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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 FISCAL YEAR ENDED SEPTEMBER 30, 2004
- 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 shares of Common Stock of the Registrant
issued and outstanding on December 10, 2004, which excludes 332,827 shares held
by all directors and officers of the Registrant as a group, was approximately
$45.5 million. This figure is based on the closing price of $28.50 per share of
the Registrant's Common stock on March 31, 2004, the last business day of the
Registrant's second fiscal quarter.
Number of shares of Common Stock outstanding as of December 10, 2004: 1,928,604
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 definitive proxy statement for the 2005 Annual Meeting of
Stockholders are incorporated into Part III.
FIRST KEYSTONE FINANCIAL, INC.
FORM 10-K
FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 2004
INDEX
Page
----
PART I
Item 1. Business 1
Item 2. Properties 36
Item 3. Legal Proceedings 37
Item 4. Submission of Matters to a Vote of Security Holders 37
PART II
Item 5. Market for Registrant's Common Stock, Related Stockholder Matters and Issuer Purchases of Equity 37
Securities
Item 6. Selected Financial Data 39
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 41
Item 7A. Quantitative and Qualitative Disclosures about Market Risk 53
Item 8. Financial Statements and Supplementary Data 55
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures 84
Item 9A. Control and Procedures 84
Item 9B. Other Information 84
PART III
Item 10. Directors and Executive Officers of the Registrant 84
Item 11. Executive Compensation 84
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 85
Item 13. Certain Relationships and Related Transactions 85
Item 14. Principal Accounting Fees and Services 85
PART IV
Item 15. Exhibits, Financial Statement Schedules, and Reports of Form 8-K 85
SIGNATURES 88
[This page left blank intentionally]
PART I.
ITEM 1. BUSINESS.
GENERAL
First Keystone Financial, Inc. (the "Company") is a Pennsylvania
corporation and the sole shareholder of First Keystone 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 18 of the Notes to
Consolidated Financial Statements for the fiscal year ended September 30, 2004
set forth in Item 8, "Financial Statements and Supplementary Data." The business
of the Company primarily consists of the business of the Bank.
The Bank is a community oriented bank emphasizing customer service and
convenience. The Bank's primary business is attracting deposits from the general
public and using 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 NOW, non-interest-bearing
accounts, money market deposit accounts ("MMDA") and passbook accounts. Core
deposits amounted to $180.0 million or 52.2% of the Bank's total deposits at
September 30, 2004. 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 located within
the Bank's market area. The Bank's management continues to remain focused on
implementation of its long-term strategic plan of shifting its loan composition
toward commercial business loans, construction loans and home equity loans and
lines of credit in order to provide a higher yielding portfolio with generally
shorter terms. This effort to keep shorter term loans in portfolio resulted in a
$10.2 million increase in outstanding balances in home equity loans and lines of
credit at September 30, 2004, representing a 30.5% increase in this category
compared to the previous fiscal year. Multi-family residential and commercial
real estate loans amounted to $64.5 million or 20.0% of the total loan portfolio
at September 30, 2004. 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, 2004.
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, 2004, the Bank's mortgage-related
securities (both available for sale and held to maturity) amounted to $135.0
million, or 23.6% of the Company's total assets, and investment securities (both
available for sale and held to maturity) amounted to $68.9 million, or 12.0% of
total assets.
1
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, Pennsylvania and Wilmington, Delaware. 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, Pennsylvania, while
Baltimore, Maryland and Washington, DC are only 80 miles and 127 miles away,
respectively.
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. Most of the businesses are in corporate and professional
services, distributive services and the manufacturing sector. Census 2000 also
shows Delaware County has a large, well-educated, and skilled labor force.
Nearly one quarter of the County's population has earned a four-year college
degree. 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 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, Mercy Health Corp and Astra-Zeneca are among the larger employers
within the Bank's market area. According to the Delaware County Chamber of
Commerce, there are 67 degree-granting institutions in the Delaware Valley
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
Commonwealth. 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.
The population of Delaware County is reported at over half a million
residents and is the fourth most populated county in the Commonwealth of
Pennsylvania. Much of the growth and development continues to be in the western
part of the county and adjacent Chester County. Unemployment in Chester County
is extremely low at 3.7% compared to the rest of the Commonwealth which is at
6.0%. The Bank continues to benefit from this growth as its Chester Heights
office, situated in a prime location in Western Delaware County, has exceeded
the Company's deposit and consumer loan projections year after year. Chester
County's growth rate 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. As a result of the anticipated growth in fiscal 2004, the Bank
expanded its Willowdale Branch office in Chester County to a full-service
free-standing branch.
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. Recognizing
that convenience, as it relates to branch locations, is still a primary
motivator in attracting new deposits, the Bank just completed the construction
of its eighth full-service free-standing branch on a corner property in Aston
Township, Delaware County, a densely populated area in the heart of the Bank's
marketplace. The building's design is part of our corporate branding strategy
and now complements our Chester Heights and Willowdale branches.
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's management remains focused on
attracting core deposits through its branch network, business development
efforts and commercial business relationships. Core deposits represented 52.2%
of the Bank's total deposit portfolio at September 30, 2004. According to
Sheshunoff, the Branches of PA 2004, First Keystone Bank ranks seventh in
deposits or 3.66% of deposit market share for Delaware County.
2
FORWARD-LOOKING STATEMENTS
In this Annual Report on Form 10-K, the Company has included certain
forward-looking statements concerning the future operations of the Company. It
is management's desire to take advantage of the safe harbor provisions of the
Private Securities Litigation Reform Act of 1995. This statement is for the
express purpose of availing the Company of the protections of such safe harbor
with respect to all forward-looking statements contained in this Annual Report.
Such forward-looking statements are subject to risks and uncertainties which
could cause actual results to differ materially from those currently anticipated
due to a number of factors. Such forward-looking statements may be identified by
the use of words such as believe, expect, should, estimated, potential and
similar expressions. Examples of forward-looking statements include, but are not
limited to, estimates with respect to the financial condition, business
strategy, expected or anticipated revenue, results of operations and the
business of the Company that are subject to various factors which could cause
actual results to differ materially from these estimates. Factors that could
affect results include interest rate trends, deposit flows, competition, the
general economic climate in Delaware and Chester counties, the mid-Atlantic
region and the United States as a whole, loan demand, real estate values, loan
delinquency rates, levels of non-performing assets, changes in federal and state
regulation, changes in accounting policies and practices and other uncertainties
described in the Company's filings with the Securities and Exchange Commission,
including the Form 10-K. These factors should be considered in evaluating the
forward-looking statements, and undue reliance should not be placed on such
statements. The Company assumes no obligation to update or revise
forward-looking statements to reflect any changed assumptions, any unanticipated
events or any changes in the future.
3
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,
----------------------------------------------------------------------------------------------
2004 2003 2002 2001 2000
----------------------------------------------------------------------------------------------
Amount % Amount % Amount % Amount % Amount %
-------- ------ -------- ------ --------- ------ --------- ------ --------- ------
(Dollars in thousands)
Real estate loans:
Single-family $163,907 50.87% $166,042 55.51% $ 173,736 57.32% $ 160,289 59.81% $ 160,143 65.54%
Multi-family and commercial 64,509 20.02 59,022 19.73 60,379 19.92 43,472 16.22 37,870 15.50
Construction and land 38,078 11.82 28,975 9.69 28,292 9.33 29,117 10.86 17,905 7.33
Home equity loans and lines of
credit 43,621 13.54 33,459 11.19 27,595 9.10 25,847 9.65 22,597 9.25
-------- ------ -------- ------ --------- ------ --------- ------ --------- ------
Total real estate loans 310,115 96.25 287,498 96.12 290,002 95.67 258,725 96.54 238,515 97.62
-------- ------ -------- ------ --------- ------ --------- ------ --------- ------
Consumer:
Deposit 133 .04 112 .04 144 .05 232 .09 251 .10
Education -- -- -- -- -- -- -- -- 285 .12
Unsecured personal loans 629 .20 547 .18 322 .11 133 .05 -- --
Other (1) 709 .21 779 .26 736 .24 760 .28 807 .33
-------- ------ -------- ------ --------- ------ --------- ------ --------- ------
Total consumer loans 1,471 .45 1,438 .48 1,202 .40 1,125 .42 1,343 .55
-------- ------ -------- ------ --------- ------ --------- ------ --------- ------
Commercial business loans 10,624 3.30 10,161 3.40 11,919 3.93 8,158 3.04 4,475 1.83
-------- ------ -------- ------ --------- ------ --------- ------ --------- ------
Total loans receivable (2) 322,210 100.00% 299,097 100.00% 303,123 100.00% 268,008 100.00% 244,333 100.00%
-------- ====== -------- ====== --------- ====== --------- ====== --------- ======
Less:
Loans in process 15,807 10,655 11,384 17,016 10,330
Deferred loan origination fees
and discounts 116 35 605 1,147 1,298
Allowance for loan losses 2,039 1,986 2,358 2,181 2,019
-------- -------- --------- --------- ---------
Total loans receivable, net $304,248 $286,421 $ 288,776 $ 247,664 $ 230,686
======== ======== ========= ========= =========
- -------------------
(1) Consists primarily of credit card loans.
(2) Does not include $172,000, $4.5 million, $501,000, $225,000 and $3.1
million of loans held for sale at September 30, 2004, 2003, 2002, 2001 and
2000, respectively.
4
Contractual Principal Repayments. The following table sets forth the
scheduled contractual maturities of the Bank's loans held to maturity at
September 30, 2004. 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
Single-family and Construction Commercial
(1) Commercial and Land Total Business Loans Total
------------- ------------ ------------ --------- -------------- --------
(Dollars in thousands)
Amounts due in:
One year or less $ 10,053 $ 5,536 $38,078 $ 53,667 $11,330 $ 64,997
After one year through three years 21,829 12,662 -- 34,491 338 34,829
After three years through five years 25,240 6,675 -- 31,915 146 32,061
After five years through ten years 86,180 14,685 -- 100,865 101 100,966
After ten years through fifteen years 37,546 12,941 -- 50,487 24 50,511
Over fifteen years 26,679 12,011 -- 38,690 156 38,846
-------- -------- ------- --------- ------- --------
Total (2) $207,527 $ 64,510 $38,078 $ 310,115 $12,095 $322,210
======== ======== ======= ========= ======= ========
Interest rate terms on amounts due
after one year:
Fixed $ 160,503 $ 454 $160,957
Adjustable 95,945 311 96,256
--------- ------- --------
Total (2) $ 256,448 $ 765 $257,213
========= ======= ========
- ----------------------
(1) Includes home equity loans and lines of credit.
(2) Does not include adjustments relating to loans in process, allowances for
loan losses and deferred fee income and discounts.
5
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,
-------------------------------------
2004 2003 2002
--------- --------- ---------
(Dollars in thousands)
Gross loans at beginning of period(1) $ 303,595 $ 303,624 $ 268,233
--------- --------- ---------
Loan originations for investment:
Real estate:
Residential 35,214 80,722 60,719
Commercial and multi-family 26,560 13,890 31,300
Construction 28,816 24,578 28,741
Home equity and lines of credit 29,133 29,920 21,710
--------- --------- ---------
Total real estate loans originated for investment 119,723 149,110 142,470
Consumer 2,695 2,927 2,825
Commercial business 13,734 17,548 21,555
--------- --------- ---------
Total loans originated for investment 136,152 169,585 166,850
Loans originated for resale 9,671 30,995 3,712
--------- --------- ---------
Total originations 145,823 200,580 170,562
--------- --------- ---------
Deduct:
Principal loan repayments and prepayments (117,069) (171,489) (131,374)
Transferred to real estate owned (153) (2,122) (361)
Loans sold in secondary market (9,814) (26,998) (3,436)
--------- --------- ---------
Subtotal (127,036) (200,609) (135,171)
--------- --------- ---------
Net increase (decrease) in loans(1) 18,787 (29) 35,391
--------- --------- ---------
Gross loans at end of period(1) $ 322,382 $ 303,595 $ 303,624
========= ========= =========
- ----------------------------
(1) Includes loans held for sale of $172,000, $4.5 million and $501,000 at
September 30, 2004, 2003 and 2002, respectively.
6
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 are obtained predominately 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
the adjustment of 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 below $250,000
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 Fannie Mae ("FNMA") or Freddie Mac ("FHLMC") limits are
approved by at least one of the following: the Bank's Director of Lending, the
Vice President of Residential Lending, the Senior Mortgage Loan underwriter or
the Loan Committee (a committee comprised of four directors and the Director of
Lending). Residential mortgage loans in excess of FNMA/FHLMC maximum amounts
(currently $333,700 for single-family properties) 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 $250,000 and construction loans must be approved by the Loan
Committee. 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 $250,000 can be
approved by the Director of Lending, the Vice President of Construction Loans,
the Vice President of Residential 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 30 year 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 and balloon loans 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 or 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 interest rate for the remaining 25 or 23 years,
respectively, of the
7
amortization period. At September 30, 2004, $144.7 million, or 88.3% of the
Bank's single-family residential mortgage loans held in portfolio were
fixed-rate loans, including $11.2 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% on any
increase or decrease in the interest rate at any adjustment date, and a maximum
adjustment limit 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, loans
tied to the one-year CMT are underwritten using methods approved by FHLMC or
FNMA which require borrowers to be qualified at 2% above the discounted loan
rate under certain conditions. At September 30, 2004, $19.2 million, or 11.7%,
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. 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 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 a
home equity loan.
Commercial and Multi-Family Residential Real Estate Loans. In fiscal 2004,
the Bank has moderately increased its investment in commercial and multi-family
residential loans. 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 continued to be under served in recent
years. Loans secured by commercial and multi-family residential real estate
amounted to $64.5 million, or 20.0%, of the Bank's total loan portfolio, at
September 30, 2004. 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 up to 1% 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 20 years with
amortization of the 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.
8
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 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 See "-Non-performing Assets" for further discussion of the Bank's
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 (including acquisition and
development loans) and revolving 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 ratio 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 0.5% to 3.0% of the amount 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 but usually not less than 25%. 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, 2004, residential construction loans totaled $15.4
million, or 4.8%, of the total loan portfolio, primarily consisting of
construction loans to developers. At September 30, 2004, commercial construction
loans totaled $3.4 million, or 1.1%, of the total loan portfolio.
9
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,
2004, land loans (including loans to acquire and develop land) totaled $19.3
million, or 6.0%, 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 $2.4 million. All have personal guaranties of the principals and are
cross-collateralized with existing loans. At September 30, 2004, loans
outstanding under builder lines of credit totaled $1.7 million, or .54%, of the
total loan portfolio, of which $700,000 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, 2004, home equity loans and lines of credit amounted to $43.6
million, or 13.5%, of the Bank's total loan portfolio.
Consumer Lending Activities. The Bank also offers a variety of consumer
loans in order to provide a full range of retail financial services to its
customers. At September 30, 2004, $1.5 million, or .5 %, of the Bank's total
loan portfolio was comprised of consumer loans. The Bank originates
substantially all of such loans in its market area. At September 30, 2004, 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, 2004, these loans totaled $629,000, or .2%, of the total loan portfolio.
Another component of the consumer loan portfolio is unsecured loans amounting to
$543,000, or .2%, of the Bank's loan portfolio at September 30, 2004.
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 in recent periods
the growth of its commercial business loan portfolio 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 this product 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, 2004, commercial business loans
amounted to $10.6 million, or 3.3%, of the Bank's total loan portfolio.
10
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, 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
non-interest-bearing deposits and increase the Bank's interest rate spread and
interest rate sensitivity.
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 $54,000, $410,000, and $84,000 during the
fiscal years ended September 30, 2004, 2003 and 2002, respectively. Profits from
sales of loans held for sale significantly decreased in fiscal 2004 due to the
slowdown in the refinancing market in 30-year loans resulting from increases in
long-term interest rates. The Bank had $172,000 and $4.5 million of mortgage
loans held for sale at September 30, 2004 and 2003, respectively. During fiscal
2004, management determined, based on its asset liability position, to retain a
substantial portion of the loans designated held for sale at September 30, 2003
in its loan portfolio.
The Bank's conforming mortgage loans sold to others are sold, generally
with servicing retained, on a loan-by-loan basis primarily to FHLMC or 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
entered into at the same time of the commitment by the Bank of a loan rate to
the borrower. These commitments are mandatory delivery contracts with FHLMC or
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. See Note 13 of the Notes to
Consolidated Financial Statements set forth in Item 8 hereof.
Loan Origination Fees and Servicing. Borrowers may be 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.
11
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,
-----------------------------------------
2004 2003 2002
------- ------- -------
(Dollars in thousands)
Loans originated by the Bank and serviced for:
FNMA $ 673 $ 822 $ 1,054
FHLMC 49,849 50,373 50,405
Others 340 352 367
------- ------- -------
Total loans serviced for others $50,862 $51,547 $51,826
======= ======= =======
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. 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. For fiscal years ended September 30, 2004, 2003 and 2002, the Bank
earned gross fees of $132,000, $140,000 and $160,000, respectively, from loan
servicing.
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, 2004, the Bank's five largest loans or groups of loans-to-one
borrower, including related entities, ranged from an aggregate of $5.3 million
to $6.9 million. The Bank's loans-to-one borrower limit was $7.1 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 Quality Review Committee. The Asset Quality Review
Committee is composed of the President and Chief Executive Officer, the Chief
Operating Officer, the Vice President of Loan Administration, the Internal
Auditor and the Vice President of Construction Lending and meets at least
monthly. 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, 2004, 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.
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.
12
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 set
forth in Item 8 hereof.
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 expensed 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" under SFAS No. 15. 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.
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.
At September 30, 2004 At September 30, 2003
-------------------------------- ---------------------------------
30 to 59 days 60 to 89 days 30 to 59 days 60 to 89 days
------------- ------------- ------------- -------------
Real estate loans:
Single-family residential $ -- $ 277 $ 84 $127
Multi-family and commercial -- 3,357(1) 531 --
Home equity -- 116 64 167
Consumer loans 5 7 12 1
Commercial business loans -- 100 60 --
---- ------ ---- ----
Total $ 5 $3,857 $751 $295
==== ====== ==== ====
- ----------------
(1) Consists of one commercial real estate loan. (See "Other Classified
Assets")
13
Non-performing Assets. The following table sets forth the amounts and
categories of the Bank's non-performing assets at the dates indicated.
September 30,
--------------------------------------------------------
2004 2003 2002 2001 2000
------ ------ ------ ------ ------
(Dollars in thousands)
Non-performing loans:
Single-family residential $ 623 $ 688 $1,237 $1,924 $2,109
Commercial and multi-family(1) -- 381 2,386 33 --
Construction(2) 770 -- -- -- --
Home equity and lines of credit 243 -- -- -- --
Consumer 6 16 19 314 48
Commercial business -- 268 138 -- 3
------ ------ ------ ------ ------
Total non-accrual loans 1,642 1,353 3,780 2,271 2,160
------ ------ ------ ------ ------
Accruing loans more than 90 days delinquent 391(3) 203(3) 1,358(3) 31 355
------ ------ ------ ------ ------
Total non-performing loans 2,033 1,556 5,138 2,302 2,515
------ ------ ------ ------ ------
Real estate owned 1,229 1,420 248 887 947
------ ------ ------ ------ ------
Total non-performing assets $3,262 $2,976 $5,386 $3,189 $3,462
====== ====== ====== ====== ======
Total non-performing loans
as a percentage of gross loans
receivable (4) 0.66% 0.53% 1.76% 0.92% 1.07%
====== ====== ====== ====== ======
Total non-performing assets
as a percentage of total assets 0.57% 0.53% 1.04% 0.65% 0.75%
====== ====== ====== ====== ======
- -----------------------------
(1) Consists of one loan at September 30, 2003, three loans at September 30,
2002 (all of which became real estate owned during fiscal 2003, and one
loan at September 30, 2001.
(2) Consists of one single-family residential construction loan at September
30, 2004.
(3) Consists of six loans at September 30, 2004, two loans at September 30,
2003 and one commercial real estate loan of $1.3 million at September 30,
2002 which returned to current status subsequent to September 30, 2002.
(4) Includes loans receivable and loans held for sale, less construction and
land loans in process and deferred loan origination fees and discounts.
14
The $623,000 of non-performing single-family residential loans at
September 30, 2004 consisted of 11 loans with principal balances ranging from
$385 to $163,000, with an average balance of approximately $56,600. Included
within the 11 loans, are two loans aggregating $225,000 to credit impaired
borrowers.
At September 30, 2004, the $770,000 of non-performing construction loans
consisted of a single construction loan for a single-family dwelling located in
New Castle County, Delaware. The borrower is refinancing the loan with another
financial institution.
The $243,000 of non-performing home equity and lines of credit at
September 30, 2004 consisted of seven loans, with an average balance of
approximately $34,700.
Loans 90 days or more past maturity which continued to make payments on a
basis consistent with the original repayment schedule amounted to $391,000 at
September 30, 2004. The Company is working with the borrowers to refinance or
extend the term of such loans.
At September 30, 2004, the $1.2 million of real estate owned (including
in-substance foreclosure) consisted of two single-family residential properties,
with an average carrying value of $102,000 with the largest having a carrying
value of $73,000 and a $1.1 million commercial real estate property. The
commercial real estate property is an 18-hole golf course and golf house,
located in Avondale, Pennsylvania. The golf facility is fully operational and
continues to generate revenues. During fiscal 2004, the Bank incurred expenses
in the amount of $147,000 relating to the workout of these loans. The property
is under agreement of sale and the buyer is operating and incurring the expense
of operating the facility.
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 four classifications for problem assets: "substandard," "doubtful", "loss"
and "special mention." 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, 2004, the Bank had $3.8 million of assets classified as
substandard, and no assets classified as doubtful, loss or special mention. A
substantial majority of all classified assets consist of non-performing assets.
Included in delinquent loans at September 30, 2004 is a $3.4 million
commercial real estate loan to one borrower secured by a commercial real estate
property is a restaurant in Chesapeake City, Maryland. Subsequent to fiscal
year-end, the loan as well as a related business line of credit extended to the
borrower was classified as special mention due to the borrower's poor payment
history.
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. However, in fiscal 2004, the level of provisions decreased due to the
Bank's evaluation of its estimate of losses and charge-offs in the loan
portfolio. As shown in the table below, at September 30, 2004, the Bank's
allowance for loan losses amounted to 100.30% and 0.67% of the Bank's
non-performing loans and gross loans receivable, respectively. At September 30,
2004, the Bank did not have any impaired loans, therefore, no related allowance
for loan losses was established.
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.
15
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,
-----------------------------------------------------------
2004 2003 2002 2001 2000
------- ------- ------- ------- -------
(Dollars in thousands)
Allowance for loan losses, beginning of period $ 1,986 $ 2,358 $ 2,181 $ 2,019 $ 1,928
Charged-off loans:
Single-family residential -- (50) (317) (492) (182)
Multi-family and commercial (62) (941) -- -- --
Construction -- -- -- -- (117)
Consumer and commercial business (259) (111) (56) (40) (64)
------- ------- ------- ------- -------
Total charged-off loans (321) (1,102) (373) (532) (363)
------- ------- ------- ------- -------
Recoveries on loans previously charged off:
Single-family residential 35 4 1 11 --
Commercial leases (1) -- -- -- 134 33
Multi-family and commercial 32 -- -- -- --
Consumer and commercial business 7 11 9 9 1
------- ------- ------- ------- -------
Total recoveries 74 15 10 154 34
------- ------- ------- ------- -------
Net loans charged-off (247) (1,087) (363) (378) (329)
Provision for loan losses 300 715 540 540 420
------- ------- ------- ------- -------
Allowance for loan losses, end of period $ 2,039 $ 1,986 $ 2,358 $ 2,181 $ 2,019
======= ======= ======= ======= =======
Net loans charged-off to average loans outstanding(2) 0.08% 0.37% 0.13% 0.16% 0.14%
======= ======= ======= ======= =======
Allowance for loan losses to gross loans receivable(2) 0.67% 0.68% 0.81% 0.87% 0.86%
======= ======= ======= ======= =======
Allowance for loan losses to total non-performing loans 100.30% 127.63% 45.89% 94.74% 80.28%
======= ======= ======= ======= =======
Net loans charged-off to allowance for loan losses 12.11% 54.73% 15.39% 17.33% 16.30%
======= ======= ======= ======= =======
Recoveries to charge-offs 23.05% 1.36% 2.68% 28.95% 9.37%
======= ======= ======= ======= =======
(1) Relate to commercial leases purchased in prior years.
(2) Gross loans receivable and average loans outstanding include loans
receivable as well as 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,
-------------------------------------------------------------------------------------------------------
2004 2003 2002 2001 2000
-------------------------------------------------------------------------------------------------------
% 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 $ 700 50.87% $ 733 55.51% $ 815 57.32% $ 615 59.81% $1,098 65.54%
Commercial and
multi-family
residential 446 20.02 317 19.73 767 19.92 566 16.22 198 15.50
Construction 467 11.82 329 9.69 304 9.33 249 10.86 171 7.33
Home equity 57 13.54 34 11.19 40 9.10 59 9.65 41 9.25
Consumer 11 .46 10 .48 10 .40 11 .42 8 .55
Commercial business 70 3.29 132 3.40 86 3.93 87 3.04 60 1.83
Unallocated 288 -- 431 -- 336 -- 594 -- 443 --
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Total allowance for
loan losses $2,039 100.00% $1,986 100.00% $2,358 100.00% $2,181 100.00% $2,019 100.00%
====== ====== ====== ====== ====== ====== ====== ====== ====== ======
17
MORTGAGE-RELATED 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
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 $333,700 (for single family dwellings).
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 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
18
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 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, 2004, $17.1 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, 2004, the Bank had an aggregate of $135.0 million, or
23.6%, of total assets invested in mortgage-related securities, net, of which
$37.4 million was held to maturity and $97.6 million was available for sale. The
Company's investment strategy is to maintain the portfolio to complement the
asset-liability structure of the Company. To protect the effect of price
volatility to the Company's financial statements, the Company's strategy during
fiscal 2004 was to increase the held to maturity portfolio. 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 level
yield method, 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 set forth in Item 8 hereof.
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) mortgage-related
securities portfolios at the dates indicated.
September 30,
------------------------------------
2004 2003 2002
------- -------- -------
(Dollars in thousands)
Available for sale:
Mortgage-backed securities:
FHLMC $ 5,811 $ 6,950 $ 5,261
FNMA 42,861 46,030 13,463
GNMA 1,270 13,639 33,621
------- -------- -------
Total mortgage-backed securities 49,942 66,619 52,345
------- -------- -------
Collateralized mortgage obligations:
FHLMC 15,649 20,239 9,509
FNMA 6,543 5,381 3,751
GNMA -- -- --
Other 25,486(1) 32,417(2) 20,069(3)
------- -------- -------
Total collateralized mortgage obligations 47,678 58,037 33,329
------- -------- -------
Total mortgage-related securities $97,620 $124,656 $85,674
======= ======== =======
Held to maturity:
Mortgage-backed securities:
FHLMC $16,226 $ 478 $ 1,433
FNMA 20,613 2,123 3,574
------- -------- -------
Total mortgage-backed securities 36,839 2,601 5,007
------- -------- -------
Collateralized mortgage obligations:
FNMA 524 886 3,848
------- -------- -------
Total collateralized mortgage obligations 524 886 3,848
------- -------- -------
Total mortgage-related securities, amortized cost $37,363 $ 3,487 $ 8,855
======= ======== =======
Total fair value(4) $37,312 $ 3,560 $ 9,090
======= ======== =======
- ----------------------------
(1) Includes "AAA" rated securities of Countrywide Home Loans, Washington
Mutual, AMAC, First Horizon and Mastr Asset with book values of $5.2
million, $4.7 million, $2.0 million, $ 4.9 million and $4.0 million,
respectively, and fair values of $5.2 million, $4.7 million, $1.9 million,
$4.9 million and $4.1 million, respectively.
(2) Includes "AAA" rated securities of Countrywide Home Loans, Washington
Mutual, AMAC and First Horizon with book values of $6.5 million, $6.8
million, $4.7 million and $ 3.6 million, respectively, and fair values of
$6.4 million, $6.7 million, $4.8 million and $3.5 million, respectively.
(3) 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 values of $3.0 million, $4.1 million, $5.1
million and $2.8 million, respectively.
(4) See Note 4 of the Notes to Consolidated Financial Statements set forth in
Item 8 hereof.
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,
-------------------------------------
2004 2003 2002
--------- --------- ---------
(Dollars in thousands)
Mortgage-related securities, beginning of period(1)(2) $ 128,143 $ 94,529 $ 129,062
--------- --------- ---------
Purchases:
Mortgage-backed securities - available for sale 11,106 50,199 9,280
Mortgage-related securities - held to maturity 37,856 -- --
CMOs - available for sale 11,222 81,942 18,231
Sales:
Mortgage-backed securities - available for sale (7,073) (4,493) --
CMOs - available for sale -- (3,064) --
Repayments and prepayments:
Mortgage-backed securities (23,006) (32,563) (26,820)
CMOs (21,262) (55,941) (34,554)
Decrease in net premium (787) (1,128) (315)
Change in net unrealized (loss) gain on mortgage-related
securities available for sale (1,216) (1,338) (355)
--------- --------- ---------
Net increase (decrease) in mortgage-related securities 6,840 33,614 (34,533)
--------- --------- ---------
Mortgage-related securities, end of period(1)(2) $ 134,983 $ 128,143 $ 94,529
========= ========= =========
- ----------------
(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, 2004, the estimated weighted average maturity of the
Bank's fixed-rate mortgage-related securities was approximately 2.5 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 2004, 2003 and 2002, 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 lower yields. During the
latter part of fiscal 2004, the Company experienced lower prepayment speeds and
refinancing activity as interest rates offered for mortgage loans in the
marketplace increased starting at the end of the second quarter.
21
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.
AT SEPTEMBER 30,
--------------------------------------------------------------
2004 2003 2002
--------------------------------------------------------------
CARRYING FAIR CARRYING FAIR CARRYING FAIR
VALUE VALUE VALUE VALUE VALUE VALUE
------- ------- ------- ------ ------- -------
(Dollars in thousands)
FHLB stock $ 9,827 $ 9,827 $ 8,294 $ 8,294 $ 6,571 $ 6,571
U.S. Government and agency
obligations
1 to 5 years 14,694 14,495 13,020 13,004 11,986 12,114
5 to 10 years -- -- 4,880 4,988 1,861 2,071
Municipal obligations 15,223 15,691 17,373 17,895 19,012 19,800
Corporate bonds 15,336 16,134 20,621 21,693 14,299 14,720
Mutual funds 14,009 13,804 14,009 13,952 14,009 14,045
Asset-backed securities 1,189 1,197 1,911 1,922 2,837 2,853
Preferred stocks 3,900 3,900 5,474 4,984 10,682 10,751
Other equity investments 1,755 3,764 3,126 5,712 3,476 4,269
------- ------- ------- ------- ------- -------
Total $75,933 $78,812 $88,708 $92,444 $84,733 $87,194
======= ======= ======= ======= ======= =======
At September 30, 2004, the Company had an aggregate of $78.8 million, or
13.8%, of its total assets invested in investment securities, of which $9.8
million consisted of FHLB stock, $63.6 million was investment securities
available for sale and $5.4 million investment securities held to maturity.
Included in U.S. Government and agency obligations are callable bonds with a
remaining term of approximately four years. The Bank's investment securities
(excluding mutual funds, equity securities and FHLB stock) had a weighted
average maturity to the call date of 5.46 years and a weighted average yield of
5.97% (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, MMDAs, certificates of deposit ranging in terms from 30 days to
five years and non-interest-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. As a result of not offering
the highest rate for certificates of deposit, the Bank experienced a decline in
overall deposits in fiscal 2004. Even with the decline in the deposits, 52.2% of
the deposits with the Bank consisted of core deposits at September 30, 2004. As
a result of the significant decline in interest rates paid on deposit products
in fiscal 2003 and 2002, due to generally declining returns on competing
investment opportunities as well as the effects of the decline of the equities
markets, the Bank did not experience disintermediation of deposits into
competing investment products in fiscal 2003 and 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,
-------------------------------------------------------------------------
2004 2003 2002
-------------------------------------------------------------------------
AMOUNT PERCENT AMOUNT PERCENT AMOUNT PERCENT
--------- ------- --------- ------- --------- -------
(Dollars in thousands)
Passbook $ 51,371 14.90% $ 47,089 12.99% $ 41,659 12.60%
MMDA 51,682 14.98 55,889 15.41 48,721 14.73
NOW 55,864 16.20 60,221 16.61 48,803 14.75
Certificates of deposit 164,917 47.82 178,489 49.22 176,242 53.28
Non-interest-bearing 21,046 6.10 20,917 5.77 15,340 4.64
--------- ------ --------- ------ --------- ------
Total deposits $ 344,880 100.00% $ 362,605 100.00% $ 330,765 100.00%
========= ====== ========= ====== ========= ======
The following table sets forth the net savings flows of the Bank during
the periods indicated.
YEAR ENDED SEPTEMBER 30,
-------------------------------------
2004 2003 2002
-------------------------------------
(Dollars in thousands)
(Decrease) increase before interest credited $ (22,744) $ 25,633 $ 10,477
Interest credited 5,019 6,207 8,687
--------- -------- --------
Net savings (decrease) increase $ (17,725) $ 31,840 $ 19,164
========= ======== ========
The following table sets forth maturities of the Bank's certificates of
deposit of $100,000 or more at September 30, 2004 and 2003 by time remaining to
maturity (amounts in thousands).
SEPTEMBER 30,
--------------------------
2004 2003
--------- ---------
Three months or less $ 19,770 $ 11,724
Over three months through six months 5,144 6,581
Over six months through twelve months 1,370 5,984
Over twelve months 5,830 9,889
--------- ---------
$ 32,114 $ 34,178
========= =========
23
The following table presents, by various interest rate categories, the
amount of certificates of deposit at September 30, 2004 and 2003 and the amounts
at September 30, 2004 which mature during the periods indicated.
AMOUNTS AT SEPTEMBER 30, 2004
SEPTEMBER 30, MATURING WITHIN
------------------------ ---------------------------------------------------------
2004 2003 ONE YEAR TWO YEARS THREE YEARS THEREAFTER
------------------------ ---------------------------------------------------------
(Dollars in thousands)
Certificates of Deposit
2.0% or less $ 67,053 $ 61,363 $ 66,004 $ 998 $ -- $ 50
2.01% to 3.0% 33,906 39,394 17,301 12,762 2,040 1,804
3.01% to 4.0% 41,147 42,191 4,337 14,346 498 21,966
4.01% to 5.0% 17,139 19,694 7,327 1,178 7,911 723
5.01% to 6.0% 5,491 6,219 2,240 3,245 6 --
6.01% to 7.0% 181 9,628 181 -- -- --
--------- --------- -------- -------- -------- --------
Total certificate accounts $ 164,917 $ 178,489 $ 97,390 $ 32,529 $ 10,455 $ 24,543
========= ========= ======== ======== ======== ========
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,
--------------------------------------------------------------------------------
2004 2003 2002
--------------------------------------------------------------------------------
AVERAGE AVERAGE AVERAGE
AVERAGE RATE AVERAGE RATE AVERAGE RATE
BALANCE PAID BALANCE PAID BALANCE PAID
--------------------------------------------------------------------------------
(Dollars in thousands)
Passbook accounts $ 50,206 .94% $ 44,105 1.20% $ 40,300 1.86%
MMDA accounts 53,054 1.14 51,756 1.42 47,245 2.19
Certificates of deposit 169,834 2.68 178,097 3.24 174,844 4.24
NOW accounts 55,115 .52 55,496 .57 49,235 .81
Non-interest-bearing deposits 19,598 -- 14,272 -- 7,720 --
--------- --------- ---------
Total deposits $ 347,807 1.70% $ 343,726 2.14% $ 319,344 3.01%
========= ==== ========= ==== ========= ====
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. During fiscal 2004 and 2003, the Company funded a portion
of its asset growth with overnight borrowings from FHLB. At September 30, 2004,
the Bank had $169.9 million in outstanding FHLB advances and overnight
borrowings. 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 one month to two years.
See Note 9 of the Notes to Consolidated Financial Statements set forth in Item 8
hereof.
The following table sets forth certain information regarding our outside
borrowings for the periods indicated.
SEPTEMBER 30,
---------------------------
2004 2003
---------------------------
(Dollars in thousands)
FHLB advances
Average balance outstanding for the period $ 152,656 $ 131,083
Maximum outstanding at any month end 169,890 141,704
Balance outstanding at end of the period 169,887 133,203
Average interest rate for the period 4.66% 5.32%
Interest rate at the end of the period 4.39% 5.41%
In addition, the Company participated in junior subordinated debentures
aggregating $21.6 million at September 30, 2004 held by statuary trusts that
issued trust preferred securities. See Note 17 of the Notes to Consolidated
Financial Statements set forth in Item 8 hereof.
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, 2004, the Bank was authorized to invest up to
approximately $11.4 million in the stock of, or loans to, service corporations.
As of September 30, 2004, the net book value of the Bank's investment in stock,
unsecured loans, and conforming loans to its service corporations was $32,000.
At September 30, 2004, in addition to the Bank, the Company has two direct
subsidiaries: FKF Management Corp., Inc. and State Street Services Corp.
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 $153.6 million at
September 30, 2004 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 ("First Keystone Insurance"), and therefore, First Keystone
Insurance is consolidated into the Company's financial statements. In addition,
State Street Services Corp. holds a 10% equity position in a title company which
offers title services.
EMPLOYEES
The Bank had 92 full-time employees and 13 part-time employees as of
September 30, 2004. 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, examination, 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 are 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 regarding 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.
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 capital distribution 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
26
covered transactions and certain other transactions between a savings
association or its subsidiaries 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 ("FRB") 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 of 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 (the "Act") 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 Act 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 are
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.
27
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.
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 is
defined by the SEC in regulations promulgated thereby) 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.
Under current Federal Deposit Insurance Corporation regulations, Savings
Association Insurance Fund-insured institutions are assigned to one of three
capital groups which are based solely on the level of an institution's capital -
"well capitalized," "adequately capitalized" and "undercapitalized" - which are
defined in the same manner as the regulations establishing the prompt corrective
action system discussed below. These three groups are then divided into three
subgroups which reflect varying levels of supervisory concern, from those which
are considered to be healthy to those which are considered to be of substantial
supervisory concern. The matrix so created results in nine assessment risk
classifications, with rates during the first six months of 2004 ranging from
zero for well capitalized, healthy institutions, such as the Bank, to 27 basis
points for undercapitalized institutions with substantial supervisory concerns.
In addition, all institutions with deposits insured by the Federal Deposit
Insurance Corporation are required to pay assessments to fund interest payments
on bonds issued by the Financing Corporation, a mixed-ownership government
corporation established to recapitalize the predecessor to the Savings
Association Insurance Fund. The assessment rate for the third quarter of 2004
was .0148% of insured deposits and is adjusted quarterly. These assessments will
continue until the Financing Corporation bonds mature in 2019.
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
28
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 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 Corrective Action." At September 30, 2004,
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, 2004, the Bank had PMSRs
totaling $239,900.
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
29
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, 2004, the Bank exceeded all of its regulatory capital
requirements, with tangible, core and risk-based capital ratios of 8.0%, 8.0%,
and 15.0%, respectively. See Note 11 to the Notes to Consolidated Financial
Statements included set forth in Item 8 hereof.
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 making any capital distributions.
30
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, 2004, 2003 and 2002.
September 30, 2004 September 30, 2003
------------------------------------------------------------------------------
Tangible Core Risk-based Tangible Core Risk-based
Capital Capital Capital Capital Capital Capital
------------------------------------------------------------------------------
(Dollars in thousands)
GAAP equity $ 46,535 $ 46,535 $ 46,535 $ 43,852 $ 43,852 $ 43,852
General valuation allowances -- -- 1,765 -- -- 1,712
-------- -------- -------- -------- -------- --------
Total regulatory capital 46,535 46,535 48,300 43,852 43,852 45,564
Minimum capital requirement 8,500 22,667 26,540 8,240 21,972 24,357
-------- -------- -------- -------- -------- --------
Excess $ 38,035 $ 23,868 $ 21,760 $ 35,612 $ 21,880 $ 21,207
======== ======== ======== ======== ======== ========
September 30, 2002
---------------------------------------
Tangible Core Risk-based
Capital Capital Capital
---------------------------------------
(Dollars in thousands)
GAAP equity $ 40,873 $ 40,873 $ 40,873
General valuation allowances -- -- 2,084
-------- -------- --------
Total regulatory capital 40,873 40,873 42,957
Minimum capital requirement 7,597 20,265 21,255
-------- -------- --------
Excess $ 33,276 $ 20,608 $ 21,702
======== ======== ========
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.
31
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,
2004, 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% loans for personal,
family and household purposes (other then credit card loans and education 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, 2004, approximately 70.6% of the Bank's assets were
invested in qualified thrift investments, which were in excess of the percentage
required to qualify the Bank under the QTL test in effect at that time.
OTS regulations govern capital distributions by savings institutions,
which include cash dividends, stock repurchases and other transactions charged
to the capital account of a savings institution to make capital distributions. A
savings institution must file an application for OTS approval of the capital
distribution if any of the following occur or would occur as a result of the
capital distribution (1) the total capital distributions for the applicable
calendar year exceed the sum of the institution's net income for that year to
date plus the institution's retained net income for the preceding two years, (2)
the institution would not be at least adequately capitalized following the
distribution, (3) the distribution would violate any applicable statute,
regulation, agreement or OTS-imposed condition, or (4) the institution is not
eligible for expedited treatment of its filings. If an application is not
required to be filed, savings institutions which are a subsidiary of a holding
company (as well as certain other institutions) must still file a notice with
the OTS at least 30 days before the Board of Directors declares a dividend or
approves a capital distribution.
32
Capital Distribution. 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 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.
Branching by Federal Saving Institutions. OTS policy permits interstate
branching to the full extent permitted by statute (which is essentially
unlimited). Generally, federal law prohibits federal savings institutions from
establishing, retaining or operating a branch outside the state in which the
federal institution has its home office unless the institution meets the IRS'
domestic building and loan test (generally, 60% of a thrift's assets must be
housing-related) ("IRS Test"). The IRS Test requirement does not apply if: (a)
the branch(es) result(s) from an emergency acquisition of a troubled savings
institution (however, if the troubled savings institution is acquired by a bank
holding company, does not have its home office in the state of the bank holding
company bank subsidiary and does not qualify under the IRS Test, its branching
is limited to the branching laws for state-chartered banks in the state where
the savings institution is located); (b) the law of the state where the branch
would be located would permit the branch to be established if the federal
savings institution were chartered by the state in which its home office is
located; or (c) the branch was operated lawfully as a branch under state law
prior to the savings institution's reorganization to a federal charter.
Furthermore, the OTS will evaluate a branching applicant's record of CRA
compliance. An unsatisfactory CRA record may be the basis for denial of a
branching application.
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, 2004, the Bank has overnight borrowings and advances aggregating
$169.9 million from the FHLB or 31.3% of its total liabilities. The Bank
currently has the ability to obtain up to $149.8 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, 2004, the Bank had $9.8 million in FHLB
stock, which was in compliance with this requirement.
The FHLBs are required to provide funds for the resolution of troubled
savings institutions and to contribute to affordable housing programs through
direct loans or interest subsidies on advances targeted for community investment
and low- and moderate-income housing projects. These contributions have
adversely affected the level of FHLB dividends paid and could continue to do so
in the future and could also result in the FHLBs imposing higher interest rates
on advances to members. These contributions also could have an adverse effect on
the value of FHLB stock in the future.
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, 2004,
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.
33
Savings institutions are authorized to borrow from a Federal Reserve Bank
"discount window," but FRB regulations require savings banks to exhaust other
reasonable alternative sources of funds, including FHLB advances, before
borrowing from a Federal Reserve Bank.
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.
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 the Bank's 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.
Prior to the Small Business Protection Act of 1996, bad debt reserves
created prior to January 1, 1988 were subject to recapture into taxable income
if the Bank failed to meet certain thrift asset and definitional tests. New
federal legislation eliminated these thrift-related recapture rules. However, to
the extent that the Bank makes "non-dividend distributions" that are considered
as made (i) from the reserve for losses on qualifying real property loans or
(ii) from the supplemental reserve for losses on loans, then an amount based on
the amount distributed will be included in its taxable income. Non-dividend
distributions include distributions in excess of the Bank's current and
accumulated earnings and profits, distributions in redemption of stock, and
distributions in partial or complete liquidation. Dividends paid out of the
Bank's current or accumulated earnings and profits, as calculated for federal
income tax purposes, will not be considered to result in a distribution from our
bad debt reserve. As a result, any dividends that would reduce amounts
appropriated to bad debt reserve and deducted for federal income tax purposes
would create a tax liability for the Bank.
34
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.
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 2004 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.
35
ITEM 2. PROPERTIES.
At September 30, 2004, 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 set forth in Item 8 hereof.
The following table sets forth certain information with respect to the
Bank's offices at September 30, 2004.
Net Book Value Amount of
Description/Address Leased/Owned of Property Deposits
- ---------------------------------------------------------------------------------------------------------
(Dollar in thousands)
Executive Offices:
22 West State Street
Media, Pennsylvania 19063 Owned(1) $ 1,150 $ 95,690
Branch Offices:
3218 Edgmont Avenue
Brookhaven, Pennsylvania 19015 Owned 615 77,588
Routes 1 and 100
Chadds Ford, Pennsylvania 19317 Leased(2) 50 28,418
23 East Fifth Street
Chester, Pennsylvania 19013 Leased(3) 50 23,910
31 Baltimore Pike
Chester Heights, Pennsylvania 19017 Leased(4) 551 39,586
106 East Street Road
Kennett Square, Pennsylvania 19348 Leased(5) 528 16,977
5000 Pennell Road
Aston, Pennsylvania 19014 Leased(6) 476 --
330 Dartmouth Avenue
Swarthmore, Pennsylvania 19081 Owned 143 62,711
-------- ---------
Total $ 3,563 $ 344,880
======== =========
----------------------------
(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, 2034. The Bank has one six-year
followed by a five-year renewal option.
(6) Branch opened in November 2004. Lease expiration date is December 31,
2033. The Bank has options to cancel on the 15th, 20th and 25th year of
the lease.
36
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.
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.
(a) On January 25, 1995 the conversion and reorganization of the Bank and
its holding company parent was completed. In connection with the consummation of
the Conversion, the Holding Company issued 2,720,000 shares of common stock. As
of September 30, 2004, there were 1,927,744 shares of common stock outstanding.
As of September 16, 2004 the Holding Company had 421 stockholders of record not
including the number of persons or entities holding stock in nominee or street
name through various brokers and banks.
The following table sets forth the high and low closing stock prices of
the Holding Company's common stock as reported by the Nasdaq Stock Market under
the symbol "FKFS" during the periods presented. Price information appears in a
major newspaper under the symbol "FstKeyst".
YEAR ENDED
------------------------------------------------------
SEPTEMBER 30, 2004 SEPTEMBER 30, 2003
----------------------- --------------------
HIGH LOW HIGH LOW
----------------------- --------------------
First Quarter $ 27.45 $ 26.00 $ 16.45 $ 13.80
Second Quarter $ 29.00 $ 26.59 $ 21.23 $ 16.11
Third Quarter $ 28.99 $ 23.50 $ 23.74 $ 21.16
Fourth Quarter $ 24.50 $ 21.40 $ 26.50 $ 21.90
The following schedule summarizes the cash dividends per share of common
stock paid by the Holding Company during the periods indicated.
YEAR ENDED SEPTEMBER 30,
---------------------------
2004 2003
-------- --------
First Quarter $ 0.10 $ 0.09
Second Quarter 0.11 0.10
Third Quarter 0.11 0.10
Fourth Quarter 0.11 0.10
On November 23, 2004, the Board of Directors declared a quarterly cash
dividend of $0.11 per share of common stock, payable on January 3, 2005, to
stockholders of record at the close of business on December 16, 2004.
37
The information for all equity based and individual compensation
arrangements is incorporated by reference from Item 12 hereof.
(b) Not applicable
(c) The following table sets forth information with respect to purchases
made by or on behalf of the Company of shares of common stock of the
Company during the indicated periods.
Total Total Number of Maximum Number of
Number Average Shares Purchased as Shares that May Yet Be
of Shares Price Paid Part of Publicly Purchased Under the
Period (1) Purchased per Share Announced Plan Plan
- ----------------------------------------------------------------------------------------------------------
July 1-31, 2004 -- -- -- 56,332
August 1-31, 2004 -- -- -- 56,332
September 1-30, 2004 -- -- -- 56,332
--- ---
Total -- -- -- 56,332
=== === === ======
- -------------------------
(1) On January 31, 2003, the Company announced its current program to repurchase
up to 101,000 of shares of common stock of the Company. The program has been
extended and does not currently have an expiration date. The table above does
not include 96,208 shares purchased at an average cost per share of $26.81 by
the Company's ESOP. The number of shares purchased in each of three periods set
forth above was 0, 9,550 and 0, respectively, at an average cost per share of
$0, $22.98 and $0, respectively. The ESOP has been authorized to purchase up to
100,000 shares.
See "Liquidity, Capital Resources and Commitments" set forth in Item 7
hereof and Notes 11 of the "Notes to Consolidated Financial Statements" set
forth in Item 8 hereof for discussion of restrictions on the Holding Company's
ability to pay dividends. Also see "Regulation-Capital Distributions" for a
discussion of restrictions on the Bank's ability to pay dividends to the Holding
Company.
38
ITEM 6. SELECTED FINANCIAL DATA.
The selected consolidated financial and other data of the Holding Company
set forth below does not purport to be complete and should be read in
conjunction with, and is qualified in its entirety by, the more detailed
information, including the Consolidated Financial Statements and related Notes,
set forth in Item 8 hereto.
AT OR FOR THE YEAR ENDED SEPTEMBER 30,
------------------------------------------------------------
(Dollars in thousands, except per share data) 2004 2003 2002 2001 2000
- --------------------------------------------- ------------------------------------------------------------
SELECTED FINANCIAL DATA:
Total assets $ 571,919 $ 559,612 $ 519,259 $ 489,680 $ 464,061
Loans receivable, net 304,248 286,421 288,776 247,664 230,686
Mortgage-related securities held to
maturity 37,363 3,487 8,855 11,454 13,056
Investment securities held to maturity 5,287 6,315 -- -- 10,000
Assets held for sale:
Mortgage-related securities 97,620 124,656 85,674 117,608 96,257
Investment securities 63,615 77,700 80,624 62,564 42,215
Loans 172 4,498 501 225 3,099
Real estate owned 1,229 1,420 248 887 947
Deposits 344,880 362,605 330,765 311,601 272,562
Borrowings 171,149 136,272 126,237 126,234 142,902
Junior subordinated debentures 21,557 21,593 21,629 16,702 16,702
Stockholders' equity 29,698 32,388 32,795 30,621 26,569
Non-performing assets 3,262 2,976 5,386 3,189 3,462
SELECTED OPERATIONS DATA:
Interest income $ 26,143 $ 27,212 $ 30,121 $ 31,860 $ 31,068
Interest expense 14,712 16,012 18,250 21,964 20,851
--------- --------- --------- --------- ---------
Net interest income 11,431 11,200 11,871 9,896 10,217
Provision for loan losses 300 715 540 540 420
--------- --------- --------- --------- ---------
Net interest income after provision for
loan losses 11,131 10,485 11,331 9,356 9,797
Service charges and other fees 1,235 1,013 1,000 952 941
Net gain (loss) on sales of
interest-earning assets 968 1,010 415 174 (680)
Other non-interest income 1,696 1,263 848 820 1,045
Non-interest expense 12,501 10,400 10,441 8,388 8,278
--------- --------- --------- --------- ---------
Income before income taxes 2,529 3,371 3,153 2,914 2,825
Income tax expense 326 632 427 443 463
--------- --------- --------- --------- ---------
Net income $ 2,203 $ 2,739 $ 2,726 $ 2,471 $ 2,362
========= ========= ========= ========= =========
PER SHARE DATA:
Basic earnings per share $ 1.21 $ 1.44 $ 1.42 $ 1.22 $ 1.14
Diluted earnings per share 1.14 1.35 1.34 1.18 1.11
Cash dividends per share 0.44 0.40 0.36 0.32 0.28
39
AT OR FOR THE YEAR ENDED SEPTEMBER 30,
--------------------------------------------------------
(Dollars in thousands, except per share data) 2004 2003 2002 2001 2000
- --------------------------------------------- --------------------------------------------------------
SELECTED OPERATING RATIOS: (1)
Average yield earned on interest-earning
assets 5.01% 5.48% 6.42% 7.25% 7.47%
Average rate paid on interest-bearing
liabilities 2.80 3.23 3.91 5.02 4.99
Average interest rate spread 2.21 2.26 2.52 2.23 2.49
Net interest margin 2.23 2.30 2.59 2.32 2.52
Ratio of interest-earning assets to
interest- bearing liabilities 100.69 101.44 101.83 101.83 100.72
Efficiency ratio (2) 81.55 64.50 66.07 62.46 63.14
Non-interest expense as a percent of
average assets 2.23 1.95 2.07 1.78 1.85
Return on average assets 0.39 0.51 0.54 0.52 0.53
Return on average equity 7.13 8.39 8.77 8.42 9.96
Ratio of average equity to average assets 5.50 6.12 6.17 6.22 5.29
Full-service offices at end of period 7 7 7 7 7
ASSET QUALITY RATIOS:(3)
Non-performing loans as a percent of gross
loans receivable 0.66% 0.53% 1.76% 0.92% 1.07%
Non-performing assets as a percent of total
assets 0.57 0.53 1.04 0.65 0.75
Allowance for loan losses as a percent of
gross loans receivable 0.67 0.68 0.81 0.87 0.86
Allowance for loan losses as a percent of
non-performing loans 100.29 127.63 45.89 94.74 80.28
Net loans charged-off to average loans
receivable 0.08 0.37 0.13 0.16 0.14
CAPITAL RATIOS:(3) (4)
Tangible capital ratio 8.21% 7.98% 8.07% 7.76% 8.32%
Core capital ratio 8.21 7.98 8.07 7.76 8.32
Risk-based capital ratio 14.56 14.97 16.17 16.81 17.70
(1) Adjusted for the effects of tax-free investments. See presentation of
reconciliation of tax-free investments in Item 7, "Management's Discussion
and Analysis - Average Balances, Net Interest Income and Yield Earned and
Rates Paid."
(2) Reflects non-interest expense as a percent of the aggregate of net
interest income and non-interest income.
(3) Asset Quality Ratios and Capital Ratios are end of period ratios except
for the ratio of loan charge-offs to average loans. With the exception of
end of period ratios, all ratios are based on average daily balances
during the indicated periods. Gross loans receivable are net of loans in
process.
(4) Regulatory capital ratios of the Holding Company's wholly owned
subsidiary, First Keystone Bank.
40
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATION.
GENERAL
First Keystone Financial, Inc. (the "Company") is the holding company for
its wholly owned subsidiary, First Keystone Bank (the "Bank"). For purposes of
this discussion, references to the Company will include its wholly owned
subsidiaries, unless otherwise indicated. The Company is a community-oriented
banking organization that focuses on providing customer and business services
within its primary market area, consisting primarily of Delaware and Chester
Counties in southeastern Pennsylvania.
The following discussion should be read in conjunction with the Company's
consolidated financial statements presented in Item 8 of this Annual Report on
Form 10-K. The primary asset of the Company is its investment in the Bank and,
accordingly, the discussion below with respect to results of operations relates
primarily to the operations of the Bank.
The Company's results of operations depend primarily on its net interest
income which is the difference between interest income on interest-earning
assets, which principally consist of loans, mortgage-related securities and
investment securities, and interest expense on interest-bearing liabilities,
which principally consist of deposits and FHLB advances. The Company's results
of operations also are affected by the provision for loan losses (the amount of
which reflects management's assessment of the known and inherent losses in its
loan portfolio that are both probable and reasonably estimable), the level of
its non-interest income, including service charges and other fees as well as
gains and losses from the sale of certain assets, the level of its operating
expenses, and income tax expense.
CRITICAL ACCOUNTING POLICIES
Accounting policies involving significant judgments and assumptions by
management, which have, or could have, a material impact on the carrying value
of certain assets or comprehensive income, are considered critical accounting
policies. In management's opinion, the most critical accounting policy affecting
the Company's financial statements is the evaluation of the allowance for loan
losses. The Company maintains an allowance for loan losses at a level management
believes is sufficient to provide for known and inherent losses in the loan
portfolio that were both probable and reasonable to estimate. The allowance for
loan losses is considered a critical accounting estimate because there is a
large degree of judgment in (i) assigning individual loans to specific risk
levels (pass, substandard, doubtful and loss), (ii) valuing the underlying
collateral securing the loans, (iii) determining the appropriate reserve factor
to be applied to specific risk levels for criticized and classified loans
(substandard, doubtful and loss) and (iv) determining reserve factors to be
applied to pass loans based upon loan type. Accordingly, there is a likelihood
that materially different amounts would be reported under different, but
reasonably plausible conditions or assumptions. For a description of the methods
the Company uses to determine the Company's allowance for loan losses, see
"Results of Operations - Provisions for Loan Losses."
ASSET AND LIABILITY MANAGEMENT
The principal objectives of the Company's asset and liability management
are to (i) evaluate the interest rate risk existing in certain assets and
liabilities, (ii) determine the appropriate level of risk given the Company's
business focus, operating environment, capital and liquidity requirements and
performance objectives, (iii) establish prudent asset and liability
compositions, and (iv) manage the assessed risk consistent with Board approved
guidelines. Through asset and liability management, the Company seeks to reduce
both the vulnerability and volatility of its operations to changes in interest
rates and to manage the ratio of interest-rate sensitive assets to interest-rate
sensitive liabilities within specified maturities or repricing periods. The
Company's actions in this regard are taken under the guidance of the
Asset/Liability Committee ("ALCO"), which is chaired by the Chief Financial
Officer and comprised of members of the Company's senior management. The ALCO
meets no less than quarterly to review, among other things, liquidity and cash
flow needs, current market conditions and the interest rate environment, the
sensitivity to changes in interest rates of the Company's assets and
liabilities, the historical and market values of assets and liabilities,
unrealized gains and losses, and the repricing and maturity characteristics of
loans, investment securities, deposits and borrowings. The ALCO reports to the
Company's Board of Directors no less than once a quarter. In addition,
management reviews at least weekly the pricing of the Company's commercial loans
and retail deposits. The pricing of residential loans, including those being
originated for sale in the secondary market, is reviewed daily.
41
The Company's primary asset/liability monitoring tools consist of various
asset/liability simulation models which are prepared on a quarterly basis. The
models are designed to capture the dynamics of the balance sheet as well as rate
and spread movements and to quantify variations in net interest income under
different interest rate scenarios.
One of the models consists of an analysis of the extent to which assets
and liabilities are interest rate sensitive and measures an institution's
interest rate sensitivity gap. An asset or liability is said to be interest rate
sensitive within a specific time period if it will mature or reprice within that
time period. An institution's interest rate sensitivity gap is defined as the
difference between interest-earning assets and interest-bearing liabilities
maturing or repricing within a given time period. A gap is considered positive
when the amount of interest rate sensitive assets exceeds the amount of interest
rate sensitive liabilities and is considered negative when the amount of
interest rate sensitive liabilities exceeds interest rate sensitive assets.
During a period of falling interest rates, a negative gap would tend to result
in an increase in net interest income, while a positive gap would tend to result
in a decline in net interest income. Conversely, during a period of rising
interest rates, a negative gap would tend to result in a decline in net interest
income, while a positive gap would tend to result in an increase in net interest
income.
The Bank's passbook, statement savings, MMDA and NOW accounts are
generally subject to immediate withdrawal. However, management considers a
portion of these deposits to be core deposits (which consists of passbook,
statement saving, MMDA and NOW accounts) having significantly longer effective
maturities based upon the Bank's experience in retaining such deposits in
changing interest rate environments. Borrowed funds are included in the period
in which they can be called or when they mature.
Management believes that the assumptions used to evaluate the
vulnerability of the Bank's operations to changes in interest rates are
considered reasonable. However, certain shortcomings are inherent in the method
of analysis presented in the table below. For example, although certain assets
and liabilities may have similar maturities or periods to repricing, they may
react in different degrees to changes in market interest rates, while interest
rates on other types may lag behind changes in market rates. Additionally,
certain assets, such as adjustable-rate loans, have features which restrict
changes in market rates both on a short-term and over the life of the asset.
Further, in the event of a change in interest rates, prepayments and early
withdrawal levels would likely deviate significantly from those assumed in
calculating the table.
42
The following table summarizes the Company's interest-earning assets and
interest-bearing liabilities as of September 30, 2004 based on certain
assumptions management has made that affect the rate at which loans will prepay
and the duration of core deposits.
More Than More Than
Within Six to One Year Three
Six Twelve to Three Years to Over Five
(Dollars in thousands) Months Months Years Five Years Years Total
- ------------------------------------------ --------- -------- --------- ---------- --------- ---------
Interest-earning assets:
Loans receivable, net(1) $ 132,095 $ 17,882 $ 46,799 $ 33,886 $ 71,553 $ 302,215
Mortgage-related securities 20,089 19,006 49,496 29,277 17,116 134,984
Loans held for sale 172 -- -- -- -- 172
Investment securities(2) 20,942 2,895 16,400 14,032 24,460 78,729
Interest-earning deposits 12,790 -- -- -- -- 12,790
--------- -------- --------- -------- --------- ---------
Total interest-earning assets $ 186,088 $ 39,783 $ 112,695 $ 77,195 $ 113,129 $ 528,890
--------- -------- --------- -------- --------- ---------
Interest-bearing liabilities:
Deposits $ 104,258 $ 45,290 $ 106,061 $ 74,582 $ 14,689 $ 344,880
Borrowed funds 160,761 -- 10,000 195 193 171,149
Trust preferred securities -- -- -- -- 21,557 21,557
--------- -------- --------- -------- --------- ---------
Total interest-bearing liabilities $ 265,019 $ 45,290 $ 116,061 $ 74,777 $ 36,439 $ 537,586
--------- -------- --------- -------- --------- ---------
Excess (deficiency) of interest-earning
assets over interest-bearing liabilities $ (78,931) $ (5,507) $ (3,366) $ 2,418 $ 76,690 $ (8,696)
========= ======== ========= ======== ========= =========
Cumulative deficiency of interest-earning
assets over interest-bearing liabilities $ (78,931) $(84,438) $ (87,804) $(85,386) $ (8,696)
========= ======== ========= ======== =========
Cumulative deficiency of
interest-earning assets over
interest-bearing liabilities as
a percentage of total assets (13.80)% (14.76)% (15.35)% (14.93)% (1.52)%
========= ======== ========= ======== =========
- --------------------------
(1) Balances have been reduced for non-accruing loans, which amounted to $1.6
million at September 30, 2004.
(2) Balance includes Federal Home Loan Bank stock.
Although an analysis of the interest rate sensitivity gap measure may be
useful, it is limited in its ability to predict trends in future earnings. It
makes no presumptions about changes in prepayment tendencies, deposit or loan
maturity preferences or repricing time lags that may occur in response to a
change in the interest rate environment. As a consequence, the Company also
utilizes an analysis of the market value of portfolio equity, which addresses
the estimated change in the value of the Bank's equity arising from movements in
interest rates. The market value of portfolio equity is estimated by valuing the
Bank's assets and liabilities under different interest rate scenarios. The
extent to which assets gain or lose value in relation to gains or losses of
liabilities as interest rates increase or decrease determines the appreciation
or depreciation in equity on a market value basis. Market value analysis is
intended to evaluate the impact of immediate and sustained shifts of the current
yield curve upon the market value of the Bank's current balance sheet.
The Company utilizes reports prepared by the Office of Thrift Supervision
("OTS") to measure interest rate risk. Using data submitted by the Bank, the OTS
performs scenario analysis to estimate the net portfolio value ("NPV") of the
Bank over a variety of interest rate scenarios. The NPV is defined as the
present value of expected cash flows from existing assets less the present value
of expected cash flows from existing liabilities plus the present value of net
expected cash inflows from existing off-balance sheet contracts.
43
The table below sets forth the Bank's NPV assuming an immediate change in
interest rates of up to 300 basis points and a decline of 100 basis points. Due
to the low prevailing interest rate environment, the OTS did not provide a
calculation for the minus 200 and minus 300 basis point change in rates. Dollar
amounts are expressed in thousands as of September 30, 2004.
Net Portfolio Value
Net Portfolio Value as a % of Assets
--------------------------------------------------------------------------------
Changes in
Rates in Basis Dollar Percentage NPV
Points Amount Change Change Ratio Change
- ---------------------------------------------------------------------------------------------------------
300 $ 34,234 $ (20,658) (38)% 6.21% (315)bp
200 42,324 (12,569) (23) 7.51 (185)
100 49,460 (5,432) (10) 8.60 (76)
0 54,892 -- -- 9.36 --
(100) 54,438 (454) (1) 9.18 (18)
(200) N/A N/A N/A N/A N/A
(300) N/A N/A N/A N/A N/A
As is the case with interest rate sensitivity gap, certain shortcomings
are inherent in the methodology used in the above interest rate risk
measurements. Modeling changes in NPV require the making of certain assumptions
which may or may not reflect the manner in which actual yields and costs respond
to changes in market interest rates. In this regard, the NPV model presented
assumes that the composition of the Bank's interest sensitive assets and
liabilities existing at the beginning of a period remains constant over the
period being measured and also assumes that a particular change in interest
rates is reflected uniformly across the yield curve regardless of the duration
to maturity or repricing of specific assets and liabilities. Although the NPV
measurements and net interest income models provide an indication of the Bank's
interest rate risk exposure at a particular point in time, such measurements are
not intended to and do not provide a precise forecast of the effect of changes
in market interest rates on the Bank's net interest income and may differ from
actual results.
The Company is aware of its interest rate risk exposure in the event of
rapidly rising rates. Due to the Company's recognition of the need to control
interest rate exposure, the Company's current policy is to sell new 30-year
fixed-rate single-family residential mortgage loans into the secondary market.
In addition, in recent years, the Company has emphasized the origination of
construction and land, multi-family and commercial real estate and consumer
loans which generally have either adjustable interest rates and/or shorter
contractual terms than single-family residential loans. The Company plans to
continue these lending strategies.
Derivative financial instruments include futures, forwards, interest rate
swaps, option contracts, and other financial instruments with similar
characteristics. The Company currently does not enter into futures, forwards,
swaps or options. However, the Company is party to financial instruments with
off-balance sheet risk in the normal course of business to meet the financing
needs of our customers. These financial instruments include commitments to
extend credit. These instruments involve, to varying degrees, elements of credit
and interest rate risk in excess of the amount recognized in the consolidated
statements of financial condition. Commitments generally have fixed expiration
dates and may require additional collateral from the borrower if deemed
necessary. Commitments to extend credit are not recorded as an asset or
liability until the instruments are exercised.
The Company is subject to certain market risks and interest rate risks
from the time a commitment is issued to originate new loans. In an effort to
protect the Company against adverse interest rate movements, at the time an
application is taken for a fixed-rate, single-family residential loan, the
Company typically enters into an agreement to sell the loan, or a loan within
the same interest-rate range, into the secondary market. This is known as a
"matched sale" approach and reduces interest-rate risk with respect to these
loans. There is still some portion of these loans which may never close for
various reasons. However, the agencies the Company sells loans to permit some
flexibility in delivering loan product to them. In certain instances, if the
loans delivered for sale do not match the characteristics outlined in the
forward sale commitments, the gain on sale may be reduced.
44
CHANGES IN FINANCIAL CONDITION
GENERAL. Total assets of the Company increased by $12.3 million, or 2.2%,
from $559.6 million at September 30, 2003 to $571.9 million at September 30,
2004. The increase primarily reflected growth of mortgage-related securities
held to maturity and to a lesser extent, loans receivable, partially offset by a
decrease in mortgage-related securities available for sale and investment
securities available for sale. The asset growth was primarily funded by advances
from the FHLB.
CASH AND CASH EQUIVALENTS. Cash and cash equivalents, which consists of
cash on hand and deposited in other banks in interest-earning and
non-interest-earning accounts, amounted to $18.0 million and $21.2 million at
September 30, 2004 and 2003, respectively. The decrease in cash and cash
equivalents was due to a $5.3 million, or 50.3%, decrease in cash due to the
reclassification of deposits resulting in a lower reserve requirement at the
Federal Reserve Bank partially offset by a $2.0 million, or 19.0% increase in
interest-bearing deposits. Cash and cash equivalents are available as a source
of funds for originations of new loans and purchases of additional investment
and mortgage-related securities.
INVESTMENT SECURITIES HELD TO MATURITY AND INVESTMENT SECURITIES AVAILABLE
FOR Sale. Total investment securities decreased by $15.1 million, or 18.0%, from
$84.0 million at September 30, 2003 to $68.9 million at September 30, 2004. The
decrease in investment securities resulted from U.S. agency, municipal and
corporate bonds being called and, to a lesser extent, the sale of certain
investment securities available for sale.
MORTGAGE-RELATED SECURITIES HELD TO MATURITY AND MORTGAGE-RELATED
SECURITIES AVAILABLE FOR SALE. Mortgage-related securities held to maturity and
mortgage-related securities available for sale increased in the aggregate by
$6.8 million, or 5.3%, to $135.0 million at September 30, 2004 compared to
$128.1 million at September 30, 2003. The available for sale portfolio has
decreased by $27.0 million, or 21.7%, as part of the Company's strategy to
reinvest the cash flows into the held to maturity portfolio to minimize the
effect of price volatility to the Company's financial statements as interest
rates increase. The held to maturity portfolio increased $33.9 million to $37.4
million at September 30, 2004.
LOANS HELD FOR SALE. At September 30, 2004, $172,000 of fixed-rate
single-family residential loans were classified as held for sale compared to
$4.5 million at September 30, 2003. The decrease of $4.3 million is due to
management's reevaluation of the Company's asset-liability position and decision
to retain in its residential loan portfolio $4.2 million of the loans originally
intended to be sold in the secondary market. In addition, the decrease is also
related to the reduction in loan refinancings with the increase in interest
rates during the fiscal year. During fiscal year 2004, the Company originated
$9.7 million and sold $9.8 million of such loans.
LOANS RECEIVABLE, NET. Total loans receivable, net, increased to $304.2
million at September 30, 2004 compared to $286.4 million at September 30, 2003.
The increase was primarily due to a $10.2 million, or 30.4%, increase in home
equity loans and lines of credit, a $9.1 million, or 31.4%, increase in
construction loans, a $5.5 million, or 9.3% increase in commercial real estate
loans partially offset by a $2.1 million, or 1.3%, decrease in single-family
residential loans. The Company has continued to sell 30-year fixed-rate
mortgages bearing low interest rates into the secondary market in order to
minimize interest rate risk in a rising interest rate environment.
NON-PERFORMING ASSETS. The Company's total non-performing loans and real
estate owned slightly increased to $3.3 million, or 0.57% of total assets, at
September 30, 2004 compared to $3.0 million, or 0.53% of total assets, at the
end of the prior fiscal year. The increase in non-performing assets in fiscal
2004 was attributable to an increase of $770,000 and $243,000 in non-performing
construction and home equity loans, respectively, partially offset by a decrease
of $271,000 in commercial real estate and business loans along with an $191,000
decrease in real estate owned.
DEPOSITS. Deposits decreased by $17.7 million, or 4.9%, from $362.6
million at September 30, 2003 to $344.9 million at September 30, 2004.
Certificates of deposit decreased by $13.6 million, or 7.6%, to $164.9 million
representing 47.8% of total deposits at September 30, 2004 from $178.5 million,
or 49.2%, of total deposits at September 30, 2003. The decrease was also
attributable to a $4.2 million, or 2.3%, decrease in the Company's core accounts
(non-interest-bearing, NOW, passbook, and MMDA accounts). The decrease in
deposits was due to the Company's unwillingness to increase deposit rates on
certificates of deposit to those paid by the competition.
45
BORROWINGS. The Company's total borrowings increased to $171.1 million at
September 30, 2004 from $136.3 million at September 30, 2003 primarily to offset
the decline in deposits and to fund asset growth. Borrowings had a weighted
average interest rate of 4.36% at September 30, 2004. See Note 9 to the
Consolidated Financial Statements for further information.
EQUITY. At September 30, 2004, total stockholders' equity was $29.7
million, or 5.2% of total assets, compared to $32.4 million, or 5.8% of total
assets, at September 30, 2003. The decrease was due to an unrealized loss on
available for sale securities of $1.3 million, the cost of repurchasing 51,092
shares of common stock at a weighted average cost of $26.21 per share during
fiscal 2004 as well as the cost of purchasing 96,208 shares for the ESOP
combined with dividend payments of $843,000 partially offset by net income for
the year of $2.2 million.
AVERAGE BALANCES, NET INTEREST INCOME AND YIELDS EARNED AND RATES PAID.
The following table sets forth, for the periods indicated, information regarding
(i) the total dollar amount of interest income of the Company from
interest-earning assets and the resultant average yields; (ii) the total dollar
amount of interest expense on interest-bearing liabilities and the resultant
average rate; (iii) net interest income; (iv) interest rate spread; and (v) net
interest margin. Information is based on average daily balances during the
indicated periods; yields were adjusted for the effects of tax-free investments
using the statutory tax rate.
The adjustment of tax exempt securities to a tax equivalent yield in the
table below may be considered to include non-GAAP financial information.
Management believes that it is a standard practice in the banking industry to
present net interest margin, net interest rate spread and net interest income on
a fully tax equivalent basis when a significant proportion of interest-earning
assets are tax-free. Therefore, management believes these measures provide
useful information to investors by allowing them to make peer comparisons. A
GAAP reconciliation also is included below.
YEAR ENDED SEPTEMBER 30,
----------------------------------------------------------------------------------------------
2004 2003
-----------------------------------------------------------------------------------
YIELD/COST
AT AVERAGE Average
SEPT.30, AVERAGE YIELD/ Average Yield/ Average
2004 BALANCE INTEREST COST Balance Interest Cost Balance
----------------------------------------------------------------------------------------------
(Dollars in thousands)
Interest-earning assets:
Loans receivable(1) (2) 5.73% $ 295,701 $ 17,529 5.93% $ 290,357 $ 18,937 6.52% $ 267,208
Mortgage-related securities(2) 3.99 137,256 5,298 3.86 114,833 4,464 3.89 113,827
Investment securities(2) 4.46 83,911 3,597 4.29 84,038 4,094 4.87 76,826
Other interest-earning assets 1.70 12,056 76 0.63 14,390 120 0.83 17,946
---------- --------- ---------- --------- ----------
Total interest-earning
assets 5.00 528,924 26,500 5.01 503,618 27,615 5.48 475,807
---------- --------- ---------- --------- ----------
Non-interest-earning assets 32,847 30,411 27,855
---------- ---------- ----------
Total assets $ 561,771 $ 534,029 $ 503,662
========== ========== ==========
Interest-bearing liabilities:
Deposits 1.66 $ 347,807 5,910 1.70 $ 343,727 7,353 2.14 $ 319,344
FHLB advances and other
borrowings 4.37 155,932 7,126 4.57 131,136 6,983 5.33 127,264
Junior subordinated debentures 8.13 21,576 1,676 7.77 21,613 1,677 7.76 20,658
---------- --------- ---------- --------- ----------
Total interest-bearing
liabilities 2.78 525,315 14,712 2.80 496,476 16,013 3.22 467,266
---------- --------- ---------- --------- ----------
Interest rate spread 2.22% 2.21% 2.26%
==== ==== ====
Non-interest-bearing liabilities 5,565 4,889 5,319
---------- ---------- ----------
Total liabilities 530,880 501,365 472,585
Stockholders' equity 30,891 32,664 31,077
---------- ---------- ----------
Total liabilities and
stockholders' equity $ 561,771 $ 534,029 $ 503,622
========== ========== ==========
Net interest-earning assets $ 3,609 $ 7,142 $ 8,541
========== ========== ==========
Net interest income $ 11,788 $ 11,602
========= =========
Net interest margin(3) 2.23% 2.30%
==== ====
Ratio of average
interest-earning assets to
average interest-bearing
liabilities 100.69% 101.44%
====== ======
--------------------
2002
---------------------
Average
Yield/
Interest Cost
---------------------
Interest-earning assets:
Loans receivable(1) (2) $ 19,379 7.25%
Mortgage-related securities(2) 6,441 5.66
Investment securities(2) 4,509 5.87
Other interest-earning assets 223 1.24
---------
Total interest-earning
assets 30,552 6.42
---------
Non-interest-earning assets
Total assets
Interest-bearing liabilities:
Deposits 9,599 3.01
FHLB advances and other
borrowings 6,941 5.45
Junior subordinated debentures 1,710 8.28
---------
Total interest-bearing
liabilities 18,250 3.90
---------
Interest rate spread 2.52%
====
Non-interest-bearing liabilities
Total liabilities
Stockholders' equity
Total liabilities and
stockholders' equity
Net interest-earning assets
Net interest income $ 12,302
=========
Net interest margin(3) 2.59%
====
Ratio of average
interest-earning assets to
average interest-bearing
liabilities 101.83%
======
- ---------------------------------
(1) Includes non-accrual loans.
(2) Includes assets classified as either available for sale or held for sale.
(3) Net interest income divided by interest-earning assets.
46
Although management believes that the above mentioned non-GAAP financial
measures enhance investor's understanding of the Company's business and
performance, these non-GAAP financials measures should not be considered an
alternative to GAAP. The reconciliation of these non-GAAP financials measures
from GAAP to non-GAAP is presented below.
FOR THE YEAR ENDED SEPTEMBER 30,
-----------------------------------------------------------------------
2004 2003 2002
-----------------------------------------------------------------------
AVERAGE AVERAGE AVERAGE
INTEREST YIELD/COST INTEREST YIELD/COST INTEREST YIELD/COST
-----------------------------------------------------------------------
(Dollars in thousands)
Investment securities - nontaxable $ 3,240 3.86% $ 3,691 4.39% $ 4,078 5.31%
Tax equivalent adjustments 357 403 431
--------- --------- ---------
Investment securities - nontaxable to a
taxable equivalent yield $ 3,597 4.29% $ 4,094 4.87% $ 4,509 5.87%
========= ========= =========
Net interest income $ 11,431 $ 11,199 $ 11,871
Tax equivalent adjustment 357 403 431
--------- --------- ---------
Net interest income, tax equivalent $ 11,788 $ 11,602 $ 12,302
========= ========= =========
Net interest rate spread, no tax
adjustment 2.14% 2.18% 2.52%
Net interest margin, no tax adjustment 2.16% 2.22% 2.59%
RATE/VOLUME ANALYSIS. The following table describes the extent to which
changes in interest rates and changes in the volume of interest-related assets
and liabilities have affected the Company's interest income and expense during
the periods indicated. For each category of interest-earning asset and
interest-bearing liability, information is provided on changes attributable to
(i) changes in volume (change in volume multiplied by prior year rate), (ii)
changes in rate (change in rate multiplied by prior year volume), and (iii)
total change in rate and volume. The combined effect of changes in both rate and
volume has been allocated proportionately to the change due to rate and the
change due to volume. The table below has been prepared on a tax-equivalent
basis.
YEAR ENDED SEPTEMBER 30,
-------------------------------------------------------------
2004 VS. 2003 2003 VS. 2002
-------------------------------------------------------------
INCREASE (DECREASE) DUE TO INCREASE (DECREASE) DUE TO
-------------------------------------------------------------
TOTAL TOTAL
INCREASE INCREASE
RATE VOLUME (DECREASE) RATE VOLUME (DECREASE)
-------- ------ ---------- --------- ------- ----------
Interest-earnings assets:
Loans receivable(1) $ (1,765) $ 357 $ (1,408) $ (3,160) $ 2,718 $ (442)
Mortgage-related securities(1) (32) 866 834 (2,035) 58 (1,977)
Investment securities(1) (2) (491) (6) (497) (927) 512 (415)
Other interest-earning assets (26) (18) (44) (64) (39) (103)
-------- ------ -------- --------- ------- --------
Total interest-earning assets (2,314) 1,199 (1,115) (6,186) 3,249 (2,937)
-------- ------ -------- --------- ------- --------
Interest-bearing liabilities:
Deposits (1,531) 88 (1,443) (3,055) 809 (2,246)
Trust preferred securities 2 (3) (1) (126) 93 (33)
FHLB advances and other borrowings (429) 572 143 (147) 189 42
-------- ------ -------- --------- ------- --------
Total interest-bearing liabilities (1,958) 657 1,301 (3,328) 1,091 (2,237)
-------- ------ -------- --------- ------- --------
Increase (decrease) in net interest income $ (356) $ 542 $ 186 $ (2,858) $ 2,158 $ (700)
======== ====== ======== ========= ======= ========
- ---------------------------------
(1) Includes assets classified as either available for sale or held for sale.
(2) Total decrease in investment securities on a nontaxable equivalent basis
would be $(451) and $(387) for the 2004 and the 2003 comparisons,
respectively, resulting in a increase (decrease) in net interest income of
$232 and $(672), respectively.
47
RESULTS OF OPERATIONS
GENERAL. The Company reported net income of $2.2 million, $2.7 million and
$2.7 million for the years ended September 30, 2004, 2003 and 2002,
respectively.
The $536,000 decrease in net income for the year ended September 30, 2004
compared to the year ended September 30, 2003 was primarily due to a $2.1
million, or 20.2%, increase in non-interest expense partially offset a $613,000,
or 18.7%, increase in non-interest income, a $646,000, or 6.2%, increase in net
interest income after provision for loan loss combined with a $306,000, or
48.4%, decrease in income tax expense.
The $13,000 increase in net income for the year ended September 30, 2003
compared to the year ended September 30, 2002 was primarily due to a $1.0
million, or 45.2%, increase in non-interest income partially offset by a
$846,000, or 7.5%, decrease in net interest income after provision for loan loss
combined with a $205,000, or 48.0%, increase in income tax expense.
NET INTEREST INCOME. Net interest income is determined by the interest
rate spread (the difference between the yields earned on interest-earning assets
and the rates paid on interest-bearing liabilities) and the relative amounts of
interest-earning assets and interest-bearing liabilities. All percentages are
reported on a fully tax-equivalent basis (see the tables on the prior page for a
recalculation of such percentages). The Company's average interest-rate spread
was 2.21%, 2.26% and 2.52% for the years ended September 30, 2004, 2003, and
2002, respectively. The Company's interest-rate spread was 2.22% at September
30, 2004. The Company's net interest margin (net interest income as a percentage
of average interest-earning assets) was 2.23%, 2.30% and 2.59% for the years
ended September 30, 2004, 2003 and 2002, respectively. Due to the continued low
interest rate environment existing during fiscal 2004 and 2003, the interest
rate compression experienced by the Company reflects the effects of the
accelerated rate of repayments and prepayments of loans and mortgage-related
securities experienced by the Company during fiscal 2004 and 2003, requiring it
to reinvest the resulting proceeds at current lower market rates of interest
without a corresponding decrease in the rates paid on deposits and borrowings.
During the latter part of fiscal 2004, refinancing and prepayment activity
significantly slowed down due to increases in market rates of interest. As a
consequence, management anticipates the yield earned on interest-earning assets
to improve, however, with the increase in short-term rates impacting the
Company's interest-bearing liabilities, the Company's net interest spread and
margin will stabilize during fiscal 2005.
Net interest income increased to $11.4 million in fiscal 2004 as compared
to $11.2 million in fiscal 2003. The $231,000, or 2.1%, increase came as a
result of a $1.3 million, or 8.1%, decrease in interest expense partially offset
by a $1.1 million, or 3.9%, decrease in interest income. The increase in net
interest income was primarily due to the historically low interest rate
environment impacting the rates paid on the Company's interest-bearing core
deposits and certificates of deposit which repriced downward to a greater degree
than its interest-earning assets.
Net interest income decreased to $11.2 million in fiscal 2003 as compared
to $11.9 million in fiscal 2002. The $671,000, or 5.7%, decrease resulted from
the $2.9 million, or 9.7%, decrease in interest income partially offset by a
$2.2 million, or 12.3%, decrease in interest expense. The decrease in net
interest income was primarily due to interest-earning assets repricing downward
due to the prolonged low interest rate environment without a corresponding
decrease in rates paid on the Company's interest-bearing liabilities.
INTEREST INCOME. The $1.1 million, or 3.9%, decrease in total interest
income during the year ended September 30, 2004 as compared to fiscal 2003 was
primarily due to a $1.4 million, or 7.4%, decrease in interest on loans
reflecting in large part the 59 basis point decrease in the average yield earned
offset partially by a $5.3 million, or 1.8%, increase in the average balance of
the loan portfolio. The decline in yield was due to the continued low interest
rate environment experienced in fiscal 2004 causing repayments of loans with the
proceeds being reinvested in lower yielding assets. Additionally, interest
income on investment securities and interest-bearing deposits decreased
$495,000, or 13.0%, due to a 45 basis point decrease in the weighted average
yield earned combined with a $2.5 million, or 2.5%, decrease in the average
balance. The decline in the yield was primarily due to the low interest rate
environment resulting in the acceleration of repayment and prepayment of such
securities, the proceeds were being reinvested in lower yielding assets. The
decrease was offset, in part, by an increase in interest income on
mortgage-related securities as a result of a $22.4 million, or 19.5%, increase
in the average balance offset by a 3 basis point decrease in the yield earned on
such assets.
48
The $2.9 million, or 9.7%, decrease in total interest income during the
year ended September 30, 2003 as compared to fiscal 2002 was primarily due to a
$2.0 million, or 30.7%, decrease in interest income from mortgage-related
securities as a result of a 177 basis point decrease in the yield earned offset,
in part, by a $1.0 million, or 0.9%, increase in the average balance of the
mortgage-related securities portfolio. Interest income on loans decreased
$442,000, or 2.3%, due to a 73 basis point decrease in the average yield earned
offset partially by a $23.1 million, or 8.7%, increase in the average balance of
the loan portfolio. The decline in yield was due to the declining interest rate
environment experienced in fiscal 2003 causing accelerated repayments of loans
with the proceeds being reinvested in lower yielding assets. In addition, the
accelerated prepayments of mortgage-related securities resulted in a significant
amortization of premiums. Additionally, interest income on investment securities
and other interest-earning assets decreased $518,000, or 10.9%, due to a 71
basis point decrease in the weighted average yield earned offset partially by a
$3.7 million, or 3.9%, increase in the average balance of such assets.
INTEREST EXPENSE. Total interest expense amounted to $14.7 million for the
year ended September 30, 2004 as compared to $16.0 million for fiscal 2003.
Total interest expense decreased by $1.3 million, or 8.1%, during the year ended
September 30, 2004 compared to fiscal 2003 due to a $1.4 million decrease in
interest expense on deposits partially offset by a $143,000 increase in interest
expense on borrowings. The decrease in interest expense on deposits was due to a
44 basis point decrease in the average rate paid thereon partially offset by a
$4.1 million increase in the average balance of deposits. The increase in
interest expense on borrowings was due to a $24.8 million increase in the
average balance of borrowings offset by a 76 basis point decrease in the average
rate paid. The decrease in the rates paid on deposits and borrowings was due to
declining interest rates experienced during the first three quarters of fiscal
year 2004.
Total interest expense amounted to $16.0 million for the year ended
September 30, 2003 as compared to $18.3 million for fiscal 2002. Total interest
expense decreased by $2.2 million, or 12.3%, during the year ended September 30,
2003 compared to fiscal 2002 due to a $2.2 million and $33,000 decrease in
interest expense on deposits and subordinated debt, respectively, partially
offset by a $42,000 increase in interest expense on borrowings. The decrease in
interest expense on deposits was due to an 87 basis point decrease in the
average rate paid thereon partially offset by a $24.4 million increase in the
average balance of deposits. The increase in interest expense on borrowings was
due to a $3.9 million increase in the average balance of borrowings offset by an
11 basis point decrease in the average rate paid. Deposits grew due to the
Company's continued marketing of its core deposit products and were used to fund
purchases of investment and mortgage-related securities. However, interest
expense decreased primarily due to lower rates paid on deposits and overnight
borrowings resulting from declining interest rates experienced during fiscal
year 2003.
PROVISIONS FOR LOAN LOSSES. Provisions for loan losses are charged to
earnings to maintain the total allowance for loan losses at a level believed by
management to cover all known and inherent losses in the Company's loan
portfolio. Management's analysis includes consideration of the Company's
historical experience, the volume and type of lending conducted by the Company,
the amount of the Company's classified assets, the status of past due principal
and interest payments, general economic conditions, particularly as they relate
to the Company's primary market area, and other factors related to the
collectibility of the Company's loan and loans held for sale portfolios.
Management of the Company assesses the allowance for loan losses on a monthly
basis and makes provisions for loan losses as deemed necessary in order to
maintain the allowance for loan losses at a level management believes covers all
known and inherent losses that are both probable and reasonably estimable. For
the years ended September 30, 2004, 2003 and 2002, the provisions for loan
losses were $300,000, $715,000 and $540,000, respectively. During fiscal 2004,
the Company lowered its provision for loan losses primarily due to its
assessment of the amount of losses and charge-offs as compared to fiscal 2003.
The Company charged off $321,000 in fiscal 2004 compared to $1.1 million in the
prior fiscal year. At September 30, 2004, the Company's allowance for loan
losses totaled $2.0 million which amounted to 100.29% of total non-performing
loans and 0.66% of gross loans receivable. During fiscal 2003, the Company
increased its provision for loan losses as compared to fiscal 2002 primarily due
to its assessment of the amount of losses it would incur with respect to
non-performing commercial real estate loans.
49
NON-INTEREST INCOME. For the year ended September 30, 2004, the Company
reported non-interest income of $3.9 million compared to $3.3 million for the
year ended September 30, 2003. The $613,000, or 18.7%, increase in non-interest
income was due primarily as a result of increases in service charges, realized
gains on sale of securities and other income partially offset by the decline in
the gains on sale of loans and the cash surrender value of certain insurance
policies.
Service charges increased $222,000, or 21.9%, primarily as a result of the
implementation of additional fee-based deposit services in the fourth quarter of
fiscal 2004. For the fiscal year ended September 30, 2004, the net gains on sale
of investment and mortgage-related securities increased $314,000 resulting from
realized gains of $2.0 million on securities partially offset by a $1.1 million
pre-tax other-than-temporary impairment of a perpetual preferred security. See
"Investment and Mortgage-Related Securities." The increase in non-interest
income was also due to a recognition of $550,000 in connection with a repayment
of a commercial real estate loan. Under the terms of the loan, certain
additional contingent payments were due upon repayment of the loan in full. The
rise in mortgage rates experienced in fiscal 2004 reduced the volume of mortgage
refinance activity as compared to fiscal 2003 resulting in a decrease of
$356,000 in the gain on sale of loans. The reduced level of mortgage refinance
activity also resulted in reduced mortgage broker activity and reduced gains on
sale of loans held for sale. In addition, the increase in cash surrender value
experienced a slower appreciation decreased $229,000 primarily due to certain
insurance policies held by the Bank to fund certain supplemental retirement
benefits in the underlying investment of equity securities compared to the same
period last year.
For the year ended September 30, 2003, the Company reported non-interest
income of $3.3 million compared to $2.3 million for the year ended September 30,
2002. The primary reason for the $1.0 million, or 45.2%, increase in
non-interest income in fiscal 2003 were increases of $326,000 and $269,000
increases in gain on the sale of loans and investments and mortgage-related
securities, respectively. These increases were the result of the Company's
strategy to sell certain single-family fixed-rate residential mortgage loans and
to restructure the securities portfolio in order to benefit in the then existing
low interest rate environment. Gain on the sale of loans was partially offset by
the recording of loans held for sale of loans at their fair value. In addition,
due to the overall improvement in the U.S. equities market, the Company
experienced a $303,000 increase in the cash surrender value of certain insurance
policies used to fund certain supplemental retirement benefits.
NON-INTEREST EXPENSE. Non-interest expense include salaries and employee
benefits, occupancy and equipment expense, Federal Deposit Insurance Corporation
(FDIC) deposit insurance premiums, professional fees, data processing expense,
advertising, deposit processing and other items.
Non-interest expense increased $2.1 million, or 20.2%, for the year ended
September 30, 2004 compared to the year ended September 30, 2003 and was
primarily due to a $1.4 million, or 27.0%, increase in compensation and employee
benefit expense. The increase in compensation and employee benefit expense was
attributable to an additional $598,000 expense relating to the funding of a
non-qualified supplemental retirement plan for certain executive officers.
Additionally, the increase occurred due to a $334,000, or 64.7%, increase in the
ESOP expense related to the appreciation of the Company's stock value as well as
the prepayment of the outstanding loan balance on the original loan. In
addition, the Company experienced increase of $463,000 in compensation and
benefit expense was due to the hiring of additional personnel for a new branch
and for building infrastructure in the lending areas, merit increases and
medical costs. In addition, the increase in non-interest expense for fiscal 2004
was due to increases of $148,000, $188,000 and $204,000 in real estate
operations, professional fees and other non-interest expenses, respectively.
Non-interest expense decreased $41,000, or 0.4%, for the year ended
September 30, 2003 compared to the year ended September 30, 2002 primarily due
to the absence of any litigation expenses which amounted $570,000 in fiscal 2002
and which related to the settlement of a lawsuit in the prior year. In addition,
the Company experienced decreases of $99,000 and $74,000 in professional fees
and advertising expenses, respectively, offset, in part by a $562,000 increase
in salaries and employee benefits. Salaries and employee benefits increased
primarily due to the increased cost of the ESOP resulting from the appreciation
of the Company's stock price as well as general compensation increases and the
cost of medical and retirement plans.
50
INCOME TAXES. The Company recognized income tax expense of $326,000, or
12.9%, of pre-tax income, for the year ended September 30, 2004, compared to
$632,000, or 18.7%, of pre-tax income, for the year ended September 30, 2003.
The Company recognized income tax expense of $427,000, or 13.5%, of pre-tax
income, for fiscal 2002. The primary reason for the decrease in the Company's
effective tax rate for fiscal year 2004 was the reduction in income before
income taxes. Comparing fiscal years 2003 and 2002, the increase in the lower
effective tax rate in fiscal 2003 reflected the reduced level of tax-free income
as well as the increase in income before income taxes.
LIQUIDITY AND CAPITAL RESOURCES
The Company's liquidity, represented by cash and cash equivalents, is a
product of its operating, investing and financing activities. The Company's
primary sources of funds are deposits, amortization, prepayments and maturities
of outstanding loans and mortgage-related securities, sales of loans, maturities
of investment securities and other short-term investments, borrowings and funds
provided from operations. While scheduled payments from the amortization of
loans and mortgage-related securities and maturing investment securities and
short-term investments are relatively predictable sources of funds, deposit
flows and loan and mortgage-related securities prepayments are greatly
influenced by general interest rates, economic conditions and competition. In
addition, the Company invests excess funds in overnight deposits and other
short-term interest-earning assets which provide liquidity to meet lending
requirements. The Company has the ability to obtain advances from the FHLB of
Pittsburgh through several credit programs with the FHLB in amounts not to
exceed the Bank's maximum borrowing capacity and subject to certain conditions,
including holding a predetermined amount of FHLB stock as collateral. As an
additional source of funds, the Company has access to the Federal Reserve
discount window, but only after it has exhausted its access to the FHLB of
Pittsburgh. At September 30, 2004, the Company had $166.4 million of outstanding
advances and $3.5 million of overnight borrowings from the FHLB of Pittsburgh.
Liquidity management is both a daily and long-term function of business
management. Excess liquidity is generally invested in short-term investments
such as overnight deposits. On a longer term basis, the Company maintains a
strategy of investing in various lending products and mortgage-related
securities. The Company uses its sources of funds primarily to meet its ongoing
commitments, to pay maturing savings certificates and savings withdrawals, fund
loan commitments and maintain a portfolio of mortgage related and investment
securities. At September 30, 2004, the total of approved loan commitments
outstanding amounted to $2.2 million. At the same date, commitments under unused
lines of credit and loans in process on construction loans amounted to an
aggregate of $51.9 million. Certificates of deposit scheduled to mature in one
year or less at September 30, 2004 totaled $97.4 million. Based upon its
historical experience, management believes that a significant portion of
maturing deposits will remain with the Company.
The OTS requires that the Bank meet minimum regulatory tangible, core,
tier 1 risk-based and total risk based capital requirements. At September 30,
2004, the Bank exceeded all regulatory capital requirements and was deemed a
well capitalized institution for regulatory purposes. See Note 11 to the
Consolidated Financial Statements.
The Company's assets consist primarily of its investment in the Bank and
investments in various corporate debt and equity instruments. Its only material
source of income consists of earnings from its investment in the Bank and
interest and dividends earned on other investments. The Company, as a separately
incorporated holding company, has no significant operations other than serving
as the sole stockholder of the Bank and paying interest to its subsidiaries,
First Keystone Capital Trust I and II, for junior subordinated debt issued in
conjunction with the issuance of trust preferred securities. See Note 17 to the
Consolidated Financial Statements. On an unconsolidated basis, the Company has
no paid employees. The expenses primarily incurred by the Company relate to its
reporting obligations under the Securities Exchange Act of 1934, related
expenses incurred as a publicly traded company, and expenses relating to the
issuance of the trust preferred securities and the junior subordinated
debentures issued in connection therewith. Management believes that the Company
has adequate liquidity available to respond to its liquidity demands. Under
applicable federal regulations, the Bank may pay dividends to the Company (as
sole stockholder) within certain limits after providing written notice to or
obtaining the approval of the OTS. See Note 11 of the Consolidated Financial
Statements.
51
DERIVATIVE FINANCIAL INSTRUMENTS, CONTRACTUAL OBLIGATIONS AND OTHER COMMITMENTS
The Company has not used, and has no intention to use, any significant
off-balance sheet financing arrangements for liquidity purposes. The Company's
primary financial instruments with off-balance sheet risk are limited to loan
servicing for others, its obligations to fund loans to customers pursuant to
existing commitments and commitments to purchase and sell mortgage loans. In
addition, the Company has not had, and has no intention to have, any significant
transactions, arrangements or other relationships with any unconsolidated,
limited purpose entities that could materially affect its liquidity or capital
resources. The Company has not, and does not intend to, trade in commodity
contracts.
We anticipate that we will continue to have sufficient funds and
alternative funding sources to meet our current commitments.
The Company's contractual cash obligations as of September 30, 2004 are as
follows:
PAYMENTS DUE BY PERIOD:
-------------------------------------------------------------
LESS THAN MORE THAN
TOTAL 1 YEAR 1-3 YEARS 3-5 YEARS 5 YEARS
-------- --------- --------- --------- ---------
(DOLLARS IN THOUSANDS)
Federal Home Loan Bank borrowings $171,149 $ 44,610 $ -- $ 40,846 $ 85,693
Operating Leases 2,324 289 392 438 1,205
-------- --------- --------- --------- ---------
Total Obligations $173,473 $ 44,899 $ 392 $ 41,284 $ 86,898
======== ========= ========= ========= =========
OFF-BALANCE-SHEET OBLIGATIONS
The Company is a party to financial instruments with off-balance-sheet
risk in the normal course of business to meet the financing needs of its
customers. These financial instruments include commitments to extend credit and
standby letters of credit. Those instruments involve, to varying degrees,
elements of credit risk in excess of the amount recognized in the balance sheet.
The Company's exposure to credit loss in the event of non-performance by the
other party to the financial instrument for commitments to extend credit and
standby letters of credit is represented by the contractual notional amount of
those instruments. The Company uses the same credit policies in making
commitments and conditional obligations as it does for on-balance-sheet
instruments (see Note 1 of the "Notes to Consolidated Financial Statements"
included in Item 8 herein).
The Company's contingent liabilities and commitments as of September 30,
2004 are as follows:
LESS THAN MORE THAN
TOTAL 1 YEAR 1-3 YEARS 3-5 YEARS 5 YEARS
-------- --------- --------- --------- ---------
(DOLLARS IN THOUSANDS)
Line of Credit $ 37,043(1) $ 9,255 $ 1,717 $ 4,011 $ 22,060
Standby letters of credit 169 169 -- -- --
Other commitments to make loans 2,239 2,239 -- -- --
Undisbursed funds on previous disbursed loans 14,163 3,666 7,991 2,506 --
-------- --------- --------- --------- ---------
Total $ 53,614 $ 15,329 $ 9,708 $ 6,517 $ 22,060
======== ========= ========= ========= =========
- -------------------------------
(1) Includes lines of credit for commercial real estate, commercial loans and
home equity loans.
INVESTMENT AND MORTGAGE-RELATED SECURITIES
The Company reviews the investment and mortgage-related securities
portfolios on a periodic basis to specifically review individual securities for
any meaningful decline in market value below amortized cost. The analysis
addresses all securities whose fair value is significantly below amortized cost
at the time of the analysis, with additional emphasis placed on securities whose
fair value has been below amortized cost for an extended period of time. As part
of the periodic review process, the Company utilizes the expertise of outside
professional asset managers who provide an updated assessment of each issuer's
current credit situation based on recent issuer activities, such as quarterly
earnings announcements or other pertinent financial news for the issuer, recent
developments in a particular industry, economic outlook for a particular
industry and rating agency actions.
52
In addition to issuer-specific financial information and general economic
data, the Company also considers the ability and intent of its operations to
hold a particular security to maturity or until the market value of the security
recovers to a level in excess of the carrying value.
At September 30, 2004, the net unrealized gain on its investment and
mortgage-related securities was $2.7 million, or 1.3% of the amortized cost
basis. The net unrealized gain on its investment assets at September 30, 2003
was $3.6 million, or 4.9% of the amortized cost basis. The net unrealized gain
included gross unrealized gains of $3.9 million and gross unrealized losses of
$1.2 million. Of the securities in an unrealized loss position, the unrealized
loss position longer than 12 months represents $549,000, or 0.27% of its
amortized cost. Securities with an unrealized loss longer than 12 months have a
fair value of $29.0 million, of which $13.2 million are mortgage-related.
For all securities that are in an unrealized loss position for an extended
period of time, an evaluation is performed of the specific events attributable
to the decline in the market value of the security. Factors that are considered
are the length of time and extent to which the security's market value has been
below cost as well as the general market conditions, industry characteristics
and the fundamental operating results of the issuer to determine if the decline
is due to changes in interest rates, changes relating to a decline in credit
quality of the issuer, or general market conditions. An additional part of the
evaluation is the Company's intent and ability to hold the security until its
market value has recovered to a level at least equal to the amortized cost. If
the security's unrealized loss is other than temporary, a realized loss is
recognized in the period in which the decline in value is determined to be other
than temporary.
Based on our evaluation as of September 30, 2004, the Company recognized a
pre-tax other-than-temporary impairment of $1.1 million with respect to one
perpetual preferred security. A number of factors, including the magnitude of
the drop in the market value of the security below the Company's cost and
recovery is not expected in a reasonable amount of time, resulted in
management's determination that the decline in value was other-than-temporary at
the end of the fourth quarter of fiscal 2004. The Company believes that all the
remaining securities with an unrealized loss position are only temporarily
impaired. The Company will continue to review these securities and evaluate the
temporary nature of the impairment on a quarterly basis.
RECENT ACCOUNTING PRONOUNCEMENTS
For discussion of recent accounting pronouncements, see Note 2 of the
Consolidated Financial Statements set forth in Item 8 hereof.
IMPACT OF INFLATION AND CHANGING PRICES
The Consolidated Financial Statements of the Company and related notes
presented herein have been prepared in accordance with accounting principles
generally accepted in the United States of America which require the measurement
of financial position and operating results in terms of historical dollars,
without considering changes in the relative purchasing power of money over time
due to inflation.
Unlike most industrial companies, substantially all of the assets and
liabilities of a financial institution are monetary in nature. As a result,
interest rates have a more significant impact on a financial institution's
performance than the effects of general levels of inflation. Interest rates do
not necessarily move in the same direction or in the same magnitude as the
prices of goods and services, since such prices are affected by inflation to a
larger extent than interest rates. In the current interest rate environment,
liquidity and the maturity structure and repricing characteristics of the
Company's assets and liabilities are critical to the maintenance of acceptable
performance levels.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The information required herein is incorporated by reference to "Asset and
Liability Management" set forth in Item 7 above.
53
[DELOITTE LOGO]
Deloitte Touche LLP
22nd Floor
1700 Market Street
Philadelphia, PA 19103-3984
Tel: 215-246-2300
Fax: 215-569-2441
www.deloitte.com
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
First Keystone Financial, Inc. and subsidiaries
Media, Pennsylvania 19063
We have audited the accompanying consolidated balance sheets of First Keystone
Financial, Inc. and subsidiaries (the "Company") as of September 30, 2004 and
2003, and the related consolidated statements of income, stockholders' equity
and cash flows for each of the three years in the period ended September 30,
2004. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of First Keystone Financial, Inc. and
subsidiaries as of September 30, 2004 and 2003, and the results of their
operations and their cash flows for each of the three years in the period ended
September 30, 2004, in conformity with accounting principles generally accepted
in the United States of America.
As discussed in Note 2, in 2004, the Company adopted the provisions of Financial
Accounting Standards Board Interpretation No. 46 (R).
/s/ Deloitte Touche LLP
December 17, 2004
Member of
DELOITTE TOUCHE TOHMATSU
54
FIRST KEYSTONE FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
SEPTEMBER 30,
---------------------
2004 2003
-------- --------
ASSETS
Cash and amounts due from depository institutions $ 5,185 $ 10,439
Interest-bearing deposits with depository institutions 12,790 10,751
-------- --------
Total cash and cash equivalents 17,975 21,190
Investment securities available for sale 63,615 77,700
Mortgage-related securities available for sale 97,620 124,656
Loans held for sale 172 4,498
Investment securities held to maturity - at amortized cost (approximate fair
value of $5,370 and $6,450 at September 30, 2004 and 2003, respectively) 5,287 6,315
Mortgage-related securities held to maturity - at amortized cost
(approximate fair value of $37,312 and $3,560 at September 30, 2004
and 2003, respectively) 37,363 3,487
Loans receivable (net of allowance for loan losses of $2,039 and $1,986
at September 30, 2004 and 2003, respectively) 304,248 286,421
Accrued interest receivable 2,577 2,654
Real estate owned 1,229 1,420
Federal Home Loan Bank stock, at cost 9,827 8,294
Office properties and equipment, net 4,275 3,427
Deferred income taxes 657 --
Cash surrender value of life insurance 16,110 15,365
Prepaid expenses and other assets 10,964 4,185
-------- --------
Total Assets $571,919 $559,612
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Deposits $344,880 $362,605
Advances from Federal Home Loan Bank and other borrowings 171,149 136,272
Junior subordinated debentures 21,557 21,593
Accrued interest payable 1,095 1,111
Advances from borrowers for taxes and insurance 815 958
Deferred income taxes -- 581
Accounts payable and accrued expenses 2,725 4,104
-------- --------
Total liabilities 542,221 527,224
-------- --------
Commitments and contingencies (see Note 13 and 14) Stockholders' Equity:
Preferred stock, $.01 par value, 10,000,000 shares authorized; none issued
Common stock, $.01 par value, 20,000,000 shares authorized; issued 2,712,556
shares; outstanding at September 30, 2004 and 2003, 1,927,744
and 1,925,337 shares, respectively 14 14
Additional paid-in capital 13,622 13,443
Employee stock ownership plan (3,189) (830)
Treasury stock at cost: 784,812 and 787,219 shares at September 30, 2004
and 2003, respectively (11,913) (11,378)
Accumulated other comprehensive income 1,734 3,069
Retained earnings-partially restricted 29,430 28,070
-------- --------
Total stockholders' equity 29,698 32,388
-------- --------
Total Liabilities and Stockholders' Equity $571,919 $559,612
======== ========
See notes to consolidated financial statements.
55
FIRST KEYSTONE FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
YEAR ENDED SEPTEMBER 30,
----------------------------
2004 2003 2002
------- ------- --------
INTEREST INCOME:
Interest and fees on loans $17,529 $18,937 $ 19,379
Interest and dividends on:
Mortgage-related securities 5,298 4,464 6,441
Investment securities:
Taxable 2,127 2,295 2,445
Tax-exempt 842 1,040 1,203
Dividends 271 356 430
Interest-bearing deposits 76 120 223
------- ------- --------
Total interest income 26,143 27,212 30,121
------- ------- --------
INTEREST EXPENSE:
Interest on:
Deposits 5,910 7,352 9,599
Federal Home Loan Bank advances and other borrowings 7,126 6,983 6,941
Junior subordinated debentures 1,676 1,677 1,710
------- ------- --------
Total interest expense 14,712 16,012 18,250
------- ------- --------
Net interest income 11,431 11,200 11,871
Provision for loan losses 300 715 540
------- ------- --------
Net interest income after provision for loan losses 11,131 10,485 11,331
------- ------- --------
NON-INTEREST INCOME:
Service charges and other fees 1,235 1,013 1,000
Net gain on sale of:
Investments and mortgage-related securities 914 600 331
Loans held for sale 54 410 84
Increase in cash surrender value 731 960 680
Other real estate fees 550 -- --
Other income 415 303 168
------- ------- --------
Total non-interest income 3,899 3,286 2,263
------- ------- --------
NON-INTEREST EXPENSE:
Salaries and employee benefits 6,807 5,358 4,796
Occupancy and equipment 1,253 1,242 1,229
Professional fees 867 679 778
Federal deposit insurance premium 53 55 57
Net cost of operation of other real estate 186 38 (4)
Data processing 478 467 478
Advertising 423 397 471
Litigation settlement -- -- 570
Deposit processing 628 562 515
Other 1,806 1,602 1,551
------- ------- --------
Total non-interest expense 12,501 10,400 10,441
------- ------- --------
Income before income tax expense 2,529 3,371 3,153
Income tax expense 326 632 427
------- ------- --------
Net income $ 2,203 $ 2,739 $ 2,726
======= ======= ========
Earnings per common share:
Basic $ 1.21 $ 1.44 $ 1.42
Diluted $ 1.14 $ 1.35 $ 1.34
See notes to consolidated financial statements.
56
FIRST KEYSTONE FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(DOLLARS IN THOUSANDS)
EMPLOYEE ACCUMULATED RETAINED
ADDITIONAL STOCK OTHER EARNINGS- TOTAL
COMMON PAID-IN OWNERSHIP TREASURY COMPREHENSIVE PARTIALLY STOCKHOLDERS'
STOCK CAPITAL PLAN STOCK INCOME (LOSS) RESTRICTED EQUITY
------ ---------- --------- -------- ------------- ---------- -------------
Balance at October 1, 2001 $ 14 $ 13,536 $ (1,147) $ (8,583) $ 2,664 $ 24,137 $ 30,621
------ ---------- --------- -------- ------------- ---------- -------------
Comprehensive income:
Net income -- -- -- -- -- 2,726 2,726
Other comprehensive income, net of tax:
Net unrealized gain on securities
net of reclassification
adjustment(1) -- -- -- -- 536 -- 536
------ ---------- --------- -------- ------------- ---------- -------------
Comprehensive income -- -- -- -- -- -- 3,262
------ ---------- --------- -------- ------------- ---------- -------------
ESOP stock committed to be released -- -- 152 -- -- -- 152
Excess of fair value above cost of ESOP
shares committed to be released -- 161 -- -- -- -- 161
Exercise of stock options -- (75) -- 421 -- -- 346
Purchase of treasury stock -- -- -- (1,013) -- -- (1,013)
Dividends paid -- -- -- -- -- (734) (734)
------ ---------- --------- -------- ------------- ---------- -------------
Balance at September 30, 2002 14 13,622 (995) (9,175) 3,200 26,129 32,795
------ ---------- --------- -------- ------------- ---------- -------------
Comprehensive income:
Net income -- -- -- -- -- 2,739 2,739
Other comprehensive income, net of tax:
Net unrealized loss on securities
net of reclassification
adjustment(1) -- -- -- -- (131) -- (131)
------ ---------- --------- -------- ------------- ---------- -------------
Comprehensive income -- -- -- -- -- -- 2,608
------ ---------- --------- -------- ------------- ---------- -------------
ESOP stock committed to be released -- -- 165 -- -- -- 165
Excess of fair value above cost of ESOP
shares committed to be released -- 231 -- -- -- -- 231
Exercise of stock options -- (410) -- 783 -- -- 373
Purchase of treasury stock -- -- -- (2,986) -- -- (2,986)
Dividends paid -- -- -- -- -- (798) (798)
------ ---------- --------- -------- ------------- ---------- -------------
Balance at September 30, 2003 14 13,443 (830) (11,378) 3,069 28,070 32,388
====== ========== ========= ======== ============= ========== =============
Comprehensive income:
Net income -- -- -- -- -- 2,203 2,203
Other comprehensive income, net of tax:
Net unrealized loss on securities
net of reclassification
adjustment(1) -- -- -- -- (1,335) -- (1,335)
------ ---------- --------- -------- ------------- ---------- -------------
Comprehensive income -- -- -- -- -- -- 868
------ ---------- --------- -------- ------------- ---------- -------------
ESOP stock committed to be released -- -- 220 -- -- -- 220
Common stock acquired by stock
benefit plan -- -- (2,579) -- -- -- (2,579)
Excess of fair value above cost of ESOP
shares committed to be released -- 417 -- -- -- -- 417
Exercise of stock options -- (238) -- 804 -- -- 566
Purchase of treasury stock -- -- -- (1,339) -- -- (1,339)
Dividends paid -- -- -- -- -- (843) (843)
------ ---------- --------- -------- ------------- ---------- -------------
Balance at September 30, 2004 $ 14 $ 13,622 $ (3,189) $(11,913) $ 1,734 $ 29,430 $ 29,698
====== ========== ========= ======== ============= ========== =============
2004 2003 2002
------- ------ -------
(1) Disclosure of reclassification amount, net of tax for the years ended:
Net unrealized (depreciation) appreciation arising during the year $ (732) $ 265 $ 754
Less: reclassification adjustment for net gains included in net income
(net of tax $311, $204 and $113, respectively) 603 396 218
------- ------ -------
Net unrealized (loss) gain on securities $(1,335) $ (131) $ 536
======= ======= =======
See notes to consolidated financial statements.
57
FIRST KEYSTONE FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
YEAR ENDED SEPTEMBER 30,
-----------------------------------
2004 2003 2002
--------- --------- ---------
OPERATING ACTIVITIES:
Net income $ 2,203 $ 2,739 $ 2,726
Adjustments to reconcile net income to net cash provided by (used in)
operating activities:
Provision for depreciation and amortization 473 426 457
Amortization of premiums and discounts 540 1,203 (4)
Increase in cash surrender value of life insurance (745) (1,003) (341)
(Gain) loss on sales of:
Loans held for sale (54) (410) (84)
Investment securities available for sale (587) (660) (331)
Mortgage-related securities available for sale (306) 60 --
Real estate owned -- 1 (124)
Provision for loan losses 300 715 540
Provision for real estate owned losses -- -- 18
Amortization of ESOP 637 396 384
Deferred income taxes (550) 225 (135)
Changes in assets and liabilities which provided (used) cash:
Origination of loans held for sale (9,671) (30,995) (3,712)
Loans sold in the secondary market 9,814 26,998 3,436
Accrued interest receivable 77 317 382
Prepaid expenses and other assets (6,779) (1,622) (397)
Accrued interest payable (16) (138) (750)
Accrued expenses (1,379) (1,224) 3,619
--------- --------- ---------
Net cash (used in) provided by operating activities (6,043) (2,972) 5,684
--------- --------- ---------
INVESTING ACTIVITIES:
Loans originated (130,824) (174,407) (172,860)
Purchases of:
Investment securities available for sale (8,579) (23,334) (37,909)
Investment securities held to maturity -- (6,329) --
Mortgage-related securities available for sale (22,329) (132,141) (27,511)
Mortgage-related securities held to maturity (37,856) -- --
(Purchase) redemption of FHLB stock (1,533) (1,723) 346
Proceeds from sales of investment and mortgage-related securities
available for sale 16,464 14,600 8,936
Proceeds from sales of real estate owned 376 150 1,003
Principal collected on loans 116,894 175,198 131,402
Proceeds from maturities, calls or repayments of:
Investment securities available for sale 13,454 20,793 12,343
Investment securities held to maturity 1,000 -- --
Mortgage-related securities available for sale 40,344 83,135 58,779
Mortgage-related securities held to maturity 3,924 5,369 2,595
Purchase of property and equipment (1,321) (362) (258)
Net expenditures on real estate owned -- -- (11)
--------- --------- ---------
Net cash used in investing activities (9,986) (39,051) (23,145)
--------- --------- ---------
FINANCING ACTIVITIES:
Net (decrease) increase in deposit accounts (17,725) 31,840 19,164
Net increase in FHLB advances and other borrowings 34,877 10,035 167
Net (decrease) increase in advances from borrowers for taxes and
insurance (143) 126 136
Issuance of junior subordinated debentures -- -- 8,248
Common stock acquired by ESOP (2,579) -- --
Repurchase of junior subordinated debentures -- -- (3,290)
Proceeds from exercise of stock options 566 373 275
Purchase of treasury stock (1,339) (2,986) (1,013)
Cash dividends (843) (798) (734)
--------- --------- ---------
Net cash provided by financing activities 12,814 38,590 22,953
--------- --------- ---------
(Decrease) increase in cash and cash equivalents (3,215) (3,433) 5,492
Cash and cash equivalents at beginning of year 21,190 24,623 19,131
--------- --------- ---------
Cash and cash equivalents at end of year $ 17,975 $ 21,190 $ 24,623
========= ========= =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW AND NON-CASH INFORMATION:
Cash payments for interest on deposits and borrowings $ 14,728 $ 14,522 $ 17,331
Cash payments of income taxes 959 800 650
Fair value adjustment to investments available for sale 1,074 -- --
Transfer of loans held for sale to loan portfolio 4,186 -- --
Transfers of loans receivable into real estate owned 153 2,122 361
See notes to consolidated financial statements.
58
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
1. NATURE OF OPERATIONS AND ORGANIZATION STRUCTURE
The primary business of First Keystone Financial, Inc. (the "Company") is
to act as the holding company for its principal wholly owned subsidiary, First
Keystone Bank (the "Bank"), a federally chartered stock savings association
founded in 1934. The Bank has two active subsidiaries, FKF Management Corp.,
Inc. which manages investment securities, and State Street Services Corporation,
which has ownership interest in a title company as well as a 51% interest in
First Keystone Insurance Services ("First Keystone Insurance"), an insurance
agency, which is consolidated into the Company's financial statements. Effective
with the adoption of FASB Interpretation ("FIN") No. 46 and FIN 46(R) (see
Recent Accounting Pronouncements, below), on December 31, 2003 the Company
deconsolidated First Keystone Capital Trust I and First Keystone Capital Trust
II, collectively, the ("Issuer Trusts").
The primary business of the Bank is to offer a wide variety of commercial
and retail products through its branch system located in Delaware and Chester
counties in Pennsylvania. The Bank is primarily supervised and regulated by the
Office of Thrift Supervision ("OTS").
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The accompanying consolidated financial statements include the accounts of
the Company, the Bank and the Company's and the Bank's wholly owned
subsidiaries. In addition, the Company consolidates First Keystone Insurance for
which one of the Bank's subsidiaries has a 51% ownership interest. The Company
evaluated Statement of Financial Accounting Standards ("SFAS") No. 131,
"Disclosure about Segments of an Enterprise and Related Information," and
determined the Company operates in one segment and that is Banking. Intercompany
accounts and transactions have been eliminated in consolidation.
USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS
The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and the disclosure of contingent assets and
liabilities at the dates of the consolidated financial statements and the
reported amounts of income and expense during the reporting periods. Actual
results could differ from those estimates.
SECURITIES HELD TO MATURITY AND SECURITIES AVAILABLE FOR SALE
Securities held to maturity are carried at amortized cost. Securities are
designated as held to maturity only if the Company has the positive intent and
ability to hold these securities to maturity. Securities available for sale are
carried at fair value with the resulting unrealized gains or losses recorded in
equity, net of tax. For the years ended September 30, 2004 and 2003, the Company
did not maintain a trading portfolio.
OTHER-THAN-TEMPORARY IMPAIRMENT OF SECURITIES
Securities are evaluated on at least a quarterly basis and more frequently
when economic or market conditions warrant such an evaluation to determine
whether a decline in their value is other than temporary. Management utilizes
criteria such as the magnitude and duration of the decline and the intent and
ability of the Company to retain its investment in the issues for a period of
time sufficient to allow for an anticipated recovery in fair value, in addition
to the reasons underlying the decline, to determine whether the loss in value is
other than temporary. The term "other than temporary" is not intended to
indicate that the decline is permanent, but indicates that the prospects for a
near-term recovery of value is not necessarily favorable, or that there is a
lack of evidence to support a realizable value equal to or greater than carrying
value of the investment. Once a decline in value is determined to be other than
temporary, the value of the security is reduced and a corresponding charge to
earnings equal is recognized.
59
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
ALLOWANCE FOR LOAN LOSSES
An allowance for loan losses is maintained at a level that management
considers adequate to provide for probable losses based upon an evaluation of
known and inherent losses in the loan portfolio. Management's evaluation of the
portfolio is based upon past loss experience, current economic conditions and
other relevant factors. While management uses the best information available to
make such evaluation, future adjustments to the allowance may be necessary if
conditions differ substantially from the assumptions used in making the
evaluations.
Impaired loans are predominantly measured based on the fair value of the
collateral. The provision for loan losses charged to expense is based upon past
loan loss experience and an evaluation of probable losses and impairment
existing in the current loan portfolio. A loan is considered to be impaired
when, based upon current information and events, it is probable that the Company
will be unable to collect all amounts due in accordance with the original
contractual terms of the loan. An insignificant delay or insignificant shortfall
in amounts of payments does not necessarily result in the loan being identified
as impaired. For this purpose, delays of less than 90 days are considered to be
insignificant. Large groups of smaller balance homogeneous loans, including
residential real estate and consumer loans, are collectively evaluated for
impairment, except for loans restructured pursuant to a troubled debt
restructuring.
Loans secured by residential real estate, including home equity and home
equity lines of credit, are classified as nonaccrual at 90 days past due, and
are recorded at the lower of cost or market value, less liquidation costs,
unless the loans are well-secured and in the process of collection. Loans other
than consumer loans are charged-off based on the facts and circumstances of the
individual loan. Consumer loans are generally charged-off in the month they
become 180 days past due.
MORTGAGE BANKING ACTIVITIES
The Company originates mortgage loans held for investment and for sale. At
origination, the mortgage loan is identified as either held for sale or for
investment. Mortgage loans held for sale are carried at the lower of cost or
forward committed contracts (which approximates market), determined on a net
aggregate basis.
At September 30, 2004, 2003 and 2002, loans serviced for others totaled
approximately $50,862, $51,547 and $51,826, respectively. Servicing loans for
others consists of collecting mortgage payments, maintaining escrow accounts,
disbursing payments to investors, and processing foreclosures. Loan servicing
income is recorded when earned and includes servicing fees from investors and
certain charges collected from borrowers, such as late payment fees. The Company
has fiduciary responsibility for related escrow and custodial funds aggregating
approximately $318 and $603 at September 30, 2004 and 2003, respectively.
The Company assesses the retained interest in the servicing asset or
liability associated with the sold loans based on the relative fair values. The
servicing asset or liability is amortized in proportion to and over the period
during which estimated net servicing income or net servicing loss, as
appropriate, will be received. Assessment of the fair value of the retained
interest is performed on a continual basis. At September 30, 2004 and 2003,
mortgage servicing rights totaling $240 and $198, respectively, were included in
other assets.
TRANSFERS OF FINANCIAL ASSETS
Transfers of financial assets are accounted for as sales when control over
the assets has been surrendered. Control is surrendered when (1) the assets have
been isolated from the Company, (2) the transferee obtains the right (free of
conditions that constrain it from taking advantage of that right) to pledge or
exchange the transferred assets, and (3) the Company does not maintain effective
control over the transferred assets through an agreement to repurchase them
before their maturity.
INCOME RECOGNITION ON LOANS
Interest on loans is credited to income when earned. Accrual of loan
interest is discontinued and a reserve established through a charge to interest
income on existing accruals if management believes after considering, among
other things, economic and business conditions and collection efforts, that the
borrowers financial condition is such that collection of interest is doubtful.
Payments received on non-accrual loans shall be applied to the oldest unpaid
balance.
60
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
REAL ESTATE OWNED
Real estate owned consists of properties acquired by foreclosure or deed
in-lieu of foreclosure. These assets are initially recorded at the lower of
carrying value of the loan or estimated fair value less selling costs at the
time of foreclosure and at the lower of the new cost basis or net realizable
value thereafter. The amounts recoverable from real estate owned could differ
materially from the amounts used in arriving at the net carrying value of the
assets at the time of foreclosure because of future market factors beyond the
control of the Company. Costs relating to the development and improvement of
real estate owned properties are capitalized and those relating to holding the
property are charged to expense.
OFFICE PROPERTIES AND EQUIPMENT
Office properties and equipment are recorded at cost. Depreciation is
computed using the straight-line method over the expected useful lives of the
assets which range from two to 40 years. The costs of maintenance and repairs
are expensed as they are incurred, and renewals and betterments are capitalized.
CASH SURRENDER VALUE OF LIFE INSURANCE
The Bank funded the purchase of insurance policies on the lives of certain
officers and employees of the Bank. The Company has recognized any increase in
cash surrender value of life insurance, net of insurance costs in the
consolidated statements of income. The cash surrender value of the insurance
policies is recorded as an asset in the statements of financial condition.
INTEREST RATE RISK
At September 30, 2004 and 2003, the Company's assets consisted primarily
of assets that earned interest at either adjustable or fixed interest rates and
the average life of which is longer term. These assets were funded primarily
with shorter term liabilities that have interest rates which vary over time with
market rates and, in some cases, certain call features that are affected by
changes in market rates of interest. The shorter duration of the
interest-sensitive liabilities indicates that the Company is exposed to interest
rate risk because, in a rising rate environment, liabilities will be repricing
faster at higher interest rates, thereby reducing the market value of long-term
assets and net interest income.
EARNINGS PER SHARE
Basic earnings per share ("EPS") is computed based on the weighted average
number of shares of common stock outstanding. Diluted earnings per common share
is computed based on the weighted average number of shares of common stock
outstanding increased by the number of common shares that are assumed to have
been purchased with the proceeds from the exercise of stock options. Weighted
average shares used in the computation of earnings per share were as follows:
YEAR ENDED SEPTEMBER 30,
----------------------------------
2004 2003 2002
--------- --------- ---------
Average common shares outstanding 1,786,047 1,901,682 1,915,818
Increase in shares due to options 106,986 127,310 118,100
--------- --------- ---------
Adjusted shares outstanding - diluted 1,893,033 2,028,992 2,033,918
========= ========= =========
For the years ended September 30, 2004 and 2003, there were no outstanding
options that were antidilutive. For the year ended September 30, 2002, 9,000
shares related to outstanding options were excluded from the calculation of
diluted EPS because the effect was antidilutive.
61
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
INCOME TAXES
Deferred income taxes are recognized for the tax consequences of temporary
differences by applying enacted statutory tax rates applicable to future years
to differences between the financial statement carrying amounts and the tax
bases of existing assets and liabilities. The effect on deferred taxes of a
change in tax rates is recognized in income in the period that includes the
enactment date.
ACCOUNTING FOR STOCK OPTIONS
The Company accounts for stock options in accordance with SFAS No. 123,
"Accounting for Stock-Based Compensation," which allows an entity to choose
between the intrinsic value method, as defined in Accounting Principles Board
("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," or the fair
value method of accounting for stock-based compensation described in SFAS No.
123. An entity using the intrinsic value method must disclose pro forma net
income and earnings per share as if stock-based compensation was accounted for
using the fair value method. The Company continues to account for stock-based
compensation using the intrinsic value method and, accordingly, has not
recognized compensation expense under this method.
Had the Company determined compensation expense based on the fair value at
the grant date for its stock options under SFAS No. 123, the Company's net
income and income per share would have been reduced to the pro forma amounts
indicated below:
YEAR ENDED SEPTEMBER 30,
2004 2003 2002
------ ------ ------
Net income:
As reported $2,203 $2,739 $2,726
Pro forma 2,183 2,665 2,649
Net income per common and common equivalent share:
Earnings per common share - diluted
- As reported $ 1.14 $ 1.35 $ 1.34
- Pro forma 1.13 1.31 1.30
Weighted average fair value of options granted during the
period N/A $ 4.83 $ 9.67
The binomial option-pricing model was used to determine the fair value of
options at the grant date. Significant assumptions used to calculate the above
fair value of the awards are as follows:
SEPTEMBER 30,
-------------------------------
2004 2003 2002
---- ------ -----
Risk-free interest rate of return N/A 3.03% 2.98%
Expected option life (months) N/A 100 100
Expected volatility N/A 27% 73%
Expected dividends N/A 1.8% 2.8%
OTHER COMPREHENSIVE INCOME
The Company presents as a component of comprehensive income the amounts
from transactions and other events which currently are excluded from the
statement of income and are recorded directly to stockholders' equity.
62
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
ACCOUNTING FOR DERIVATIVE INSTRUMENTS
In April 2003, the Financial Accounting Standards Board ("FASB") issued
SFAS Statement No.149, "Amendment of Statement No.133 on Derivative Instruments
and Hedging Activities," which establishes accounting and reporting standards
for derivative instruments, including derivatives imbedded in other contracts
and hedging activities. SFAS No. 133 "Accounting for Derivative Instruments and
Hedging Activities," as amended by SFAS Nos. 137 and 138 and interpreted by the
FASB and the Derivative Implementation Group through Statement 133
Implementation Issues, requires that an entity recognize all derivatives as
either assets or liabilities in the statement of financial condition and measure
those instruments at fair value. In accordance with SFAS No. 149 and SFAS No.
133, the accounting for changes in the fair value of a derivative depends on the
intended use of the derivative and the resulting designation. Currently, the
Company does not have any embedded derivatives and does not employ hedging
activities.
STATEMENT OF CASH FLOWS
For purposes of reporting cash flows, cash and cash equivalents include
cash and amounts due from depository institutions and interest-bearing deposits
with depository institutions.
RECENT ACCOUNTING PRONOUNCEMENTS
In November 2002, the FASB issued FIN No. 45, "Guarantor's Accounting and
Disclosure Requirements for Guarantees, including Indirect Guarantees of
Indebtedness of Others." This Interpretation elaborates on the disclosures to be
made by a guarantor in its interim and annual financial statements about its
obligations under certain guarantees that it has issued. It also clarifies that
a guarantor is required to recognize, at the inception of a guarantee, a
liability for the fair value of the obligation undertaken in issuing the
guarantee. This Interpretation also incorporates, without change, the guidance
in FIN No. 34, "Disclosure of Indirect Guarantees of Indebtedness of Others,"
which is being superseded. The initial recognition and initial measurement
provisions of this Interpretation are applicable on a prospective basis to
guarantees issued or modified after December 31, 2002, irrespective of the
guarantor's fiscal year-end. The disclosure requirements in this Interpretation
are effective for financial statements of interim or annual periods ending after
December 15, 2002. The Company currently has no guarantees that would be
required to be recognized, measured or disclosed under this Interpretation.
In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable
Interest Entities." In December 2003, the FASB issued a revision of FIN 46 (FIN
46(R)). The Interpretation clarifies the application of Accounting Research
Bulletin No. 51, "Consolidated Financial Statements," to certain entities in
which equity investors do not have the characteristics of a controlling
financial interest or do not have sufficient equity at risk for the entity to
finance its activities without additional subordinated financial support from
other parties. The Company has participated in the issue of trust preferred
securities through trusts established for such purpose. These trusts are subject
to the requirements of FIN No. 46 and FIN No. 46(R). Effective December 31,
2003, the Company adopted FIN No. 46(R). requiring the Company to deconsolidate
the trust preferred security trusts. The Company previously classified its trust
preferred securities after total liabilities and before stockholders' equity on
the Consolidated Statements of Financial Condition. Under the provisions of FIN
No. 46(R), these securities were reclassified as borrowed funds effective
December 31, 2003. Additionally, the related dividends were reclassified from
non-interest expense and included in interest expense in the consolidated
statements of income. Reclassifications of prior period amounts were made to
conform to this presentation. The Company is not a party to any other variable
interest entities covered by FIN No. 46(R). The adoption of FIN No. 46(R) did
not have a material impact on the Company's financial statements.
63
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity." This
Statement establishes standards for how an issuer classifies and measures
certain financial instruments with characteristics of both liabilities and
equity. It requires that an issuer classify a financial instrument that is
within its scope as a liability (or an asset in some circumstances). The FASB is
addressing certain implementation issues associated with the application of SFAS
No. 150. In October 2003, the FASB decided to defer certain provisions of SFAS
No. 150 related to mandatorily redeemable financial instruments representing
non-controlling interests in subsidiaries included in consolidated financial
statements. The Company will monitor the actions of the FASB and assess the
impact, if any, that these actions may have on the Company's financial
statements. Currently, the Company has no financial instruments entered into or
modified that require application of this Statement. The adoption of this
Statement did not have a material impact on the Company's financial condition or
results of operations.
In March 2004, the FASB Emerging Issues Task Force ("EITF") reached a
consensus regarding EITF 03-1, "The Meaning of Other-Than-Temporary Impairment
and Its Application to Certain Investments." The consensus provides guidance for
evaluating whether an investment is other-than-temporarily impaired and was
effective for other-than-temporary impairment evaluations made in reporting
periods beginning after June 15, 2004. However, the guidance contained in
paragraphs 10-20 of this Issue has been delayed by FASB Staff Position ("FSP")
EITF Issue 03-1-1, "Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1,
The Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments," posted September 30, 2004. The delay of the effective date for
paragraphs 10-20 will be superseded concurrent with the final issuance of
proposed FSP EITF Issue 03-1a, "Implication Guidance for the Application of
Paragraph 16 of EITF Issue No. 03-1, The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments." The proposed FSP would
provide implementation guidance with respect to debt securities that are
impaired solely due to interest rates and/or sector spreads and analyzed for
other-than-temporary impairment. The disclosures continue to be effective for
the Company's consolidated financial statements for fiscal years ending after
December 15, 2003, for investments accounted for under SFAS No. 115 and No. 124.
For all other investments within the scope of this Issue, the disclosures
continue to be effective for fiscal years ending after June 15, 2005. The
additional disclosures for cost method investments continue to be effective for
fiscal years ending after June 15, 2004.
RECLASSIFICATIONS
Certain reclassifications have been made to the September 30, 2003 and
2002 consolidated financial statements to conform with the September 30, 2004
presentation. Such reclassifications had no impact on the reported net income.
64
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
3. INVESTMENT SECURITIES
The amortized cost and approximate fair value of investment securities
available for sale and investment securities held to maturity are as follows:
SEPTEMBER 30, 2004
--------------------------------------------
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED APPROXIMATE
COST GAIN LOSS FAIR VALUE
--------- ---------- ---------- -----------
Available for Sale:
U.S. Treasury securities and securities
Of U.S. Government agencies:
1 to 5 years $ 14,694 $ -- $ (199) $ 14,495
5 to 10 years -- -- -- --
Municipal obligations 11,963 418 -- 12,381
Corporate bonds 13,309 770 (5) 14,074
Mutual funds 14,009 -- (205) 13,804
Asset-backed securities 1,189 8 -- 1,197
Preferred stocks 3,900 -- -- 3,900
Other equity investments 1,755 2,009 -- 3,764
--------- ---------- ---------- -----------
Total $ 60,819 $ 3,205 $ (409) $ 63,615
--------- ---------- ---------- -----------
Held to Maturity:
Municipal obligations $ 3,260 $ 50 $ -- $ 3,310
Corporate bonds 2,027 33 -- 2,060
--------- ---------- ---------- -----------
Total $ 5,287 $ 83 $ -- $ 5,370
========= ========== ========== ===========
Provided below is a summary of investment securities available for sale
and held to maturity which were in an unrealized loss position at September 30,
2004.
Loss Position Loss Position
Less than 12 Months 12 Months or Longer Total
------------------------ ----------------------- --------------------------
Unrealized Unrealized Unrealized
Fair Value Losses Fair Value Losses Fair Value Losses
---------- ---------- ---------- ---------- ---------- ----------
U.S. Government
and agency bonds $ 12,544 $ (150) $ 1,951 $ (49) $ 14,495 $ (199)
Corporate bonds 1,995 (5) -- -- 1,995 (5)
Mutual fund -- -- 13,804 (205) 13,804 (205)
---------- ---------- ---------- ---------- ---------- ----------
Total $ 14,539 $ (155) $ 15,755 $ (254) $ 30,294 $ (409)
========== ========== ========== ========== ========== ==========
At September 30, 2004, investment securities in a gross unrealized loss
position for twelve months or longer consist of two securities having an
aggregate depreciation of 1.6% from the Company's amortized cost basis.
Management believes that the estimated fair value of the securities disclosed
above is primarily dependent upon the movement in market interest rates.
Although the fair value will fluctuate as the market interest rates move, the
majority of the Company's investment portfolio consists of low risk securities
from government agencies. The Company has the ability and intent to hold these
securities until such time as the value recovers or the securities mature.
Management does not believe any individual unrealized loss as of September 30,
2004 represents an other-than-temporary impairment.
65
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
Based on management's evaluation as of September 30, 2004, the Company
recognized a pre-tax other-than-temporary impairment of $1.1 million resulting
from a determination that a $5.0 million investment available for sale in
Federal Home Loan Mortgage Corporation ("FHLMC") floating rate perpetual
preferred stock was impaired due to its decline in value and a determination
that it is not expected to recover in the near future. The FHLMC preferred stock
is rated AA- and is fully performing.
SEPTEMBER 30, 2003
---------------------------------------------------
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED APPROXIMATE
COST GAIN LOSS FAIR VALUE
--------- ---------- ---------- -----------
Available for Sale:
U.S. Treasury securities and securities
Of U.S. Government agencies:
1 to 5 years $ 13,020 $ 35 $ (51) $ 13,004
5 to 10 years 4,880 139 (31) 4,988
Municipal obligations 14,112 503 -- 14,615
Corporate bonds 17,567 1,288 (332) 18,523
Mutual funds 14,009 -- (57) 13,952
Asset-backed securities 1,911 11 -- 1,922
Preferred stocks 5,474 34 (524) 4,984
Other equity investments 3,126 2,586 -- 5,712
--------- ---------- ---------- -----------
Total $ 74,099 $ 4,596 $ (995) $ 77,700
--------- ---------- ---------- -----------
Held to Maturity:
Municipal obligations $ 3,261 $ 19 $ -- $ 3,280
Corporate bonds 3,054 116 -- 3,170
--------- ---------- ---------- -----------
Total $ 6,315 $ 135 $ -- $ 6,450
========= ========== ========== ===========
For the years ended September 30, 2004, 2003 and 2002, proceeds from sales
of investment securities available for sale amounted to $9,986, $7,309 and
$7,066, respectively. For such periods, gross realized gains on sales amounted
to $1,716, $660 and $351, respectively, while gross realized losses amounted to
$61, $0 and $20, respectively. The tax provision applicable to these net
realized gains and losses amounted to $583, $224 and $112, respectively. Gains
are realized and recorded on specific identification method.
Investment securities with an aggregate carrying value of $4,906 and
$4,930 were pledged as collateral at September 30, 2004 and 2003, respectively
for financings (see Note 8).
66
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
4. MORTGAGE-RELATED SECURITIES
Mortgage-related securities available for sale and mortgage-related
securities held to maturity are summarized as follows:
SEPTEMBER 30, 2004
----------------------------------------------
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED APPROXIMATE
COST GAIN LOSS FAIR VALUE
--------- ---------- ---------- ----------
Available for Sale:
FHLMC pass-through certificates $ 5,838 $ 15 $ (42) $ 5,811
FNMA pass-through certificates 42,805 259 (203) 42,861
GNMA pass-through certificates 1,250 20 -- 1,270
Collateralized mortgage obligations 47,895 141 (358) 47,678
--------- ---------- ---------- -----------
Total $ 97,788 $ 435 $ (603) $ 97,620
========= ========== ========== ===========
Held to Maturity:
FHLMC pass-through certificates $ 16,226 $ 85 $ (101) $ 16,210
FNMA pass-through certificates 20,613 74 (106) 20,581
Collateralized mortgage obligations 524 -- (3) 521
--------- ---------- ---------- -----------
Total $ 37,363 $ 159 $ (210) $ 37,312
========= ========== ========== ===========
Provided below is a summary of mortgage-related securities available for
sale and held to maturity which were in an unrealized loss position at September
30, 2004.
Loss Position Loss Position
Less than 12 Months 12 Months or Longer Total
----------------------- ----------------------- ----------------------
Unrealized Unrealized Unrealized
Fair Value Losses Fair Value Losses Fair Value Losses
---------- ---------- ---------- ---------- ---------- ----------
Pass-through
certificates $ 30,639 $ (285) $ 6,859 $ (167) $ 37,498 $ (452)
Collateralized
mortgage
obligations 26,003 (233) 6,344 (128) 32,347 (361)
---------- ---------- ---------- ---------- ---------- ----------
Total $ 56,642 $ (518) $ 13,203 $ (295) $ 69,845 $ (813)
========== ========== ========== ========== ========== ==========
At September 30, 2004, mortgage-related securities in a gross unrealized
loss position for twelve months or longer consist of seven securities having an
aggregate depreciation of 2.2% from the Company's amortized cost basis.
Management does not believe any individual unrealized loss as of September 30,
2004 represents an other-than-temporary impairment. The unrealized losses
reported for mortgage-related securities relate primarily to securities issued
by the Federal National Mortgage Association, the Federal Home Loan Mortgage
Corporation and private institutions. The majority of the unrealized losses
associated with mortgage-related securities are primarily attributable to
changes in interest rates and not from the deterioration of the creditworthiness
of the issuer.
67
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
SEPTEMBER 30, 2003
-----------------------------------------------
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED APPROXIMATE
COST GAIN LOSS FAIR VALUE
--------- ---------- ---------- -----------
Available for Sale:
FHLMC pass-through certificates $ 6,862 $ 126 $ (38) $ 6,950
FNMA pass-through certificates 45,740 412 (122) 46,030
GNMA pass-through certificates 13,043 596 -- 13,639
Collateralized mortgage obligations 57,961 433 (357) 58,037
--------- ---------- ---------- -----------
Total $ 123,606 $ 1,567 $ (517) $ 124,656
========= ========== ========== ===========
Held to Maturity:
FHLMC pass-through certificates $ 478 $ 22 $ -- $ 500
FNMA pass-through certificates 2,123 40 (3) 2,160
Collateralized mortgage obligations 886 14 -- 900
--------- ---------- ---------- -----------
Total $ 3,487 $ 76 $ (3) $ 3,560
========= ========== ========== ===========
The collateralized mortgage obligations contain both fixed and
adjustable-rate classes of securities which are repaid in accordance with a
predetermined priority. The underlying collateral of the securities consisted of
loans which are primarily guaranteed by FHLMC, FNMA and GNMA.
For the years ended September 30, 2004 and 2003, proceeds from sales of
mortgage-related securities available for sale amounted to $7,174 and $7,485,
respectively. Gross realized gains amounted to $299 and $39 for the years ended
September 30, 2004 and 2003, respectively. Gross realized losses amounted to $4
for the year ended September 30, 2004. The tax provision (benefit) applicable to
these net realized gains and losses amounted to $102 and $(38) for the years
ended September 30, 2004 and 2003, respectively. Gains are realized and recorded
on specific identification method. During the year ended September 30, 2002,
there were no sales of mortgage-related securities.
Mortgage-related securities with aggregate carrying values of $17,064 and
$13,059 were pledged as collateral at September 30, 2004 and 2003, respectively,
for municipal deposits and financings (see Note 8).
5. ACCRUED INTEREST RECEIVABLE
The following is a summary of accrued interest receivable by category:
SEPTEMBER 30,
----------------
2004 2003
----- -------
Loans $1,401 $ 1,438
Mortgage-related securities 524 513
Investment securities 652 703
------ -------
Total $2,577 $ 2,654
====== =======
68
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
6. LOANS RECEIVABLE
Loans receivable consist of the following:
SEPTEMBER 30,
---------------------
2004 2003
-------- --------
Single-family $163,907 $166,042
Construction and land 38,078 28,975
Multi-family and commercial 64,509 59,022
Home equity and lines of credit 43,621 33,459
Consumer loans 1,471 1,438
Commercial loans 10,624 10,161
-------- --------
Total loans 322,210 299,097
Loans in process (15,807) (10,655)
Allowance for loan losses (2,039) (1,986)
Deferred loan fees (116) (35)
-------- --------
Loans receivable net $304,248 $286,421
======== ========
The Company originates loans primarily in its local market area of
Delaware and Chester Counties, Pennsylvania to borrowers that share similar
attributes. This geographic concentration of credit exposes the Company to a
higher degree of risk associated with this economic region.
The Company participated in the origination and sale of fixed-rate
single-family residential loans in the secondary market. The Company recognized
gains on sale of conforming agency loans held for sale of $54, $410 and $84 for
fiscal years ended September 30, 2004, 2003 and 2002, respectively.
The Company offers loans to its directors and senior officers on terms
permitted by Regulation O. There were approximately $2,985, $2,068 and $1,578 of
loans outstanding to senior officers and directors as of September 30, 2004,
2003 and 2002, respectively. The amount of repayments during the years ended
September 30, 2004, 2003 and 2002, totaled $458, $1,038 and $948, respectively.
There were $1,375, $1,527 and $725 of new loans granted during fiscal years
2004, 2003 and 2002, respectively.
The Company had undisbursed portions under consumer and commercial lines
of credit as of September 30, 2004 of $24,863 and $12,690, respectively.
69
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
The Company originates both adjustable and fixed interest rate loans and
purchases mortgage-related securities in the secondary market. The originated
adjustable-rate loans have annual and lifetime interest rate adjustment
limitations and are generally indexed to U.S. Treasury securities plus a fixed
margin. Future market factors may affect the correlation of the interest rate
adjustment with rates the Company pays on the short-term deposits that have been
the primary funding source for these loans. The adjustable-rate mortgage-related
securities adjust to various national indices plus a fixed margin. At September
30, 2004, the composition of these loans and mortgage-related securities was as
follows:
FIXED-RATE
TERM TO MATURITY BOOK VALUE
- ------------------- ----------
1 month to 1 year $ 2,598
1 year to 3 years 3,665
3 years to 5 years 15,800
5 years to 10 years 88,601
Over 10 years 172,545
----------
Total $ 283,209
==========
ADJUSTABLE-RATE
TERM TO RATE ADJUSTMENT BOOK VALUE
- ----------------------- ----------
1 month to 1 year $ 69,396
1 year to 3 years 29,076
3 years to 5 years 59,705
----------
Total $ 158,177
==========
The following is an analysis of the allowance for loan losses:
YEAR ENDED
SEPTEMBER 30,
-----------------------------
2004 2003 2002
------- ------- -------
Beginning balance $ 1,986 $ 2,358 $ 2,181
Provisions charged to income 300 715 540
Charge-offs (321) (1,102) (373)
Recoveries 74 15 10
------- ------- -------
Total $ 2,039 $ 1,986 $ 2,358
======= ======= =======
At September 30, 2004 and 2003, non-performing loans (which include loans
in excess of 90 days delinquent) amounted to approximately $2,033 and $1,556,
respectively. At September 30, 2004, non-performing loans consisted of loans
that were collectively evaluated for impairment.
As of September 30, 2004 and 2003, the Company had impaired loans with a
total recorded investment of $0 and $320, respectively, and an average recorded
investment of $85,000 and $2.3 million, respectively. There was not any cash
basis interest income recognized on these impaired loans during the years ended
September 30, 2004 and 2003. Interest income of approximately $8, $168 and $150,
respectively, was not recognized as interest income due to the non-accrual
status of loans during 2004, 2003 and 2002.
70
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
7. OFFICE PROPERTIES AND EQUIPMENT
Office properties and equipment are summarized by major classification as
follows:
SEPTEMBER 30,
-----------------
2004 2003
------ -------
Land and buildings $7,038 $ 6,082
Furniture, fixtures and equipment 4,921 4,555
------ -------
Total 11,959 10,637
Accumulated depreciation and amortization (7,684) (7,210)
------ -------
Net $4,275 $ 3,427
====== =======
The future minimum rental payments required under operating leases that
have initial or remaining non-cancelable lease terms in excess of one year as of
September 30, 2004 are as follows:
September 30,
2005 $ 289
2006 194
2007 199
2008 214
2009 223
Thereafter 1,205
------
Total minimum future rental payments $2,324
======
Leasehold expense was approximately $356, $375 and $335 for the years
ended September 30, 2004, 2003 and 2002, respectively.
Depreciation expense amounted to $473, $426 and $457 for the years ended
September 30, 2004, 2003 and 2002, respectively.
8. DEPOSITS
Deposits consist of the following major classifications:
SEPTEMBER 30,
-------------------------------------------
2004 2003
------------------- --------------------
AMOUNT PERCENT AMOUNT PERCENT
-------- ------- --------- -------
Non-interest-bearing $ 21,046 6.1% $ 20,917 5.8%
NOW 55,864 16.2 60,221 16.6
Passbook 51,371 14.9 47,089 13.0
Money Market 51,682 15.0 55,889 15.4
Certificates of Deposit 164,917 47.8 178,489 49.2
-------- ------ -------- ------
Total $344,880 100.0% $362,605 100.0%
======== ====== ======== ======
The weighted average interest rates paid on deposits were 1.66% and 1.77%
at September 30, 2004 and 2003, respectively.
Included in deposits as of September 30, 2004 and 2003 are deposits
greater than $100 totaling approximately $96,891 and $103,734, respectively.
Deposits in excess of $100 are not federally insured.
At September 30, 2004 and 2003, the Company had pledged certain
mortgage-related securities aggregating approximately $17,064 and $12,867,
respectively, as collateral for municipal deposits.
71
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
A summary of scheduled maturities of certificates is as follows:
SEPTEMBER 30,
---------------------------
2004 2003
-------- --------
Within one year $ 97,389 $106,631
One to two years 32,530 42,069
Two to three years 10,455 7,962
Thereafter 24,543 21,827
-------- --------
Total $164,917 $178,489
======== ========
A summary of interest expense on deposits is as follows:
YEAR ENDED SEPTEMBER 30,
-----------------------------
2004 2003 2002
------ ------ -------
NOW $ 287 $ 316 $ 401
Passbook 473 530 750
Money Market 606 736 1,036
Certificates of Deposit 4,544 5,771 7,412
------ ------ -------
Total $5,910 $7,353 $ 9,599
====== ====== =======
9. BORROWINGS
A summary of borrowings is as follows:
SEPTEMBER 30,
--------------------
2004 2003
-------- --------
FHLB advances $166,387 $126,403
Repurchase agreements 1,110 2,885
FHLB overnight borrowings 3,500 6,800
Other 152 184
-------- --------
Total borrowings $171,149 $136,272
======== ========
Advances from the FHLB bear fixed interest rates with remaining periods
until maturity, summarized as follows:
SEPTEMBER 30,
--------------------
2004 2003
-------- --------
Over one year through five years (1) $ 80,695 $ 25,704
Over five years through ten years (1) 85,499 100,500
Over 10 years 193 199
-------- --------
$166,387 $126,403
======== ========
(1) Although the remaining maturities of these borrowings are between one and
ten years, the FHLB has the right to convert these advances to
adjustable-rate advances. The amount of FHLB advances with the convertible
feature at September 30, 2004, which are subject to conversion in each of
fiscal 2005 and 2006, is $151.0 million and $15.0 million, respectively.
Included in the table above at September 30, 2004 and 2003 are FHLB
advances whereby the FHLB has the option at predetermined times to convert the
fixed interest rate to an adjustable rate tied to the London Interbank Offered
Rate (LIBOR). The Company then has the option to prepay these advances if the
FHLB converts the interest rate. These advances are included in the periods in
which they mature. The average balance of FHLB advances was $166.4 million with
an average cost of 4.11% for the year ended September 30, 2004.
Advances from the FHLB are collateralized by all FHLB stock owned by the
Bank in addition to a blanket pledge of eligible assets in an amount required to
be maintained so that the estimated fair value of such eligible assets exceeds,
at all times, 110% of the outstanding advances.
72
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
The Company enters into sales of securities under agreements to
repurchase. These agreements are recorded as financing transactions, and the
obligation to repurchase is reflected as a liability in the consolidated
statements of financial condition. The securities underlying the agreements are
delivered to the dealer with whom each transaction is executed. The dealers, who
may sell, loan or otherwise dispose of such securities to other parties in the
normal course of their operations, agree to resell to the Company substantially
the same securities at the maturities of the agreements. The Company retains the
right of substitution of collateral throughout the terms of the agreement.
At September 30, 2004, outstanding FHLB repurchase agreements were secured
by U.S. Government securities. The average balance of FHLB repurchase agreements
during the year ended September 30, 2004 was $2.3 with an average cost of 27
basis points. The maximum amount outstanding at any month end during the year
ended September 30, 2004 was $2.9 million.
At September 20, 2003, outstanding FHLB repurchase agreements were secured
by US Government securities. The average balance of FHLB repurchase agreements
during the year ended September 30, 2003 was $8 with an average cost of 25 basis
points. The maximum amount outstanding at any month end during the year ended
September 30, 2003 was $2.9 million.
10. INCOME TAXES
The Company and its subsidiaries file a consolidated federal income tax
return. The Company uses the specific charge-off method for computing reserves
for bad debts. The bad debt deduction allowable under this method is available
to large banks with assets of greater than $500 million. Generally, this method
allows the Company to deduct an annual addition to the reserve for bad debts
equal to its net charge-offs.
Retained earnings at September 30, 2004 and 2003 included approximately
$2.5 million representing bad debt deductions for which no income tax has been
provided.
Income tax expense is comprised of the following:
YEAR ENDED SEPTEMBER 30,
-------------------------
2004 2003 2002
----- ----- ----
Federal:
Current $876 $407 $562
Deferred (550) 225 (135)
State -- -- --
---- ---- ----
Total $326 $632 $427
==== ==== ====
The tax effect of temporary differences that give rise to significant
portions of the deferred tax accounts, calculated at 34%, is as follows:
SEPTEMBER 30,
----------------
2004 2003
---- ----
Deferred tax assets:
Accelerated depreciation $ 402 $ 374
Allowance for loan losses 695 689
Realized loss on available for sale securities 374 --
Accrued expenses 507 297
Other -- --
--------- --------
Total deferred tax assets 1,978 1,360
========= ========
Deferred tax liabilities:
Deferred loan fees (303) (310)
Unrealized gain on available for sale securities (893) (1,581)
Other (125) (50)
--------- --------
Total deferred tax liabilities (1,321) (1,941)
--------- --------
Net deferred income taxes $ 657 $ (581)
========= ========
73
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
The Company's effective tax rate is less than the statutory federal income tax
rate for the following reasons:
YEAR ENDED SEPTEMBER 30,
---------------------------------------------------------------------
2004 2003 2002
---------------------------------------------------------------------
PERCENTAGE PERCENTAGE PERCENTAGE
OF PRETAX OF PRETAX OF PRETAX
AMOUNT INCOME AMOUNT INCOME AMOUNT INCOME
------- ---------- ------- ---------- ------- ----------
Tax at statutory rate $ 860 34.0% $ 1,146 34.0% $ 1,072 34.0%
Decrease in taxes resulting from:
Tax exempt interest, net (246) (9.7) (274) (8.2) (290) (9.2)
Increase in cash surrender value (206) (8.2) (223) (6.6) (231) (7.4)
Dividend received deduction (49) (1.9) (45) (1.3) (59) (1.9)
Other (33) (1.3) 28 0.8 (65) (2.0)
------- ---- ------- ---- ------- ----
Total $ 326 12.9% $ 632 18.7% $ 427 13.5%
======= ==== ======= ==== ======= ====
11. REGULATORY CAPITAL REQUIREMENTS
The Bank is subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum regulatory
capital requirements can result in certain mandatory, and possibly additional
discretionary, actions by regulators that, if undertaken, could have a direct
material effect on the Company's financial statements. Under capital adequacy
guidelines and the regulatory framework for prompt corrective action, the Bank
must meet specific capital guidelines that involve quantitative measures of the
Bank's assets, liabilities, and certain off-balance sheet items as calculated
under regulatory accounting practices. The Bank's capital amounts and
classification are also subject to qualitative judgments by regulators about
components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Bank to maintain minimum amounts and ratios (set forth below) of
tangible and core capital (as defined in the regulations) to adjusted assets (as
defined), and of Tier I and total capital (as defined) to average assets (as
defined). Management believes, as of September 30, 2004, that the Bank meets all
capital adequacy requirements to which it is subject.
As of September 30, 2004, the most recent notification from the OTS
categorized the Bank as well capitalized under the regulatory framework for
prompt corrective action. To be considered as well capitalized, the Bank must
maintain minimum total risk-based, Tier-1 risk-based, and Tier-1 core capital
ratios as set forth in the table below. There are no conditions or events since
that notification that management believes have changed the institution's
category.
REQUIRED FOR WELL CAPITALIZED
CAPITAL ADEQUACY UNDER PROMPT
ACTUAL PURPOSE CORRECTIVE ACTION
-----------------------------------------------------------------------
AMOUNT PERCENTAGE AMOUNT PERCENTAGE AMOUNT PERCENTAGE
----------- ----------- ----------- ----------- ----------- -----------
At September 30, 2004:
Core Capital (to Adjusted Tangible Assets) $46,535 8.21% $22,667 4.0% $28,334 5.0%
Tier I Capital (to Risk-Weighted Assets) 46,535 14.03 N/A N/A 19,905 6.0
Total Capital (to Risk-Weighted Assets) 48,300 14.56 26,540 8.0 33,175 10.0
Tangible Capital (to Tangible Assets) 46,535 8.21 8,500 1.5 N/A N/A
At September 30, 2003:
Core Capital (to Adjusted Tangible Assets) $43,852 8.0% $21,972 4.0% $27,465 5.0%
Tier I Capital (to Risk-Weighted Assets) 43,852 14.4 N/A N/A 18,268 6.0
Total Capital (to Risk-Weighted Assets) 45,564 15.0 24,357 8.0 30,446 10.0
Tangible Capital (to Tangible Assets) 43,852 8.0 8,240 1.5 N/A N/A
74
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
The Bank's capital at September 30, 2004 and 2003 for financial statement
purposes differs from tangible, core (leverage), and Tier-1 risk-based capital
amounts by $16,767 and $11,464, respectively, representing the inclusion for
regulatory capital purposes of unrealized gain on securities available for sale
and a portion of capital securities (see Note 17) that qualifies as regulatory
capital as well as adjustments to the Bank's capital that do not affect the
parent company.
At September 30, 2004 and 2003, total risk-based capital, for regulatory
requirements, was increased by $1,765 and $1,712, respectively, of general loan
loss reserves, for a total of $48,300 and $45,564, respectively.
At the date of the Bank's conversion from the mutual to stock form in
January 1995 (the "Conversion"), the Bank established a liquidation account in
an amount equal to its retained income as of August 31, 1994. The liquidation
account is maintained for the benefit of eligible account holders and
supplemental eligible account holders who continue to maintain their accounts at
the Bank after the Conversion. The liquidation account is reduced annually to
the extent that eligible account holders and supplemental eligible account
holders (as such terms are defined in the Bank's plan of conversion) have
reduced their qualifying deposits as of each anniversary date. Subsequent
increases in such balances will not restore an eligible account holder's or
supplemental eligible account holder's interest in the liquidation account. In
the event of a complete liquidation of the Bank, each eligible account holder
and supplemental eligible account holder will be entitled to receive a
distribution from the liquidation account in an amount proportionate to the
current adjusted qualifying balances for accounts then held.
The principal source of cash flow for the Company is dividends from the
Bank. Various federal banking regulations and capital guidelines limit the
amount of dividends that may be paid to the Company by the Bank. Future payment
of dividends by the Bank is dependent on individual regulatory capital
requirements, levels of profitability, and safety and soundness concerns. In
addition, loans or advances made by the Bank to the Company are generally
limited to 10 percent of the Bank's capital stock and surplus on a secured
basis. Accordingly, funds available for loans or advances by the Bank to the
Company amounted to $4,694.
12. EMPLOYEE BENEFITS
401(k) PROFIT SHARING PLAN
The Bank's 401(k) profit sharing plan covers substantially all full-time
employees of the Company and provides for pre-tax contributions by the employees
with matching contributions at the discretion of the Board of Directors
determined at the beginning of the calendar year. All amounts are fully vested.
For calendar years 2003, 2002 and 2001, the Company matched twenty-five cents
for every dollar contributed up to 5% of a participant's salary. The profit
sharing expense for the plan was $37, $38 and $36 for the years ended September
30, 2004, 2003 and 2002, respectively.
EMPLOYEE STOCK OWNERSHIP PLAN
In connection with the Conversion, the Company established an employee
stock ownership plan ("ESOP") for the benefit of eligible employees. During
fiscal 2004, the ESOP purchased an additional 96,208 shares of common stock. At
September 30, 2004, 263,493 shares were committed to be released, of which
24,669 shares have not yet been allocated to participant accounts. The Company
accounts for its ESOP in accordance with AICPA Statement of Position 93-6,
"Employers Accounting for Employee Stock Ownership Plans," which requires the
Company to recognize compensation expense equal to the fair value of the ESOP
shares during the periods in which they become committed to be released. To the
extent that the fair value of the ESOP shares released differs from the cost of
such shares, this difference is charged or credited to equity as additional
paid-in capital. Management expects the recorded amount of expense in any given
period to fluctuate from period to period as continuing adjustments are made to
reflect changes in the fair value of the ESOP shares. The Company's ESOP, which
is internally leveraged, does not report the loans receivable extended to the
ESOP as assets and does not report the ESOP debt due the Company. The Company
recorded compensation and employee benefit expense related to the ESOP of $850,
$516 and $395 for the years ended September 30, 2004, 2003 and 2002,
respectively.
75
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
RECOGNITION AND RETENTION PLAN
Under the 1995 Recognition and Retention Plan and Trust (the "RRP"), there
are 81,600 shares authorized under the RRP. At September 30, 2002, the Company
awarded 79,350 shares to the Company's non-employee directors and executive
officers subject to vesting and other provisions of the RRP. At September 30,
2004, all the shares awarded had been allocated to plan participants. Since all
the shares awarded have been allocated, no compensation expense was recognized
relating to the RRP for fiscal years ended September 30, 2004, 2003 and 2002.
STOCK OPTION PLANS
Under the 1995 Stock Option Plan (the "Option Plan"), common stock
totaling 272,000 shares has been reserved for issuance pursuant to the exercise
of options. During fiscal year 1999, stockholders approved the adoption of the
1998 Stock Option Plan ("1998 Option Plan") (collectively with the Option Plan,
the "Plans") which reserves an additional 111,200 shares of common stock for
issuance. Options covering an aggregate of 357,106 shares have been granted to
the Company's executive officers, nonemployee directors and other key employees,
subject to vesting and other provisions of the Plans. At September 30, 2004,
2003 and 2002, the number of shares exercisable was 181,023, 210,209 and
261,913, respectively, and the weighted average exercise price of those options
was $9.84, $9.19 and $8.91, respectively.
The following table summarizes transactions regarding the stock option
plans:
Weighted
Average
Number of Exercise Exercise Price
Option Shares Price Range per share
------------- --------------- --------------
Outstanding at October 1, 2001 324,533 $ 7.50 - 14.25 $ 9.11
Granted 13,300 14.84 - 16.15 15.73
Exercised (30,856) 7.50 - 12.38 7.97
------------- --------------- -------------
Outstanding at September 30, 2002 306,977 $ 7.50 - 16.15 $ 9.52
Granted 3,000 16.15 - 16.15 16.15
Exercised (62,678) 7.50 - 14.25 8.79
------------- --------------- -------------
Outstanding at September 30, 2003 247,299 $ 7.50 - 16.15 $ 9.78
Granted -- -- --
Exercised (54,436) $ 7.50 - 14.25 8.39
------------- --------------- -------------
Outstanding at September 30, 2004 192,863 $ 7.50 - 16.15 $ 10.17
============= =============== =============
A summary of the exercise price range at September 30, 2004 is as
follows:
Weighted Average Weighted Average
Number of Option Remaining Contractual Exercise Price per
Shares Exercise Price Range Life Share
- ------------------- ------------------------ ------------------------- ---------------------
101,743 $ 7.50 - 10.13 1.31 $ 7.66
91,120 12.13 - 16.15 5.50 12.96
------- ---------------
192,863 $ 7.50 - 16.15 3.29 $10.17
======= =============== ==== ======
76
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
SUPPLEMENTAL RETIREMENT BENEFITS
During fiscal 2004, the Bank implemented a defined contribution
supplemental executive retirement plan (the "SERP") covering certain senior
executive officers of the Bank. For the initial year of the SERP, the crediting
rate on the amounts contributed was established at 5.0% and will remain in
effect until such time that the Company's Compensation Committee administering
the SERP chooses to change it. Upon retirement of a participant, he or she will
receive his or her account balance paid out in equal annual payments for a
period not to exceed 15 years provided that a participant did not make a prior
election to receive his or her distribution in a lump sum. The SERP also
provides for benefits in the event of the death of the participant or the
termination of the employment of the participant subsequent to a change in
control of the Company.
In addition, the Bank previously maintained split dollar insurance
arrangements with certain senior executive officers. Such arrangements were
terminated in December 2003. For the fiscal years ended September 30, 2004 and
2003, the pension expense relating to supplemental retirement benefits was
approximately $837 and $444, respectively. For fiscal year ended September 30,
2002, the pension expense of $431 was related to the write-down in the cash
surrender value of certain life insurance policies established for the purpose
of providing such supplemental retirement benefits.
The Bank also provides supplemental retirement benefits to certain
directors and Advisory Board members. The expense relating to this plan was
approximately $88, $65 and $18 for the years ended September 30, 2004, 2003 and
2002, respectively.
13. DERIVATIVE FINANCIAL INSTRUMENTS
The Company concurrently adopted the provisions of SFAS No. 133, and SFAS
No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging
Activities -- an amendment of FASB Statement No. 133" on October 1, 2000. The
Company adopted the provisions of SFAS No. 149 effective July 1, 2003. The
Company's derivative instruments outstanding during fiscal year end September
30, 2004 include commitments to fund loans held-for-sale and forward loan sale
agreements.
The Company adopted new accounting requirements relating to SFAS No. 149
which requires that mortgage loan commitments related to loans originated for
sale be accounted for as derivative instruments. In accordance with SFAS No. 133
and SFAS No. 149, derivative instruments are recognized in the statement of
financial condition at fair value and changes in the fair value thereof are
recognized in the statement of operations. The Company originates single-family
residential loans for sale pursuant to programs with FHLMC. Under the structure
of the programs, at the time the Company initially issues a loan commitment in
connection with such programs, it does not lock in a specific interest rate. At
the time the interest rate is locked in by the borrower, the Company
concurrently enters into a forward loan sale agreement with respect to the sale
of such loan at a set price in an effort to manage the interest rate risk
inherent in the locked loan commitment. The forward loan sale agreement also
meets the definition of a derivative instrument under SFAS No. 133. Any change
in the fair value of the loan commitment after the borrower locks in the
interest rate is substantially offset by the corresponding change in the fair
value of the forward loan sale agreement related to such loan. The period from
the time the borrower locks in the interest rate to the time the Company funds
the loan and sells it to FHLMC is generally 60 days. The fair value of each
instrument will rise or fall in response to changes in market interest rates
subsequent to the dates the interest rate locks and forward loan sale agreements
are entered into. In the event that interest rates rise after the Company enters
into an interest rate lock, the fair value of the loan commitment will decline.
However, the fair value of the forward loan sale agreement related to such loan
commitment should increase by substantially the same amount, effectively
eliminating the Company's interest rate and price risk.
At September 30, 2004, the Company had $1.3 million of loan commitments
outstanding related to loans being originated for sale which were subject to
interest rate locks. At September 30, 2004, the Company had $1.3 million of
forward loan sale agreements. The Company concluded that the fair value of these
derivative instruments involving loan commitments were not material to the
consolidated statements of the financial condition and operations of the Company
as of and for the year ended September 30, 2004.
77
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
14. COMMITMENTS AND CONTINGENCIES
The Company has outstanding loan commitments, excluding undisbursed
portion of loans in process and equity lines of credit, of approximately $2,239
and $5,922 as of September 30, 2004 and 2003, respectively, all of which are
expected to be funded within four months. Of these commitments outstanding, the
breakdown between fixed and adjustable-rate loans is as follows:
SEPTEMBER 30,
-----------------
2004 2003
-------- --------
Fixed-rate (ranging from 4.74% to 6.25%) $1,924 $5,578
Adjustable-rate 315 344
------ ------
Total $2,239 $5,922
====== ======
Depending on cash flow, interest rate, risk management and other
considerations, longer term fixed-rate residential loans are sold in the
secondary market. There was approximately $1,256 and $1,307 in outstanding
commitments to sell loans at September 30, 2004 and 2003, respectively.
In the fourth quarter of fiscal 2002, the Company settled a lawsuit
related to certain loan sales. The lawsuit was instituted by the purchaser of
five residential mortgage loans from the Bank that alleged that it suffered
losses in connection with these loans and that the Bank was required to purchase
the loans or compensate the purchaser for its alleged losses. The Bank settled
all the purchaser's claims for $570.
There are various claims and pending actions against the Company and its
subsidiaries arising out of the conduct of its business. In the opinion of the
Company's management and based upon advice of legal counsel, the resolution of
these matters will not have a material adverse impact on the consolidated
financial position or the results of operations of the Company and its
subsidiaries.
15. RELATED PARTY TRANSACTIONS
The Company retains the services of a law firm in which one of the
Company's directors is a member. In addition to providing general legal counsel
to the Company, the firm also prepares mortgage documents and attends loan
closings for which it is paid directly by the borrower.
The Company utilizes two of the Company's directors as consultants on
various real estate and general business matters. In addition, one of the
Company's board members has an interest in an insurance agency, First Keystone
Insurance Services, LLC, in which one of the Bank's subsidiaries has a 51%
ownership interest and, therefore, First Keystone Insurance is consolidated with
the Company's financial statements.
78
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
16. FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair value amounts have been determined by the Company using
available market information and appropriate valuation methodologies. However,
considerable judgment is required to interpret market data to develop the
estimates of fair value. Accordingly, the estimates presented herein are not
necessarily indicative of the amounts the Company could realize in a current
market exchange. The use of different market assumptions and/or estimation
methodologies may have a material effect on the estimated fair value amounts.
SEPTEMBER 30,
----------------------------------------------------
2004 2003
----------------------------------------------------
CARRYING/ ESTIMATED CARRYING/ ESTIMATED
NOTIONAL FAIR NOTIONAL FAIR
AMOUNT VALUE AMOUNT VALUE
-------- --------- -------- ---------
Assets:
Cash and cash equivalents $ 17,975 $ 17,975 $ 21,190 $ 21,190
Investment securities 68,902 68,985 84,015 84,150
Loans 304,248 299,287 286,421 287,996
Loans held for sale 172 172 4,498 4,498
Mortgage-related securities 134,983 134,932 128,143 129,646
FHLB stock 9,827 9,827 8,294 8,294
Liabilities:
Passbook deposits 51,371 51,371 47,089 47,089
NOW and money market deposits 107,546 107,546 116,110 116,110
Certificates of deposit 164,917 163,801 178,489 179,699
Borrowings 171,149 171,416 136,272 137,709
Off balance sheet commitments 51,921 51,921 43,024 43,024
The fair value of cash and cash equivalents is their carrying value due to
their short-term nature. The fair value of investments and mortgage-related
securities is based on quoted market prices, dealer quotes, and prices obtained
from independent pricing services. The fair value of loans is estimated, based
on present values using approximate current entry value interest rates,
applicable to each category of such financial instruments. The fair value of
FHLB stock approximates its carrying amount.
The fair value of NOW deposits, money market deposits and passbook
deposits is the amount reported in the financial statements. The fair value of
certificates of deposit and FHLB advances is based on a present value estimate,
using rates currently offered for deposits and borrowings of similar remaining
maturity.
Fair values for off-balance sheet commitments are based on fees currently
charged to enter into similar agreements, taking into account the remaining
terms of the agreements and the counterparties credit standings.
No adjustment was made to the entry-value interest rates for changes in
credit performing commercial loans, construction loans, and land loans for which
there are no known credit concerns. Management believes that the risk factor
embedded in the entry-value interest rates, along with the general reserves
applicable to the performing commercial, construction, and land loan portfolios
for which there are no known credit concerns, result in a fair valuation of such
loans on an entry-value basis. The fair value of non-performing loans, with a
recorded book value of approximately $2,033 and $1,556 (which are collateralized
by real estate properties with property values in excess of carrying amounts) as
of September 30, 2004 and 2003, respectively, was not estimated because it is
not practicable to reasonably assess the credit adjustment that would be applied
in the marketplace for such loans. The fair value estimates presented herein are
based on pertinent information available to management as of September 30, 2004
and 2003. Although management is not aware of any factors that would
significantly affect the estimated fair value amounts, such amounts have not
been comprehensively revalued for purposes of these financial statements since
September 30, 2004 and 2003 and, therefore, current estimates of fair value may
differ significantly from the amounts presented herein.
79
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
17. CAPITAL SECURITIES
The Company had previously established Issuer Trusts that issued
guaranteed preferred beneficial interests in the Company's junior subordinated
debentures. Prior to FIN 46 and FIN 46 (R), the Company classified its Issuer
Trusts after total liabilities and before shareholders' equity on its
consolidated statement of financial position under the caption "Guaranteed
Preferred Beneficial Interest in Company's Subordinated Debt" and the retained
common capital securities of the Issuer Trusts were eliminated against the
Company's investment in the Issuer Trusts. Distributions on the preferred
securities were recorded as interest expense on the consolidated statement of
income. Under the provisions of FIN 46 (R), these securities were reclassified
as borrowed funds.
As a result of the adoption of FIN 46 and FIN 46 (R), the Company
deconsolidated all the Issuer Trusts. As a result, the junior subordinated
debentures issued by the Company to the Issuer Trusts, totaling $21.6 million,
are reflected in the Company's consolidated statement of financial position in
the liabilities section at September 30, 2004, under the caption "Junior
Subordinated Debentures." The Company records interest expense on the
corresponding debentures in its consolidated statements of income. The Company
also recorded the common capital securities issued by the Issuer Trusts in
"Prepaid expenses and other assets" in its consolidated statement of financial
position at September 30, 2004.
On August 21, 1997, First Keystone Capital Trust I (the "Trust"), a trust
formed under Delaware law, that is a subsidiary of the Company, issued $16.2
million of preferred securities (the "Preferred Securities") at an interest rate
of 9.7%, with a scheduled maturity of August 15, 2027. The Company owns all the
common stock of the Trust. The proceeds from the issue were invested in Junior
Subordinated Debentures (the "Debentures") issued by the Company. The Debentures
are unsecured and rank subordinate and junior in right of payment to all
indebtedness, liabilities and obligations of the Company. On November 15, 2001,
the Company purchased $3.5 million of the Preferred Securities. Debentures
represent the sole assets of the Trust. Interest on the Preferred Securities is
cumulative and payable semiannually in arrears. The Company has the option,
subject to required regulatory approval, if any, to prepay the securities
beginning August 15, 2007. The Company has, under the terms of the Debentures
and the related Indenture as well as the other operative corporate documents,
agreed to irrevocably and unconditionally guarantee the Trust's obligations
under the Debentures. The Company contributed approximately $6.0 million of the
net proceeds to the Bank to support the Bank's lending activities.
On November 28, 2001, First Keystone Capital Trust II (the "Trust II"), a
trust formed under Delaware law, that is a subsidiary of the Company, issued
$8.0 million of securities ("Preferred Securities II") in a pooled securities
offering at a floating rate of 375 basis over the six month LIBOR with a
maturity date of December 8, 2031. The Company owns all the common stock of the
Trust II. The proceeds from the issue were invested in Junior Subordinated
Debentures (the "Debentures II") issued by the Company. The Debentures II are
unsecured and rank subordinate and junior in right of payment to all
indebtedness, liabilities and obligations of the Company. The Debentures II
represent the sole assets of the Trust II. Interest on the Preferred Securities
II is cumulative and payable semi-annually in arrears. The Company has the
option, subject to required regulatory approval, if any, to prepay the
securities beginning December 8, 2006.
80
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
18. PARENT COMPANY ONLY FINANCIAL INFORMATION
Condensed financial statements of First Keystone Financial, Inc. are as
follows:
CONDENSED STATEMENTS OF FINANCIAL CONDITION
SEPTEMBER 30,
-------------------
2004 2003
------- -------
Assets:
Interest-bearing deposits $ 426 $ 1,800
Investment securities available for sale 3,764 6,246
Investment in subsidiaries 47,921 46,482
Other assets 414 1,089
------- -------
Total assets $52,525 $55,617
======= =======
Liabilities and Stockholders' Equity:
Junior subordinated debentures $21,557 $21,593
Other liabilities 1,270 1,636
------- -------
Total liabilities 22,827 23,229
Stockholders' equity 29,698 32,388
------- -------
Total liabilities and stockholders' equity $52,525 $55,617
======= =======
CONDENSED STATEMENTS OF INCOME
YEAR ENDED SEPTEMBER 30,
-------------------------------
2004 2003 2002
------- ------- -------
Interest and dividend income:
Dividends from subsidiary $ 9 $ 9 $ 5
Loan to ESOP 59 79 92
Interest and dividends on investments 173 286 502
Interest on deposits 17 50 67
------- ------- -------
Total interest and dividend income 258 424 666
------- ------- -------
Interest on debt and other borrowed money 1,676 1,677 1,723
Other income 1,393 241 44
Operating expenses 210 194 154
------- ------- -------
Loss before income taxes and equity
in undistributed income (loss) of subsidiaries (235) (1,206) (1,167)
Income tax benefit (69) (402) (385)
------- ------- -------
Loss before equity in undistributed (loss) income
Of subsidiaries (166) (804) (782)
Equity in undistributed income of subsidiaries 2,369 3,543 3,508
------- ------- -------
Net income $ 2,203 $ 2,739 $ 2,726
======= ======= =======
81
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
CONDENSED STATEMENTS OF CASH FLOWS
YEAR ENDED SEPTEMBER 30,
-------------------------------
2004 2003 2002
------- ------- -------
Cash flows from operating activities:
Net income $ 2,203 $ 2,739 $ 2,726
Adjustment to reconcile net income to cash provided by
(used in) operations:
Equity in undistributed income of subsidiaries (2,369) (3,543) (3,508)
Amortization of common stock acquired by stock benefit plans 637 396 384
Gain (loss) on sales of investment securities available for sale (1,390) (241) 44
Amortization of premium (37) 26 (22)
(Increase) decrease in other assets 675 709 (1,453)
(Increase) decrease in other liabilities (159) 165 145
------- ------- -------
Net cash (used in) provided by operating activities (440) 251 (1,684)
------- ------- -------
Cash flows from financing activities:
Purchase of investments available for sale (578) -- (3,870)
Proceeds from calls or repayments of investment securities 500 1,100 --
Proceeds from sale of investments available for sale 3,339 1,591 4,956
------- ------- -------
Net cash provided by investing activities 3,261 2,691 1,086
------- ------- -------
Cash flows from financing activities:
Issuance of junior subordinated debentures -- -- 8,248
Repurchase of junior subordinated debentures -- -- (3,290)
Repayment of other borrowed money -- -- (815)
Purchase of treasury stock (1,339) (2,986) (1,013)
Common stock acquired by ESOP (2,579) -- --
Dividends paid (843) (798) (734)
Proceeds from exercise of stock options 566 373 275
------- ------- -------
Net cash provided by (used in) financing activities (4,195) (3,411) 2,671
------- ------- -------
Increase (decrease) in cash (1,374) (469) 2,073
Cash at beginning of year 1,800 2,269 196
------- ------- -------
Cash at end of year $ 426 $ 1,800 $ 2,269
======= ======= =======
82
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
19. QUARTERLY FINANCIAL DATA (UNAUDITED)
Unaudited quarterly financial data for the years ended September 30, 2004
and 2003 is as follows:
2004 2003
------------------------------------- -------------------------------------
1ST 2ND 3RD 4TH 1ST 2ND 3RD 4TH
QTR QTR QTR QTR QTR QTR QTR QTR
------ ------ ------ ------- ------- ------- ------- -------
Interest income $ 6,636 $ 6,439 $ 6,505 $ 6,563 $ 7,217 $ 6,973 $ 6,615 $ 6,407
Interest expense 3,740 3,666 3,586 3,720 4,136 3,991 3,993 3,882
------- ------- ------- ------- ------- ------- ------- -------
Net interest income 2,896 2,773 2,919 2,843 3,081 2,982 2,622 2,525
Provision for loan losses 75 75 75 75 195 195 195 130
------- ------- ------- ------- ------- ------- ------- -------
Net income after
provision for loan losses 2,821 2,698 2,844 2,768 2,886 2,787 2,427 2,395
Non-interest income 1,064 2,169 575 91 624 551 1,008 1,102
Non-interest expense 2,933 4,094 2,646 2,827 2,510 2,507 2,622 2,770
------- ------- ------- ------- ------- ------- ------- -------
Income before income taxes 952 773 773 32 1,000 831 813 727
Income tax expense (benefit) 209 146 146 (175) 219 138 148 127
------- ------- ------- ------- ------- ------- ------- -------
Net income $ 743 $ 627 $ 627 $ 207 $ 781 $ 693 $ 665 $ 600
======= ======= ======= ======= ======= ======= ======= =======
Per Share:
Earnings per share - basic $ .40 $ .34 $ .34 $ .12 $ .41 $ .36 $ .35 $ .32
Earnings per share - diluted $ .37 $ .32 $ .32 $ .11 $ .39 $ .34 $ .33 $ .29
Dividend per share $ .11 $ .11 $ .11 $ .11 $ .10 $ .10 $ .10 $ .10
Certain reclassifications have been made to the quarters presented to conform
with the presentation. Such reclassifications had no impact on the reported net
income.
****
83
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
Not applicable.
ITEM 9-A. 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 (as defined in Rule 13a-15(e) or 15d-15(e)
under the Exchange Act) as of September 30, 2004. Based on such evaluation, the
Company's chief executive officer and chief financial officer have concluded
that these controls and procedures are designed to ensure that the information
required to be disclosed by the Company in reports that it files or submits
under the Exchange Act is recorded, processed, summarized and reported within
the time periods specified in the SEC's rules and regulations and are operating
in an effective manner.
No change in the Company's internal control over financial reporting (as
defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during
the fourth fiscal quarter of fiscal 2004 that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting.
ITEM 9-B. OTHER INFORMATION.
There is no information to be reported on Form 8-K that has not already
been reported pursuant thereto.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required herein with respect to directors and executive
officers of the Company is incorporated by reference from the information
contained in the sections captioned "Information with Respect to Nominees for
Director, Directors Whose Terms Continue and Executive Officers" and "Section
16(a) Beneficial Ownership Reporting Compliance" in the Company's definitive
Proxy Statement for the Annual Meeting of Stockholders to be held on January 26,
2005 (the "Proxy Statement"), a copy of which will be filed with the SEC within
120 days of the end of the Company's fiscal year.
The Company has adopted a Code of Conduct and Ethics that applies to its
principal executive officer and principal financial officer, as well as other
officers and employees of the Company and the Bank. A copy of the Code of
Ethics, included as Exhibit 99. 1 to the Annual Report on Form 10-K for the year
ended September 30, 2003 filed with the SEC.
ITEM 11. EXECUTIVE COMPENSATION.
The information required herein is incorporated by reference from the
information contained in the section captioned "Executive Compensation" in of
the Registrant's Proxy Statement. The reports of the Audit Committee and the
Compensation Committee included in the Registrant's Proxy Statement should not
be deemed filed or incorporated into this filing or any other filing by the
Company under the Exchange Act or the Securities Act of 1933 except to the
extent the Company specifically incorporates said reports herein or therein by
reference thereto.
84
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS.
The information required herein is incorporated by reference from the
information contained in the section captioned "Beneficial Ownership of Common
Stock by Certain Beneficial Owners and Management" in 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, 2004.
Number of Shares to be Issued Number of Shares Remaining
Upon the Exercise of Weighted Average Available for Future
Outstanding Options, Exercise Price of Issuance (Excluding Shares
Plan Category Warrants and Rights Outstanding Options Reflected in the First Column)
- ------------------------------ ------------------------------ ------------------- ------------------------------
Equity Compensation Plans
Approved by Security
Holders 192,863 $10.17 26,468
Equity Compensation Plans Not
Approved by Security
Holders -- -- --
------- ------ ------
Total 192,863 $10.17 26,468
======= ====== ======
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required herein is incorporated by reference from the
information contained in the section captioned "Transactions with Certain
Related Persons" in the Registrant's Proxy Statement.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
The information required herein is incorporated by reference from the
information contained in the section captioned "Ratification of Appointment of
Auditors" in the Registrant's Proxy Statement.
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 Registered Public Accounting Firm.
Consolidated Statements of Financial Condition at September
30, 2004 and 2003.
Consolidated Statements of Income for the Years Ended
September 30, 2004, 2003 and 2002.
Consolidated Statements of Changes in Stockholders' Equity for
the Years Ended September 30, 2004, 2003 and 2002.
Consolidated Statements of Cash Flows for the Years Ended
September 30, 2004, 2003 and 2002.
Notes to the Consolidated Financial Statements.
85
(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.
(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. 1
3.2 Amended and Restated Bylaws of First Keystone Financial, Inc. 1
4 Specimen Stock Certificate of First Keystone Financial, Inc. 1
10.1 Employee Stock Ownership Plan and Trust of First Keystone Financial,
Inc. 1, *
10.2 401(K)/ Profit-sharing Plan of First Keystone Federal Savings Bank.
1, *
10.3 Employment Agreement between First Keystone Financial, Inc. and
Donald S. Guthrie dated December 1, 2004. 5,*
10.4 Employment Agreement between First Keystone Financial, Inc. and
Stephen J. Henderson dated December 1, 2004. 2
10.5 Employment Agreement between First Keystone Financial, Inc. and
Thomas M. Kelly dated December 1, 2004. 5,*
10.6 Severance Agreement between First Keystone Financial, Inc. and
Elizabeth M. Mulcahy dated December 1, 2004. 5,*
10.8 Severance Agreement between First Keystone Financial, Inc. and
Carol Walsh dated December 1, 2004. 5,*
10.9 1995 Stock Option Plan.3, *
10.10 1995 Recognition and Retention Plan and Trust Agreement.3,*
10.11 1998 Stock Option Plan.4, *
10.12 Employment Agreement between First Keystone Bank and Donald S. Guthrie
dated December 1, 2004. 5, *
10.13 Employment Agreement between First Keystone Federal Savings Bank and
Stephen J. Henderson dated December 1, 2004. 2
10.14 Employment Agreement between First Keystone Bank and Thomas M. Kelly
dated December 1, 2004. 5, *
10.15 Severance Agreement between First Keystone Bank and Elizabeth M.
Mulcahy dated December 1, 2004. 5, *
10.16 Severance Agreement between First Keystone Bank and Carol Walsh
dated December 1, 2004. 5, *
10.17 First Keystone Bank Supplemental Executive Retirement Plan. 7,*
10.18 Consulting Agreement between First Keystone Bank and Edmund Jones. *
11 Statement re: computation of per share earnings. See Note 2 to the
Consolidated Financial Statements included in Item 8 hereof.
21 Subsidiaries of the Registrant - Reference is made to Item 1
"Business," for the required information.
23 Consent of Deloitte & Touche LLP.
86
31.1 Certification of Chief Executive Officer
31.2 Certification of Chief Financial Officer
32.1 Certification of Chief Executive Officer pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002
32.2 Certification of Chief Financial Officer pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002
99.1 Codes of Ethics 6
- --------------
(1) 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.
(2) Incorporated by reference from the Form 10-K filed by the Registrant with
the SEC on December 29, 1999 (File No. 000-25328).
(3) Incorporated by reference from the Form 10-K filed by the Registrant with
SEC on December 29, 1995 (File No. 000-25328).
(4) Incorporated from Appendix A of the Registrant's definitive proxy
statement dated December 24, 1998 (File No. 000-25328).
(5) Incorporated by reference from the Form 8-K filed by the Registrant with
the SEC on December 7, 2004 (File No. 000-25328).
(6) Incorporated by reference from the Form 10-K filed by the Registrant with
the SEC on December 23, 2003.
(7) Incorporated by reference from the Form 10-K filed by the Registrant with
the SEC on May 17, 2004.
(*) Consists of a management contract or compensatory plan
(b) Exhibits. See the list set forth above under subsection (a) (3)
(c) Financial Statement Schedules.
Not applicable.
87
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
FIRST 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 29, 2004
- -------------------------------------------------
Donald S. Guthrie
Chairman of the Board and Chief Executive Officer
(Principal Executive Officer)
/s/ Thomas M. Kelly December 29, 2004
- -------------------------------------------------
Thomas M. Kelly
President and Chief Operating Officer
/s/ Edward Calderoni December 29, 2004
- -------------------------------------------------
Edward Calderoni
Director
/s/ Edmund Jones December 29, 2004
- -------------------------------------------------
Edmund Jones
Director
/s/ Donald G. Hosier, Jr. December 29, 2004
- -------------------------------------------------
Donald G. Hosier, Jr.
Director
/s/ Marshall J. Soss December 29, 2004
- -------------------------------------------------
Marshall J. Soss
Director
/s/ William J. O' Donnell December 29, 2004
- -------------------------------------------------
William J. O' Donnell
Director
/s/ Bruce C. Hendrixson December 29, 2004
- -------------------------------------------------
Bruce C. Hendrixson
Director
/s/ Jerry A. Naessens December 29, 2004
- -------------------------------------------------
Jerry A. Naessens
Director
/s/ Rose M. DiMarco December 29, 2004
- -------------------------------------------------
Rose M. DiMarco
Senior Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)
88