - - - PSB $71,840 19.11% > $30,080 > 8.0% > $37,601 > 10.0% - - - - Tier 1 Capital (to Risk Weighted Assets) PFSC $70,445 18.65% > $15,111 > 4.0% > $22,666 > 6.0% - - - - PSB $67,140 17.86% > $15,040 > 4.0% > $22,561 > 6.0% - - - - Tier 1 Capital (to Average Assets) PFSC $70,445 12.11% > $ * > * > $29,081 > 5.0% - - - - PSB $67,140 11.62% > $ * > * > $28,900 > 5.0% - - - -
PFSC - *3.0% ($17,449), 4.0% ($23,265) or 5.0% ($29,081) depending on the bank's CAMELS Rating and other regulatory risk factors. PSB - *3.0% ($17,340), 4.0% ($23,120) or 5.0% ($28,900) depending on the bank's CAMELS Rating and other regulatory risk factors. 14 15 PART 1. FINANCIAL INFORMATION, ITEM 2 -- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following commentary provides an overview of the financial condition and significant changes in the results of operations of Penseco Financial Services Corporation and its subsidiary, Penn Security Bank and Trust Company, at June 30, 2008, for the three and six month periods ended June 30, 2008 and June 30, 2007. All information is presented in thousands of dollars, except as indicated. CRITICAL ACCOUNTING POLICIES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Provision (allowance) for possible loan losses - The provision for loan losses is based on past loan loss experience, management's evaluation of the potential loss in the current loan portfolio under current economic conditions and such other factors as, in management's best judgment, deserve current recognition in estimating loan losses. The annual provision for loan losses charged to operating expense is that amount which is sufficient to bring the balance of the allowance for possible loan losses to an adequate level to absorb anticipated losses. Actuarial assumptions associated with pension, post-retirement and other employee benefit plans - These assumptions include discount rate, rate of future compensation increases and expected return on plan assets. Provision for income taxes - Management believes that the assumptions and judgments used to record tax related assets or liabilities have been appropriate. Fair value of certain investment securities - Fair value of investment securities are based on quoted market prices. Loan servicing rights - Mortgage servicing rights are evaluated for impairment based on the fair value of those rights. Fair values are estimated using discounted cash flows based on current market rates of interest and current expected future prepayment rates. For purposes of measuring impairment, the rights must be stratified by one or more predominant risk characteristics of the underlying loans. The Company stratifies its capitalized mortgage servicing rights based on the product type, interest rate and term of the underlying loans. The amount of impairment recognized is the amount, if any, by which the amortized cost of the rights for each stratum exceed the fair value. Premium amortization - The amortization of premiums on mortgage-backed securities is done based on management's estimate of the lives of the securities, adjusted, when necessary, for advanced prepayments in excess of those estimates. NON-GAAP FINANCIAL MEASURES: (VISA TRANSACTION) Certain financial measures contained in this 10-Q exclude the decrease of the liability accrual related to VISA's covered litigation provision as well as the gain from the mandatory redemption of a portion of the Company's class B shares in VISA. Financial measures which exclude the above-referenced items have not been determined in accordance with generally accepted accounting principles and are therefore non-GAAP financial measures. Management of the Company believes that investors' understanding of the Company's performance is enhanced by disclosing these non-GAAP financial measures as a reasonable basis for comparison of the Company's ongoing results of operations. These non-GAAP measures should not be considered a substitute for GAAP-basis measures and results. Our non-GAAP measures may not be comparable to non-GAAP measures of other companies. The attached Non-GAAP Reconciliation Schedule provides a reconciliation of these non-GAAP financial measures to the most closely analogous measure determined in accordance with GAAP. 15 16 In March 2008, VISA, Inc. (VISA) completed its initial public offering. Penn Security Bank & Trust Company and certain other VISA member banks are shareholders in VISA. Following the initial public offering, the Company received $1.2 million in proceeds from the offering, as a mandatory partial redemption of 28,351 shares, reducing the Company's holding from 73,333 to 44,982 shares of Class B common stock. Using proceeds from this offering, VISA established a $3.0 billion escrow account to cover the resolution of pending litigation and related claims. The partial redemption proceeds of $1.2 million are reflected in other non-interest income in the first quarter of 2008. The remaining unredeemed shares of VISA Class B common stock are restricted and may not be transferred until the later of (1) three years from the date of the initial public offering or (2) the period of time necessary to resolve the covered litigation. A conversion ratio of 0.71429 was established for the conversion rate of Class B shares into Class A shares. If the funds in the escrow account are insufficient to settle all the covered litigation, VISA may sell additional Class A shares, use the proceeds to settle litigation, and further reduce the conversion ratio. If funds remain in the escrow account after all litigation is settled, the Class B conversion ratio will be increased to reflect that surplus. As of June 30, 2008, the value of the Class A shares was $81.31 per share. The value of unredeemed Class A equivalent shares owned by the Company was $2.6 million as of June 30, 2008, and has not yet been reflected in the accompanying financial statements. In connection with VISA's establishment of the litigation escrow account, the Company reversed a $497,000 reserve in the first quarter of 2008, reflected as a reduction of other non-interest expense. This reserve was created in the fourth quarter of 2007, pending completion of the VISA, Inc. initial public offering as a charge to other non-interest expense. NON-GAAP RECONCILIATION SCHEDULE PENSECO FINANCIAL SERVICES CORPORATION (UNAUDITED) (IN THOUSANDS) The following tables present the reconciliation of non-GAAP financial measures to reported GAAP financial measures.
Six Months Ended June 30, 2008 2007 Change -------------- -------------- -------------- Net interest income after provision for loan losses $ 10,793 $ 10,367 $ 426 Non-interest income 5,982 4,076 1,906 Non-interest expense (10,515) (10,343) (172) Income tax provision (1,375) (730) (645) -------------- -------------- -------------- Net income 4,885 3,370 1,515 ADJUSTMENTS ----------- Non-interest income Gain on mandatory redemption of VISA, Inc. class B common stock (1,213) - (1,213) Non-interest expense Covered litigation provision (497) - (497) -------------- -------------- -------------- Total Adjustments pre-tax (1,710) - (1,710) Income tax provision 581 - 581 -------------- -------------- -------------- After tax adjustments to GAAP (1,129) - (1,129) -------------- -------------- -------------- Adjusted net income $ 3,756 $ 3,370 $ 386 ============== ============== ============== Return on Average Assets 1.24% 1.16% Return on Average Equity 10.45% 9.96%
Return on average equity (ROE) and return on average assets (ROA) for the six months ended June 30, 2008 was 13.59% (10.45% excluding the VISA IPO impact) and 1.62% (1.24% excluding the VISA IPO impact), respectively. ROE was 9.96% and ROA was 1.16% for the same period last year. 16 17 EXECUTIVE SUMMARY Penseco Financial Services Corporation reported an increase in net income of $228 or 13.4% for the three months ended June 30, 2008 to $1,928 or $.89 per share compared with $1,700 or $.79 per share from the year ago period. Largely, the increase in net income was attributed to increased net interest income of $325 or 6.1% and higher non interest income. Interest on investments increased mainly due to purchases of securities of states & political subdivisions and U.S. Agencies while total interest expense declined mainly from lower deposit costs. The provision for loan losses increased $92 from the year ago period. While the Company's asset quality improved, management felt it prudent to increase the allowance for loan losses due to the general decline in market and economic conditions. Non-interest income increased $384 or 19.4% to $2,364 for the three months ended June 30, 2008, compared with $1,980 for the similar period of 2007. Total non-interest expense increased $346 or 6.8% to $5,457 for the three months ended June 30, 2008 compared with $5,111 for the same period of last year. For the six months ended June 30, 2008, net income increased $1,515 or 45%, to $4,885 or $2.27 per share compared with the year ago period of $3,370 or $1.57 per share. Largely, the increase in net income was attributed to one time after tax income of $1,129 ($.53 per share) related to VISA, Inc.'s Initial Public Offering, which consisted of a gain from the mandatory partial share redemption by VISA and the reversal of a litigation liability accrual that had been recorded by the Company in the fourth quarter of 2007. Excluding the impact of the VISA transaction, net income increased $386 or 11.5% from the first six months of 2007(1). Net interest income increased $657 or 6.2% to $11,244 for the six months ended June 30, 2008 compared to $10,587 for the same quarter of 2007. The increase resulted from higher interest income on loans of $245 or 1.9% due to net loan growth of $35.7 million since June 30, 2007, including $17.2 million from December 31, 2007. Interest on investments declined due to maturing investments being redeployed to fund loan demand and total interest expense declined mainly from lower deposit costs. Net interest income after provision for loan losses increased $426 or 4.1% as the provision for loan losses increased $231 from the year ago period. While the Company's asset quality improved, management felt it prudent to increase the allowance for loan losses due to the general decline in market and economic conditions. Non-interest income increased $1,906 or 46.8% to $5,982 for the six months ended June 30, 2008, compared with $4,076 for the similar period of 2007 due primarily to the gain on the VISA stock redemption of $1,213. Total non-interest expenses increased $172 or 1.7% to $10,515 for the six months ended June 30, 2008 compared with $10,343 for the same period of 2007 primarily due increased salaries and employee benefits. Without the impact of the VISA reversal, total non-interest expenses would have increased $669 or 6.5%. NET INTEREST INCOME AND NET INTEREST MARGIN Net interest income, the largest contributor to the Company's earnings, is defined as the difference between interest income on assets and the cost of funds supporting those assets. Average earning assets are composed primarily of loans and investments while deposits, short-term and long-term borrowings represent interest-bearing liabilities. Variations in the volume and mix of these assets and liabilities, as well as changes in the yields earned and rates paid, are determinants of changes in net interest income. Net interest income after provision for loan losses increased $233 or 4.5% to $5,451 for the three months ended June 30, 2008 compared to $5,218 for the three months ended June 30, 2007. The average yield on interest earning assets decreased 45 basis points, largely from the Federal Reserve Bank lowering its target for the federal funds rate 325 basis points from the fall of 2007 through the first quarter of 2008, offset by increases in the investment securities portfolio. ----------------------------- (1) See pages 15 & 16 for a reconciliation of GAAP net income to net income excluding the gain related to the VISA, Inc. initial public offering during the six months ended June 30, 2008. 17 18 The net interest margin represents the Company's net yield on its average interest earning assets and is calculated as net interest income divided by average interest earning assets. In the three months ended June 30, 2008, net interest margin was 3.86% increasing one basis point from 3.85% in the same period of 2007. Total average interest earning assets and average interest bearing funds increased in the three months ended June 30, 2008 as compared to 2007. Average interest earning assets increased $32.5 million or 5.9%, from $554.8 million in 2007 to $587.3 million in 2008 and average interest bearing funds increased $28.8 million, or 6.6%, from $439.2 million to $468.0 million for the same period, mainly due to higher loans and increases in money market accounts, repurchase agreements, and short-term borrowings, offset by lower time-deposits. Long-term borrowings increased a net of $16.9 million or 27.3% reflecting new borrowings during the first quarter of 2008. Average earning assets, including Bank-Owned Life Insurance (BOLI), increased to 96.4% for the three months ended June 30, 2008 from 96.0% for the year ago period. Changes in the mix of both interest earning assets and funding sources also impacted net interest income in the three months ended June 30, 2008 and 2007. Average loans as a percentage of average interest earning assets increased from 68.6% in 2007 to 70.4% in 2008, due in part to the increase of new and refinanced residential mortgages. Average investments increased $19.0 million from 27.1% to 28.8% of interest earning assets. Average short-term investments, federal funds sold and interest bearing balances with banks decreased $19.4 million to $4.9 million from $24.3 million. Average time deposits decreased $15.1 million to $108.4 million from $123.5 million, average long-term borrowings increased, a net of $16.9 million, while repurchase agreements increased $9.2 million. Shifts in the interest rate environment and competitive factors affected the rates paid for funds as well as the yields earned on assets. The investment securities tax equivalent yield increased 4 basis points from 5.72% for the three months ended June 30, 2007 to 5.76% for the three months ended June 30, 2008. Average loan yields decreased 67 basis points, from 6.90% for the three months ended June 30, 2007 to 6.23% for the three months ended June 30, 2008. The average time deposit costs decreased 57 basis points from 4.42% for the three months ended June 30, 2007 to 3.85% for the three months ended June 30, 2008, along with the average cost of money market accounts decreasing 125 basis points from 3.14% for the three months ended June 30, 2007 to 1.89% for the three months ended June 30, 2008. 18 19 DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS' EQUITY/INTEREST RATES AND INTEREST DIFFERENTIAL The table below presents average balances, interest income on a fully taxable equivalent basis and interest expense, as well as average rates earned and paid on the Company's major asset and liability items for the three months ended June 30, 2008 and June 30, 2007.
----------------------------------------------------------------------------------------------------------- June 30, 2008 June 30, 2007 ASSETS Average Revenue/ Yield/ Average Revenue/ Yield/ Balance Expense Rate Balance Expense Rate ----------------------------------------------------------------------------------------------------------- Investment Securities Available-for-sale: U.S. Agency obligations $ 54,708 $ 670 4.90% $ 40,116 $ 459 4.58% States & political subdivisions 41,115 448 6.60% 30,248 335 6.71% Federal Home Loan Bank stock 4,733 46 3.89% 3,925 63 6.42% Other 3,035 23 3.03% 3,829 34 3.55% Held-to-maturity: U.S. Agency obligations 36,311 430 4.74% 42,698 493 4.62% States & political subdivisions 29,237 388 8.04% 29,247 389 8.06% Loans, net of unearned income: Real estate mortgages 266,310 4,037 6.06% 241,096 3,860 6.40% Commercial real estate 86,626 1,364 6.30% 75,418 1,436 7.62% Commercial 24,384 413 6.77% 23,650 498 8.42% Consumer and other 35,909 622 6.93% 40,287 765 7.60% Federal funds sold - - - 16,579 219 5.28% Interest on balances with banks 4,903 23 1.88% 7,734 102 5.28% ----------------------------------------------------------------------------------------------------------- Total Interest Earning Assets/ Total Interest Income $587,271 $8,464 6.06% $554,827 $8,653 6.51% ----------------------------------------------------------------------------------------------------------- Cash and due from banks 10,197 10,284 Bank premises and equipment 9,139 9,855 Accrued interest receivable 3,299 3,259 Cash surrender value of life insurance 7,476 7,159 Other assets 4,671 3,977 Less: Allowance for loan losses 4,933 4,203 ----------------------------------------------------------------------------------------------------------- Total Assets $617,120 $585,158 ----------------------------------------------------------------------------------------------------------- LIABILITIES AND STOCKHOLDERS' EQUITY Deposits: Demand-Interest bearing $ 54,413 104 0.76% 57,555 163 1.13% Savings 76,082 106 0.56% 81,528 241 1.18% Money markets 111,071 526 1.89% 85,883 675 3.14% Time - Over $100 36,649 355 3.87% 43,213 527 4.88% Time - Other 71,773 688 3.83% 80,269 836 4.17% Federal funds purchased - - - - - - Repurchase agreements 37,488 253 2.70% 28,333 240 3.39% Short-term borrowings 1,505 9 2.39% 281 4 5.69% Long-term borrowings 79,044 756 3.83% 62,108 625 4.03% ----------------------------------------------------------------------------------------------------------- Total Interest Bearing Liabilities/ Total Interest Expense 468,025 $2,797 2.39% 439,170 $3,311 3.02% ----------------------------------------------------------------------------------------------------------- Demand - Non-interest bearing 70,721 73,226 All other liabilities 5,114 4,636 Stockholders' equity 73,260 68,126 ----------------------------------------------------------------------------------------------------------- Total Liabilities and Stockholders' Equity $617,120 $585,158 ----------------------------------------------------------------------------------------------------------- Interest Spread 3.67% 3.49% ----------------------------------------------------------------------------------------------------------- Net Interest Income $ 5,667 $5,342 ----------------------------------------------------------------------------------------------------------- FINANCIAL RATIOS Net interest margin 3.86% 3.85% Return on average assets 1.25% 1.16% Return on average equity 10.53% 9.98% Average equity to average assets 11.87% 11.64% Dividend payout ratio 46.07% 46.84% -----------------------------------------------------------------------------------------------------------
19 20 Net interest income after provision for loan losses increased $426 or 4.1% to $10,793 for the six months ended June 30, 2008, compared to $10,367 for the six months ended June 30, 2007. The average yield on interest earning assets decreased 25 basis points, largely from the Federal Reserve Bank lowering its target for the federal funds rate 325 basis points from the fall of 2007 through the first quarter of 2008, offset by increases in the investment securities portfolio. The net interest margin represents the Company's net yield on its average interest earning assets and is calculated as net interest income divided by average interest earning assets. For the six months ended June 30, 2008, net interest margin was 3.92% increasing 6 basis points from 3.86% in the same period of 2007. Total average interest earning assets and average interest bearing funds increased for the six months ended June 30, 2008 as compared to the six months ended June 30, 2007. Average interest earning assets increased $24.9 million or 4.5%, from $549.2 million in 2007 to $574.1 million in 2008 and average interest bearing funds increased $23.7 million, or 5.5%, from $432.4 million to $456.1 million for the same periods. As a percentage of average assets, average earning assets, including BOLI, increased to 96.3% for the six months ended June 30, 2008 from 96.0% for the year ago period. Changes in the mix of both interest earning assets and funding sources also impacted net interest income in the six months ended June 30, 2008 and 2007. Average loans as a percentage of average interest earning assets increased from 68.2% in 2007 to 71.5% in 2008, due in part to the increase of new and refinanced residential mortgages as well as an increase in commercial loans secured by real estate. Average investments increased $4.9 million year over year however decreased as a percentage of average assets to 27.9% at June 30, 2008 from 28.3% at June 30, 2007. Average short-term investments, federal funds sold and interest bearing balances with banks, decreased $15.9 million to $3.2 from $19.1 and also decreased as a percentage of average interest earning assets from 3.5% in 2007 to 0.6% in 2008. Average time deposits decreased $16.6 million or 13.3% from 28.8% of interest bearing liabilities in 2007 to 23.7% in 2008. Average short-term borrowings increased $8.2 million; average long-term borrowings increased $7.9 million, while repurchase agreements increased $7.7 million. Shifts in the interest rate environment and competitive factors affected the rates paid for funds as well as the yields earned on assets. The investment securities tax equivalent yield increased 19 basis points from 5.65% for the six months ended June 30, 2007 to 5.84% for the six months ended June 30, 2008. Also, average loan yields decreased 48 basis points, from 6.86% for the six months ended June 30, 2007 to 6.38% in the same period of 2008. The average time deposit costs decreased 35 basis points from 4.38% for the six months ended June 30, 2007 to 4.03% for the six months ended June 30, 2008, along with the average cost of money market accounts decreasing 96 basis points from 3.08% for the six months ended June 30, 2007 to 2.12% for the six months ended June 30, 2008. 20 21 DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS' EQUITY/INTEREST RATES AND INTEREST DIFFERENTIAL The table below presents average balances, interest income on a fully taxable equivalent basis and interest expense, as well as average rates earned and paid on the Company's major asset and liability items for the six months ended June 30, 2008 and June 30, 2007.
----------------------------------------------------------------------------------------------------------- June 30, 2008 June 30, 2007 ASSETS Average Revenue/ Yield/ Average Revenue/ Yield/ Balance Expense Rate Balance Expense Rate ----------------------------------------------------------------------------------------------------------- Investment Securities Available-for-sale: U.S. Agency obligations $ 45,349 $1,140 5.03% $ 42,964 $ 977 4.55% States & political subdivisions 40,855 896 6.65% 30,219 670 6.72% Federal Home Loan Bank stock 4,809 94 3.91% 4,083 132 6.47% Other 2,885 49 3.40% 5,448 106 3.89% Held-to-maturity: U.S. Agency obligations 37,270 865 4.64% 43,490 986 4.53% States & political subdivisions 29,238 776 8.04% 29,248 775 8.03% Loans, net of unearned income: Real estate mortgages 264,659 8,136 6.15% 236,503 7,544 6.38% Commercial real estate 85,520 2,808 6.57% 74,599 2,807 7.53% Commercial 24,045 857 7.13% 23,359 987 8.45% Consumer and other 36,287 1,296 7.14% 40,154 1,514 7.54% Federal funds sold - - - 11,564 304 5.26% Interest on balances with banks 3,192 34 2.13% 7,522 193 5.13% ----------------------------------------------------------------------------------------------------------- Total Interest Earning Assets/ Total Interest Income 574,109 $16,951 6.21% 549,153 $16,995 6.46% ----------------------------------------------------------------------------------------------------------- Cash and due from banks 10,049 10,345 Bank premises and equipment 9,198 9,690 Accrued interest receivable 3,317 3,251 Cash surrender value of life insurance 7,436 7,120 Other assets 4,720 4,035 Less: Allowance for loan losses 4,818 4,197 ----------------------------------------------------------------------------------------------------------- Total Assets $604,011 $579,397 ----------------------------------------------------------------------------------------------------------- LIABILITIES AND STOCKHOLDERS' EQUITY Deposits: Demand-Interest bearing $ 53,424 $ 216 0.81% $ 54,425 $ 257 0.94% Savings 76,943 237 0.62% 80,688 455 1.13% Money markets 107,355 1,136 2.12% 86,097 1,325 3.08% Time - Over $100 38,390 806 4.20% 42,107 1,036 4.92% Time - Other 69,496 1,368 3.94% 82,369 1,690 4.10% Federal funds purchased - - - - - - Repurchase agreements 30,571 407 2.66% 22,913 361 3.15% Short-term borrowings 8,670 149 3.44% 458 12 5.25% Long-term borrowings 71,228 1,388 3.90% 63,345 1,272 4.02% ----------------------------------------------------------------------------------------------------------- Total Interest Bearing Liabilities/ Total Interest Expense 456,077 $5,707 2.50% 432,402 $6,408 2.96% ----------------------------------------------------------------------------------------------------------- Demand - Non-interest bearing 70,784 74,452 All other liabilities 5,264 4,864 Stockholders' equity 71,886 67,679 ----------------------------------------------------------------------------------------------------------- Total Liabilities and Stockholders' Equity $604,011 $579,397 ----------------------------------------------------------------------------------------------------------- Interest Spread 3.71% 3.50% ----------------------------------------------------------------------------------------------------------- Net Interest Income 11,244 10,587 ----------------------------------------------------------------------------------------------------------- FINANCIAL RATIOS Net interest margin 3.92% 3.86% Return on average assets 1.62% 1.16% Return on average equity 13.59% 9.96% Average equity to average assets 11.90% 11.68% Dividend payout ratio 36.12% 47.13% -----------------------------------------------------------------------------------------------------------
21 22 INVESTMENTS The Company's investment portfolio consists primarily of two functions: To provide liquidity and to contribute to earnings. To provide liquidity the Company may invest in short-term securities such as Federal funds sold, interest bearing deposits with banks, U.S. Treasury securities and U.S. Agency securities all with maturities of one year or less. These funds are invested short-term to ensure the availability of funds to meet customer demand for credit needs. The Company enhances interest income by securing long-term investments within its investment portfolio, by means of U.S. Treasury securities, U.S. Agency securities, municipal securities and mortgage-backed securities, generally with maturities greater than one year. The Company's mortgage-backed securities portfolio does not contain any sub-prime or Alt-A credits. Investments in securities are classified in two categories and accounted for as follows: Securities Held-to-Maturity Bonds, notes, debentures and mortgage-backed --------------------------- securities for which the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for amortization of premiums and accretion of discounts computed on the straight-line basis, which approximates the interest method, over the remaining period to maturity. Securities Available-for-Sale Bonds, notes, debentures, mortgage-backed ----------------------------- securities and certain equity securities not classified as securities to be held to maturity are carried at fair value with unrealized holding gains and losses, net of tax, reported as a net amount in a separate component of stockholders' equity until realized. The amortization of premiums on mortgage-backed securities is done based on management's estimate of the lives of the securities, adjusted, when necessary, for advanced prepayments in excess of those estimates. Realized gains and losses on the sale of securities available-for-sale are determined using the specific identification method and are reported as a separate component of other income in the Statements of Income. Unrealized gains and losses are included as a separate item in computing comprehensive income. DEPOSITS The Company is largely dependent on its core deposit base to fund operations. Management has competitively priced its deposit products in checking, savings, money market and time deposits to provide a stable source of funding. As general interest rates in the economy change, there is migration of some deposits among investment options as customers seek increased yields. Historically, such changes in the Company's deposit base have been minimal. PROVISION FOR LOAN LOSSES The provision for loan losses represents management's determination of the amount necessary to bring the allowance for loan losses to a level that management considers adequate to reflect the risk of future losses inherent in the Company's loan portfolio. The process of determining the adequacy of the allowance is necessarily judgmental and subject to changes in external conditions. The allowance for loan losses reflects management's judgment as to the level considered appropriate to absorb such losses based upon a review of many factors, including historical loss experience, adverse situations that may affect the borrower's ability to repay (including the timing of future payments), economic conditions and trends, loan portfolio volume and mix, loan performance trends, the value and adequacy of collateral, and the Company's internal credit review process. Accordingly, there can be no assurance that existing levels of the allowance will ultimately prove adequate to cover actual loan losses. The quarterly provision for loan losses charged to operating expense is that amount which is sufficient to bring the balance of the allowance for possible loan losses to an adequate level to absorb anticipated losses. Based on this ongoing evaluation, management determines the provision necessary to maintain an appropriate allowance. For the three months ended June 30, 2008, the provision for loan losses increased to $92 from $124 in the three months ended June 30, 2007 to $216 in the three months ended June 30, 2008. Loans charged off totaled $12 and recoveries were $11 for the three months ended June 30, 2008. In the same period of 2007, loans charged off totaled $4 and recoveries were $0. For the six months ended June 30, 2008, the provision for loan losses was $451, an increase from $220 in the first six months of 2007. Loans charged-off totaled $27 and recoveries were $16 for the six months ended June 30, 2008. In the same period of 2007 loans charged off were $102, offset by recoveries of $2. At June 30, 2008 the allowance for loan losses was $5,140, or 1.22% of gross loans. 22 23 NON-INTEREST INCOME The following table sets forth information by category of non-interest income for the Company for three months ended June 30, 2008 and June 30, 2007, respectively:
June 30, June 30, Three Months Ended: 2008 2007 ------------------------------------------------------------------------------- Trust department income $ 382 $ 367 Service charges on deposit accounts 396 260 Merchant transaction income 935 873 Other fee income 489 373 Bank-owned life insurance income 80 77 Other operating income 82 30 VISA mandatory share redemption - - Realized gains (losses) on securities, net - - ------------------------------------------------------------------------------- Total Non-Interest Income $2,364 $1,980 -------------------------------------------------------------------------------
Total non-interest income increased $384 or 19.4% to $2,364 for the three months ended June 30, 2008, compared with $1,980 for the same period of 2007. Merchant transaction income increased $62 or 7.1% due to higher transaction volume and new business. Service charges on deposit accounts increased $136 or 52.3% primarily due to increased service charge fees. Other fee income increased $116 or 31.1% from prior year levels mostly due to increases in brokerage income of $119. The following table sets forth information by category of non-interest income for the Company for six months ended June 30, 2008 and June 30, 2007, respectively:
June 30, June 30, Six Months Ended: 2008 2007 ------------------------------------------------------------------------------- Trust department income $ 747 $ 739 Service charges on deposit accounts 659 511 Merchant transaction income 2,119 1,920 Other fee income 968 654 Bank-owned life insurance income 158 155 Other operating income 118 46 VISA mandatory share redemption 1,213 - Realized gains (losses) on securities, net - 51 ------------------------------------------------------------------------------- Total Non-Interest Income $5,982 $4,076 -------------------------------------------------------------------------------
Total non-interest income increased $1,906 or 46.8% to $5,982 during the first half of 2008 from $4,076 for the same period of 2007. Service charges on deposit accounts increased $148 or 29.0%. Merchant transaction income increased $199 or 10.4%, mainly due to higher transaction volume and new business. Other fee income increased $314 or 48.0% mainly from increased brokerage fee income of $280 compared to last year. Other operating income increased $72 or 156.5% due to a gain in other real estate owned of $43, gains on the sale of mortgage loans of $16, along with an increase in general operating income. The Company realized a gain of $1,213 related to VISA, Inc.'s Initial Public Offering, which consisted of a mandatory partial share redemption, during the first quarter of 2008, discussed earlier, compared to a realized gain of $51 due to the sale of equity securities in the first quarter of 2007. NON-INTEREST EXPENSES The following table sets forth information by category of non-interest expenses for the Company for the three months ended June 30, 2008 and June 30, 2007, respectively:
June 30, June 30, Three Months Ended: 2008 2007 ------------------------------------------------------------------------------- Salaries and employee benefits $2,509 $2,330 Expense of premises and fixed assets 667 725 Merchant transaction expenses 703 671 Other operating expenses 1,578 1,385 ------------------------------------------------------------------------------- Total Non-Interest Expenses $5,457 $5,111 -------------------------------------------------------------------------------
23 24 Total non-interest expenses increased $346 or 6.8% to $5,457 for the three months ended June 30, 2008 compared with $5,111 for the same period of 2007. Salaries and employee benefits expense increased $179 or 7.7% mainly due to increased salaries resulting from additional employees from year ago levels, along with increased commissions related to our wealth management division. Expense of premises and equipment decreased $58 or 8.0% due to a reduction of general occupancy expenses. Merchant transaction expense increased $32 or 4.8% due to higher transaction volume. Other operating expenses increased $193 or 13.9% with the largest increases in advertising expenses of $35, professional services of $44 and general operating expenses. The following table sets forth information by category of non-interest expenses for the Company for the six months ended June 30, 2008 and June 30, 2007, respectively:
June 30, June 30, Six Months Ended: 2008 2007 ------------------------------------------------------------------------------- Salaries and employee benefits $ 4,924 $ 4,705 Expense of premises and fixed assets 1,435 1,350 Merchant transaction expenses 1,605 1,495 Other operating expenses 2,551 2,793 ------------------------------------------------------------------------------- Total Non-Interest Expenses $10,515 $10,343 -------------------------------------------------------------------------------
Total non-interest expenses increased $172 or 1.7% to $10,515 during the first half of 2008 compared with $10,343 for the same period of 2007. Salaries and employee benefits expense increased $219 or 4.7% mainly due to increased salaries resulting from additional employees from year ago levels, along with increased commissions related to our wealth management division. Premises and fixed assets expense increased $85 or 6.3% due to computer system upgrades and increased occupancy expense. Merchant transaction expenses increased $110 or 7.4% due to higher transaction volume. Other operating expenses decreased $242 or 8.7% due to the reversal in the first quarter of 2008 of the $497 VISA litigation accrual recorded by the Company in the fourth quarter of 2007, offset by an increase in advertising expenses of $69, professional services of $62 and increased general operating expenses. Without the impact of the VISA reversal, total other expenses would have increased $669 or 6.5%. INCOME TAXES Applicable income taxes increased $43 or 11.1% to $430 for the three months ended June 30, 2008 due to increased overall operating income. Also, applicable income taxes increased $645 or 88.4% during the first half of 2008 primarily due to the income on the VISA initial public offering and overall higher income. LOAN PORTFOLIO Details regarding the Company's loan portfolio are as follows:
June 30, December 31, As of: 2008 2007 ------------------------------------------------------------------------------- Real estate - construction and land development $ 24,657 $ 25,858 Real estate mortgages 337,936 318,437 Commercial 24,583 24,505 Credit card and related plans 3,114 3,324 Installment and other 27,363 26,542 Obligations of states & political subdivisions 4,640 5,973 ------------------------------------------------------------------------------- Loans, net of unearned income 422,293 404,639 Less: Allowance for loan losses 5,140 4,700 ------------------------------------------------------------------------------- Loans, net $417,153 $399,939 -------------------------------------------------------------------------------
The Company does not engage in any sub-prime or Alt-A credit lending. Therefore, the Company is not subject to any credit risks associated with such loans. 24 25 LOAN QUALITY The lending activities of the Company are guided by the comprehensive lending policy established by the Board of Directors. Loans must meet criteria which include consideration of the character, capacity and capital of the borrower, collateral provided for the loan, and prevailing economic conditions. Regardless of credit standards, there is risk of loss inherent in every loan portfolio. The allowance for loan losses is an amount that management believes will be adequate to absorb possible losses on existing loans that may become uncollectible, based on evaluations of the collectibility of the loans. The evaluations take into consideration such factors as change in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, industry experience, collateral value and current economic conditions that may affect the borrower's ability to pay. Management believes that the allowance for loan losses is adequate. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance based on their judgment of information available to them at the time of their examination. The allowance for loan losses is increased by periodic charges against earnings as a provision for loan losses, and decreased periodically by charge-offs of loans (or parts of loans) management has determined to be uncollectible, net of actual recoveries on loans previously charged-off. NON-PERFORMING ASSETS The following table sets forth information regarding non-accrual loans and loans past due 90 days or more and still accruing interest:
June 30, December 31, June 30, As of: 2008 2007 2007 ----------------------------------------------------------------------------------------- Non-accrual loans $ 550 $ 1,610 $ 2,825 Other real estate owned - - 31 ----------------------------------------------------------------------------------------- Total non-performing assets $ 550 $ 1,610 $ 2,856 ----------------------------------------------------------------------------------------- Loans past due 90 days or more and accruing: Secured by real estate $ 442 $ 57 $ 494 Guaranteed student loans 236 408 440 Credit card loans 9 2 7 Commercial - - - Other loans to individuals for household, family, and other personal expenditures - 12 - ----------------------------------------------------------------------------------------- Total loans past due 90 days or more and accruing $ 687 $ 479 $ 941 -----------------------------------------------------------------------------------------
Non-accrual loans decreased $2,275 to $550 at June 30, 2008 from $2,825 at June 30, 2007. This decrease was due to two borrowing relationships being resolved during the first quarter of 2008. Loans are generally placed on a non-accrual status when principal or interest is past due 90 days or when payment in full is not anticipated. When a loan is placed on non-accrual status, all interest previously accrued but not collected is charged against current income. Loans are returned to accrual status when past due interest is collected and the collection of principal is probable. Loans on which the accrual of interest has been discontinued or reduced amounted to $550,000 at June 30, 2008 down from $2,825,000 at June 30, 2007. If interest on those loans had been accrued, such income would have been $28 and $209 for the six months ended June 30, 2008 and June 30, 2007, respectively. Interest income on those loans, which is recorded only when received, amounted to $15 and $127 for June 30, 2008 and June 30, 2007, respectively. There are no commitments to lend additional funds to individuals whose loans are in non-accrual status. 25 26 The management process for evaluating the adequacy of the allowance for loan losses includes reviewing each month's loan committee reports which list all loans that do not meet certain internally developed criteria as to collateral adequacy, payment performance, economic conditions and overall credit risk. These reports also address the current status and actions in process on each listed loan. From this information, adjustments are made to the allowance for loan losses. Such adjustments include both specific loss allocation amounts and general provisions by loan category based on present and past collection experience, nature and volume of the loan portfolio, overall portfolio quality, and current economic conditions that may affect the borrower's ability to pay. As of June 30, 2008 there are no significant loans as to which management has serious doubt about their collectibility. During the second quarter of 2008, the Company was notified that The Education Resources Institute, Inc. (TERI), a guarantor of a portion of our student loan portfolio, had filed for Reorganization under Chapter 11 of the Bankruptcy Act. Currently, the Company holds $8.6 million of TERI loans out of a total student loan portfolio of $21.2 million. The Company does not anticipate that TERI's bankruptcy filing will significantly impact the Company's financial statements. These loans are placed on non-accrual status when they become more than 90 days past due. At June 30, 2008 there were $162,000 of such loans placed on non-accrual status. At June 30, 2008 and December 31, 2007, the Company did not have any loans specifically classified as impaired. Most of the Company's lending activity is with customers located in the Company's geographic market area and repayment thereof is affected by economic conditions in this market area. LOAN LOSS EXPERIENCE The following tables present the Company's loan loss experience during the periods indicated:
June 30, June30, Three Months Ended: 2008 2007 ------------------------------------------------------------------------ Balance at beginning of period $ 4,925 $ 4,200 Charge-offs: Real estate mortgages - - Commercial and all others - - Credit card and related plans 4 4 Installment loans 8 - ------------------------------------------------------------------------ Total charge-offs 12 4 ------------------------------------------------------------------------ Recoveries: Real estate mortgages - - Commercial and all others 10 - Credit card and related plans 1 - Installment loans - - ------------------------------------------------------------------------ Total recoveries 11 - ------------------------------------------------------------------------ Net charge-offs (recoveries) 1 4 ------------------------------------------------------------------------ Provision charged to operations 216 124 ------------------------------------------------------------------------ Balance at End of Period $ 5,140 $ 4,320 ------------------------------------------------------------------------ Ratio of net charge-offs (recoveries) to average loans outstanding 0.000% 0.001% ------------------------------------------------------------------------
26 27
June 30, June30, Six Months Ended: 2008 2007 ------------------------------------------------------------------------ Balance at beginning of period $ 4,700 $ 4,200 Charge-offs: Real estate mortgages - 84 Commercial and all others - - Credit card and related plans 14 16 Installment loans 13 2 ------------------------------------------------------------------------ Total charge-offs 27 102 ------------------------------------------------------------------------ Recoveries: Real estate mortgages - - Commercial and all others 13 - Credit card and related plans 3 1 Installment loans - 1 ------------------------------------------------------------------------ Total recoveries 16 2 ------------------------------------------------------------------------ Net charge-offs (recoveries) 11 100 ------------------------------------------------------------------------ Provision charged to operations 451 220 ------------------------------------------------------------------------ Balance at End of Period $ 5,140 $ 4,320 ------------------------------------------------------------------------ Ratio of net charge-offs (recoveries) to average loans outstanding 0.003% 0.027% ------------------------------------------------------------------------
The allowance for loan losses at June 30, 2008 was $5,140 or 1.22% of total loans compared to $4,320 or 1.12% of total loans at June 30, 2007. Management believes the loan loss reserve is adequate. The allowance for loan losses is allocated as follows:
As of: June 30, 2008 December 31, 2007 June 30, 2007 ----------------------------------------------------------------------------------------------- Amount % * Amount % * Amount % * ----------------------------------------------------------------------------------------------- Real estate mortgages $1,200 86% $1,200 85% $1,200 84% Commercial and all others 3,340 6% 2,900 7% 2,600 6% Credit card and related plans 300 1% 300 1% 250 1% Personal installment loans 300 7% 300 7% 270 9% ----------------------------------------------------------------------------------------------- Total $5,140 100% $4,700 100% $4,320 100% -----------------------------------------------------------------------------------------------
* Percent of loans in each category to total loans LIQUIDITY The objective of liquidity management is to maintain a balance between sources and uses of funds in such a way that the cash requirements of customers for loans and deposit withdrawals are met in the most economical manner. Management monitors its liquidity position continuously in relation to trends of loans and deposits for short-term as well as long-term requirements. Liquid assets are monitored on a daily basis to assure maximum utilization. Management also manages its liquidity requirements by maintaining an adequate level of readily marketable assets and access to short-term funding sources. Management does not foresee any adverse trends in liquidity. The Company remains in a highly liquid condition both in the short and long term. Sources of liquidity include the Company's U.S. Agency bond portfolios, additional deposits, earnings, overnight loans to and from other companies (Federal Funds) and lines of credit at the Federal Reserve Bank and the Federal Home Loan Bank (FHLB). The Company is not a party to any commitments, guarantees or obligations that could materially affect its liquidity. The Company offers collateralized repurchase agreements, which have a one day maturity, as an alternative deposit option for its customers. The Company also has long-term debt outstanding to the FHLB, which was used to purchase a Freddie 27 28 Mac pool of residential mortgages, as described earlier in this report. At June 30, 2008 the Company had $150,861 of available borrowing capacity with the FHLB. COMMITMENTS AND CONTINGENT LIABILITIES In the normal course of business, there are outstanding commitments and contingent liabilities, created under prevailing terms and collateral requirements such as commitments to extend credit, financial guarantees and letters of credit, which are not reflected in the accompanying Financial Statements. The Company does not anticipate any losses as a result of these transactions. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Balance Sheets. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have expiration dates of one year or less or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. At June 30, 2008 the Bank has entered into contracts, for the renovation of various branches, in the amount of $3,094. RELATED PARTIES The Company does not have any material transactions involving related persons or entities, other than traditional banking transactions, which are made on the same terms and conditions as those prevailing at the time for comparable transactions with unrelated parties. At June 30, 2008 the Bank has issued standby letters of credit for the accounts of related parties in the amount of $8,194. CAPITAL RESOURCES A strong capital position is important to the continued profitability of the Company and promotes depositor and investor confidence. The Company's capital provides a basis for future growth and expansion and also provides additional protection against unexpected losses. Additional sources of capital would come from retained earnings from the operations of the Company and from the sale of additional common stock. Management has no plans to offer additional common stock at this time. The Company's total risk-based capital ratio was 19.67% at June 30, 2008. The Company's risk-based capital ratio is more than the 10.00% ratio that Federal regulators use as the "well capitalized" threshold. This is the current criteria which the FDIC uses in determining the lowest insurance rate for deposit insurance. The Company's risk-based capital ratio is more than double the 8.00% limit, which determines whether a company is "adequately capitalized". Under these rules, the Company could significantly increase its assets and still comply with these capital requirements without the necessity of increasing its equity capital. PART 1. FINANCIAL INFORMATION, ITEM 3 -- QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company currently does not enter into derivative financial instruments, which include futures, forwards, interest rate swaps, option contracts and other financial instruments with similar characteristics. However, the Company is party to traditional financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, financial guarantees and letters of credit. These traditional instruments involve to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Consolidated Balance Sheets. 28 29 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. Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party up to a stipulated amount and with specified terms and conditions. Commitments to extend credit and standby letters of credit are not recorded as an asset or liability by the Company until the instrument is exercised. The Company's exposure to market risk is reviewed on a regular basis by its Asset/Liability Committee. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. Management realizes certain risks are inherent and that the goal is to identify and minimize the risks. Tools used by management include the standard GAP report and an interest rate shock simulation report. The Company has no market risk sensitive instruments held for trading purposes. It appears the Company's market risk is reasonable at this time. For a discussion of the Company's asset and liability management policies, as well as the potential impact of interest rate changes upon the market value of the Company's financial instruments, see Item 7A in the Company's Annual Report on Form 10-K for the year ended December 31, 2007. Management, as part of its regular practices, performs periodic reviews of the impact of interest rate changes upon net interest income and market value of the Company's portfolio equity. Based on, among other factors, such reviews, management believes that there have been no material changes in the market risk of the Company's asset and liability position since December 31, 2007. PART 1. FINANCIAL INFORMATION, ITEM 4 -- CONTROLS AND PROCEDURES Under the supervision and with the participation of our management, including our Chief Executive Officer and Controller, we conduction an evaluation of our disclosure controls and procedures, as such term is defined under Rule 12a-15(e) under the Securities Exchange Act of 1934. Based upon this evaluation, our Chief Executive Officer and our Controller (our Principal Financial Officer) concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report. The Company continually assesses the adequacy of its internal control over financial reporting and enhances its controls in response to internal control assessments, and internal and external audit and regulatory recommendations. Management maintains a comprehensive system of controls intended to ensure that transactions are executed in accordance with management's authorization, assets are safeguarded, and financial records are reliable. Management also takes steps to see that information and communication flows are effective and to monitor performance, including performance of internal control procedures. 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 due to changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. There have been no substantive changes in the internal control over financial reporting during the quarter ended June 30, 2008 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. 29 30 PART II. OTHER INFORMATION ITEM 1 -- LEGAL PROCEEDINGS None. ITEM 1A -- RISK FACTORS In addition to the other information set forth in this report, you should carefully consider the factors discussed below, which could materially affect our business, financial condition or future results. The risks described below are not the only risks that the Company faces. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and /or operating results. RISKS RELATED TO OUR BUSINESS CREDIT RISK Changes in the credit quality of our loan portfolio may impact the level of our allowance for loan losses. We make various judgments about the collectibility of our loans, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for our loans. In determining the amount of the allowance for loan losses, we review our loans and our loan loss and delinquency experience, and we evaluate economic conditions. If our judgments are incorrect, our allowance for loan losses may not be sufficient to cover future losses, which will result in additions to our allowance through increased provisions for loan losses. In addition, bank regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs. Increased provisions for loan losses would increase our expenses and reduce our profits. Nonetheless, to the best of management's knowledge, there are also no particular risk elements in the local economy that put a group or category of loans at increased risk. The Company does not engage in any sub-prime or Alt-A credit lending. Therefore, the Company is not subject to any credit risks associated with such loans. Also the Company is not dependent upon a single customer, or a few customers, the loss of one or more of which would have a material adverse effect on its operations. The operations and earnings of the Corporation are also not materially affected by seasonal changes. MARKET RISK CHANGES IN INTEREST RATES COULD AFFECT OUR INVESTMENT VALUES AND NET INTEREST INCOME WHICH COULD HURT OUR PROFITS. At June 30, 2008, the Company owned approximately $103.2 million of marketable securities available for sale. These securities are carried at fair value on the consolidated balance sheets. Unrealized gains or losses on these securities, that is, the difference between the fair value and the amortized cost of these securities, is reflected in stockholders' equity, net of deferred taxes. As of June 30, 2008, the Company's available for sale marketable securities portfolio had a net unrealized gain, net of taxes, of $61.4 thousand. The fair value of the Company's available for sale marketable securities is subject to interest rate change, which would not affect recorded earnings, but would increase or decrease comprehensive income and stockholders' equity. The principal component of the Company's earnings is net interest income, which is the difference between interest and fees earned on interest-earning assets and interest paid on deposits and other borrowings. The most significant impact on net interest income between periods is derived from the interaction of changes in the volume of and rates earned or paid on interest-earning assets and interest-bearing liabilities. The volume of earning dollars in loans and investments, compared to the volume of interest-bearing liabilities represented by deposits and borrowings, combined with the spread, produces the changes in net interest income between periods. 30 31 The Company continually monitors the relationship of its interest rate sensitive assets and liabilities through its Asset/Liability Committee. STRONG COMPETITION WITHIN OUR MARKET COULD AFFECT OUR PROFITS AND INHIBIT GROWTH. The Bank operates in a competitive environment in which it must share its market with many local independent banks as well as several banks which are affiliates or branches of very large regional holding companies. The Bank encounters competition from diversified financial institutions, ranging in size from small banks to the nationwide banks operating in its region. The competition includes commercial banks, savings and loan associations, credit unions, other lending institutions and mortgage originators. The principal competitive factors among the Company's competitors can be grouped into two categories: pricing and services. In the Company's primary service area, interest rates on deposits, especially time deposits, and interest rates and fees charged to customers on loans are very competitive. From a service perspective, the Bank competes in areas such as convenience of location, types of services, service costs and banking hours. Our profitability depends on our continued ability to compete successfully in our market area. COMPLIANCE RISK WE OPERATE IN A HIGHLY REGULATED ENVIRONMENT AND MAY BE ADVERSELY AFFECTED BY CHANGES IN LAWS AND REGULATIONS. The Company is registered as a financial holding company under the Bank Holding Company Act of 1956, as amended, and, as such, is subject to supervision and regulation by the Board of Governors of the Federal Reserve System ("FRB"). The Company is required to file quarterly reports of its operations with the FRB. As a financial holding company, the Company is permitted to engage in banking-related activities as authorized by the FRB, directly or through subsidiaries or by acquiring companies already established in such activities subject to the FRB regulations relating to those activities. Our banking subsidiary, Penn Security Bank and Trust Company, as a Pennsylvania state-chartered financial institution, is subject to supervision, regulation and examination by the Commonwealth of Pennsylvania Department of Banking and by the Federal Deposit Insurance Corporation (the "FDIC"), which insures the Bank's deposits to the maximum extent permitted by law. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, legislation or supervisory actions, may have a material impact on our operations. OPERATIONAL RISK THE COMPANY NEEDS TO CONTINUALLY ATTRACT AND RETAIN QUALIFIED PERSONNEL FOR ITS OPERATIONS. High quality customer services, as well as efficient and profitable operations, are dependent on the Company's ability to attract and retain qualified individuals for key positions within the organization. The Company has successfully recruited several individuals for management positions in recent years. As of June 30, 2008, the Company employed 178 full-time equivalent employees. The employees of the Company are not represented by any collective bargaining group. Management of the Company considers relations with its employees to be good. OUR OPERATIONS COULD BE AFFECTED IF WE DO NOT HAVE ACCESS TO MODERN AND RELIABLE TECHNOLOGY. The Company operates in a highly-automated environment, wherein almost all transactions are processed by computer software to produce results. To remain competitive, the Company must continually evaluate the adequacy of its data processing capabilities and make revisions as needed. The Company regularly tests its ability to restore data capabilities in the event of a natural disaster, sustained power failure or other inability to utilize its primary systems. 31 32 LIQUIDITY RISK INCREASED NEEDS FOR DISBURSEMENT OF FUNDS ON LOANS AND DEPOSITS CAN AFFECT OUR LIQUIDITY. The objective of liquidity management is to maintain a balance between sources and uses of funds in such a way that the cash requirements of customers for loans and deposit withdrawals are met in the most economical manner. Management monitors its liquidity position continuously in relation to trends of loans and deposits for short-term as well as long-term requirements. Liquid assets are monitored on a daily basis to assure maximum utilization. Management also manages its liquidity requirements by maintaining an adequate level of readily marketable assets and access to short-term funding sources. Management does not foresee any adverse trends in liquidity. OUR FUTURE PENSION PLAN COSTS AND CONTRIBUTIONS COULD BE UNFAVORABLY IMPACTED BY THE FACTORS THAT ARE USED IN THE ACTUARIAL CALCULATIONS. Our costs of providing non-contributory defined benefit pension plans are dependent upon a number of factors, such as the rates of return on plan assets, discount rates, the level of interest rates used to measure the required minimum funding levels of the plans, future government regulation and our required or voluntary contributions made to the plans. Without sustained growth in the pension investments over time to increase the value of our plan assets and depending upon the other factors impacting our costs as listed above, we could be required to fund our plans with higher amounts of cash than are anticipated by our actuaries. Such increased funding obligations could have a material impact on our liquidity by reducing our cash flows. ITEM 2 -- UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS None. ITEM 3 -- DEFAULTS UPON SENIOR SECURITIES None. ITEM 4 -- SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Annual Meeting of Shareholders of Penseco Financial Services Corporation was held on May 6, 2008. The results of the items submitted for a vote are as follows: The following three Directors, whose term will expire in 2012, were elected:
Number of votes Number of votes Number of cast for director cast against director votes not cast ----------------- --------------------- -------------- Russell C. Hazelton 1,751,813 76,679 319,508 Robert W. Naismith, Ph.D. 1,785,675 42,817 319,508 Emily S. Perry 1,758,138 70,354 319,508
The Penseco Financial Services Corporation 2008 Long-Term Incentive Plan. Votes for 1,240,357 Votes against 107,480 Votes abstained 70,652 Votes not cast 729,511 The ratification of the appointment of McGrail Merkel Quinn and Associates as independent auditors for the year ending December 31, 2008. Votes for 1,796,346 Votes against 18,469 Votes abstained 13,674 Votes not cast 319,511 32 33 ITEM 5 -- OTHER INFORMATION None. ITEM 6 -- EXHIBITS 31 Rule 13a-14(a) / 15-d-4(a) Certifications 32 Section 1350 Certifications SIGNATURES Pursuant to the requirements 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. PENSECO FINANCIAL SERVICES CORPORATION By /s/ CRAIG W. BEST ---------------------------------- Craig W. Best President and CEO Dated: August 6, 2008 By /s/ PATRICK SCANLON ---------------------------------- Patrick Scanlon Senior Vice President, Controller (Principal Financial Officer) Dated: August 6, 2008 33 34 EXHIBIT 31 CERTIFICATIONS I, Craig W. Best, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Penseco Financial Services Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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; c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors: a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. August 4, 2008 /s/ CRAIG W. BEST ------------------------------ Craig W. Best President and CEO 34 35 CERTIFICATIONS I, Patrick Scanlon, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Penseco Financial Services Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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; c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors: a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. August 4, 2008 /s/ PATRICK SCANLON ------------------------------ Patrick Scanlon Senior Vice President, Controller (Principal Financial Officer) 35 36 Exhibit 32 CERTIFICATIONS Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (subsection (a) and (b) of Section 1350, Chapter 63 of Title 18, United States Code), the undersigned officer of Penseco Financial Services Corporation (the "Company") certifies to his knowledge that: (1) The Quarterly Report on Form 10-Q of the Company for the quarter ended June 30, 2008 (the "Form 10-Q") fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Form 10-Q fairly presents, in all material respects, the financial conditions and results of operations of the Company as for the dates and for the periods referred to in the Form 10-Q. /s/ CRAIG W. BEST ----------------------------- Craig W. Best President and CEO August 4, 2008 CERTIFICATIONS Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (subsection (a) and (b) of Section 1350, Chapter 63 of Title 18, United States Code), the undersigned officer of Penseco Financial Services Corporation (the "Company") certifies to his knowledge that: (1) The Quarterly Report on Form 10-Q of the Company for the quarter ended June 30, 2008 (the "Form 10-Q") fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Form 10-Q fairly presents, in all material respects, the financial conditions and results of operations of the Company as for the dates and for the periods referred to in the Form 10-Q. /s/ PATRICK SCANLON ----------------------------- Patrick Scanlon Senior Vice President, Controller (Principal Financial Officer) August 4, 2008 36