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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE YEAR ENDED SEPTEMBER 30, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File Number: 0-25328
FIRST KEYSTONE FINANCIAL, INC.
(Exact name of registrant as specified in its charter)
Pennsylvania 23-0469351
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)
22 West State Street
Media, Pennsylvania 19063
(Address of principal executive office) (Zip Code)
Registrant's telephone number, including area code: (610) 565-6210
Securities registered pursuant to Section 12(b) of the Act:
NOT APPLICABLE
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK (PAR VALUE $.01 PER SHARE)
Indicate by check mark whether the Registrant (1) has filed all reports required
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 check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.
-------
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 126-2). Yes [ ] No [X]
The aggregate market value of the 1,582,119 shares of Common Stock of the
Registrant issued and outstanding on December 16, 2002, which excludes 424,068
shares held by all directors and officers of the Registrant as a group, was
approximately $23.6 million. This figure is based on the closing price of $14.90
per share of the Registrant's Common stock on March 28, 2002, the last business
day of the Registrant's second fiscal quarter.
Number of shares of Common Stock outstanding as of December 16, 2002: 2,006,187
DOCUMENTS INCORPORATED BY REFERENCE
Listed hereunder are the documents incorporated by reference and the Part of the
Form 10-K into which the document is incorporated:
(1) Portions of the Annual Report to Stockholders for the fiscal year ended
September 30, 2002 are incorporated into Part II.
(2) Portions of the definitive proxy statement for the 2002 Annual Meeting of
Stockholders are incorporated into Part III.
PART I.
ITEM 1. BUSINESS.
GENERAL
First Keystone Financial, Inc. (the "Company") is a Pennsylvania
corporation and sole shareholder of First Keystone Federal Savings Bank, a
federally chartered stock savings bank (the "Bank"), which converted to the
stock form of organization in January 1995. The only significant assets of the
Company are the capital stock of the Bank, the Company's loan to its employee
stock ownership plan, and various equity and other investments. See Note 17 of
the Notes to Consolidated Financial Statements in the Annual Report to
Stockholders for the fiscal year ended September 30, 2002 set forth as Exhibit
13 hereto ("Annual Report"). The business of the Company primarily consists of
the business of the Bank.
The Bank is a traditional, community oriented bank emphasizing customer
service and convenience. The Bank's primary business is to attract deposits from
the general public and invest those funds together with other available sources
of funds, primarily borrowings, to originate loans. A substantial portion of the
Bank's deposits are comprised of core deposits consisting of passbook, money
market ("MMDA"), NOW and non-interest-bearing accounts. Core deposits amounted
to $154.5 million or 46.7% of the Bank's total deposits at September 30, 2002.
The Bank's primary lending emphasis is the origination of loans secured by first
and second liens on single-family (one-to-four units) residences located in
Delaware and Chester Counties, Pennsylvania and to a lesser degree, Montgomery
County, Pennsylvania and New Castle County, Delaware. The Bank originates
residential first mortgage loans with either fixed and/or adjustable rates.
Adjustable-rate loans are retained for the Bank's portfolio while fixed-rate
loans may be sold in the secondary market depending on the Bank's
asset/liability strategy, cash flow needs and current market conditions. The
Bank also originates for portfolio, due to their generally shorter terms,
adjustable or variable interest rates and generally higher yields, loans secured
by commercial and multi-family residential real estate properties as well as
residential and commercial construction loans secured by properties located in
the Bank's market area. The level of the Bank's originations of commercial,
construction and multi-family residential loans has remained strong as a direct
result of the Bank's continued emphasis on developing business loan products.
Multi-family residential and commercial real estate loans amounted to $60.4
million or 19.9% of the total loan portfolio at September 30, 2002 as compared
to $43.5 million or 16.2% at September 30, 2001. In addition, the Bank
originates for sale in the secondary market, servicing released, non-conforming
loans in excess of Fannie Mae ("FNMA") and Freddie Mac ("FHLMC") limits. The
Bank has on occasion purchased loan participation interests in both residential
and commercial real estate loans depending on market conditions and portfolio
needs, although no such purchases were made during the fiscal year ended
September 30, 2002.
To a lesser extent, the Bank also originates consumer loans (consisting
almost entirely of home equity loans and lines of credit) and other mortgage
loans.
In addition to its deposit gathering and lending activities, the Bank
invests in mortgage-related securities, which are issued or guaranteed by U.S.
Government agencies and government sponsored or private enterprises, as well as
U.S. Treasury and federal government agency obligations, corporate bonds and
municipal obligations. At September 30, 2002, the Bank's mortgage-related
securities (including mortgage-related securities available for sale) amounted
to $94.5 million, or 18.2% of the Company's total assets, and investment
securities available for sale amounted to $80.6 million, or 15.6% of total
assets.
MARKET AREA AND COMPETITION
The Bank's primary market area is in Delaware and Chester Counties,
which is located in the southeastern corner of Pennsylvania between two
metropolitan areas, Philadelphia, PA and Wilmington, DE. There is easy access to
I-95, the Philadelphia International Airport and the Delaware River. The Bank is
fortunate to be located in such a desirable geographic area. New York City is
just 92 miles away from the Bank's headquarters in Media, PA, Baltimore, MD is
only 80 miles, and the distance to Washington, DC is just 127 miles.
Through an extensive highway and telecommunications network, the
Delaware County's economy is knitted tightly into a regional economy of more
than 2.5 million workers. Census 2000 lists Delaware County as having 14,394
business establishments with the number of jobs in the County (258,922) at an
all time high. Most of the businesses are in corporate and professional
services, distributive services and the manufacturing sector. Census 2000 shows
Delaware County has a large, well-educated, and skilled local labor force of
258,782. Nearly one quarter of the County's population is 25 years or older and
has earned a four-year college degree. The total number of people employed as
executives, managers, professionals, and technicians is 101,646. Philadelphia's
central location in the Northeast corridor, infrastructure and other factors has
made the Bank's market area attractive to many large corporate employers
including Comcast Corp., Boeing, State Farm Insurance, United Parcel Service,
PECO Energy, SAP America, Inc., Wawa, the Franklin Mint and many others.
The Philadelphia area economy is typical of many large Northeastern
cities where the traditional manufacturing based economy has declined and has
been replaced by the service sector including the health care market.
Crozer/Keystone Health System and Mercy Health Corp are amongst the larger
employers within the Bank's market area. According to the Delaware County
Chamber of Commerce, there are 82 degree-granting institutions and 47,000
graduates annually in the region, representing more colleges and universities
than any other area in the United States. Delaware County also has one of the
nation's lowest unemployment rates and one of the most active Chamber of
Commerce Offices in the State. The U.S. Small Business Administration,
Philadelphia District Office, named the Delaware County Chamber the Eastern
Region Chamber of the Year in 2001. This is the second time the Chamber received
this level of recognition.
According to the 2000 Census, the population of Delaware County is
550,864, a modest 0.6% increase since 1990. During the year 2000, Delaware
County Planning Commission reviewed proposals for almost twice as many
residential units compared to 1997. Due to the availability of land still
suitable for development, the majority of this growth has occurred in the
western part of Delaware County, and its contiguous neighbor Chester County. The
Bank had benefitted from this growth with the opening of its Chester Heights
office in December 1999 which has exceeded the Company's deposit and consumer
loan projections. Chester County has grown over 15% since 1990 and is expected
to increase further in the next decade. The communities in Chester County that
are experiencing growth are East Marlborough Township, New Garden Township and
East Goshen which surround the Bank's Chester County office.
The Bank faces strong competition both in attracting deposits and
making real estate loans. Its most direct competition for deposits has
historically come from other savings associations, credit unions and commercial
banks located in its market area including many large regional financial
institutions which have greater financial and marketing resources available to
them. The ability of the Bank to attract and retain core deposits depends on its
ability to provide a competitive rate of return, liquidity and risk comparable
to that offered by competing investment opportunities.
The Bank experiences strong competition for real estate loans
principally from other savings associations, commercial banks and
mortgage-banking companies. The Bank competes for loans principally through the
interest rates and loan fees it charges, the efficiency and quality of the
services it provides borrowers and the convenient locations of its branch office
network. Competition may increase as a result of the continuing reduction of
restrictions on the interstate operations of financial institutions.
2
LENDING ACTIVITIES
Loan Portfolio Composition. The following table sets forth the composition
of the Bank's loan portfolio by type of loan at the dates indicated (excluding
loans held for sale).
September 30,
---------------------------------------------------------------------
2002 2001 2000
-------------------- ------------------- --------------------
Amount % Amount % Amount %
--------- -------- --------- ------ --------- -------
(Dollars in thousands)
Real estate loans:
Single-family $ 173,736 57.32% $ 160,289 59.81% $ 160,143 65.54%
Multi-family and commercial 60,379 19.92 43,472 16.22 37,870 15.5
Construction and land 28,292 9.33 29,117 10.86 17,905 7.33
Home equity loans and lines of credit 27,595 9.10 25,847 9.65 22,597 9.25
------- ----- ------- ----- ------- -----
Total real estate loans 290,002 95.67 258,725 96.54 238,515 97.62
======= ===== ======= ===== ======= =====
Consumer:
Deposit 144 .05 232 .09 251 .10
Education -- -- -- -- 285 .12
Unsecured personal loans 322 .11 133 .05 -- --
Other(1) 736 .24 760 .28 807 .33
------- ----- ------- ----- ------- -----
Total consumer loans 1,202 .40 1,125 .42 1,343 .55
------- ----- ------- ----- ------- -----
Commercial business loans 11,919 3.93 8,158 3.04 4,475 1.83
------- ----- ------- ----- ------- -----
Total loans receivable (2) 303,123 100.00% 268,008 100.00% 244,333 100.00%
------- ====== ------- ====== ------- ======
Less:
Loans in process (construction and land) 11,384 17,016 10,330
Deferred loan origination fees and discounts 605 1,147 1,298
Allowance for loan losses 2,358 2,181 2,019
-------- -------- --------
Total loans receivable, net $288,776 $247,664 $230,686
======== ======== ========
(1) Consists primarily of credit card loans.
(2) Does not include $501,000, $225,000. $3.1 million, $1.8 million and $2.8
million of loans held for sale at September 30, 2002, 2001, 2000, 1999 and
1998, respectively.
1999 1998
--------- -------- --------- --------
Amount % Amount %
--------- -------- --------- --------
Real estate loans:
Single-family $166,802 69.82% $ 148,088 71.34%
Multi-family and commercial 31,188 13.05 20,563 9.91
Construction and land 18,426 7.71 15,858 7.64
Home equity loans and lines of credit 18,624 7.8 19,609 9.45
-------- ----- ------- -----
Total real estate loans 235,040 98.38 204,118 98.34
-------- ----- ------- -----
Consumer:
Deposit 243 .10 181 0.09
Education 365 .15 449 0.21
Unsecured personal loans -- -- -- --
Other (1) 1,080 .45 1,429 0.69
------- ----- ------- -----
Total consumer loans 1,688 .70 2,059 0.99
------- ----- ------- -----
Commercial business loans 2,190 .92 1,390 0.67
------- ----- ------- -----
Total loans receivable (2) 238,918 100.00% 207,567 100.00%
------- ====== ------- ======
Less:
Loans in process (construction and land) 9,005 5,781
Deferred loan origination fees and discounts 1,610 1,705
Allowance for loan losses 1,928 1,738
-------- -------
Total loans receivable, net $226,375 $198,343
======== ========
3
Contractual Principal Repayments. The following table sets forth the scheduled
contractual maturities of the Bank's loans held to maturity at September 30,
2002. Demand loans, loans having no stated schedule of repayments and no stated
maturity and overdraft loans are reported as due in one year or less. The
amounts shown for each period do not take into account loan prepayments and
normal amortization of the Bank's loan portfolio held to maturity.
Real Estate Loans
-----------------------------------------------------------
Multi-family Consumer and
and Construction Commercial
Single-family (2) Commercial and Land Total Business Loans Total
----------------- ---------- ------------ ----- -------------- --------
(Dollars in thousands)
Amounts due in:
One year or less $ 8,893 $ 6,935 $ 28,292 $ 44,120 $ 11,800 $ 55,920
After one year through three years 18,170 10,368 -- 28,538 249 28,787
After three years through five years 21,381 12,340 -- 33,721 132 33,853
After five years through ten years 60,657 12,068 -- 72,725 290 73,015
After ten years through fifteen years 37,663 9,098 -- 46,761 42 46,803
Over fifteen years 54,567 9,570 -- 64,137 608 64,745
-------- -------- -------- -------- -------- --------
Total (1) $201,331 $ 60,379 $ 28,292 $290,002 $ 13,121 $303,123
======== ======== ======== ======== ======== ========
Interest rate terms on amounts due after one year:
Fixed $145,635 $ 15,943 $161,578
Adjustable 74,672 10,953 85,625
-------- -------- --------
Total (1) $220,307 $ 26,896 $247,203
======== ======== ========
- ----------
(1) Does not include adjustments relating to loans in process, allowances for
loan losses and deferred fee income.
(2) Includes home equity loans and lines of credit.
4
Scheduled contractual amortization of loans does not reflect the expected
term of the Bank's loan portfolio. The average life of loans is substantially
less than their contractual terms because of prepayments and due-on-sale
clauses, which give the Bank the right to declare a conventional loan
immediately due and payable in the event, among other things, that the borrower
sells the real property subject to the mortgage and the loan is not repaid. The
average life of mortgage loans tends to increase when current mortgage loan
rates are higher than rates on existing mortgage loans and, conversely, decrease
when current mortgage loan rates are lower than rates on existing mortgage loans
(due to refinancings of adjustable-rate and fixed-rate loans at lower rates).
Under the latter circumstances, the weighted average yield on loans decreases as
higher yielding loans are repaid or refinanced at lower rates.
Loan Origination, Purchase and Sale Activity. The following table shows
the loan origination, purchase and sale activity of the Bank during the periods
indicated.
Year Ended September 30,
-------------------------------------
2002 2001 2000
--------- --------- ---------
(In thousands)
Gross loans at beginning of period(1) $ 268,233 $ 247,532 $ 240,710
--------- --------- ---------
Loan originations for investment:
Real estate:
Residential 60,719 25,889 20,002
Commercial and multi-family 31,300 11,265 10,704
Construction 28,741 18,503 15,470
Home equity and lines of credit 21,710 10,363 9,038
--------- --------- ---------
Total real estate loans originated for investment 142,470 66,020 55,214
Consumer 2,825 1,287 1,007
Commercial business 21,555 12,102 4,443
--------- --------- ---------
Total loans originated for investment 166,850 79,409 60,664
Participations purchased(2) -- 1,124 353
Loans originated for resale 3,712 20,685 39,531
--------- --------- ---------
Total originations 170,562 101,218 100,548
--------- --------- ---------
Deduct:
Principal loan repayments and prepayments (131,374) (56,086) (54,325)
Transferred to real estate owned (361) (872) (1,177)
Loans sold in secondary market (3,436) (23,559) (38,224)
--------- --------- ---------
Subtotal (135,171) (80,517) 93,726
--------- --------- ---------
Net increase in loans(1) 35,391 20,701 6,822
--------- --------- ---------
Gross loans at end of period(1) $ 303,624 $ 268,233 $ 247,532
========= ========= =========
(1) Includes loans held for sale of $501,000, $225,000 and $3.1 million at
September 30, 2002, 2001 and 2000, respectively.
(2) Consist of commercial real estate loans.
5
The residential lending activities of the Bank are subject to written
underwriting standards and loan origination procedures established by the Bank's
Board of Directors and management. Loan applications may be taken at all of the
Bank's branch offices by the branch manager or other designated loan officers.
Applications for single-family residential mortgage loans for portfolio
retention also are obtained through loan originators who are employees of the
Bank. The Bank's residential loan originators will take loan applications
outside of the Bank's offices at the customer's convenience and are compensated
on a commission basis. The Residential Lending Department supervises the process
of obtaining credit reports, appraisals and other documentation involved with a
loan. In most cases, the Bank requires that a property appraisal be obtained in
connection with all new first mortgage loans. Generally, appraisals are not
required on home equity loans because alternative means of valuation are used
(i.e. tax assessments). Property appraisals generally are performed by an
independent appraiser from a list approved by the Bank's Board of Directors. The
Bank requires that title insurance (other than with respect to home equity
loans) and hazard insurance be maintained on all security properties and that
flood insurance be maintained if the property is within a designated flood
plain.
Residential mortgage loan applications are primarily developed from
referrals from real estate brokers and builders, existing customers and walk-in
customers. Commercial and multi-family real estate loan applications are
obtained primarily from previous borrowers, direct solicitations by Bank
personnel, as well as referrals. Consumer loans originated by the Bank are
obtained primarily through existing and walk-in customers who have been made
aware of the Bank's programs by advertising and other means.
Applications for single-family residential mortgage loans which are
originated for resale in the secondary market or loans designated for portfolio
retention that conform to the requirements for resale into the secondary market
and do not exceed FNMA/FHLMC limits are approved by at least one of the
following: the Bank's Chief Lending Officer, the Vice President of Mortgage
Lending, the Senior Mortgage Loan underwriter or the Loan Committee (a committee
comprised of four directors and the Bank's Chief Lending Officer). Residential
mortgage loans in excess of FNMA/FHLMC maximum amounts (currently $300,700) but
less than $1.0 million must be approved by the Loan Committee. All mortgage
loans in excess of $1.0 million must be approved by the Bank's Board of
Directors or the Executive Committee thereof. Commercial and multi-family
residential real estate loans in excess of $200,000 and construction loans must
be approved by the Board of Directors. All mortgage loans which do not require
approval by the Board of Directors are submitted to the Board at its next
meeting for review and ratification. Home equity loans and lines of credit up to
$100,000 can be approved by the Chief Lending Officer, the Vice President of
Construction Loans, the Vice President of Mortgage Lending or the Senior
Mortgage Loan Underwriter. Loans in excess of such amount must be approved by
the Loan Committee.
Single-Family Residential Loans. Substantially all of the Bank's
single-family residential mortgage loans consist of conventional loans.
Conventional loans are loans that are neither insured by the Federal Housing
Administration or partially guaranteed by the Department of Veterans Affairs.
The vast majority of the Bank's single-family residential mortgage loans are
secured by properties located in Pennsylvania, primarily in Delaware and Chester
counties, and are originated under terms and documentation which permit their
sale to FHLMC or FNMA. The Bank, consistent with its asset/liability management
strategies, sells some of its newly originated longer term fixed-rate
residential mortgage loans and to a limited degree, existing longer term
fixed-rate residential mortgage loans while retaining adjustable-rate mortgage
loans and shorter term fixed-rate residential mortgage loans. See "-
Mortgage-Banking Activities."
The single-family residential mortgage loans offered by the Bank
currently consist of fixed-rate loans, including bi-weekly, balloon and
adjustable-rate loans. Fixed-rate loans generally have maturities ranging from
15 to 30 years and are fully amortizing with monthly loan payments sufficient to
repay the total amount of the loan with interest by the end of the loan term.
The Bank's fixed-rate loans are originated under terms, conditions and
documentation which permit them to be sold to U.S. Government-sponsored
agencies, such as FHLMC and FNMA, and other purchasers in the secondary mortgage
market. The Bank also offers bi-weekly loans under the terms of which the
borrower makes payments every two weeks. Although such loans have a 30 year
amortization schedule, due to the bi-weekly payment schedule, such loans repay
substantially more rapidly than a standard monthly amortizing 30-year fixed-rate
loan. The Bank also offers five and seven year balloon loans which provide that
the borrower can conditionally renew the loan at the fifth or seventh year at a
then to-be-determined rate for the remaining 25 or 23 years, respectively, of
the amortization period. At September 30, 2002, $168.6 million, or 83.4%, of the
Bank's single-family residential mortgage loans held in portfolio were
fixed-rate loans, including $19.9 million of bi-weekly, fixed-rate residential
mortgage loans.
The adjustable-rate loans currently offered by the Bank have interest rates
which adjust every one, three or five years in accordance with a designated
index, such as U.S. Treasury obligations, adjusted to a constant maturity
("CMT"), plus a stipulated margin. The Bank's adjustable-rate single-family
residential real estate loans generally have a cap of 2%
6
on any increase or decrease in the interest rate at any adjustment date, and a
cap and floor of 6% on any such increase or decrease over the life of the loan.
In order to increase the originations of adjustable-rate loans, the Bank has
been originating loans which bear a fixed interest rate for a period of three to
five years after which they convert to one-year adjustable-rate loans. The
Bank's adjustable-rate loans require that any payment adjustment resulting from
a change in the interest rate of an adjustable-rate loan be sufficient to result
in full amortization of the loan by the end of the loan term and, thus, do not
permit any of the increased payment to be added to the principal amount of the
loan, creating negative amortization. Although the Bank does offer
adjustable-rate loans with initial rates below the fully indexed rate, such
loans are underwritten using methods approved by FHLMC and FNMA which require
borrowers to be qualified at 2% above the discounted loan rate under certain
conditions. At September 30, 2002, $33.6 million, or 16.6%, of the Bank's
single-family residential mortgage loans held for portfolio were adjustable-rate
loans.
Adjustable-rate loans decrease the risks associated with changes in
interest rates but involve other risks, primarily because in the event interest
rates increase, the loan payment by the borrower also increases to the extent
permitted by the terms of the loan, thereby increasing the potential for
default. In addition, adjustable-rate loans tend to prepay and convert to fixed
rates when the overall interest rate environment is low. Moreover, as with
fixed-rate loans, as interest rates increase, the marketability of the
underlying collateral property may be adversely affected by higher interest
rates. The Bank believes that these risks, which have not had a material adverse
effect on the Bank to date, generally are less than the risks associated with
holding fixed-rate loans in an increasing interest rate environment.
For conventional residential mortgage loans held in portfolio and also
for those loans originated for sale in the secondary market, the Bank's maximum
loan-to-value ("LTV") ratio is 97%, and is based on the lesser of sales price or
appraised value. On most loans with a LTV ratio of over 80%, private mortgage
insurance may be required to be obtained or the Bank may lend the excess as an
equity loan.
Commercial and Multi-Family Residential Real Estate Loans. The Bank has
moderately increased its investment in commercial and multi-family residential
lending. Such loans are being made primarily to small- and medium-sized
businesses located in the Bank's primary market area, a segment of the market
that the Bank believes has been underserved in recent years. Loans secured by
commercial and multi-family residential real estate amounted to $60.4 million,
or 19.9%, of the Bank's total loan portfolio, at September 30, 2002. The Bank's
commercial and multi-family residential real estate loans are secured primarily
by professional office buildings, small retail establishments, warehouses and
apartment buildings (with 36 units or less) located in the Bank's primary market
area.
The Bank's adjustable-rate multi-family residential and commercial real
estate loans generally are either three or five-year adjustable-rate loans
indexed to the CMT plus a margin. In addition, depending on collateral value and
strength of the borrower, fixed-rate balloon loans and longer term fixed-rate
loans may be originated. Generally, fees of 1% to 3% of the principal loan
balance are charged to the borrower upon closing. Although terms for
multi-family residential and commercial real estate loans may vary, the Bank's
underwriting standards generally provide for terms of up to 25 years with
amortization of principal over the term of the loan and LTV ratios of not more
than 75%. Generally, the Bank obtains personal guarantees of the principals of
the borrower as additional security for any commercial real estate and
multi-family residential loans and requires that the borrower have at least a
25% equity investment in any such property.
The Bank evaluates various aspects of commercial and multi-family
residential real estate loan transactions in an effort to mitigate risk to the
extent possible. In underwriting these loans, consideration is given to the
stability of the property's cash flow history, future operating projections,
current and projected occupancy, position in the market, location and physical
condition. In recent periods, the Bank has generally imposed a debt coverage
ratio (the ratio of net cash from operations before payment of debt service to
debt service) of not less than 110%. The underwriting analysis also includes
credit checks and a review of the financial condition of the borrower and
guarantor, if applicable. An appraisal report is prepared by a state-licensed
and certified appraiser (generally an appraiser who is qualified as a Member of
the Appraisal Institute ("MAI")) commissioned by the Bank to substantiate
property values for every commercial real estate and multi-family loan
transaction. All appraisal reports are reviewed by the commercial loan
underwriter prior to the closing of the loan.
Multi-family residential and commercial real estate lending entails
different and significant risks when compared to single-family residential
lending because such loans often involve large loan balances to single borrowers
and because
7
the payment experience on such loans is typically dependent on the successful
operation of the project or the borrower's business. These risks also can be
significantly affected by supply and demand conditions in the local market for
apartments, offices, warehouses or other commercial space. The Bank attempts to
minimize its risk exposure by limiting such lending to proven developers/owners,
only considering properties with existing operating performance which can be
analyzed, requiring conservative debt coverage ratios, and periodically
monitoring the operation and physical condition of the collateral. During fiscal
2002, the Bank has experienced difficulties with two borrowers in its commercial
real estate loan portfolio which has increased non-performing assets. See
"-Non-performing Assets" for further discussion of these non-performing
non-performing loans.
Construction Loans. Substantially all of the Bank's construction loans
consist of loans for acquisition and development of properties to construct
single-family properties extended either to individuals or to selected
developers with whom the Bank is familiar to build such properties on a pre-sold
or limited speculative basis.
To a lesser extent, the Bank provides financing for construction to
permanent commercial real estate properties. Commercial construction loans have
a maximum term of 24 months during the construction period with interest based
upon the prime rate published in the Wall Street Journal ("Prime Rate") plus a
margin and have LTV ratios of 80% or less of the appraised value upon
completion. The loans convert to permanent commercial real estate loans upon
completion of construction. With respect to construction loans to individuals,
such loans have a maximum term of 12 months, have variable rates of interest
based upon the Prime Rate plus a margin and have LTV ratios of 80% or less of
the appraised value of the property upon completion and generally do not require
the amortization of principal during the term. Upon completion of construction,
the borrower is required to refinance the loan although the Bank may be the
lender of the permanent loan secured by the property.
The Bank also provides construction loans and lines of credit to
developers. The majority of construction loans consist of loans to selected
local developers with whom the Bank is familiar and who build single-family
dwellings on a pre-sold or, to a significantly lesser extent, on a speculative
basis. The Bank generally limits to two the number of unsold units that a
developer may have under construction in a project. Such loans generally have
terms of 36 months or less, have generally a maximum LTV ratios of 75% of the
appraised value of the property upon completion and do not require the
amortization of the principal during the term. The loans are made with variable
rates of interest based on the Prime Rate plus a margin adjusted on a monthly
basis. The Bank also receives origination fees that generally range from .5% to
3.0% of the loan commitment. The borrower is required to fund a portion of the
project's costs, the exact amount being determined on a case-by-case basis. Loan
proceeds are disbursed by percentage of completion of the cost of the project
after inspections indicate that such disbursements are for costs already
incurred and which have added to the value of the project. Only interest
payments are due during the construction phase and the Bank may provide the
borrower with an interest reserve from which it can pay the stated interest due
thereon.
At September 30, 2002, residential construction loans totaled $16.7
million, or 5.5%, of the total loan portfolio, primarily consisting of
construction loans to developers. At September 30, 2002, commercial construction
loans totaled $2.6 million, or .85%, of the total loan portfolio.
8
The Bank also originates ground or land loans to individuals to
purchase a property on which they intend to build their primary residences, as
well as to developers to purchase lots to build speculative homes at a later
date. Such loans have terms of 36 months or less with a maximum LTV ratio of 75%
of the lower of appraised value or sale price. The loans are made with variable
rates based on the Prime Rate plus a margin. The Bank also receives origination
fees, which generally range between 1.0% and 3.0% of the loan amount. At
September 30, 2002, land loans (including loans to acquire and develop land)
totaled $9.0 million, or 3.0%, of the total loan portfolio.
Loans to developers include both secured and unsecured lines of credit
(which are classified as commercial business loans) with outstanding commitments
totaling $2.2 million. All have personal guaranties of the principals and are
cross-collateralized with existing loans. At September 30, 2002, loans
outstanding under builder lines of credit totaled $1.2 million, or .39%, of the
total loan portfolio, of which $690,300 were unsecured and given only to the
Bank's most creditworthy long standing customers.
Prior to making a commitment to fund a construction loan, the Bank
requires an appraisal of the property by an appraiser approved by the Board of
Directors. In addition, during the term of the construction loan, the project is
inspected by an independent inspector.
Construction financing generally is considered to involve a higher
degree of risk of loss than long-term financing on improved, owner-occupied real
estate. Risk of loss on a construction loan is dependent largely upon the
accuracy of the initial estimate of the property's value at completion of
construction or development and the estimated cost (including interest) of
construction. During the construction phase, a number of factors could result in
delays and cost overruns. If the estimate of value proves to be inaccurate, the
Bank may be confronted, at or prior to the maturity of the loan, with a project,
when completed, having a value which is insufficient to assure full repayment.
Loans on lots may run the risk of adverse zoning changes as well as
environmental or other restrictions on future use.
Home Equity Loans and Lines of Credit. Home equity loans and home
equity lines of credit are secured by the underlying equity in the borrower's
primary residence or, occasionally, other types of real estate. Home equity
loans are amortizing loans with fixed interest rates and generally maximum terms
of 15 years while equity lines of credit have adjustable interest rates indexed
to the Prime Rate. Generally home equity loans or home equity lines of credit do
not exceed $100,000. The Bank's home equity loans and lines of credit generally
require combined LTV ratios of 80% or less. Loans with higher LTV ratios are
available but with higher interest rates and stricter credit standards. At
September 30, 2002, home equity loans and lines of credit amounted to $27.6
million, or 9.1%, of the Bank's total loan portfolio.
Consumer Lending Activities. The Bank offers consumer loans in order to
provide a full range of retail financial services to its customers. At September
30, 2002, $1.2 million, or .4 %, of the Bank's total loan portfolio was
comprised of consumer loans. The Bank originates substantially all of such loans
in its primary market area. At September 30, 2002, the Bank's consumer loan
portfolio was comprised of credit card, deposit, unsecured personal loans and
other consumer loans. The Bank's credit card program is primarily offered to
only the Bank's most creditworthy customers. At September 30, 2002, these loans
totaled $581,000, or .2%, of the total loan portfolio.
Consumer loans generally have shorter terms and higher interest rates
than mortgage loans but generally involve more credit risk than mortgage loans
because of the type and nature of the collateral and, in certain cases, the
absence of collateral.
Commercial Business Loans. The Bank has also emphasized the growth in
commercial business loans by granting such loans directly to business
enterprises that are located in its market area. The majority of such loans are
for less than $1.0 million. The Bank actively targets and markets to small- and
medium-sized businesses. Applications for commercial business loans are obtained
from existing commercial customers, branch and customer referrals, direct
inquiry and those that are obtained by our commercial lending officers. As of
September 30, 2002, commercial business loans amounted to $11.9 million, or
3.9%, of the Bank's total loan portfolio.
The commercial business loans consist of a limited number of commercial
lines of credit secured by real estate, securities, some working capital
financings secured by accounts receivable and inventory and, to a limited
extent,
9
unsecured lines of credit. Commercial business loans originated by the Bank
ordinarily have terms of five years or less and fixed rates or adjustable rates
tied to the Prime Rate plus a margin.
Although commercial business loans generally are considered to involve
greater credit risk than other certain types of loans, management intends to
continue to offer commercial business loans to small- and medium-sized
businesses in an effort to better serve our community's needs, obtain core
noninterest-bearing deposits and increase the Bank's interest rate spread.
Mortgage-Banking Activities. Due to customer preference for fixed-rate
loans, the Bank has continued to originate fixed-rate loans. Long-term
(generally 30 years) fixed-rate loans not taken into portfolio for
asset/liability purposes are sold into the secondary market. The Bank's net gain
on sales of mortgage loans amounted to $84,000, $122,000, and $206,000 during
the fiscal years ended September 30, 2002, 2001 and 2000, respectively. Profits
from sales of loans held for sale have declined due to declining profitability
on subprime lending and the Bank's decision in fiscal 2001 to exit the subprime
line of business. The Bank had $501,000 and $225,000 of mortgage loans held for
sale at September 30, 2002 and 2001, respectively.
The Bank's conforming mortgage loans sold to others are sold, generally
with servicing retained, on a loan-by-loan basis primarily to FHLMC and FNMA. A
period of less than five days generally elapses between the closing of the loan
by the Bank and its purchase by the investor. Mortgages with established
interest rates generally will decrease in value during periods of increasing
interest rates. Accordingly, fluctuations in prevailing interest rates may
result in a gain or loss to the Bank as a result of adjustments to the carrying
value of loans held for sale or upon sale of loans. The Bank attempts to protect
itself from these market fluctuations through the use of forward commitments at
the time of the commitment by the Bank of a loan rate to the borrower. These
commitments are mandatory delivery contracts with FHLMC and FNMA within a
certain time frame and within certain dollar amounts by a price determined at
the commitment date. Market risk does exist as non-refundable points paid by the
borrower may not be sufficient to offset fees associated with closing the
forward commitment contract.
Loan Origination Fees and Servicing. Borrowers are generally charged an
origination fee, which is a percentage of the principal balance of the loan. In
accordance with the provisions of Statement of Financial Accounting Standards
("SFAS") No. 91, "Accounting for Nonrefundable Fees and Costs Associated with
Originating or Acquiring Loans and Initial Direct Costs of Leases," the various
fees received by the Bank in connection with the origination of loans are
deferred and amortized as a yield adjustment over the lives of the related loans
using the interest method. However, when such loans are sold, the remaining
unamortized fees (which is all or substantially all of such fees due to the
relatively short period during which such loans are held) are recognized as
income on the sale of loans held for sale.
The Bank, for conforming loan products, generally retains the servicing
on all loans sold to others. In addition, the Bank services substantially all of
the loans that it retains in its portfolio. Loan servicing includes collecting
and remitting loan payments, accounting for principal and interest, making
advances to cover delinquent payments, making inspections as required of
mortgaged premises, contacting delinquent mortgagors, supervising foreclosures
and property dispositions in the event of unremedied defaults and generally
administering the loans. Funds that have been escrowed by borrowers for the
payment of mortgage-related expenses, such as property taxes and hazard and
mortgage insurance premiums, are maintained in noninterest-bearing accounts at
the Bank.
10
The following table presents information regarding the loans serviced
by the Bank for others at the dates indicated. Substantially all the loans were
secured by properties in Pennsylvania. A small percentage of the loans are
secured by properties located in Delaware, Maryland or New Jersey.
September 30,
--------------------------
2002 2001 2000
---- ---- ----
(In thousands)
Loans originated by the Bank and serviced for:
FNMA $ 1,054 $ 1,726 $ 2,140
FHLMC 50,405 64,195 67,858
Others 367 380 392
------- ------- -------
Total loans serviced for others $51,826 $66,301 $70,390
======= ======= =======
The Bank receives fees for servicing mortgage loans, which generally
amount to 0.25% per annum on the declining principal balance of mortgage loans.
Such fees serve to compensate the Bank for the costs of performing the servicing
function. Other sources of loan servicing revenues include late charges. For
fiscal years ended September 30, 2002, 2001 and 2000, the Bank earned gross fees
of $103,000, $148,000 and $150,000, respectively, from loan servicing. The Bank
retains a portion of funds received from borrowers on the loans it services for
others in payment of its servicing fees received on loans serviced for others.
Loans-to-One Borrower Limitations. Regulations impose limitations on
the aggregate amount of loans that a savings institution could make to any one
borrower, including related entities. Under such regulations, the permissible
amount of loans-to-one borrower follows the national bank standard for all loans
made by savings institutions, which generally does not permit loans-to-one
borrower to exceed 15% of unimpaired capital and surplus. Loans in an amount
equal to an additional 10% of unimpaired capital and surplus also may be made to
a borrower if the loans are fully secured by readily marketable securities. At
September 30, 2002, the Bank's five largest loans or groups of loans-to-one
borrower, including related entities, ranged from an aggregate of $4.3 million
to $5.4 million. The Bank's loans-to-one borrower limit was $6.2 million at such
date.
ASSET QUALITY
General. As a part of the Bank's efforts to improve its asset quality,
it has developed and implemented an asset classification system. All of the
Bank's assets are subject to review under the classification system, but
particular emphasis is placed on the review of multi-family residential and
commercial real estate loans, construction loans and commercial business loans.
All assets of the Bank are periodically reviewed and the classification
recommendations submitted to the Asset Classification Committee at least
monthly. The Asset Classification Committee is composed of the President and
Chief Executive Officer, the Chief Financial Officer, the Vice President of Loan
Administration, the Internal Auditor and the Vice President of Construction
Lending. All assets are placed into one of the four following categories: Pass,
Substandard, Doubtful and Loss. The criteria used to review and establish each
asset's classification are substantially identical to the asset classification
system used by the Office of Thrift Supervision (the "OTS") in connection with
the examination process. As of September 30, 2002, the Bank did not have any
assets which it had classified as doubtful or loss. See "- Non-Performing
Assets" and "- Other Classified Assets" for a discussion of certain of the
Bank's assets which have been classified as substandard and regulatory
classification standards generally.
11
When a borrower fails to make a required payment on a loan, the Bank
attempts to cure the deficiency by contacting the borrower and requesting
payment. Contact is generally made after the expiration of the grace period
(usually fifteen days) in the form of telephone calls and/or correspondence. In
most cases, deficiencies are cured promptly. If the delinquency increases, the
Bank will initiate foreclosure actions or legal collection actions if a borrower
fails to enter into satisfactory repayment arrangements. Such actions generally
commence at sixty to ninety days of delinquency.
Loans are placed on non-accrual status when, in the judgment of
management, the probability of collection of interest is deemed to be
insufficient to warrant further accrual. When a loan is placed on non-accrual
status, previously accrued but unpaid interest is deducted from interest income.
As a matter of policy, the Bank does not accrue interest on loans past due 90
days or more. See Note 2 of the Notes to Consolidated Financial Statements
included in the Company's Annual Report.
Real estate acquired by the Bank as a result of foreclosure or by
deed-in-lieu of foreclosure is classified as real estate owned until sold. Real
estate owned is initially recorded at the lower of fair value less estimated
costs to sell the property, or cost (generally the balance of the loan on the
property at the date of acquisition). After the date of acquisition, all costs
incurred in maintaining the property are expenses and costs incurred for the
improvement or development of such property are capitalized up to the extent of
their net realizable value.
Under accounting principles generally accepted in the United States of
America ("GAAP"), the Bank is required to account for certain loan modifications
or restructurings as "troubled debt restructurings." In general, the
modification or restructuring of a debt constitutes a troubled debt
restructuring if the Bank, for economic or legal reasons related to the
borrower's financial difficulties, grants a concession to the borrower that the
Bank would not otherwise consider under current market conditions. Debt
restructuring or loan modifications for a borrower do not necessarily always
constitute troubled debt restructuring, however, and troubled debt restructuring
does not necessarily result in non-accrual loans.
12
Delinquent Loans. The following table sets forth information concerning
delinquent loans at the dates indicated, in dollar amounts and as a percentage
of each category of the Bank's loan portfolio. The amounts presented represent
the total outstanding principal balances of the related loans, rather than the
actual payment amounts which are past due.
September 30, 2002 September 30, 2001
------------------------------------------ ----------------------------------------
30-59 Days 60-89 Days 30-59 Days 60-89 Days
--------------------- ------------------ ------------------ -------------------
Percent Percent Percent Percent
of of of of
Loan Loan Loan Loan
Amount Category Amount Category Amount Category Amount Category
------ -------- ------ -------- ------ -------- ------ --------
(Dollars in thousands)
Real estate loans:
Single-family
residential $ -- --% $405 .23% $526 .33% $ 80 .05%
Commercial 246 .41 -- -- -- -- -- --
Home equity -- -- 35 .13 -- -- -- --
Construction -- -- -- -- -- -- -- --
Consumer loans 18 1.50 23 1.91 204 .76 46 .17
Commercial
business loans 33 .28 -- -- -- -- -- --
---- --- ---- --- ---- --- ---- ---
Total $297 .10% $463 .15% $730 .27% $126 .05%
==== === ==== === ==== === ==== ===
13
Non-performing Assets. The following table sets forth the amounts and categories
of the Bank's non-performing assets and troubled debt restructurings at the
dates indicated.
September 30,
--------------------------------------------------------------------------
2002 2001 2000 1999 1998
------ ------ ------ ------ ------
(Dollars in thousands)
Non-performing loans:
Single-family residential $1,237 $1,924 $2,109 $2,312 $2,341
Commercial and multi-family(1) 2,386 33 -- 289 323
Construction(2) -- -- -- 556 895
Consumer 19 314 48 16 43
Commercial business 138 -- 3 6 83
------ ------ ------ ------ ------
Total non-performing loans 3,780 2,271 2,160 3,179 3,685
------ ------ ------ ------ ------
Accruing loans more than
90 days delinquent (5) 1,358 31 355 1 19
------ ------ ------ ------ ------
Total non-performing loans 5,138 2,302 2,515 3,180 3,704
------ ------ ------ ------ ------
Real estate owned 248 887 947 297 1,663
------ ------ ------ ------ ------
Total non-performing assets $5,386 $3,189 $3,462 $3,477 $5,367
====== ====== ====== ====== ======
Troubled debt restructurings (3) $ -- $ -- $ -- $ 24 $ 46
====== ====== ====== ====== ======
Total non-performing loans and
troubled debt restructurings
as a percentage of gross loans
receivable (4) 1.76% .92% 1.07% 1.39% 1.85%
====== ====== ====== ====== ======
Total non-performing assets
as a percentage of total assets 1.04% .65% .75% .77% 1.29%
====== ====== ====== ====== ======
Total non-performing assets and
troubled debt restructurings as
percentage of total assets 1.04% .65% .75% .78% 1.30%
====== ====== ====== ====== ======
- ----------
(1) Consists of three loans at September 30, 2002, one loan at September 30,
2001and two loans at September 30, 1999, and 1998.
(2) Consists of three loans made to two borrowers at September 30, 1999, and
six loans made to three borrowers at September 30, 1998.
(3) Consists of lease financing receivables at September 30, 1999 and 1998
from the Bennett Funding Group of Syracuse, New York ("Bennett Funding").
The troubled debt restructurings entered into in 1997 performed in
accordance with the terms of the agreements since the restructurings.
(4) Includes loans receivable and loans held for sale, less construction and
land loans in process and deferred loan origination fees and discounts.
(5) Consists of one commercial real estate loan of $1.3 million which returned
to current status subsequent to September 30, 2002.
14
The $1.2 million of non-performing single-family residential loans at
September 30, 2002 consisted of 21 loans with principal balances ranging from
$5,000 to $219,000, with an average balance of approximately $58,900. Included
within the 21 loans, are four loans aggregating $495,000 to credit impaired
borrowers.
At September 30, 2002, non-performing commercial real estate loans were
comprised of three commercial real estate loans totaling $2.4 million. In one
relationship, the Bank owns a 25% participation interest in two loans totaling
$1.9 million which consist of loans secured by an 18-hole golf course and golf
house, located in Avondale, Pennsylvania. The golf facility is fully operational
and continues to generate revenues. However, during fiscal 2002, the Bank has
incurred expenses in the amount of $213,000 relating to the workout of these
loans. Management expects the costs associated with these loans to continue into
the next fiscal year. The other relationship is another participating loan of
$495,000, which represents a 25% participation interest. The loan is secured by
a partially completed storage facility in Clifton Heights, Pennsylvania. The
lead lender is in the process of foreclosing on these loans.
At September 30, 2002, the $248,000 of real estate owned consisted of
four single-family residential properties, with an average carrying value of
$62,000 with the largest having a carrying value of $137,000.
Other Classified Assets. Federal banking regulations require that each
insured savings association classify its assets on a regular basis. In addition,
in connection with examinations of insured institutions, federal examiners have
authority to identify problem assets and, if appropriate, classify them. There
are three classifications for problem assets: "substandard," "doubtful" and
"loss." Substandard assets have one or more defined weaknesses and are
characterized by the distinct possibility that the insured institution will
sustain some loss if the deficiencies are not corrected. Doubtful assets have
the weaknesses of substandard assets with the additional characteristic that the
weaknesses make collection or liquidation in full, on the basis of currently
existing facts, conditions and values questionable, and there is a high
possibility of loss. An asset classified loss is considered uncollectible and of
such little value that continuance as an asset of the institution is not
warranted.
At September 30, 2002, the Bank had $5.5 million of assets classified
as substandard, and no assets classified as doubtful or loss. Substantially all
classified assets consist of non-performing assets.
Allowance for Loan Losses. The Bank's policy is to establish reserves
for estimated losses on delinquent loans when it determines that losses are
probable. The allowance for losses on loans is maintained at a level believed by
management to cover all known and inherent losses in its loan portfolio.
Management's analysis of the adequacy of the allowance is based on an evaluation
of the loan portfolio, past loss experience, current economic conditions,
volume, growth and composition of the portfolio, and other relevant factors. The
allowance is increased by provisions for loan losses which are charged against
income. The level of provisions remained at the same level in fiscal 2002 and
2001 due to the Bank's re-evaluation of its estimate of losses with respect to
its non-conforming loans, which it ceased originating in fiscal 2001, and the
reallocation of a portion of the allowance to commercial real estate and
commercial business loans. As shown in the table below, at September 30, 2002,
the Bank's allowance for loan losses amounted to 45.89% and .81% of the Bank's
non-performing loans and gross loans receivable, respectively.
On July 6, 2001, the Securities and Exchange Commission (the "SEC")
issued Staff Accounting Bulletin ("SAB") No. 102, Selected Loan Loss Allowance
Methodology and Documentation Issues. The guidance contained in the SAB was
effective immediately. This SAB expresses the views of the SEC staff regarding a
registrant's development, documentation, and application of a systematic
methodology for determining the allowance for loan and lease losses, as required
by SEC Financial Reporting Release No. 28. The guidance in SAB No. 102 focuses
on the documentation the SEC staff normally expects registrants to prepare and
maintain in support of the allowance for loans and lease losses.
Concurrent with the SEC's issuance of SAB No. 102, the federal banking
agencies (the Federal Deposit Insurance Corporation (the "FDIC"), the Board of
Governors of the Federal Reserve System, the Office of the Comptroller of the
Currency and the OTS represented by the Federal Financial Institutions
Examination Council issued an interagency policy statement entitled Allowance
for Loan and Lease Losses Methodologies and Documentation for Banks and Savings
Institutions (the "Policy Statement"). SAB No. 102 and the Policy Statement were
the result of an agreement between the SEC and the federal banking agencies in
March 1999 to provide guidance on allowance for loan and lease methodologies and
supporting documentation.
15
The guidance contained in SAB No. 102 does not prescribe specific
allowance estimation methodologies registrants should employ in estimating their
allowance for loan and lease losses, but rather emphasizes the need for a
systematic methodology that is properly designed and implemented by registrants.
Management of the Bank presently believes that its allowance for loan
losses is adequate to cover any probable losses in the Bank's loan portfolio.
However, future adjustments to this allowance may be necessary, and the Bank's
results of operations could be adversely affected if circumstances differ
substantially from the assumptions used by management in making its
determinations in this regard.
The following table provides information regarding the changes in the
allowance for loan losses and other selected statistics for the periods
presented.
Year Ending September 30,
-----------------------------------------------------------------------
2002 2001 2000 1999 1998
------- ------- -------- ------- -------
(Dollars in thousands)
Allowance for loan losses, beginning of $ 2,181 $ 2,019 $ 1,928 $ 1,738 $ 1,628
period
Charged-off loans:
Single-family residential (317) (492) (182) (12) (86)
Construction -- -- (117) -- --
Consumer and commercial business (56) (40) (64) (60) (28)
------- ------- ------- ------- -------
Total charged-off loans (373) (532) (363) (72) (114)
------- ------- ------- ------- -------
Recoveries on loans previously charged off:
Single-family residential 1 11 -- 2 22
Construction -- -- -- -- 14
Commercial leases (1) -- 134 33 -- --
Consumer and commercial business 9 9 1 1 2
------- ------- ------- ------- -------
Total recoveries 10 154 34 3 38
------- ------- ------- ------- -------
Net loans charged-off (363) (378) (329) (69) (76)
Provision for loan losses 540 540 420 259 186
------- ------- ------- ------- -------
Allowance for loan losses, end of period $ 2,358 $ 2,181 $ 2,019 $ 1,928 $ 1,738
======= ======= ======= ======= =======
Net loans charged-off to average
loans outstanding(2) .13% .16% .14% .03% .04%
======= ======= ======= ======= =======
Allowance for loan losses
to gross loans receivable(2) .81% .87% .86% .84% .86%
======= ======= ======= ======= =======
Allowance for loan losses
to total non-performing loans 45.89% 94.74% 80.28% 60.63% 46.92%
======= ======= ======= ======= =======
Net loans charged-off to
allowance for loan losses 15.39% 17.33% 16.30% 3.58% 4.37%
======= ======= ======= ======= =======
Recoveries to charge-offs 2.68% 28.95% 9.37% 4.17% 33.33%
======= ======= ======= ======= =======
(1) Relate to commercial lease purchases in prior years.
(2) Gross loans receivable and average loans outstanding include loans
receivable and loans held for sale, less construction and land loans in
process and deferred loan origination fees and discounts.
16
The following table presents the Bank's allocation of the allowance for loan
losses to the total amount of loans in each category listed at the dates
indicated.
September 30,
--------------------------------------------------------------------------------------------------------
2002 2001 2000 1999 1998
-------------------- -------------------- ---------------------- --------------------- -----------------
% of Loans % of Loans % of Loans % of Loans % of Loans
in Each in Each in Each in Each in Each
Category to Category to Category to Category to Category to
Amount Total Loans Amount Total Loans Amount Total Loans Amount Total Loans Amount Total Loans
------- ----------- ------ ----------- ------ ----------- ------ ----------- ------ -----------
(Dollars in thousands)
Single-family
residential $ 815 57.32% $ 615 59.81% $1,098 65.54% $ 572 69.82% $ 446 71.34%
Commercial and multi-
family 767 19.92 566 16.22 198 15.50 166 13.05 109 9.91
Construction 304 9.33 249 10.86 171 7.33 320 7.71 382 7.64
Home equity 40 9.10 59 9.65 41 9.25 34 7.80 49 9.45
Consumer 10 .40 11 .42 8 .55 8 .70 14 .99
Commercial business 86 3.93 87 3.04 60 1.83 14 .92 20 .67
Unallocated 336 -- 594 -- 443 -- 814 -- 718 --
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Total allowance for
loan losses $2,358 100.00% $2,181 100.00% $2,019 100.00% $1,928 100.00% $1,738 100.00%
====== ====== ====== ====== ====== ====== ====== ====== ====== ======
17
MORTGAGE-RELATED SECURITIES AND INVESTMENT SECURITIES
Mortgage-Related Securities. Federally chartered savings institutions
have authority to invest in various types of liquid assets, including U.S.
Treasury obligations, securities of various federal agencies and of state and
municipal governments, certificates of deposit at federally insured banks and
savings and loan associations, certain bankers' acceptances and federal funds.
Subject to various restrictions, federally chartered savings institutions also
may invest a portion of their assets in commercial paper, corporate debt
securities and mutual funds, the assets of which conform to the investments that
federally chartered savings institutions are otherwise authorized to make
directly.
The Bank maintains a significant portfolio of mortgage-related
securities (including mortgage-backed securities and collateralized mortgage
obligations ("CMOs") as a means of investing in housing-related mortgage
instruments without the costs associated with originating mortgage loans for
portfolio retention and with limited credit risk of default which arises in
holding a portfolio of loans to maturity. Mortgage-backed securities (which also
are known as mortgage participation certificates or pass-through certificates)
represent a participation interest in a pool of single-family or multi-family
residential mortgages. The principal and interest payments on mortgage-backed
securities are passed from the mortgage originators, as servicer, through
intermediaries (generally U.S. Government agencies and government-sponsored
enterprises) that pool and repackage the participation interests in the form of
securities, to investors such as the Bank. Such U.S. Government agencies and
government sponsored enterprises, which guarantee the payment of principal and
interest to investors, primarily include FHLMC, FNMA and the Government National
Mortgage Association ("GNMA"). The Bank also invests in certain privately
issued, credit enhanced mortgage-related securities rated AAA by national
securities rating agencies.
FHLMC is a public corporation chartered by the U.S. Government. FHLMC
issues participation certificates backed principally by conventional mortgage
loans. FHLMC guarantees the timely payment of interest and the ultimate return
of principal on participation certificates. FNMA is a private corporation
chartered by the U.S. Congress with a mandate to establish a secondary market
for mortgage loans. FNMA guarantees the timely payment of principal and interest
on FNMA securities. FHLMC and FNMA securities are not backed by the full faith
and credit of the United States, but because FHLMC and FNMA are U.S.
Government-sponsored enterprises, these securities are considered to be among
the highest quality investments with minimal credit risks. GNMA is a government
agency within the Department of Housing and Urban Development which is intended
to help finance government-assisted housing programs. GNMA securities are backed
by Federal Housing Administration ("FHA") insured and the Department of Veterans
Affairs ("VA") guaranteed loans, and the timely payment of principal and
interest on GNMA securities are guaranteed by the GNMA and backed by the full
faith and credit of the U.S. Government. Because FHLMC, FNMA and GNMA were
established to provide support for low- and middle-income housing, there are
limits to the maximum size of loans that qualify for these programs which is
currently $300,700.
Mortgage-related securities typically are issued with stated principal
amounts, and the securities are backed by pools of mortgages that have loans
with interest rates that are within a range and have varying maturities. The
underlying pool of mortgages can be composed of either fixed-rate or
adjustable-rate loans. As a result, the risk characteristics of the underlying
pool of mortgages (i.e., fixed-rate or adjustable rate) as well as prepayment
risk, are passed on to the certificate holder. Thus, the life of a
mortgage-backed pass-through security thus approximates the life of the
underlying mortgages.
The Bank's mortgage-related securities include regular interests in
CMOs. CMOs were developed in response to investor concerns regarding the
uncertainty of cash flows associated with the prepayment option of the
underlying mortgagor and are typically issued by governmental agencies,
governmental sponsored enterprises and special purpose entities, such as trusts,
corporations or partnerships, established by financial institutions or other
similar institutions. A CMO can be (but is not required to be) collateralized by
loans or securities which are insured or guaranteed by FNMA, FHLMC or the GNMA.
In contrast to pass-through mortgage-related securities, in which cash flow is
received pro rata by all security holders, the cash flow from the mortgages
underlying a CMO is segmented and paid in accordance with a predetermined
priority to investors holding various CMO classes. By allocating the principal
and interest cash flows from the underlying collateral among the separate CMO
classes, different classes of bonds are created, each with its own stated
maturity, estimated average life, coupon rate and prepayment characteristics.
The short-term classes of a CMO usually carry a lower coupon rate than
the longer term classes and, therefore, the interest differential cash flow on a
residual interest is greatest in the early years of the CMO. As the early coupon
classes are
18
extinguished, the residual income declines. Thus, the longer the lower coupon
classes remain outstanding, the greater the cash flow accruing to CMO residuals.
As interest rates decline, prepayments accelerate, the interest differential
narrows, and the cash flow from the CMO declines. Conversely, as interest rates
increase, prepayments decrease, generating a larger cash flow to residuals.
A senior-subordinated structure often is used with CMOs to provide
credit enhancement for securities which are backed by collateral which is not
guaranteed by FNMA, FHLMC or the GNMA. These structures divide mortgage pools
into various risk classes: a senior class and one or more subordinated classes.
The subordinated classes provide protection to the senior class. When cash flow
is impaired, debt service goes first to the holders of senior classes. In
addition, incoming cash flows also may go into a reserve fund to meet any future
shortfalls of cash flow to holders of senior classes. The holders of
subordinated classes may not receive any funds until the holders of senior
classes have been paid and, when appropriate, until a specified level of funds
has been contributed to the reserve fund.
Mortgage-related securities generally bear yields which are less than
those of the loans which underlie such securities because of their payment
guarantees or credit enhancements which reduce credit risk to nominal levels.
However, mortgage-related securities are more liquid than individual mortgage
loans and may be used to collateralize certain obligations of the Bank. At
September 30, 2002, $12.9 million of the Bank's mortgage-related securities were
pledged to secure various obligations of the Bank, treasury tax and loan
processing and as collateral for certain municipal deposits.
The Bank's mortgage-related securities are classified as either "held
to maturity" or "available for sale" based upon the Bank's intent and ability to
hold such securities to maturity at the time of purchase, in accordance with
GAAP. As of September 30, 2002, the Bank had an aggregate of $94.5 million, or
18.2%, of total assets invested in mortgage-related securities, net, of which
$8.9 million was held to maturity and $85.7 million was available for sale. The
mortgage-related securities of the Bank which are held to maturity are carried
at cost, adjusted for the amortization of premiums and the accretion of
discounts using a method which approximates a level yield, while
mortgage-related securities available for sale are carried at the current fair
value. See Notes 2 and 4 of the Notes to Consolidated Financial Statements in
the Company's Annual Report.
19
The following table sets forth the composition of the Bank's available
for sale (at fair value) and held to maturity (at amortized cost) of the
mortgage-related securities portfolios at the dates indicated.
September 30,
------------------------------------------
2002 2001 2000
-------- -------- --------
Available for sale: (In thousands)
Mortgage-backed securities:
FHLMC $ 5,261 $ 9,175 $ 5,771
FNMA 13,463 15,056 23,546
GNMA 33,621 43,907 38,421
-------- -------- --------
Total mortgage-backed securities 52,345 68,138 67,738
-------- -------- --------
Collateralized mortgage obligations:
FHLMC 9,509 10,994 9,117
FNMA 3,751 6,215 6,905
GNMA -- 17 309
Other 20,069(1) 32,244(2) 12,188
-------- -------- --------
Total collateralized mortgage obligations 33,329 49,470 28,519
-------- -------- --------
Total mortgage-related securities $ 85,674 $117,608 $ 96,257
======== ======== ========
Held to maturity:
Mortgage-backed securities:
FHLMC $ 1,433 $ 2,285 $ 2,898
FNMA 3,574 4,684 5,674
-------- -------- --------
Total mortgage-backed securities 5,007 6,969 8,572
-------- -------- --------
Collateralized mortgage obligations:
FNMA 3,848 4,485 4,484
-------- -------- --------
Total collateralized mortgage obligations 3,848 4,485 4,484
-------- -------- --------
Total mortgage-related securities, amortized cost $ 8,855 $ 11,454 $ 13,056
======== ======== ========
Total fair value(3) $ 9,090 $ 11,550 $ 12,580
======== ======== ========
- ----------
(1) Includes "AAA" rated securities of Northwest Asset Securities Corporation,
Credit Suisse First Boston, Washington Mutual and Countrywide Home Loans
with book values of $2.9 million, $4.1 million, $5.1 million and $2.7
million, respectively, and fair value of $3.0 million, $4.1 million, $5.1
million and $2.8 million, respectively.
(2) Includes "AAA" rated securities of Northwest Asset Securities Corporation,
Chase Mortgage Services, Washington Mutual and Countrywide Home Loans with
book values of $5.5 million, $3.1 million, $4.2 million and $5.0 million,
respectively, and fair values of $5.7 million, $3.1 million, $4.3 million
and $5.0 million, respectively.
(3) See Note 4 of the Notes to Consolidated Financial Statements in the
Company's Annual Report.
20
The following table sets forth the purchases, sales and principal
repayments of the Bank's mortgage-related securities for the periods indicated.
Year Ended September 30,
-----------------------------------------
2002 2001 2000
--------- --------- ---------
(In thousands)
Mortgage-related securities, beginning of period(1)(2) $ 129,062 $ 109,313 $ 127,543
--------- --------- ---------
Purchases:
Mortgage-backed securities - available for sale 9,280 24,501 11,873
CMOs - available for sale 18,231 34,162 3,965
Sales:
Mortgage-backed securities - available for sale -- (6,888) (13,407)
CMOs - available for sale -- -- (5,132)
Repayments and prepayments:
Mortgage-backed securities (26,820) (21,568) (10,410)
CMOs (34,554) (14,808) (5,675)
Decrease in net premium (315) (145) (62)
Change in net unrealized gain (loss) on mortgage-related securities
available for sale (355) 4,495 618
--------- --------- ---------
Net increase (decrease) in mortgage-related securities (34,533) 19,749 (18,230)
--------- --------- ---------
Mortgage-related securities, end of period(1) (2) $ 94,529 $ 129,062 $ 109,313
========= ========= =========
- ----------
(1) Includes both mortgage-related securities available for sale and held to
maturity.
(2) Calculated at amortized cost for securities held to maturity and at fair
value for securities available for sale.
At September 30, 2002, the estimated weighted average maturity of the
Bank's fixed-rate mortgage-related securities was approximately 2.89 years. The
actual maturity of a mortgage-backed security is less than its stated maturity
due to prepayments of the underlying mortgages. Prepayments that are faster than
anticipated may shorten the life of the security and adversely affect its yield
to maturity. The yield is based upon the interest income and the amortization of
any premium or discount related to the mortgage-backed security. In accordance
with GAAP, premiums and discounts are amortized over the estimated lives of the
securities, which decrease and increase interest income, respectively. The
prepayment assumptions used to determine the amortization period for premiums
and discounts can significantly affect the yield of the mortgage-backed
security, and these assumptions are reviewed periodically to reflect actual
prepayments. Although prepayments of underlying mortgages depend on many
factors, including the type of mortgages, the coupon rate, the age of mortgages,
the geographical location of the underlying real estate collateralizing the
mortgages and general levels of market interest rates, the difference between
the interest rates on the underlying mortgages and the prevailing mortgage
interest rates generally is the most significant determinant of the rate of
prepayments. During periods of declining mortgage interest rates, such as the
Bank experienced during fiscal 2002 and 2001, if the coupon rates of the
underlying mortgages exceed the prevailing market interest rates offered for
mortgage loans, refinancings generally increase and accelerate the prepayment
rate of the underlying mortgages and the related securities. Conversely, during
periods of increasing mortgage interest rates, if the coupon rates of the
underlying mortgages are less than the prevailing market interest rates offered
for mortgage loans, refinancings generally decrease and decrease the prepayment
rate of the underlying mortgages and the related securities. As a result of the
declining interest rate environment, the Bank experienced high levels of
repayments and accelerated prepayments, and consequently, the Bank reinvested
the proceeds of such repayments and prepayments at a lower yield.
Investment Securities. The following table sets forth information
regarding the carrying and fair value of the Company's investment securities,
both held to maturity and available for sale, at the dates indicated
21
At September 30,
-------------------------------------------------------------------
2002 2001 2000
------------------- ------------------- -------------------
Carrying Fair Carrying Fair Carrying Fair
Value Value Value Value Value Value
-------- ------- -------- ------- -------- -------
(In thousands)
FHLB stock $ 6,571 $ 6,571 $ 6,917 $ 6,917 $ 6,672 $ 6,672
U.S. Government and agency
obligations
1 to 5 years 11,986 12,114 2,961 3,133 2,936 2,970
5 to 10 years 1,861 2,071 1,843 2,050 6,997 6,745
Municipal securities 19,012 19,800 21,890 22,626 18,930 18,153
Corporate bonds 14,299 14,720 14,333 14,087 4,910 4,596
Mutual funds 14,009 14,045 5,009 5,004 2,000 1,970
Asset backed securities 2,837 2,853 2,986 2,970
Preferred stocks 10,682 10,751 9,474 9,197 5,528 4,732
Other equity investments 3,476 4,269 2,778 3,497 2,778 3,049
------- ------- ------- ------- ------- -------
Total $84,733 $87,194 $68,191 $69,481 $50,751 $48,887
======= ======= ======= ======= ======= =======
At September 30, 2002, the Company had an aggregate of $87.2 million, or
16.8%, of its total assets invested in investment securities, of which $6.6
million consisted of FHLB stock and $80.6 million was investment securities
available for sale. Included in U.S. Government and agency obligations is a
callable bond with a remaining term of approximately two years. The Bank's
investment securities (excluding mutual funds, equity securities and FHLB stock)
had a weighted average maturity to the call date of 5.8 years and a weighted
average yield of 6.9% (adjusted to a fully taxable equivalent yield).
SOURCES OF FUNDS
General. The Bank's principal source of funds for use in lending and for
other general business purposes has traditionally come from deposits obtained
through the Bank's branch offices. The Bank also derives funds from contractual
payments and prepayments of outstanding loans and mortgage-related securities,
from sales of loans, from maturing investment securities and from advances from
the FHLB of Pittsburgh and other borrowings. Loan repayments are a relatively
stable source of funds, while deposits inflows and outflows are significantly
influenced by general interest rates and money market conditions. The Bank uses
borrowings to supplement its deposits as a source of funds.
Deposits. The Bank's current deposit products include passbook accounts, NOW
accounts, MMDA, certificates of deposit ranging in terms from 30 days to five
years and noninterest-bearing personal and business checking accounts. The
Bank's deposit products also include Individual Retirement Account ("IRA")
certificates and Keogh accounts.
The Bank's deposits are obtained primarily from residents in Delaware and
Chester counties in southeastern Pennsylvania. The Bank attracts local deposit
accounts by offering a wide variety of accounts, competitive interest rates, and
convenient branch office locations and service hours. The Bank utilizes
traditional marketing methods to attract new customers and savings deposits,
including print media, radio advertising and direct mailings. However, the Bank
does not solicit funds through deposit brokers nor does it pay any brokerage
fees if it accepts such deposits.
22
The Bank has been competitive in the types of accounts and interest rates it
has offered on its deposit products but does not necessarily seek to match the
highest rates paid by competing institutions. Even with the significant decline
in interest rates paid on deposit products in fiscal 2002, due to generally
declining returns on competing investment opportunities as well as the effects
of the stock market decline, the Bank did not experience disintermediation of
deposits into competing investment products in fiscal 2002.
The following table shows the distribution of, and certain information
relating to, the Bank's deposits by type of deposit as of the dates indicated.
September 30,
-----------------------------------------------------------------------
2002 2001 2000
-------------------- -------------------- -------------------
Amount Percent Amount Percent Amount Percent
-------- ------- -------- ------- -------- -------
(Dollars in thousands)
Passbook $ 41,659 12.60% $ 37,806 12.13% $ 37,861 13.89%
MMDA 48,722 14.73 40,781 13.09 23,583 8.65
NOW 54,048 16.34 45,161 14.49 38,898 14.27
Certificates of deposit 176,242 53.28 182,155 58.46 165,456 60.71
Noninterest-bearing 10,094 3.05 5,698 1.83 6,764 2.48
-------- ------- -------- ------- -------- -------
Total deposits $330,765 100.00% $311,601 100.00% $272,562 100.00%
======== ======= ======== ======= ======== =======
The following table sets forth the net savings flows of the Bank during the
periods indicated.
Year Ended September 30,
----------------------------------
2002 2001 2000
-------- -------- --------
(In thousands)
Increase before interest credited $ 10,477 $ 27,876 $ 1,894
Interest credited 8,687 11,163 9,842
-------- -------- --------
Net savings increase $ 19,164 $ 39,039 $ 11,736
======== ======== ========
The following table sets forth maturities of the Bank's certificates of
deposit of $100,000 or more at September 30, 2002 by time remaining to maturity
(amounts in thousands).
Three months or less $10,764
Over three months through six months 5,509
Over six months through twelve months 6,679
Over twelve months 9,618
-------
$32,570
=======
23
The following table presents, by various interest rate categories, the
amount of certificates of deposit at September 30, 2002 and 2001 and the amounts
at September 30, 2002 which mature during the periods indicated.
Amounts at September 30, 2002
September 30, Maturing Within
--------------------- ---------------------------------------------------
Certificates of
Deposit 2002 2001 One Year Two Years Three Years Thereafter
- -------------------------- -------- -------- -------- --------- ----------- ----------
(Dollars in thousands)
2.0% or less $ 2,575 $ 131 $ 1,908 $ 667 $ -- $ --
2.01% to 3.0% 63,105 3,563 58,324 2,505 1,265 1,011
3.01% to 4.0% 68,059 23,209 41,999 24,659 758 643
4.01% to 5.0% 22,664 45,287 3,840 1,913 7,369 9,542
5.01% to 6.0% 10,117 26,107 3,509 709 2,228 3,671
6.01% to 7.0% 9,722 83,858 114 9,376 232 --
-------- -------- -------- -------- -------- --------
Total certificate accounts $176,242 $182,155 $109,694 $ 39,829 $ 11,852 $ 14,867
======== ======== ======== ======== ======== ========
The following table presents the average balance of each deposit type and
the average rate paid on each deposit type for the periods indicated.
September 30,
----------------------------------------------------------------------
2002 2001 2000
-------------------- -------------------- --------------------
Average Average Average
Average Rate Average Rate Average Rate
Balance Paid Balance Paid Balance Paid
-------- ------- -------- ------- -------- -------
(Dollars in thousands)
Passbook accounts $ 40,300 1.86% $ 37,661 2.41% $ 39,498 2.41%
MMDA accounts 47,245 2.19 31,645 3.86 17,345 3.44
Certificates of deposit 174,844 4.24 177,086 5.87 164,783 5.61
NOW accounts 49,235 .81 40,681 1.32 39,918 1.40
Noninterest-bearing deposits 7,720 -- 7,658 -- 6,613 --
-------- -------- --------
Total deposits $319,344 3.01% $294,731 4.43% $268,157 4.23%
======== ====== ======== ====== ======== ======
24
Borrowings. The Bank may obtain advances from the FHLB of Pittsburgh upon
the security of the common stock it owns in the FHLB and certain of its
residential mortgage loans and securities held to maturity, provided certain
standards related to creditworthiness have been met. Such advances are made
pursuant to several credit programs, each of which has its own interest rate and
range of maturities. The increase in core deposits funded asset growth during
fiscal 2002, therefore borrowing from the FHLB was not necessary. During fiscal
2001, deposit increases exceeded asset growth which allowed the Bank to repay
some of the existing FHLB advances. The Bank, during fiscal 2000 and 1999,
increased its FHLB borrowings to fund asset growth. At September 30, 2002, the
Bank had $126.2 million in outstanding FHLB advances. The FHLB advances have
certain call features whereby the FHLB of Pittsburgh can call the borrowings
after the expiration of certain time frames. The time frames on the callable
borrowings range from three months to seven years. See Note 9 of the Notes to
Consolidated Financial Statements in the Company's Annual Report for additional
information.
SUBSIDIARIES
The Bank is permitted to invest up to 2% of its assets in the capital stock
of, or secured or unsecured loans to, service corporations, with an additional
investment of 1% of assets when such additional investment is utilized primarily
for community development purposes. It may invest essentially unlimited amounts
in subsidiaries deemed operating subsidiaries that can only engage in activities
that the Bank is permitted to engage in. Under such limitations, as of September
30, 2002, the Bank was authorized to invest up to approximately $10.2 million in
the stock of, or loans to, service corporations. As of September 30, 2002, the
net book value of the Bank's investment in stock, unsecured loans, and
conforming loans to its service corporations was $42,700.
At September 30, 2002, in addition to the Bank, the Company has five direct
or indirect subsidiaries: First Keystone Capital Trust I, First Keystone Capital
Trust II, FKF Management Corp., Inc., State Street Services Corp., First Pointe,
Inc. and First Chester Services, Inc.
First Keystone Capital Trust I (the "Trust") is a Delaware statutory
business trust wholly owned by the Company formed in 1997 for the purpose of
issuing trust preferred securities and investing the proceeds therefrom in
Junior Subordinated Debentures issued by the Company. See Note 16 of the Notes
to Consolidated Financial Statements in the Company's Annual Report for further
discussion regarding the issuance of trust preferred securities.
First Keystone Capital Trust II (the "Trust II") is a Delaware statutory
business trust wholly owned by the Company formed in 2001 for the purpose of
issuing trust preferred securities and investing the proceeds in Junior
Subordinated Debentures issued by the Company. See Note 16 of the Notes to the
Consolidated Financial Statements in the Company's Annual Report for further
discussion regarding the issuance of trust preferred securities.
FKF Management Corp., Inc., a Delaware corporation, is a wholly owned
operating subsidiary of the Bank established in 1997 for the purpose of managing
certain assets of the Bank. Assets under management totaled $149.0 million at
September 30, 2002 and were comprised principally of investment and
mortgage-related securities.
State Street Services Corp. is a wholly owned subsidiary of the Bank
established in 1999 for the purpose of offering a full array of insurance
products through its ownership of a 51% interest in First Keystone Insurance
Services, LLC. In addition, it holds a 10% equity position in a title company
which offers title services.
The Bank has two remaining subsidiaries, First Chester Services, Inc. and
First Pointe, Inc., which were both involved in real estate management but are
now inactive.
EMPLOYEES
The Bank had 81 full-time employees and 13 part-time employees as of
September 30, 2002. None of these employees is represented by a collective
bargaining agreement. The Bank believes that it enjoys excellent relations with
its personnel.
25
REGULATION
The Company. The Company as a savings and loan holding company within the
meaning of the Home Owners' Loan Act, as amended ("HOLA"), is registered as such
with the OTS and is subject to OTS regulations, examinations, supervision and
reporting requirements. As a subsidiary of a savings and loan holding company,
the Bank is subject to certain restrictions in its dealings with the Company and
affiliates thereof.
Federal Activities Restrictions. The Company operates as a unitary savings
and loan holding company. Generally, there are only limited restrictions on the
activities of a unitary savings and loan holding company which applied to become
or was a unitary saving and loan holding company prior to May 4, 1999 and its
non-savings institution subsidiaries. Under the Gramm-Leach-Bliley Act of 1999
(the "GLBA"), companies which apply to the OTS to become unitary savings and
loan holding companies will be restricted to only engaging in those activities
traditionally permitted to multiple saving and loan holding companies. However,
if the Director of the OTS determines that there is reasonable cause to believe
that the continuation by a savings and loan holding company of an activity
constitutes a serious risk to the financial safety, soundness or stability of
its subsidiary savings association, the Director may impose such restrictions as
deemed necessary to address such risk, including limiting (i) payment of
dividends by the savings association; (ii) transactions between the savings
association and its affiliates; and (iii) any activities of the savings
association that might create a serious risk that the liabilities of the holding
company and its affiliates may be imposed on the savings association.
Notwithstanding the above rules as to permissible business activities of
grandfathered unitary savings and loan holding companies under the GLBA (such as
the Company), if the savings association subsidiary of such a holding company
fails to meet the Qualified Thrift Lender ("QTL") test, then such unitary
holding company also shall become subject to the activities restrictions
applicable to multiple savings and loan holding companies and, unless the
savings association qualifies as a QTL within one year thereafter, shall
register as, and become subject to the restrictions applicable to, a bank
holding company. See "- The Bank - Qualified Thrift Lender Test."
If the Company were to acquire control of another savings association, other
than through merger or other business combination with the Bank, the Company
would thereupon become a multiple savings and loan holding company and would
thereafter be subject to further restrictions on its activities.
The GLBA also imposes financial privacy obligations and reporting
requirements on all financial institutions. The privacy regulations require,
among other things, that financial institutions establish privacy policies and
disclose such policies to its customers at the commencement of a customer
relationship and annually thereafter. In addition, financial institutions are
required to permit customers to opt out of the financial institution's
disclosure of the customer's financial information to non-affiliated third
parties.
The HOLA requires every savings institution subsidiary of a savings and loan
holding company to give the OTS at least 30 days' advance notice of any proposed
dividends to be made on its guarantee, permanent or other nonwithdrawable stock,
or else such dividend will be invalid. See "- The Bank - Restrictions on Capital
Distributions."
Limitations on Transactions with Affiliates. Transactions between savings
associations and any affiliate are governed by Sections 23A and 23B of the
Federal Reserve Act ("FRA") and OTS regulations issued in connection therewith.
Affiliates of a savings institution include, among other entities, the savings
institution's holding company and companies that are controlled by or under
common control with the savings institution. Generally, Sections 23A and 23B (i)
limit the extent to which the savings association or its subsidiaries may engage
in "covered transactions" with any one affiliate to an amount equal to 10% of
such association's capital stock and surplus, and contain an aggregate limit on
all such transactions with all affiliates to an amount equal to 20% of such
capital stock and surplus and (ii) require that all such transactions be on
terms substantially the same, or at least as favorable, to the association or
subsidiary as those provided to a non-affiliate. The term "covered transaction"
includes, among other things, the making of loans or extension of credit to an
affiliate, purchase of assets, issuance of a guarantee and similar transactions.
In addition to the restrictions imposed by Sections 23A and 23B, under OTS
regulations no savings association may (i) loan or otherwise extend credit to an
affiliate, except for any affiliate which engages only in activities which are
permissible for bank holding companies, (ii) a savings association may not
purchase or invest in securities of an affiliate other than shares of a
subsidiary; (iii) a savings association and its subsidiaries may not purchase a
low-quality asset from an affiliate; (iv) and covered transactions and certain
other transactions between a savings association or its subsidiaries
26
and an affiliate must be on terms and conditions that are consistent with safe
and sound banking practices. With certain exceptions, each extension of credit
by a savings association to an affiliate must be secured by collateral with a
market value ranging from 100% to 130% (depending on the type of collateral) of
the amount of the loan or extension of credit.
OTS regulations generally exclude all non-bank and non-savings association
subsidiaries of savings associations from treatment as affiliates, except to the
extent that the OTS or the Federal Reserve Board decides to treat such
subsidiaries as affiliates. The regulations also require savings associations to
make and retain records that reflect affiliate transactions in reasonable
detail, and provide that certain classes of savings associations may be required
to give the OTS prior notice of affiliate transactions.
Restrictions on Acquisitions. Except under limited circumstances, savings
and loan holding companies are prohibited from acquiring, without prior approval
of the Director of the OTS, (i) control of any other savings association or
savings and loan holding company or substantially all the assets thereof; or
(ii) more than 5% of the voting shares of a savings association or holding
company thereof which is not a subsidiary. Except with the prior approval of the
Director of the OTS, no director or officer of a savings and loan holding
company or person owning or controlling by proxy or otherwise more than 25% of
such company's stock, may acquire control of any savings association, other than
a subsidiary savings association, or of any other savings and loan holding
company.
Federal Securities Laws. The Company's Common Stock is registered with the
SEC under the Securities Exchange Act of 1934, as amended ("Exchange Act"). The
Company is subject to the information, proxy solicitation, insider trading
restrictions and other requirements under the Exchange Act.
Shares of Common Stock owned by an affiliate of the Company are subject to
the resale restrictions of Rule 144 under the Securities Act of 1933, as amended
("Securities Act"). As long as the Company meets the current public information
requirements of Rule 144 under the Securities Act, each affiliate of the Company
who complies with the other conditions of Rule 144 (including those that require
the affiliate's sale to be aggregated with those of certain other persons)
generally is able to sell in the public market, without registration, a number
of shares not to exceed, in any three-month period, the greater of (i) 1% of the
outstanding shares of the Company or (ii) the average weekly volume of trading
in such shares during the preceding four calendar weeks.
Sarbanes-Oxley Act of 2002. On July 30, 2002, the President signed into law
the Sarbanes-Oxley Act of 2002 implementing legislative reforms intended to
address corporate and accounting fraud. In addition to the establishment of a
new accounting oversight board which will enforce auditing, quality control and
independence standards and will be funded by fees from all publicly traded
companies, the bill restricts provision of both auditing and consulting services
by accounting firms. To ensure auditor independence, any non-audit services
being provided to an audit client will require preapproval by the company's
audit committee members. In addition, the audit partners must be rotated. The
bill requires chief executive officers and chief financial officers, or their
equivalent, to certify to the accuracy of periodic reports filed with the SEC,
subject to civil and criminal penalties if they knowingly or willfully violate
this certification requirement. In addition, under the Act, counsel will be
required to report evidence of a material violation of the securities laws or a
breach of fiduciary duty by a company to its chief executive officer or its
chief legal officer, and, if such officer does not appropriately respond, to
report such evidence to the audit committee or other similar committee of the
board of directors or the board itself.
Longer prison terms and increased penalties will also be applied to
corporate executives who violate federal securities laws, the period during
which certain types of suits can be brought against a company or its officers
has been extended, and bonuses issued to top executives prior to restatement of
a company's financial statements are now subject to disgorgement if such
restatement was due to corporate misconduct. Executives are also prohibited from
insider trading during retirement plan "blackout" periods, and loans to company
executives are restricted. In addition, a provision directs that civil penalties
levied by the SEC as a result of any judicial or administrative action under the
Act be deposited to a fund for the benefit of harmed investors. The Federal
Accounts for Investor Restitution ("FAIR") provision also requires the SEC to
develop methods of improving collection rates. The legislation accelerates the
time frame for disclosures by public companies, as they must immediately
disclose any material changes in their financial condition or operations.
Directors and executive officers must also provide information for most changes
in ownership in a company's securities within two business days of the change.
27
The Act also increases the oversight of, and codifies certain requirements
relating to audit committees of public companies and how they interact with the
company's "registered public accounting firm" ("RPAF"). Audit committee members
must be independent and are barred from accepting consulting, advisory or other
compensatory fees from the issuer. In addition, companies must disclose whether
at least one member of the committee is a "financial expert" (as such term will
be defined by the SEC) and if not, why not. Under the Act, a RPAF is prohibited
from performing statutorily mandated audit services for a company if such
company's chief executive officer, chief financial officer, comptroller, chief
accounting officer or any person serving in equivalent positions has been
employed by such firm and participated in the audit of such company during the
one-year period preceding the audit initiation date. The Act also prohibits any
officer or director of a company or any other person acting under their
direction from taking any action to fraudulently influence, coerce, manipulate
or mislead any independent public or certified accountant engaged in the audit
of the company's financial statements for the purpose of rendering the financial
statement's materially misleading. The Act also requires the SEC to prescribe
rules requiring inclusion of an internal control report and assessment by
management in the annual report to stockholders. The Act requires the RPAF that
issues the audit report to attest to and report on management's assessment of
the company's internal controls. In addition, the Act requires that each
financial report required to be prepared in accordance with (or reconciled to)
accounting principles generally accepted in the United States of America and
filed with the SEC reflect all material correcting adjustments that are
identified by a RPAF in accordance with accounting principles generally accepted
in the United States of America and the rules and regulations of the SEC.
The Bank. The OTS has extensive regulatory authority over the operations of
savings associations such as the Bank. As part of this authority, savings
associations are required to file periodic reports with the OTS and are subject
to periodic examinations by the OTS. The investment and lending authority of
savings associations are prescribed by federal laws and regulations and they are
prohibited from engaging in any activities not permitted by such laws and
regulations. Those laws and regulations generally are applicable to all
federally chartered savings associations and may also apply to state-chartered
savings associations. Such regulation and supervision is primarily intended for
the protection of depositors.
Insurance of Accounts. The deposits of the Bank are insured to the maximum
extent permitted by the SAIF, which is administered by the FDIC, and are backed
by the full faith and credit of the U. S. Government. As insurer, the FDIC is
authorized to conduct examinations of, and to require reporting by, FDIC-insured
institutions. It also may prohibit any FDIC-insured institution from engaging in
any activity the FDIC determines by regulation or order to pose a serious threat
to the FDIC. The FDIC also has the authority to initiate enforcement actions
against savings associations, after giving the OTS an opportunity to take such
action.
The FDIC may terminate the deposit insurance of any insured depository
institution, including the Bank, if it determines after a hearing that the
institution has engaged or is engaging in unsafe or unsound practices, is in an
unsafe or unsound condition to continue operations, or has violated any
applicable law, regulation, order or any condition imposed by an agreement with
the FDIC. It also may suspend deposit insurance temporarily during the hearing
process for the permanent termination of insurance, if the institution has no
tangible capital. If insurance of accounts is terminated, the accounts at the
institution at the time of the termination, less subsequent withdrawals, shall
continue to be insured for a period of six months to two years, as determined by
the FDIC. Management is not aware of any existing circumstances which could
result in termination of the Bank's deposit insurance.
Capital requirements. Current OTS capital standards require savings
associations to satisfy three different capital requirements. Under these
standards, savings associations must maintain "tangible" capital equal to 1.5%
of adjusted total assets, "core" capital equal to 4% (3% if the association
receives the OTS' highest rating) of adjusted total assets and "total" capital
(a combination of core and "supplementary" capital) equal to 8.0% of
"risk-weighted" assets. For purposes of the regulation, core capital generally
consists of common stockholders' equity (including retained earnings),
noncumulative perpetual preferred stock and related surplus, minority interests
in the equity accounts of fully consolidated subsidiaries, certain
nonwithdrawable accounts and pledged deposits and "qualifying supervisory
goodwill." Tangible capital is given the same definition as core capital but
does not include qualifying supervisory goodwill and is reduced by the amount of
all the savings association's intangible assets, with only a limited exception
for purchased mortgage servicing rights ("PMSRs"). Both core and tangible
capital are further reduced by an amount equal to a savings association's debt
and equity investments in subsidiaries engaged in activities not permissible for
national banks (other than subsidiaries engaged in activities undertaken as
agent for customers or in mortgage banking activities and subsidiary
28
depository institutions or their holding companies). In addition, under the
Prompt Corrective Action provisions of the OTS regulations, all but the most
highly rated institutions must maintain a minimum leverage ratio of 4% in order
to be adequately capitalized. See "- Prompt Corrrective Action." At September
30, 2002, the Bank did not have any investment in subsidiaries engaged in
impermissible activities and required to be deducted from its capital
calculation.
The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA")
granted the OTS the authority to prescribe rules for the amount of PMSRs that
may be included in a savings association's regulatory capital and required that
the value of readily marketable PMSRs included in the calculation of a savings
association's regulatory capital not exceed 90% of fair market value and that
such value be determined at least quarterly. Under OTS regulations, (i) PMSRs do
not have to be deducted from tangible and core regulatory capital, provided that
they do not exceed 50% of core capital, (ii) savings associations are required
to determine the fair market value and to review the book value of their PMSRs
at least quarterly and to obtain an independent valuation of PMSRs annually,
(iii) savings associations that desire to include PMSRs in regulatory capital
may not carry them at a book value under GAAP that exceeds the discounted value
of their future net income stream and (iv) for purposes of calculating
regulatory capital, the amount of PMSRs reported as balance sheet assets should
amount to the lesser of 90% of their fair market value, 90% of their original
purchase price or 100% of their remaining unamortized book value. At September
30, 2002, the Bank had PMSRs totaling $20,600.
A savings association is allowed to include both core capital and
supplementary capital in the calculation of its total capital for purposes of
the risk-based capital requirements, provided that the amount of supplementary
capital does not exceed the savings association's core capital. Supplementary
capital generally consists of hybrid capital instruments; perpetual preferred
stock which is not eligible to be included as core capital; subordinated debt
and intermediate-term preferred stock; and, subject to limitations, general
allowances for loan losses. Assets are adjusted under the risk-based guidelines
to take into account different risk characteristics, with the categories ranging
from 0% (requiring no additional capital) for assets such as cash to 100% for
repossessed assets or loans more than 90 days past due. Single- family
residential real estate loans which are not past-due or non-performing and which
have been made in accordance with prudent underwriting standards are assigned a
50% level in the risk-weighing system, as are certain privately-issued
mortgage-backed securities representing indirect ownership of such loans.
Off-balance sheet items also are adjusted to take into account certain risk
characteristics.
The OTS amended its risk-based capital requirements that would require
institutions with an "above normal" level of interest rate risk to maintain
additional capital. A savings association is considered to have a "normal" level
of interest rate risk if the decline in the market value of its portfolio equity
after an immediate 200 basis point increase or decrease in market interest rates
(whichever leads to the greater decline) is less than two percent of the current
estimated market value of its assets. The market value of portfolio equity is
defined as the net present value of expected cash inflows and outflows from an
association's assets, liabilities, and off-balance sheet items. The amount of
additional capital, that an institution with an above normal interest rate risk
is required to maintain (the "interest rate risk component") equals one-half of
the dollar amount by which its measured interest rate risk exceeds the normal
level of interest rate risk. The interest rate risk component is in addition to
the capital otherwise required to satisfy the risk-based capital requirement.
Implementation of this component has been postponed by the OTS. The final rule
was to be effective as of January 1, 1994, subject however to a three quarter
lag time in implementation. However, because of continuing delays by the OTS,
the interest rate risk component has never been operative.
At September 30, 2002, the Bank exceeded all of its regulatory capital
requirements, with tangible, core and risk-based capital ratios of 8.1%, 8.1%,
and 16.2%, respectively. See Note 11 to the Notes to Consolidated Financial
Statements included in the Company's Annual Report.
The OTS and the FDIC generally are authorized to take enforcement action
against a savings association that fails to meet its capital requirements, which
action may include restrictions on operations and banking activities, the
imposition of a capital directive, a cease-and-desist order, civil money
penalties or harsher measures such as the appointment of a receiver or
conservator or a forced merger into another institution. In addition, under
current regulatory policy, an association that fails to meet its capital
requirements is prohibited from paying any dividends.
29
The following is a reconciliation of the Bank's equity determined in
accordance with GAAP to regulatory tangible, core and risk-based capital at
September 30, 2002, 2001 and 2000.
September 30, 2002 September 30, 2001 September 30, 2000
------------------------------ ------------------------------ ------------------------------
Tangible Core Risk-based Tangible Core Risk-based Tangible Core Risk-based
Capital Capital Capital Capital Capital Capital Capital Capital Capital
-------- ------- ---------- -------- ------- ---------- -------- ------- ----------
(In thousands)
GAAP equity $ 40,873 $40,873 $ 40,873 $ 37,211 $37,211 $ 37,211 $ 38,127 $38,127 $ 38,127
Assets required to be deducted(1) -- -- -- -- -- -- -- -- (511)
General valuation allowances -- -- 2,084 -- -- 1,883 -- -- 1,667
-------- ------- -------- -------- ------- -------- -------- ------- --------
Total regulatory capital 40,873 40,873 42,957 37,211 37,211 39,094 38,127 38,127 39,283
Minimum capital requirement 7,597 20,265 21,255 7,189 19,172 18,602 6,874 18,332 17,782
-------- ------- -------- -------- ------- -------- -------- ------- --------
Excess $ 33,276 $20,608 $ 21,702 $ 30,022 $18,039 $ 20,492 $ 31,253 $19,795 $ 21,501
======== ======= ======== ======== ======= ======== ======== ======= ========
(1) Consists of an equity investment which was non-includable in regulatory
capital.
These capital requirements are viewed as minimum standards by the OTS, and
most institutions are expected to maintain capital levels well above the
minimum. In addition, the OTS regulations provide that minimum capital levels
higher than those provided in the regulations may be established by the OTS for
individual savings association's capital, upon a determination that
circumstances exist that higher individual minimum capital requirements may be
appropriate.
30
Prompt Corrective Action. Under the prompt corrective action regulations of
the OTS, an institution shall be deemed to be (i) "well capitalized" if it has
total risk-based capital of 10% or more, has a Tier I risk-based capital ratio
of 6% or more, has a Tier I leverage capital ratio of 5% or more and is not
subject to any order or final capital directive to meet and maintain a specific
capital level for any capital measure, (ii) "adequately capitalized" if it has a
total risk- based capital ratio of 8% or more, a Tier I risk-based capital ratio
of 4% or more and a Tier I leverage capital ratio of 4% or more (3% under
certain circumstances) and does not meet the definition of "well capitalized,"
(iii) "undercapitalized" if it has a total risk-based capital ratio that is less
than 8%, a Tier I risk-based capital ratio that is less than 4% or a Tier I
leverage capital ratio that is less than 4% (3% under certain circumstances),
(iv) "significantly undercapitalized" if it has a total risk-based capital ratio
that is less than 6%, a Tier I risk-based capital ratio that is less than 3% or
a Tier I leverage capital ratio that is less than 3%, and (v) "critically
undercapitalized" if it has a ratio of tangible equity to total assets that is
equal to or less than 2%. Under specified circumstances, the OTS may reclassify
a well capitalized institution as adequately capitalized and may require an
adequately capitalized institution or an undercapitalized institution to comply
with supervisory actions as if it were in the next lower category (except that
the FDIC may not reclassify a significantly undercapitalized institution as
critically undercapitalized). At September 30, 2002, the Bank met the
requirements of a "well capitalized" institution under OTS regulations.
Qualified Thrift Lender Test(the "QTL"). A savings association can comply
with the QTL test by either meeting the QTL test set forth in the HOLA and the
implementing regulations or qualifying as a domestic building and loan
association as defined in Section 7701(a)(19) of the Internal Revenue Code of
1986, as amended ("Code"). Currently, the portion of the QTL test that is based
on the HOLA rather than the Code requires that 65% of an institution's
"portfolio assets" (as defined) consist of certain housing and consumer-related
assets on a monthly average basis in nine out of every 12 months. Assets that
qualify without limit for inclusion as part of the 65% requirement are loans
made to purchase, refinance, construct, improve or repair domestic residential
housing and manufactured housing, home equity loans, mortgage-backed securities
(where the mortgages are secured by domestic residential housing or manufactured
housing), stock issued by the FHLB, and direct or indirect obligations of the
FDIC. In addition, small business loans, credit card loans, student loans and
loans for personal, family and household purposes are allowed to be included
without limitation as qualified investments. The following assets, among others,
also may be included in meeting the test subject to an overall limit of 20% of
the savings institution's portfolio assets: 50% of residential mortgage loans
originated and sold within 90 days of origination, 100% of consumer and
educational loans (limited to 10% of total portfolio assets) and stock issued by
FHLMC or FNMA. Portfolio assets consist of total assets minus the sum of (i)
goodwill and other intangible assets, (ii) property used by the savings
institution to conduct its business, and (iii) liquid assets up to 20% of the
institution's total assets.
A savings institution that does not comply with the QTL test must either
convert to a bank charter or comply with certain restrictions on its operations.
Upon the expiration of three years from the date the association ceases to be a
QTL, it must cease any activity and not retain any investment not permissible
for a national bank and immediately repay any outstanding FHLB advances (subject
to safety and soundness considerations).
At September 30, 2002, approximately 70.7% of the Bank's assets were
invested in qualified thrift investments, which was in excess of the percentage
required to qualify the Bank under the QTL test in effect at that time.
Restrictions on Capital Distributions. OTS regulations govern capital
distributions by savings associations, which include cash dividends, stock
redemptions or repurchases, cash-out mergers, interest payments on certain
convertible debt and other transactions charged to the capital account of a
savings association to make capital distributions. Generally, the regulation
creates a safe harbor for specified levels of capital distributions (as a
percentage of income) from savings associations meeting at least their minimum
capital requirements, so long as such associations notify the OTS and receive no
objection to the distribution from the OTS. Savings institutions and
distributions that do not qualify for the safe harbor are required to obtain
prior OTS approval before making any capital distributions.
Generally, savings associations such as the Bank can, upon 30 days prior
notice, distribute during each calendar year an amount equal to or less than its
net income for the year to date plus retained net income (which takes into
account distributions during such periods) for the preceding two years. Amounts
in excess of this must be approved by the OTS.
OTS regulations also prohibit the Bank from declaring or paying any
dividends or from repurchasing any of its stock if, as a result, the regulatory
(or total) capital of the Bank would be reduced below the amount required to be
maintained
31
for the liquidation account established by it for certain depositors in
connection with its conversion from mutual to stock form.
Community Reinvestment. Under the Community Reinvestment Act of 1977, as
amended ("CRA"), as implemented by OTS regulations, a savings association has a
continuing and affirmative obligation consistent with its safe and sound
operation to help meet the credit needs of its entire community, including low
and moderate income neighborhoods. The CRA does not establish specific lending
requirements or programs for financial institutions nor does it limit an
institution's discretion to develop the types of products and services that it
believes are best suited to its particular community, consistent with the CRA.
The Bank received a satisfactory CRA rating as a result of its last OTS
evaluation.
Policy Statement on Nationwide Branching. OTS policy on branching by
federally chartered savings associations permits nationwide branching to the
extent allowed by federal statute. Current OTS policy generally permits a
federally chartered savings association to establish branch offices outside of
its home state if the association meets the domestic building and loan test in
Section 7701(a)(19) of the Code or the asset composition test of subparagraph
(c) of that section, and if, with respect to each state outside of its home
state where the association has established branches, the branches, taken alone,
also satisfy one of the two tax tests. An association seeking to take advantage
of this authority would have to have a branching application approved by the
OTS, which would consider the regulatory capital of the association and its
record under the CRA, as amended, among other things.
Federal Home Loan Bank System. The Bank is a member of the FHLB of
Pittsburgh, which is one of 12 regional FHLBs that administers the home
financing credit function of savings associations. Each FHLB serves as a reserve
or central bank for its members within its assigned region. It is funded
primarily from proceeds derived from the sale of consolidated obligations of the
FHLB System. It makes loans to members (i.e., advances) in accordance with
policies and procedures established by the Board of Directors of the FHLB. As of
September 30, 2002, the Bank has advances of $126.2 million from the FHLB or
27.2% of its total liabilities. At such date, the Bank had the ability to obtain
up to $148.8 million additional advances from FHLB of Pittsburgh.
As a member, the Bank is required to purchase and maintain stock in the FHLB
of Pittsburgh in an amount equal to at least 1% of its aggregate unpaid
residential mortgage loans, home purchase contracts or similar obligations at
the beginning of each year or 5% of its advances from the FHLB of Pittsburgh,
whichever is greater. At September 30, 2002, the Bank had $6.6 million in FHLB
stock, which was in compliance with this requirement.
The FHLBs are required to provide funds for the resolution of insolvent
thrifts and to contribute funds for affordable housing programs. These
requirements could reduce the amount of dividends that the FHLBs pay to their
members and could also result in the FHLBs imposing a higher rate of interest on
advances to their members. For the years ended September 30, 2002, 2001 and
2000, dividends from the FHLB to the Bank amounted to approximately $278,000,
$471,000 and $428,000, respectively. If dividends were reduced, the Bank's net
interest income would likely also be reduced. Further, there can be no assurance
that the impact of recent or future legislation on the FHLBs will not also cause
a decrease in the value of FHLB stock held by the Bank, if any.
Federal Reserve System. The Board of Governors of the Federal Reserve System
("FRB") requires all depository institutions to maintain reserves against their
transaction accounts (primarily NOW and Super NOW checking accounts) and
non-personal time deposits. At September 30, 2002, the Bank was in compliance
with applicable requirements. However, because required reserves must be
maintained in the form of vault cash or a noninterest-bearing account at a FRB,
the effect of this reserve requirement is to reduce an institution's earning
assets.
Safety and Soundness Guidelines. The OTS and the other federal banking
agencies have established guidelines for safety and soundness, addressing
operational and managerial, as well as compensation matters for insured
financial institutions. Institutions failing to meet these standards are
required to submit compliance plans to their appropriate federal regulators. The
OTS and the other agencies have also established guidelines regarding asset
quality and earnings standards for insured institutions.
32
FEDERAL AND STATE TAXATION
General. The Company and the Bank are subject to the corporate tax
provisions of the Code, as well as certain additional provisions of the Code
which apply to thrift and other types of financial institutions. The following
discussion of tax matters is intended only as a summary and does not purport to
be a comprehensive description of the tax rules applicable to the Company and
the Bank.
Fiscal Year. The Company and the Bank and its subsidiaries file a
consolidated federal income tax return on a fiscal year basis ending September
30.
Method of Accounting. The Bank maintains its books and records for federal
income tax purposes using the accrual method of accounting. The accrual method
of accounting generally requires that items of income be recognized when all
events have occurred that establish the right to receive the income and the
amount of income can be determined with reasonable accuracy, and that items of
expense be deducted at the later of (i) the time when all events have occurred
that establish the liability to pay the expense and the amount of such liability
can be determined with reasonable accuracy or (ii) the time when economic
performance with respect to the item of expense has occurred.
Bad Debt Reserves. The Bank is permitted to establish reserves for bad debts
and to make annual additions thereto which qualify as deductions from taxable
income. The Company, as of October 1, 1996, changed its method of computing
reserves for bad debts to the experience method (the "Experience Method"). The
bad debt deduction allowable under this method is available to small banks with
assets less than $500 million. Beginning October 1, 2001, the Company changed
its method of computing reserves for bad debts to the specific charge-off
method. The bad debt deduction allowable under this method is available to large
banks with assets greater than $500 million. Generally, this method allows the
Company to deduct an annual addition to the reserve for bad debts equal to it
its net charge-offs.
The Bank treated such change as a change in a method of accounting
determined solely with respect to the "applicable excess reserves" of the
institution. The amount of applicable excess reserves is taken into account
ratably over a six taxable-year period, beginning with the first taxable year
beginning after December 31, 1995. For financial reporting purposes, the Company
has not incurred any additional tax expense. Amounts that had been previously
deferred will be reversed for financial reporting purposes and will be included
in the income tax return of the Company, increasing income tax payable. The
change from the experience method to the specific charge-off method in the
current year did not result in a recapture of bad debt reserves for tax
purposes.
Distributions. While the Bank maintains a bad debt reserve, if it were to
distribute cash or property to its sole stockholder having a total fair market
value in excess of its accumulated tax-paid earnings and profits, or were to
distribute cash or property to its stockholder in redemption of its stock, the
Bank would generally be required to recognize as income an amount which, when
reduced by the amount of federal income tax that would be attributable to the
inclusion of such amount in income, is equal to the lesser of: (i) the amount of
the distribution or (ii) the sum of (a) the amount of the accumulated bad debt
reserve of the Bank with respect to qualifying real property loans (to the
extent that additions to such reserve exceed the additions that would be
permitted under the experience method) and (b) the amount of the Bank's
supplemental bad debt reserve.
Minimum Tax. The Code imposes an alternative minimum tax at a rate of 20% on
a base of regular taxable income plus certain tax preferences ("alternative
minimum taxable income" or "AMTI"). The alternative minimum tax is payable to
the extent such AMTI is in excess of an exemption amount. The Code provides that
an item of tax preference is the excess of the bad debt deduction allowable for
a taxable year pursuant to the percentage of taxable income method over the
amount allowable under the experience method. The other items of tax preference
that constitute AMTI include (a) tax-exempt interest on newly-issued (generally,
issued on or after August 8, 1986) private activity bonds other than certain
qualified bonds and (b) for taxable years beginning after 1989, 75% of the
excess (if any) of (i) adjusted current earnings as defined in the Code, over
(ii) AMTI (determined without regard to this preference and prior to reduction
by net operating losses). Net operating losses can offset no more than 90% of
AMTI. Certain payments of alternative minimum tax may be used as credits against
regular tax liabilities in future years.
Audit by IRS. The Bank's consolidated federal income tax returns for taxable
years through September 30, 1998 have been closed for the purpose of examination
by the IRS.
33
STATE TAXATION
The Company and the Bank's subsidiaries are subject to the Pennsylvania
Corporate Net Income Tax and Capital Stock and Franchise Tax. The Corporate Net
Income Tax rate for fiscal 2002 is 9.99% and is imposed on the Company's
unconsolidated taxable income for federal purposes with certain adjustments. In
general, the Capital Stock and Franchise Tax is a property tax imposed at the
rate of 1.1% of a corporation's capital stock value, which is determined in
accordance with a fixed formula.
The Bank is taxed under the Pennsylvania Mutual Thrift Institutions Tax Act
(the ("MTIT"), as amended to include thrift institutions having capital stock.
Pursuant to the MTIT, the Bank's tax rate is 11.5%. The MTIT exempts the Bank
from all other taxes imposed by the Commonwealth of Pennsylvania for state
income tax purposes and from all local taxation imposed by political
subdivisions, except taxes on real estate and real estate transfers. The MTIT is
a tax upon net earnings, determined in accordance with GAAP with certain
adjustments. The MTIT, in computing GAAP income, allows for the deduction of
interest earned on state and federal securities, while disallowing a percentage
of a thrift's interest expense deduction in the proportion of interest income on
those securities to the overall interest income of the Bank. Net operating
losses, if any, thereafter can be carried forward three years for MTIT purposes.
34
ITEM 2. PROPERTIES.
At September 30, 2002, the Bank conducted business from its executive
offices located in Media, Pennsylvania and six full-service offices located in
Delaware and Chester Counties, Pennsylvania. See also Note 7 of the Notes to
Consolidated Financial Statements in the Annual Report.
The following table sets forth certain information with respect to the
Bank's offices at September 30, 2002.
Net Book Value Amount of
Description/Address Leased/Owned of Property Deposits
- -------------------------------- ------------ -------------- ---------
(In thousands)
Executive Offices:
22 West State Street
Media, Pennsylvania 19063 Owned(1) $ 1,297 $ 95,384
Branch Offices:
3218 Edgmont Avenue
Brookhaven, Pennsylvania 19015 Owned 422 84,313
Routes 1 and 100
Chadds Ford, Pennsylvania 19318 Leased(2) 78 26,436
23 East Fifth Street
Chester, Pennsylvania 19013 Leased(3) 122 26,304
31 Baltimore Pike
Chester Heights, Pennsylvania 19017 Leased(4) 625 28,831
Route 82 and 926
Kennett Square, Pennsylvania 19348 Leased(5) 38 11,561
330 Dartmouth Avenue
Swarthmore, Pennsylvania 19081 Owned 105 57,936
-------- --------
Total $ 2,687 $330,765
======== ========
- ----------------------------
(1) Also a branch office.
(2) Lease expiration date is September 30, 2005. The Bank has one five-year
renewal option.
(3) Lease expiration date is December 31, 2005. The Bank has one ten-year
renewal option.
(4) Lease expiration date is December 31, 2028. The Bank has options to cancel
on the 15th, 20th and 25th year of the lease.
(5) Lease expiration date is September 30, 2006. The Bank has three five-year
renewal options.
35
ITEM 3. LEGAL PROCEEDINGS.
The Company is involved in routine legal proceedings occurring in the
ordinary course of business which, in the aggregate, are believed by management
to be immaterial to the financial condition of the Company.
In late September 2001, the Bank was served in the following action: Aurora
Loan Services, Inc. v. First Keystone Federal Savings Bank, Civil Action No.
01-CV-4774 (United States District Court for the Eastern District of
Pennsylvania). This is a civil action arising out of five residential mortgage
loans that Aurora holds in its portfolio. Aurora alleges that it suffered losses
in connection with these loans (all of which were purchased by Aurora from the
Bank more than 18 months prior to September 2001) and that the Bank is required
to purchase the loans or compensate Aurora for its alleged losses. The Complaint
asserts claims for breach of contract (Count One), violation of the New York
Consumer Protection Law (Count Two) and Unjust Enrichment (Count Three). During
September 2002, the lawsuit was settled with the plaintiff in the amount of
$570,000. Under the terms of the settlement, the plaintiff will release the Bank
from any and all claims it could assert relating to these five mortgage loans.
In October 2002, the Bank was served with a Demand for Arbitration from
Impac Funding Corp. before the American Arbitration Association. The arbitration
proceedings are captioned In the Matter of Arbitration between Impac Funding
Corp. and First Keystone Federal Savings Bank, American Arbitration Association,
Arbitration No. 73- 148-00498-02-JUBA. In its arbitration demand, Impac asserted
breach of contract claims relating to its purchase of five residential mortgage
loans. Impac Funding is claiming damages of $182,000 plus attorney fees. The
Bank submitted their response to the arbitration demand on November 10, 2002. In
the Bank's response, the Bank has asserted all defenses on the merit of the
claims and denied liability. The Bank believes that its defenses to these claims
are meritorious. As of the date hereof, no discovery has been conducted in this
case and no hearing date has been set.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
Not applicable.
PART II.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The information required herein is incorporated by reference on page 38 of
the Registrant's Annual Report and from Part III, Item 12 hereof.
ITEM 6. SELECTED FINANCIAL DATA.
The information required herein is incorporated by reference from pages 7 to
8 of the Registrant's Annual Report.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATION.
The information required herein is incorporated by reference from pages 9 to
19 of the Registrant's Annual Report.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The information required herein is incorporated by reference from pages 10
to 12 of the Registrant's Annual Report.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The financial statements and supplementary data required herein are
incorporated by reference from pages 20 to 38 of the Company's Annual Report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
Not applicable.
36
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required herein is incorporated by reference from pages 3
to 7 and page 17 of the Registrant's Proxy Statement dated December 30, 2002
("Proxy Statement").
ITEM 11. EXECUTIVE COMPENSATION.
The information required herein is incorporated by reference from pages 11
to 16 of the Registrant's Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS.
The information required herein is incorporated by reference from pages 8 to
10 of the Registrant's Proxy Statement.
EQUITY COMPENSATION PLAN INFORMATION. The following table sets forth certain
information for all equity compensation plans and individual compensation
arrangements (whether with employees or non-employees, such as directors), in
effect as of September 30, 2002.
Number of Shares to be Number of Shares Remaining
issued upon the Exercise Weighted-Average Available for Future Issuance
of Outstanding Options, Exercise Price of (Excluding Shares Reflected
Plan Category Warrants and Rights Outstanding Options in the First Column)
- ----------------------------- ------------------------ ------------------- -----------------------------
Equity Compensation Plans
Approved by Security Holders 306,977 $ 9.52 32,344
Equity Compensation Plans Not
Approved by Security Holders -- -- --
------- ------- -------
Total 306,977 $ 9.52 32,344
======= ======= =======
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required herein is incorporated by reference from page 17 of
the Registrant's Proxy Statement.
37
ITEM 14. CONTROLS AND PROCEDURES.
Under the supervision and with the participation of the Company's
management, including its chief executive officer and chief financial officer,
the Company has evaluated the effectiveness of the design and operation of its
disclosure controls and procedures within 90 days of the filing date of this
annual report, and based on their evaluation, the Company's chief executive
officer and chief financial officer have concluded that these controls and
procedures are effective. There were no significant changes in the Company's
internal controls or in other factors that could significantly affect these
controls subsequent to the date of their evaluation.
Disclosure controls and procedures are the Company's controls and other
procedures that are designed to ensure that information required to be disclosed
by the Company in the reports that the Company files or submits under the
Exchange Act is recorded, processed, summarized and reported, within the time
periods specified in the Securities and Exchange Commission's rules and forms.
Disclosure controls and procedures include, without limitation, controls and
procedures designed to ensure that information required to be disclosed by the
Company in the reports that the Company files under the Exchange Act is
accumulated and communicated to the Company management, including its chief
executive officer and chief financial officer, as appropriate to allow timely
decisions regarding required disclosure.
PART IV.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) Documents filed as part of this Report.
(1) The following documents are filed as part of this report and are
incorporated herein by reference from the Registrant's Annual
Report.
Report of Independent Auditors.
Consolidated Statements of Financial Condition at September 30, 2002
and 2001.
Consolidated Statements of Income for the Years Ended September 30,
2002, 2001 and 2000.
Consolidated Statements of Changes in Stockholders' Equity for the
Years Ended September 30, 2002, 2001 and 2000.
Consolidated Statements of Cash Flows for the Years Ended September
30, 2002, 2001 and 2000.
Notes to the Consolidated Financial Statements.
(2) All schedules for which provision is made in the applicable accounting
regulation of the SEC are omitted because they are not applicable or the
required information is included in the Consolidated Financial
Statements or notes thereto.
38
(3) The following exhibits are filed as part of this Form 10-K, and this
list includes the Exhibit Index.
No Description
-- -----------
3.1 Amended and Restated Articles of Incorporation of First Keystone
Financial, Inc. *
3.2 Amended and Restated Bylaws of First Keystone Financial, Inc. *
4 Specimen Stock Certificate of First Keystone Financial, Inc. *
10.1 Employee Stock Ownership Plan and Trust of First Keystone
Financial, Inc. *
10.2 401(K)/ Profit-sharing Plan of First Keystone Federal Savings
Bank. *
10.3 Employment Agreement between First Keystone Financial, Inc. and
Donald S. Guthrie dated May 26, 1999. **
10.4 Employment Agreement between First Keystone Financial, Inc. and
Stephen J. Henderson dated May 26, 1999. **
10.5 Employment Agreement between First Keystone Financial, Inc. and
Thomas M. Kelly dated May 26, 1999. **
10.6 Form of Severance Agreement between First Keystone Financial,
Inc. and Elizabeth M. Mulcahy dated May 26, 1999. **
10.8 Form of Severance Agreement between First Keystone Financial,
Inc. and Carol Walsh dated May 26, 1999. **
10.9 1995 Stock Option Plan.***
10.10 1995 Recognition and Retention Plan and Trust Agreement.***
10.11 1998 Stock Option Plan.****
10.12 Employment Agreement between First Keystone Federal Savings Bank
and Donald S. Guthrie dated May 26, 1999. **
10.13 Employment Agreement between First Keystone Federal Savings Bank
and Stephen J. Henderson dated May 26, 1999. **
10.14 Employment Agreement between First Keystone Federal Savings Bank
and Thomas M. Kelly dated May 26, 1999. **
10.15 Form of Severance Agreement between First Keystone Federal
Savings Bank and Elizabeth M. Mulcahy dated May 26, 1999. **
10.16 Form of Severance Agreement between First Keystone Federal
Savings Bank and Carol Walsh dated May 26, 1999. **
39
11 Statement re: computation of per share earnings. See Note 2 to
the Consolidated Financial Statements included in the Annual
Report set forth as Exhibit 13 hereto.
13 Annual Report to Stockholders.
21 Subsidiaries of the Registrant - Reference is made to Item 1
"Business," for the required information.
23 Consent of Deloitte & Touche LLP.
99.1 Certification of Chief Executive Officer pursuant to Section 906
of the Sarbanes-Oxley Act of 2002
99.2 Certification of Chief Financial Officer pursuant to Section 906
of the Sarbanes-Oxley Act of 2002
-----------------------
(*) Incorporated by reference from the Registration Statement Form
S-1 (Registration No. 33-84824) filed by the Registrant with the
SEC on October 6, 1994, as amended.
(**) Incorporated by reference from the Form 10-K filed by the
Registrant with the SEC on December 29, 1999 (File No.
000-25328).
(***) Incorporated by reference from the Form 10-K filed by the
Registrant with SEC on December 29, 1995 (File No. 000-25328).
(****) Incorporated from Appendix A of the Registrant's definitive proxy
statement dated December 24, 1998 (File No. 000-25328).
(b) Reports filed on Form 8-K.
None.
40
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
FIRST KEYSTONE FINANCIAL, INC.
By: /s/ Donald S. Guthrie
--------------------------------
Donald S. Guthrie
Chairman of the Board and
Chief Executive Officer
Pursuant to the requirements of the Securities and Exchange Act of 1934,
this report had been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
/s/ Donald S. Guthrie December 27, 2002
- --------------------------------------------------
Donald S. Guthrie
Chairman of the Board and Chief Executive Officer
(Principal Executive Officer)
/s/ Thomas M. Kelly December 27, 2002
- --------------------------------------------------
Thomas M. Kelly
President and Chief Financial Officer
(Principal Financial and Accounting Officer)
/s/ Donald A. Purdy December 27, 2002
- --------------------------------------------------
Donald A. Purdy
Director
/s/ Edward Calderoni December 27, 2002
- --------------------------------------------------
Edward Calderoni
Director
/s/ Edmund Jones December 27, 2002
- --------------------------------------------------
Edmund Jones
Director
/s/ Donald G. Hosier, Jr. December 27, 2002
- --------------------------------------------------
Donald G. Hosier, Jr.
Director
/s/ Marshall J. Soss December 27, 2002
- --------------------------------------------------
Marshall J. Soss
Director
/s/ William J. O'Donnell December 27, 2002
- --------------------------------------------------
William J. O'Donnell
Director
41
CERTIFICATION
I, Donald S. Guthrie, Chairman of the Board and Chief Executive Officer of
First Keystone Financial, Inc., certify that:
1. I have reviewed this annual report on Form 10-K of First Keystone
Financial, Inc.;
2. Based on my knowledge, this annual 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 annual report;
3. Based on my knowledge, the financial statements and other financial
information included in this annual 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 annual
report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
have:
a) designed such disclosure controls and procedures 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 annual
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date
of this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
Date: December 27, 2002 /s/ Donald S. Guthrie
-------------------------------------------------
Donald S. Guthrie
Chairman of the Board and Chief Executive Officer
42
CERTIFICATION
I, Thomas M. Kelly, President and Chief Financial Officer of First Keystone
Financial, Inc., certify that:
1. I have reviewed this annual report on Form 10-K of First Keystone
Financial, Inc.;
2. Based on my knowledge, this annual 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 annual report;
3. Based on my knowledge, the financial statements and other financial
information included in this annual 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 annual
report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
have:
a) designed such disclosure controls and procedures 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 annual
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date
of this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
Date: December 27, 2002 /s/ Thomas M. Kelly
---------------------------------------
Thomas M. Kelly
President and Chief Financial Officer
43