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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
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|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the Fiscal Year Ended December 31, 2004
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Transition Period from _____ to _____
Commission File Number: 0-50801
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SI FINANCIAL GROUP, INC.
(Exact name of registrant as specified in its charter)
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United States 84-1655232
(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.)
803 Main Street, Willimantic, Connecticut 06226
(Address of principal executive offices) (Zip Code)
(860) 423-4581
(Registrant's telephone number, including area code)
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Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $0.01 per share
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate by 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 Rule 12b-2 of the Act). Yes |_| No |X|
The aggregate market value of the voting and non-voting common equity held
by non-affiliates as of June 30, 2004 was $0.
As of March 14, 2005, there were 12,563,750 shares of the Registrant's
Common Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of SI Financial Group, Inc.'s Proxy Statement for the 2005 Annual
Meeting of Stockholders are incorporated by reference in Part III of this Form
10-K.
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SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
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TABLE OF CONTENTS
PART I. Page No.
- ------- --------
Item 1. Business 1
Item 2. Properties 33
Item 3. Legal Proceedings 34
Item 4. Submission of Matters to a Vote of Security Holders 35
PART II.
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Item 5. Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer
Purchases of Equity Securities 35
Item 6. Selected Financial Data 35
Item 7. Management's Discussion and Analysis of Financial Condition and Results of
Operation 37
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 50
Item 8. Financial Statements and Supplementary Data 52
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure 52
Item 9A. Controls and Procedures 53
Item 9B. Other Information 53
PART III.
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Item 10. Directors and Executive Officers of the Registrant 53
Item 11. Executive Compensation 53
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters 53
Item 13. Certain Relationships and Related Transactions 54
Item 14. Principal Accountant Fees and Services 54
PART IV.
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Item 15. Exhibits and Financial Statement Schedules 54
Signatures 56
This report contains forward-looking statements that are based on assumptions
and may describe future plans, strategies and expectations of SI Financial
Group, Inc. (the "Company"). These forward-looking statements are generally
identified by the use of the words "believe," "expect," "intend," "anticipate,"
"estimate," "project" or similar expressions. The Company's ability to predict
results or the actual effect of future plans or strategies is inherently
uncertain. Factors which could have a material adverse effect on the operations
of the Company and its subsidiaries include, but are not limited to, changes in
interest rates, national and regional economic conditions, legislative and
regulatory changes, monetary and fiscal policies of the United States
government, including policies of the United States Treasury and the Federal
Reserve Board, the quality and composition of the loan or investment portfolios,
demand for loan products, deposit flows, competition, demand for financial
services in the Company's market area, changes in real estate market values in
the Company's market area and changes in relevant accounting principles and
guidelines. These risks and uncertainties should be considered in evaluating
forward-looking statements and undue reliance should not be placed on such
statements. Except as required by applicable law or regulation, the Company does
not undertake, and specifically disclaims any obligation, to release publicly
the result of any revisions that may be made to any forward-looking statements
to reflect events or circumstances after the date of the statements or to
reflect the occurrence of anticipated or unanticipated events.
PART I.
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Item 1. Business.
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General
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In certain instances where appropriate, the terms "we," "us" and "our" refer to
SI Financial Group, Inc. and Savings Bank and Trust Company or both.
Savings Institute Bank and Trust Company (the "Bank" or "Savings Institute")
became the wholly-owned subsidiary of SI Financial Group, Inc., which was
established on August 6, 2004, in connection with the conversion of SI Bancorp,
Inc., the Bank's former mutual holding company parent, and Savings Institute
from state-chartered to federally-chartered institutions. The Company's business
is the ownership of the outstanding capital stock of the Bank and management of
the investment of the proceeds it retained from the stock offering. The Company
does not own or lease any property but instead uses the premises, equipment and
other property of the Bank. Thus, the financial information and discussion
contained herein primarily relates to the activities of the Bank.
The Savings Institute was incorporated by an act of the Connecticut legislature
in 1842 under the name Willimantic Savings Institute. It was shortened to
Savings Institute in 1991 to reflect the Bank's expanded geographic territory.
In 2000, the Bank converted to stock form and became the wholly-owned subsidiary
of SI Bancorp, Inc., a Connecticut-chartered mutual holding company. On August
6, 2004, Savings Institute converted to a federal charter and now operates under
the name Savings Institute Bank and Trust Company. At that time, SI Bancorp,
Inc. converted to a federal charter operating under the name SI Bancorp, MHC and
transferred all of the common stock of the Bank to SI Financial Group, Inc.
The Bank operates as a community-oriented financial institution offering a full
range of financial services to consumers and businesses in our market area,
including insurance, trust and investment services. The Bank attracts deposits
from the general public and uses those funds to originate one- to four-family
residential, multi-family and commercial real estate, commercial business and
consumer loans, which we hold primarily for investment.
Availability of Information
- ---------------------------
The Company's annual report on Form 10-K, quarterly reports on Form 10-Q,
current reports on Form 8-K and any amendments to such reports filed or
furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of
1934, as amended, are made available free of charge on our website,
www.mysifi.com, as soon as reasonably practicable after the Company
electronically files such material with, or furnishes it to, the Securities and
Exchange Commission. The information on our website shall not be considered as
incorporated by reference into this Form 10-K.
1
Market Area
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The Company is headquartered in Willimantic, Connecticut, which is located in
eastern Connecticut approximately 30 miles east of Hartford. In addition to the
Bank's main office located in Windham County, we operate fourteen branch offices
in Hartford, New London, Tolland and Windham Counties, which the Bank considers
its primary market area. The economy in our market area is primarily oriented to
the educational, service, entertainment, manufacturing and retail industries.
The major employers in the area include several institutions of higher
education, the Mohegan Sun and Foxwoods casinos, General Dynamics Defense
Systems and Pfizer, Inc. According to published statistics, Windham County's
population in 2003 was approximately 113,000 and consisted of 41,000 households.
The population increased approximately 3.2% from 2000. Median household income
in Windham County is $45,000, compared to $54,000 for Connecticut as a whole and
$43,000 nationally. Hartford, New London and Tolland Counties have median
household incomes of $51,000, $51,000 and $59,000, respectively.
Competition
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The Bank faces significant competition for the attraction of deposits and
origination of loans. Our most direct competition for deposits has historically
come from the several financial institutions operating in our market area and,
to a lesser extent, from other financial service companies, such as brokerage
firms, credit unions and insurance companies. We also face competition for
investors' funds from money market funds and other corporate and government
securities. At June 30, 2004, which is the most recent date for which data is
available from the Federal Deposit Insurance Corporation ("FDIC"), we held
approximately 17.55% of the deposits in Windham County, which is the largest
market share out of eleven financial institutions with offices in this county.
Also, at June 30, 2004, we held approximately 0.79% of the deposits in Hartford,
New London and Tolland Counties, which is the 14th market share out of 37
financial institutions with offices in these counties. In addition, banks owned
by Bank of America Corp., Webster Financial Corporation, Banknorth Group, Inc.,
Sovereign Bancorp, Inc. and Citizens Financial Group, Inc., all of which are
large regional bank holding companies, also operate in our market area. These
institutions are significantly larger than us and, therefore, have significantly
greater resources.
The Bank's competition for loans comes primarily from financial institutions in
our market area, and to a lesser extent from other financial service providers,
such as mortgage companies and mortgage brokers. Competition for loans also
comes from the increasing number of non-depository financial service companies
entering the mortgage market, such as insurance companies, securities companies
and specialty finance companies.
We expect competition to increase in the future as a result of legislative,
regulatory and technological changes and the continuing trend of consolidation
in the financial services industry. Technological advances, for example, have
lowered barriers to entry, allowed banks to expand their geographic reach by
providing services over the Internet and made it possible for non-depository
institutions to offer products and services that traditionally have been
provided by banks. Changes in federal law permit affiliation among banks,
securities firms and insurance companies, which promotes a competitive
environment in the financial services industry. Competition for deposits and the
origination of loans could limit our growth in the future.
Lending Activities
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General. Our loan portfolio consists primarily of one- to four-family
residential mortgage loans, multi-family and commercial real estate loans and
commercial business loans. To a much lesser extent, our loan portfolio includes
construction and consumer loans. We historically and currently originate loans
primarily for investment purposes. At December 31, 2004, we had $200,000 in
loans that were held for sale.
2
The following table summarizes the composition of the Bank's loan portfolio in
dollar amounts and as a percentage of the respective portfolio at the dates
indicated.
At December 31,
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(Dollars in Thousands) 2004 2003 2002
-------------------- -------------------- --------------------
Percent Percent Percent
Amount of Total Amount of Total Amount of Total
--------- -------- --------- -------- --------- --------
Real estate loans:
Residential - 1 to 4 Family $ 252,180 55.99% $ 226,881 58.29% $ 213,831 63.29%
Multi-family and
commercial 82,213 18.25 73,428 18.87 61,214 18.12
Construction 35,773 7.94 20,652 5.30 21,104 6.25
--------- ------ --------- ------ --------- ------
Total real estate loans 370,166 82.18 320,961 82.46 296,149 87.66
Consumer loans:
Home equity 18,335 4.07 14,411 3.70 10,786 3.19
Other 2,790 0.62 3,107 0.80 3,936 1.16
--------- ------ --------- ------ --------- ------
Total consumer loans 21,125 4.69 17,518 4.50 14,722 4.35
Commercial business loans 59,123 13.13 50,746 13.04 27,003 7.99
--------- ------ --------- ------ --------- ------
Total loans 450,414 100.00% 389,225 100.00% 337,874 100.00%
====== ====== ======
Deferred loan origination
costs, net of fees 743 387 (209)
Allowance for loan losses (3,200) (2,688) (3,067)
--------- --------- ---------
Loans, net $ 447,957 $ 386,924 $ 334,598
========= ========= =========
At December 31,
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(Dollars in Thousands) 2001 2000
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Percent Percent
Amount of Total Amount of Total
--------- -------- --------- --------
Real estate loans:
Residential - 1 to 4 Family $ 193,672 65.36% $ 174,186 65.14%
Multi-family and
commercial 56,376 19.02 47,016 17.58
Construction 10,155 3.43 11,815 4.42
--------- ------ --------- ------
Total real estate loans 260,203 87.81 233,017 87.14
Consumer loans:
Home equity 7,752 2.62 6,888 2.58
Other 7,174 2.42 6,039 2.26
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Total consumer loans 14,926 5.04 12,927 4.84
Commercial business loans 21,192 7.15 21,442 8.02
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Total loans 296,321 100.00% 267,386 100.00%
====== ======
Deferred loan origination
costs, net of fees (349) (228)
Allowance for loan losses (2,861) (2,605)
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Loans, net $ 293,111 $ 264,553
========= =========
One- to Four-Family Residential Loans. Our primary lending activity is the
origination of mortgage loans to enable borrowers to purchase or refinance
existing homes or to construct new residential dwellings in our market area. We
offer fixed-rate and adjustable-rate mortgage loans with terms up to 30 years.
Borrower demand for adjustable-rate loans versus fixed-rate loans is a function
of the level of interest rates, the expectations of changes in the level of
interest rates, the difference between the interest rates and loan fees offered
for fixed-rate mortgage loans and the initial period interest rates and loan
fees for adjustable-rate loans. The relative amount of fixed-rate mortgage loans
and adjustable-rate mortgage loans that can be originated at any time is largely
determined by the demand for each in a competitive environment and the effect
each has on our interest rate risk. The loan fees charged, interest rates and
other provisions of mortgage loans are determined by us on the basis of our own
pricing criteria and competitive market conditions.
The Bank offers fixed-rate loans with terms of 15, 20 or 30 years. Our
adjustable-rate mortgage loans are based on 15, 20 or 30 year amortization
schedules. Interest rates and payments on our adjustable-rate mortgage loans
adjust annually after a one, three, five, seven or ten-year initial fixed
period. Interest rates and payments on our adjustable-rate loans are adjusted to
a rate typically equal to 2.75% (2.875% for jumbo loans) above the one-year
constant maturity Treasury index. The maximum amount by which the interest rate
may be increased or decreased is generally 2% per adjustment period and the
lifetime interest rate cap is generally 6% over the initial interest rate of the
loan.
While we anticipate that adjustable-rate loans will better offset the adverse
effects of an increase in interest rates as compared to fixed-rate mortgages,
the increased mortgage payments required of adjustable-rate loan borrowers in a
rising interest rate environment could cause an increase in delinquencies and
defaults. The marketability of the underlying property also may be adversely
affected in a high interest rate environment. In addition, although
adjustable-rate mortgage loans help make our asset base more responsive to
changes in interest rates, the extent of this interest sensitivity is limited by
the annual and lifetime interest rate adjustment limits.
We generally do not make conventional loans with loan-to-value ratios exceeding
95% and generally make loans with a loan-to-value ratio in excess of 80% only
when secured by first liens on owner-occupied one- to four-family residences.
Loans with loan-to-value ratios in excess of 80% generally require private
mortgage insurance or additional collateral. We require all properties securing
mortgage loans to be appraised by a board approved
3
independent licensed appraiser. We require title insurance on all first mortgage
loans. Borrowers must obtain hazard insurance and flood insurance for loans on
property located in a flood zone, before closing the loan.
In an effort to provide financing for moderate income and first-time buyers, we
offer Federal Housing Authority, Veterans Administration and Connecticut Housing
Finance Agency loans and a first-time home buyers program. We offer fixed-rate
residential mortgage loans through these programs to qualified individuals and
originate the loans using modified underwriting guidelines.
Multi-Family and Commercial Real Estate Loans. The Bank offers fixed rate and
adjustable-rate mortgage loans secured by multi-family and commercial real
estate. Our multi-family and commercial real estate loans are generally secured
by condominiums, apartment buildings, single-family subdivisions as well as
owner occupied properties located in our market area and used for businesses. We
intend to continue to grow this segment of our loan portfolio.
We originate adjustable-rate multi-family and commercial real estate loans for
terms up to 25 years. Interest rates and payments on these loans typically
adjust every five years after a five-year initial fixed rate period. Interest
rates and payments on our adjustable-rate loans are adjusted to a rate typically
2.5-3.5% above the classic advance rates offered by the Federal Home Loan Bank
of Boston ("FHLB"). There are no adjustment period or lifetime interest rate
caps. Loans are secured by first mortgages that generally do not exceed 75% of
the property's appraised value. At December 31, 2004, the largest outstanding
commercial real estate loan commitment was $2.9 million, of which $2.9 million
was outstanding. This loan is secured by the assets of a healthcare facility and
was performing according to its terms at December 31, 2004.
Loans secured by multi-family and commercial real estate generally have larger
balances and involve a greater degree of risk than one- to four-family
residential mortgage loans. Of primary concern in multi-family and commercial
real estate lending is the borrower's creditworthiness and the feasibility and
cash flow potential of the project. Payments on loans secured by income
properties often depend on successful operation and management of the
properties. As a result, repayment of such loans may be subject, to a greater
extent than residential real estate loans, to adverse conditions in the real
estate market or the economy. To monitor cash flows on income properties, we
require borrowers and loan guarantors, if any, to provide annual financial
statements on multi-family and commercial real estate loans. In reaching a
decision on whether to make a multi-family or commercial real estate loan, we
consider the net operating income of the property, the borrower's expertise,
credit history and profitability and the value of the underlying property. In
addition, with respect to commercial real estate rental properties, we will also
consider the term of the lease and the quality of the tenants. We have generally
required that the properties securing these real estate loans have debt service
coverage ratios of at least 1.25. The debt service coverage ratio is equal to
cash flows before interest, rent, income taxes and required principal payments
divided by amounts paid for interest, rent, income taxes and required principal
payments. Environmental surveys are generally required for commercial real
estate loans over $250,000.
Construction Loans. The Bank originates loans to individuals, and to a lesser
extent, builders, to finance the construction of residential dwellings. We also
make construction loans for commercial development projects, including
condominiums, apartment buildings, single-family subdivisions as well as
owner-occupied properties used for businesses. Our construction loans generally
provide for the payment of interest only during the construction phase, which is
usually twelve months. At the end of the construction phase, the loan generally
converts to a permanent mortgage loan. Loans generally can be made with a
maximum loan to value ratio of 85% on residential construction and 75% on
commercial construction of the lower of appraised value or cost of the project,
whichever is less. At December 31, 2004, the largest outstanding residential
construction loan commitment was for $1.0 million, of which $600,000 was
outstanding. At December 31, 2004, the largest outstanding commercial
construction loan commitment was $4.1 million, of which $1.9 million was
outstanding. These loans were performing according to their terms at December
31, 2004. Before making a commitment to fund a residential construction loan, we
require an appraisal of the property by a board approved independent licensed
appraiser. We also will require an inspection of the property before
disbursement of funds during the term of the construction loan.
4
The Bank also originates land loans to individuals and local contractors and
developers only for the purpose of making improvements on approved building
lots, subdivisions and condominium projects within two years of the date of the
loan. Such loans to individuals generally are written with a maximum
loan-to-value ratio based upon the appraised value or purchase price of the land
of 75% for a 10-year loan and 60% for a 15-year loan, whichever is less. We
offer fixed-rate land loans and variable-rate land loans that adjust annually.
Interest rates and payments on our adjustable-rate land loans are adjusted to a
rate typically equal to 2.75% above the one-year constant maturity Treasury
index. The maximum amount by which the interest rate may be increased or
decreased is generally 2% annually and the lifetime interest rate cap is
generally 6% over the initial rate of the loan. If applicable, we require title
insurance and a hazardous waste survey reporting that the land is free of
hazardous or toxic waste.
Construction financing is generally considered to involve a higher degree of
risk of loss than long-term financing on improved, occupied real estate. Risk of
loss on a construction loan depends 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 construction costs proves to be inaccurate, we may
be required to advance funds beyond the amount originally committed to permit
completion of the development. If the estimate of value proves to be inaccurate,
we may be confronted, at or before the maturity of the loan, with a project
having a value which is insufficient to assure full repayment. As a result of
the foregoing, construction lending often involves the disbursement of
substantial funds with repayment dependent, in part, on the success of the
ultimate project rather than the ability of the borrower or guarantor to repay
principal and interest. If we are forced to foreclose on a project before or at
completion due to a default, there can be no assurance that we will be able to
recover all of the unpaid balance of, and accrued interest on, the loan as well
as related foreclosure and holding costs.
Commercial Loans. The Bank makes commercial business loans to a variety of
professionals, sole proprietorships and small businesses primarily in our market
area. We offer a variety of commercial lending products, the maximum amount of
which is limited by our in-house loans-to-one-borrower limit, which was $6.0
million at December 31, 2004. Our largest commercial loan was a $900,000 loan
secured by accounts receivable, of which $702,000 was outstanding as of December
31, 2004. This loan was performing according to its original terms at December
31, 2004.
Until November 2004, we maintained a Business Manager Program under which
accounts receivable financing was offered to small and medium-sized businesses
in our market area. Under that program, we purchased accounts receivable on a
full recourse basis. Our income from the program arose primarily from: (1)
service charges, which range from two to five percent, which are discounted from
each receivable purchased, and (2) the interest, if any, charged to account
debtors on unpaid balances. To mitigate the risk associated with such lending, a
flexible cash reserve was established for each participant. Any excess reserves
were returned to the small business once a month. Additionally, we obtained
accounts receivable fraud insurance to protect our exposure on these loans. The
Company decided to discontinue the Business Manager Program when it was
determined that the volume of new business was not sufficient to warrant the
time and cost associated with maintenance on the accounts under the program. The
outstanding balances at December 31, 2004 under the Business Manager Program,
totaling $1.4 million, will be either converted to one of our traditional
commercial loan products or transferred to another lender that offers the
Business Manager Program.
We also offer loans secured by business assets other than real estate, such as
business equipment and inventory. These loans are originated with maximum
loan-to-value ratios of 75% of the value of the personal property. We originate
lines of credit to finance the working capital needs of businesses to be repaid
by seasonal cash flows or to provide a period of time during which the business
can borrow funds for planned equipment purchases. These loans convert to a term
loan at the expiration of a draw period, which is not to exceed twelve months
and will be paid over a pre-defined amortization period. We also offer time
notes, letters of credit and Small Business Administration guaranteed loans.
Time notes are short-term loans and will only be granted on the basis of a
defined source of repayment of principal and interest from a specific
foreseeable event.
5
When making commercial business loans, we consider the financial statements of
the borrower, the borrower's payment history of both corporate and personal
debt, the debt service capabilities of the borrower, the projected cash flows of
the business, viability of the industry in which the customer operates and the
value of the collateral.
Unlike residential mortgage loans, which generally are made on the basis of the
borrower's ability to make repayment from his or her employment or other income,
and which are secured by real property whose value tends to be more easily
ascertainable, commercial loans are of higher risk and typically are made on the
basis of the borrower's ability to make repayment from the cash flow of the
borrower's business. As a result, the availability of funds for the repayment of
commercial loans may depend substantially on the success of the business itself.
Further, any collateral securing such loans may depreciate over time, may be
difficult to appraise and may fluctuate in value.
Consumer Loans. To a much lesser extent, the Bank offers a variety of consumer
loans, primarily home equity lines of credit, and, to a lesser extent, loans
secured by marketable securities, passbook or certificate accounts, motorcycles,
automobiles and recreational vehicles as well as unsecured loans. Unsecured
loans generally have a maximum borrowing limit of $15,000 and a maximum term of
five years.
The procedures for underwriting consumer loans include an assessment of the
applicant's payment history on other debts and their ability to meet existing
obligations and payments on the proposed loans. Although the applicant's
creditworthiness is a primary consideration, the underwriting process also
includes a comparison of the value of the collateral, if any, to the proposed
loan amount. Home equity lines of credit have adjustable rates of interest that
are indexed to the prime rate as reported in The Wall Street Journal. We will
offer home equity loans with maximum combined loan-to-value ratios of 100%,
provided that loans in excess of 80% will be charged a higher rate of interest.
A home equity line of credit may be drawn down by the borrower for an initial
period of five years from the date of the loan agreement. During this period,
the borrower has the option of paying, on a monthly basis, either principal and
interest or only interest. If not renewed, the borrower has to pay back the
amount outstanding under the line of credit over a term not to exceed ten years,
beginning at the end of the five-year period.
Consumer loans may entail greater risk than do residential mortgage loans,
particularly in the case of consumer loans that are unsecured or secured by
assets that depreciate rapidly. In such cases, repossessed collateral for a
defaulted consumer loan may not provide an adequate source of repayment for the
outstanding loan and the remaining deficiency often does not warrant further
substantial collection efforts against the borrower. In addition, consumer loan
collections depend on the borrower's continuing financial stability, and
therefore, are more likely to be adversely affected by job loss, divorce,
illness or personal bankruptcy. Furthermore, the application of various federal
and state laws, including federal and state bankruptcy and insolvency laws, may
limit the amount which can be recovered on such loans.
Loan Originations, Loan Purchases and Sales and Servicing of Loans. Loan
originations come from a number of sources. The primary source of loan
originations are our in-house loan originators, and to a lesser extent, local
mortgage brokers, advertising and referrals from customers.
From time to time, the Bank will purchase whole participations in loans fully
guaranteed by the United States Department of Agriculture and the Small Business
Administration. The loans are primarily for commercial and agricultural
properties located throughout the United States. We purchased $12.2 million and
$26.4 million of these loans in fiscal 2004 and 2003, respectively.
The Bank generally originates loans for portfolio but from time to time will
sell loans in the secondary market, primarily fixed-rate one- to four-family
residential mortgage loans with servicing retained, based on prevailing market
interest rate conditions, an analysis of the composition and risk of the loan
portfolio, liquidity needs and interest rate risk management. Generally, loans
are sold without recourse. The Bank utilizes the proceeds from these sales
primarily to meet liquidity needs and manage interest rate risk. We sold $15.5
million, $23.0 million and $12.8 million of loans in the years ended December
31, 2004, 2003 and 2002, respectively.
6
At December 31, 2004, the Bank retained the servicing rights on $50.5 million of
loans for others, consisting primarily of fixed-rate mortgage loans sold with or
without recourse to third parties. Loan servicing includes collecting and
remitting loan payments, accounting for principal and interest, contacting
delinquent mortgagors, processing insurance and tax payments on behalf of
borrowers, assisting in foreclosures and property dispositions when necessary
and general administration of loans. The gross servicing fee income from loans
sold with servicing rights retained is typically 25 basis points of the total
balance of serviced loans. The servicing rights, included in other assets,
related to these loans was $165,000 and $124,000 at December 31, 2004 and 2003,
respectively. Amortization of mortgage servicing rights totaled $24,000, $0 and
$0 for the years ended December 31, 2004, 2003 and 2002, respectively.
The following table sets forth the Bank's loan originations and purchases, loan
sales, principal repayments, charge-offs and other reductions on loans for the
periods indicated.
Years Ended December 31,
---------------------------------
(Dollars in Thousands) 2004 2003 2002
--------- --------- ---------
Loans at beginning of period $ 389,225 $ 337,874 $ 296,321
Originations:
Real estate loans 147,899 180,962 133,150
Commercial business loans 14,465 10,034 4,025
Consumer loans 16,063 16,682 11,837
--------- --------- ---------
Total loan originations 178,427 207,678 149,012
Loans Purchased 12,152 26,448 3,538
Deductions:
Principal loan repayments, prepayments and other 113,803 157,095 97,821
Sale of loans, principal balance 15,549 22,996 12,795
Loan charge-offs, net 38 1,981 331
Transfers to OREO -- 703 50
--------- --------- ---------
Total deductions 129,390 182,775 110,997
--------- --------- ---------
Net loan activity 61,189 51,351 41,553
--------- --------- ---------
Loans at end of period $ 450,414 $ 389,225 $ 337,874
========= ========= =========
Loan Maturity. The following table shows the contractual maturity of the Bank's
loan portfolio at December 31, 2004. The table does not reflect any estimate of
prepayments, which significantly shortens the average life of all loans, and may
cause our actual repayment experience to differ from that shown below. Demand
loans having no stated schedule of repayment and no stated maturity are reported
as due in one year or less.
7
Amounts Due In
--------------------------------------------------
(Dollars in Thousands) More Than Total
One Year or One to Five More Than Amount
Less Years Five Years Due
----------- ----------- ---------- ---------
Real estate loans:
Residential - 1 to 4 family $ 34 $ 5,055 $ 247,091 $ 252,180
Multi-family and commercial 312 2,877 79,024 82,213
Construction 8,629 4,092 23,052 35,773
-------- -------- --------- ---------
Total real estate loans 8,975 12,024 349,167 370,166
Commercial business loans 8,815 7,237 43,071 59,123
Consumer loans 859 17,837 2,429 21,125
-------- -------- --------- ---------
Total loans $ 18,649 $ 37,098 $ 394,667 $ 450,414
======== ======== ========= =========
While one- to four-family residential real estate loans are normally originated
with up to 30-year terms; such loans typically remain outstanding for
substantially shorter periods because borrowers often prepay their loans in full
upon the sale of the property pledged as security or upon refinancing the
original loan. Therefore, average loan maturity is a function of, among other
factors, the level of purchase and sale activity in the real estate market,
prevailing interest rates and the interest rates payable on outstanding loans.
The following table sets forth, at December 31, 2004, the dollar amount of gross
loans receivable contractually due after December 31, 2005, and whether such
loans have either fixed interest rates, floating or adjustable interest rates.
The amounts shown below exclude deferred loan fees and costs and the allowance
for loan losses and include $944,000 of nonperforming loans.
Floating or
(Dollars in Thousands) Fixed Adjustable
Rates Rates Total
--------- ----------- ---------
Real estate loans:
Residential - 1 to 4 family $ 204,279 $ 47,867 $ 252,146
Multi-family and commercial 10,527 71,374 81,901
Construction 21,623 5,521 27,144
--------- --------- ---------
Total real estate loans 236,429 124,762 361,191
Commercial business loans 21,715 28,593 50,308
Consumer loans 7,186 13,080 20,266
--------- --------- ---------
Total loans $ 265,330 $ 166,435 $ 431,765
========= ========= =========
Loan Approval Procedures and Authority. The Bank's lending activities follow
written, nondiscriminatory, underwriting standards and loan origination
procedures established by our Board of Directors and management. All residential
mortgages and consumer home equity lines of credit in excess of $6.0 million or
all commercial loans and other consumer loans in excess of $2.0 million require
the approval of the Board of Directors. The loan committee has the authority to
approve: (1) residential mortgage loans and consumer home equity lines of credit
of up to $6.0 million and (2) commercial and other consumer loans of up to $2.0
million. The President and the Senior Credit Officer have approval for: (1)
residential mortgage loans that conform to Fannie Mae and Freddie Mac standards
up to $2.0 million or $359,650 for those that are non-conforming, (2) consumer
and commercial loans up to $250,000 individually or $2.0 million jointly for
consumer home equity lines of credit or $1.0 million
8
jointly for commercial and other consumer loans. The Senior Commercial Officer
may approve consumer home equity lines of credit and commercial loans of up to
$200,000 individually or $500,000 with the additional approval of the President
or Senior Credit Officer. Various bank personnel have been delegated authority
to approve loans up to $359,650.
Loans to One Borrower. The maximum amount that we may lend to one borrower and
the borrower's related entities is limited, by regulation, to generally 15% of
our stated capital and reserves. At December 31, 2004, our regulatory limit on
loans to one borrower was $9.4 million. At that date, our largest lending
relationship was $9.0 million, of which $5.0 million was outstanding, and
included fourteen commercial real estate loans, all of which were performing
according to the original repayment terms at December 31, 2004.
Loan Commitments. The Bank issues commitments for fixed-rate and adjustable-rate
mortgage loans conditioned upon the occurrence of certain events. Commitments to
originate mortgage loans are legally binding agreements to lend to our customers
and generally expire in 90 days or less from the date of application.
Delinquencies. When a borrower fails to make a required loan payment, the Bank
takes a number of steps to have the borrower cure the delinquency and restore
the loan to current status. We make initial contact with the borrower when the
loan becomes 15 days past due. If payment is not then received by the 30th day
of delinquency, additional letters and phone calls generally are made. When the
loan becomes 90 days past due, we send a letter notifying the borrower that we
will commence foreclosure proceedings if the loan is not brought current within
30 days. When the loan becomes 120 days past due, we will commence foreclosure
proceedings against any real property that secures the loan or attempt to
repossess any personal property that secures a consumer or commercial loan. If a
foreclosure action is instituted and the loan is not brought current, paid in
full, or refinanced before the foreclosure sale, the real property securing the
loan is typically sold at foreclosure. We may consider loan workout arrangements
with certain borrowers under certain circumstances.
Management informs the Board of Directors monthly of the amount of loans
delinquent more than 30 days, all loans in foreclosure and all foreclosed and
repossessed property that we own.
The following table sets forth the delinquencies in the Bank's loan portfolio as
of the dates indicated.
December 31, 2004 December 31, 2003
----------------------------------------------- -----------------------------------------------
(Dollars in Thousands) 60 - 89 Days 90 Days or More 60 - 89 Days 90 Days or More
---------------------- ---------------------- ---------------------- ----------------------
Principal Principal Principal Principal
Number of Balance of Number of Balance of Number of Balance of Number of Balance of
Loans Loans Loans Loans Loans Loans Loans Loans
--------- ---------- --------- ---------- --------- ---------- --------- ----------
Real estate loans:
Residential - 1 to 4 family 5 $ 547 2 $ 522 2 $ 169 3 $ 205
Multi-family and commercial -- -- 3 421 -- -- 2 873
Construction -- -- -- -- -- -- -- --
--- ----- --- ----- --- ----- --- -------
Total real estate loans 5 547 5 943 2 169 5 1,078
Consumer loans:
Home equity 1 20 -- -- -- -- -- --
Other -- -- 1 1 1 1 -- --
--- ----- --- ----- --- ----- --- -------
Total consumer loans 1 20 1 1 1 1 -- --
Commercial business loans -- -- -- -- -- -- -- --
--- ----- --- ----- --- ----- --- -------
Total delinquent loans (1) 6 $ 567 6 $ 944 3 $ 170 5 $ 1,078
=== ===== === ===== === ===== === =======
- ----------
(1) Represents delinquent loans 60 days or more past due.
Classified Assets. Management of the Company, including the Watched Asset
Committee, consisting of a number of the Bank's officers, review and classify
the assets of the Company on a monthly basis and the Board of Directors reviews
the results of the reports on a quarterly basis. Federal regulations and the
Company's internal policies require that management utilize an internal asset
classification system to monitor and evaluate the credit
9
risk inherent in its loan portfolio. The Company currently classifies problem
and potential problem assets as "substandard," "doubtful" or "loss" assets. An
asset is considered "substandard" if it is inadequately protected by the current
net worth and paying capacity of the obligor or of the collateral pledged, if
any. "Substandard" assets include those assets that are characterized by the
distinct possibility that the Company will sustain some loss if the deficiencies
are not corrected. Assets characterized as "doubtful" have all the weaknesses
inherent in those classified as "substandard" with the additional characteristic
that the weaknesses present make collection or liquidation in full, on the basis
of currently existing facts, conditions and values, questionable, and there is a
high probability of loss. Assets classified as "loss" are those assets
considered uncollectible and of such little value that their continuance as
assets, without the establishment of a specific loss reserve, is not warranted.
In addition, assets which do not currently expose the Company to sufficient risk
to warrant classification in one of the aforementioned categories but possess
credit deficiencies or potential weaknesses are required to be designated
"special mention." When we classify an asset as "substandard" or "doubtful," we
may establish a specific allowance for loan losses. If an asset is classified as
a "loss," the Company charges-off an amount equal to the portion of the asset
classified as "loss." All the loans mentioned above are included in the
Company's Watch List Report. This report serves as an integral part in the
evaluation of the adequacy of the Company's allowance for loan losses.
The following table sets forth the Company's classified loans as of December 31,
2004.
Loss Doubtful Substandard Special Mention
Principal Principal Principal Principal
(Dollars in Thousands) Balance Balance Balance Balance
--------- --------- ----------- ---------------
Real estate loans:
Residential - 1 to 4 family $ -- $ -- $ 682 $ 226
Multi-family and commercial -- -- 421 3,136
Construction -- -- -- --
---- ---- ------- -------
Total real estate loans -- -- 1,103 3,362
Consumer loans:
Home equity -- -- 20 --
Other 1 -- -- 2
---- ---- ------- -------
Total consumer loans 1 -- 20 2
Commercial business loans -- -- -- 1,271
---- ---- ------- -------
Total classified loans $ 1 $ -- $ 1,123 $ 4,635
==== ==== ======= =======
Of the $1.1 million of substandard loans at December 31, 2004, $943,000 are
considered nonperforming loans. Of the $4.6 million of special mention loans,
only $104,000 are more than 30 days past due at December 31, 2004.
Nonperforming Assets and Restructured Loans. When a loan becomes 90 days
delinquent, the loan is placed on nonaccrual status at which time the accrual of
interest ceases and the allowance for any uncollectible accrued interest is
established and charged against operations. Typically, payments received on
nonaccrual loans are applied to the outstanding principal and interest balance
as determined at the time of collection of the loan.
We consider repossessed assets and loans that are 90 days or more past due to be
nonperforming assets. Real estate that we acquire as a result of foreclosure or
by deed-in-lieu of foreclosure is classified as real estate owned until it is
sold. When property is acquired it is recorded at the lower of its cost, which
is the unpaid balance of the loan plus foreclosure costs or fair value at the
date of the foreclosure. Holding costs and declines in fair value after
acquisition of the property are charged against income as incurred.
10
The following table provides information with respect to the Company's
nonperforming assets and troubled debt restructurings as of the dates indicated.
December 31,
-----------------------------------------------
(Dollars in Thousands) 2004 2003 2002 2001 2000
------- ------- ------- ------- -------
Nonaccrual loans:
Real estate loans $ 943 $ 1,295 $ 1,347 $ 1,597 $ 1,028
Commercial business loans -- -- 418 517 86
Consumer loans 1 -- 72 29 23
------- ------- ------- ------- -------
Total nonaccrual loans 944 1,295 1,837 2,143 1,137
Accruing loans past due 90 days or more:
Real estate loans -- -- 5 46 394
Commercial business loans -- -- -- 1 --
Consumer loans -- -- -- -- --
------- ------- ------- ------- -------
Total accruing loans past due 90 days
or more -- -- 5 47 394
------- ------- ------- ------- -------
Total nonperforming loans 944 1,295 1,842 2,190 1,531
Real estate owned, net (1) -- 328 43 43 43
------- ------- ------- ------- -------
Total nonperforming assets 944 1,623 1,885 2,233 1,574
Troubled debt restructurings 76 77 78 78 79
------- ------- ------- ------- -------
Total nonperforming assets and troubled
debt restructurings $ 1,020 $ 1,700 $ 1,963 $ 2,311 $ 1,653
======= ======= ======= ======= =======
Total nonperforming loans to total loans 0.21% 0.33% 0.55% 0.74% 0.57%
Total nonperforming loans to total assets 0.15% 0.25% 0.38% 0.51% 0.41%
Total nonperforming assets and troubled
debt restructurings to total assets 0.16% 0.33% 0.40% 0.54% 0.44%
- ----------
(1) Real estate owned balances are shown net of related loss allowance.
Other than disclosed in the above table, there are no other loans at December
31, 2004 that management has serious doubts about the ability of the borrowers
to comply with the present loan repayment terms.
Interest income that would have been recorded for the years ended December 31,
2004 and December 31, 2003 had nonaccruing loans and troubled debt
restructurings been current in accordance with their original terms and had been
outstanding throughout the period amounted to $56,000 and $67,000, respectively.
The amount of interest related to nonaccrual loans and troubled debt
restructurings included in interest income was $9,000 and $0 for the years ended
December 31, 2004 and 2003, respectively.
Allowance for Loan Losses. The allowance for loan losses is a valuation
allowance for probable incurred losses inherent in the loan portfolio. The
allowance is maintained through a provision for loan losses that is charged to
earnings. Actual loan losses are charged against the allowance when management
believes the uncollectibility of the loan balance is confirmed. Subsequent
recoveries, if any, are credited to the allowance. The Company evaluates the
allowance for loan losses on a regular basis.
11
The methodology for assessing the appropriateness of the allowance for loan
losses consists of three key elements:
o Specific allowances for identified problem loans, including certain
impaired or collateral-dependent loans;
o General valuation allowance on certain identified problem loans; and
o General valuation allowance on the remainder of the loan portfolio
Specific Allowance on Identified Problem Loans. The loan portfolio is segregated
first between loans that are on our "watch list" and loans that are not. Our
watch list includes: (1) loans that are 60 or more days delinquent, (2) loans
with anticipated losses, (3) loans referred to attorneys for collection or in
the process of foreclosure, (4) nonaccrual loans, (5) loans classified as
"substandard," "doubtful" or "loss" by either our internal classification system
or by regulators during the course of their examination of us, and (6) troubled
debt restructurings and other nonperforming loans.
The Watched Asset Committee, consisting of a number of the Bank's officers, will
review each loan on the watch list and establish an individual reserve
allocation on certain loans based on such factors as (1) the strength of the
customer's personal or business cash flow; (2) the availability of other sources
of repayment; (3) the amount due or past due; (4) the type and value of
collateral; (5) the strength of our collateral position; (6) the estimated cost
to sell the collateral; and (7) the borrower's effort to cure the delinquency.
The Company reviews and establishes, as needed, a specific allowance for certain
identified non-homogeneous problem loans. In accordance with the Statement of
Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment
of a Loan" ("SFAS 114"), a loan is impaired when, based on current information
and events, it is probable that a creditor will be unable to collect all amounts
due under the contractual terms of the loan agreement. Measurement of the
impairment is based on the present value of expected future cash flows or the
fair value of the collateral, if the loan is collateral dependent. A specific
allowance on impaired loans is established if the present value of the expected
future cash flows, or fair value of the collateral for collateral dependent
loans, is lower than the carrying value of the loan.
General Valuation Allowance on Certain Identified Problem Loans. The Company
establishes a general allowance for watch list loans that do not have an
individual allowance. We segregate these loans by loan category and assign
allowance percentages to each category based on inherent losses associated with
each type of lending and consideration that these loans, in the aggregate,
represent an above-average credit risk and that more of these loans will prove
to be uncollectible compared to loans in the general portfolio.
General Valuation Allowance on the Remainder of the Loan Portfolio. The Company
establishes another general allowance for loans that are not on the watch list
to recognize the probable losses associated with lending activities, but which,
unlike specific allowances, has not been allocated to particular problem assets.
This general valuation allowance is determined by segregating the loans by loan
category and assigning allowance percentages based on our historical loss
experience and delinquency trends. The allowance may be adjusted for significant
factors that, in management's judgment, affect the collectibility of the
portfolio as of the evaluation date. These significant factors may include
changes in lending policies and procedures, changes in existing general economic
and business conditions affecting our primary lending areas, credit quality
trends, collateral value, loan volumes and concentrations, seasoning of the loan
portfolio, specific industry conditions within portfolio segments, recent loss
experience in particular segments of the portfolio, duration of the current
business cycle and bank regulatory examination results. The applied loss factors
are re-evaluated annually to ensure their relevance in the current economic
environment.
The Office of Thrift Supervision ("OTS"), as an integral part of its examination
process, periodically reviews our allowance for loan losses. The OTS may require
us to make additional provisions for loan losses based on judgments different
from that of the Company.
Although we believe that we use the best information available to establish the
allowance for loan losses, future adjustments to the allowance for loan losses
may be necessary and our results of operations could be adversely affected if
circumstances differ substantially from the assumptions used in making the
determinations.
12
Furthermore, while management believes we have established our allowance for
loan losses in conformity with generally accepted accounting principles, there
can be no assurance that regulators, in reviewing our loan portfolio, will not
request us to increase our allowance for loan losses. In addition, because
future events affecting borrowers and collateral cannot be predicted with
certainty, there can be no assurance that the existing allowance for loan losses
is adequate or that increases will not be necessary should the quality of any
loans deteriorate as a result of the factors discussed above. Any material
increase in the allowance for loan losses may adversely affect our financial
condition and results of operations.
The following table sets forth an analysis of the allowance for loan losses for
the periods indicated.
Years Ended December 31,
-----------------------------------------------------
(Dollars in Thousands) 2004 2003 2002 2001 2000
-------- -------- -------- -------- ---------
Allowance at beginning of period $ 2,688 $ 3,067 $ 2,861 $ 2,605 $ 2,284
Provision for loan losses 550 1,602 537 440 290
Charge-offs:
Real estate loans -- 1,523 77 40 86
Commercial business loans 13 374 111 218 18
Consumer loans 62 216 218 146 5
-------- -------- -------- -------- ---------
Total charge-offs 75 2,113 406 404 109
Recoveries:
Real estate loans 19 89 35 40 60
Commercial business loans 6 24 32 161 70
Consumer loans 12 19 8 19 10
-------- -------- -------- -------- ---------
Total recoveries 37 132 75 220 140
-------- -------- -------- -------- ---------
Net charge-offs/(recoveries) 38 1,981 331 184 (31)
-------- -------- -------- -------- ---------
Allowance at end of period $ 3,200 $ 2,688 $ 3,067 $ 2,861 $ 2,605
======== ======== ======== ======== =========
Allowance to total loans outstanding at
end of period 0.71% 0.69% 0.91% 0.97% 0.97%
Allowance to nonperforming loans 338.98% 207.57% 166.50% 130.64% 170.15%
Net charge-offs (recoveries) to average
loans outstanding during the period 0.01% 0.55% 0.11% 0.07% (0.01)%
Recoveries to charge-offs 49.30% 6.25% 18.47% 54.46% (128.44)%
Lower charge-offs in 2004, as compared to 2003, were primarily the result of
improved asset quality in the Bank's loan portfolio. In addition, charge-offs
for 2003 included the charge-off of two commercial business loans and two
commercial real estate loans that aggregated $1.8 million. The larger of the two
commercial real estate loans, which at the time of charge-off had a principal
balance of $1.6 million, was charged-off after the loan was nonperforming and
the Company determined that the value of the real estate underlying the loan was
insufficient to cover the outstanding principal balance. Additionally, because
we held a junior collateral position, the Company determined that the likelihood
of any recovery was remote. During the year ended December 31, 2003, charge-offs
exceeded the provision for loan losses as specific allowances of $237,000 were
established in prior periods for a portion of the charged-off loans once it had
been determined that collection or liquidation in full was unlikely.
13
The following table sets forth the breakdown of the allowance for loan losses by
loan category at the dates indicated.
December 31,
------------------------------------------------------------------------------------------------
2004 2003 2002
----------------------------- ------------------------------ ------------------------------
% of % of % of
Loans in Loans in Loans in
% of each % of each % of each
Allowance Category Allowance Category Allowance Category
to Total to Total to Total to Total to Total to Total
(Dollars in Thousands) Amount Allowance Loans Amount Allowance Loans Amount Allowance Loans
------- --------- -------- ------- -------------------- ------- --------- -------
Real estate loans $ 2,403 75.08% 82.18% $ 2,093 77.86% 82.46% $ 2,237 72.94% 87.66%
Commercial business 641 20.02 13.13 461 17.15 13.04 488 15.91 7.99
Consumer loans 152 4.74 4.69 80 2.98 4.50 318 10.37 4.35
Unallocated 4 0.16 -- 54 2.01 -- 24 0.78 --
------- ------ ------ ------- ------ ------ ------- ------ ------
Total allowance for
loan losses $ 3,200 100.00% 100.00% $ 2,688 100.00% 100.00% $ 3,067 100.00% 100.00%
======= ====== ====== ======= ====== ====== ======= ====== ======
December 31,
---------------------------------------------------------------
2001 2000
----------------------------- ------------------------------
% of % of
Loans in Loans in
% of each % of each
Allowance Category Allowance Category
to Total to Total to Total to Total
(Dollars in Thousands) Amount Allowance Loans Amount Allowance Loans
------- --------- -------- ------------------------------
Real estate loans $ 1,866 65.22% 87.81% $ 1,759 67.52% 87.14%
Commercial business 647 22.62 7.15 537 20.61 8.02
Consumer loans 277 9.68 5.04 139 5.34 4.84
Unallocated 71 2.48 -- 170 6.53 --
------- ------ ------ ------- ------ ------
Total allowance for
loan losses $ 2,861 100.00% 100.00% $ 2,605 100.00% 100.00%
======= ====== ====== ======= ====== ======
Investment Activities
- ---------------------
The Company has legal authority to invest in various types of liquid assets,
including U.S. Treasury obligations, securities of various federal agencies,
state and municipal governments, mortgage-backed securities and certificates of
deposit of federally-insured institutions. Within certain regulatory limits, we
also may invest a portion of our assets in corporate securities and mutual
funds. We also are required to maintain an investment in FHLB stock. While we
have the authority under applicable law and our investment policies to invest in
derivative securities, we had no such investments at December 31, 2004.
The Company's investment objectives are to provide and maintain liquidity, to
maintain a balance of high quality, diversified investments to minimize risk, to
provide collateral for pledging requirements, to establish an acceptable level
of interest rate and credit risk, to provide an alternate source of low-risk
investments when demand for loans is weak, to generate a favorable return and to
assist in the financing needs of various local public entities, subject to
credit quality review and liquidity concerns. Our Board of Directors has the
overall responsibility for the investment portfolio, including approval of the
investment policy and appointment of the Investment Committee. The Investment
Committee is responsible for approval of investment strategies and monitoring
our investment performance. The Chief Financial Officer, in conjunction with the
Chief Executive Officer, is primarily responsible for implementation of the
investment policies. The Board of Directors provides designated individuals with
authority to make investment decisions. Currently, the President and Chief
Executive Officer and the Chief Financial Officer are authorized to enter into
fixed income transactions up to $2.5 million and equity transactions up to
$250,000. Two Senior Vice Presidents may enter into fixed income transactions up
to $1.0 million and equity transactions up to $100,000. Transactions exceeding
these limitations require the approval of two of these officers, one of whom
must be either the President and Chief Executive Officer or the Chief Financial
Officer. Individual
14
investment transactions will be reviewed and approved by the Board of Directors
on a monthly basis, while portfolio composition and performance will be reviewed
at least quarterly by the Investment Committee.
Statement of Financial Accounting Standards No. 115, "Accounting for Certain
Investments in Debt and Equity Securities" ("SFAS No. 115"), requires that
securities be categorized as either "held to maturity," "trading securities" or
"available for sale" based on management's intent as to the ultimate disposition
of each security. Debt securities may be classified as "held-to-maturity," and
reported in the financial statements at amortized cost, only if the Company has
the positive intent and ability to hold those securities until maturity.
Securities purchased and held principally for the purpose of trading in the near
term are classified as "trading securities." These securities are reported at
fair value in the financial statements, with unrealized gains and losses
recognized in earnings. Debt and equity securities not classified as either
"held to maturity" or "trading securities" are classified as "available for sale
securities." These securities are reported at fair value with unrealized gains
and losses excluded from earnings and reported in other comprehensive income,
net of taxes.
At December 31, 2004, the Company's investment portfolio included only available
for sale securities which totaled $120.6 million and represented 19.3% of
assets. The Company's available for sale securities consisted primarily of U.S.
government and agency securities with maturities of 15 years or less,
mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae with
stated final maturities of 30 years or less, corporate debt securities and
securities of state and municipal governments.
The following table sets forth the amortized cost and fair values of our
securities portfolio at the dates indicated.
December 31,
-------------------------------------------------------------------
(Dollars in Thousands) 2004 2003 2002
--------------------- -------------------- --------------------
Amortized Fair Amortized Fair Amortized Fair
Cost Value Cost Value Cost Value
--------- --------- --------- -------- --------- --------
Available for sale securities:
U.S. Government and agency
securities $ 73,950 $ 73,676 $ 38,583 $ 38,999 $ 27,931 $ 28,821
Mortgage-backed securities 40,926 40,594 19,050 18,364 32,569 32,770
Corporate debt securities 3,498 3,563 15,540 16,451 21,054 21,779
Obligations of state and political
subdivisions 1,499 1,584 3,129 3,217 3,199 3,309
Tax-exempt 560 560 -- -- -- --
Other debt securities 75 75 75 75 75 75
--------- --------- -------- -------- -------- --------
Total debt securities 120,508 120,052 76,377 77,106 84,828 86,754
Marketable equity securities 488 505 531 587 1,251 1,160
--------- --------- -------- -------- -------- --------
Total available for sale securities 120,996 120,557 76,908 77,693 86,079 87,914
Held to maturity securities:
Mortgage-backed securities -- -- 1,728 1,344 9,463 8,985
--------- --------- -------- -------- -------- --------
Total securities $ 120,996 $ 120,557 $ 78,636 $ 79,037 $ 95,542 $ 96,899
========= ========= ======== ======== ======== ========
The Company had no investments that had an aggregate book value in excess of 10%
of its equity at December 31, 2004.
The following table sets forth the amortized cost, weighted average yields and
contractual maturities of securities at December 31, 2004. Weighted average
yields on tax-exempt securities are not presented on a tax equivalent basis
because the impact would be insignificant. Certain mortgage-backed securities
have adjustable interest rates and will reprice periodically within the various
maturity ranges. These repricing schedules are not reflected in the table below.
At December 31, 2004, mortgage-backed securities with adjustable rates totaled
$13.5 million.
15
More than One Year More than Five Years
(Dollars in Thousands) One Year or Less to Five Years to Ten Years More than Ten Years
-------------------- -------------------- -------------------- --------------------
Weighted Weighted Weighted Weighted
Amortized Average Amortized Average Amortized Average Amortized Average
Cost Yield Cost Yield Cost Yield Cost Yield
--------- -------- --------- -------- --------- -------- --------- --------
Available for sale
securities:
U.S. government and agency
securities $ 13,559 3.65% $ 52,876 3.42% $ 5,308 4.01% $ 2,207 3.59%
Mortgage-backed securities -- -- 3,385 5.61 8,724 4.00 28,817 4.29
Corporate debt securities 2,998 7.83 -- -- -- -- 500 5.13
Obligations of state and
political subdivisions -- -- 999 6.80 -- -- 500 5.67
Tax-exempt securities 70 3.87 280 3.87 210 3.88 -- --
Other debt securities -- -- 50 4.72 25 7.30 -- --
-------- -------- -------- --------
Total debt securities 16,627 4.40 57,590 3.59 14,267 4.00 32,024 4.28
Marketable equity
securities -- -- -- -- -- -- 488 5.34
-------- -------- -------- --------
Total available for sale
securities $ 16,627 4.40% $ 57,590 3.59% $ 14,267 4.00% $ 32,512 4.30%
======== ======== ======== ========
(Dollars in Thousands) Total
--------------------
Weighted
Amortized Average
Cost Yield
--------- --------
Available for sale
securities:
U.S. government and agency
securities $ 73,950 3.51%
Mortgage-backed securities 40,926 4.34
Corporate debt securities 3,498 7.45
Obligations of state and
political subdivisions 1,499 6.42
Tax-exempt securities 560 3.87
Other debt securities 75 5.58
---------
Total debt securities 120,508 3.92
Marketable equity
securities 488 5.34
---------
Total available for sale
securities $ 120,996 3.93%
=========
Deposit Activities and Other Sources of Funds
- ---------------------------------------------
General. Deposits and loan repayments are the major sources of our funds for
lending and other investment purposes. Our primary source of funds are retail
deposit accounts held primarily by individuals and businesses within our market
area. Loan repayments are a relatively stable source of funds, while deposit
inflows and outflows and loan prepayments are significantly influenced by
general interest rates and money market conditions.
Deposit Accounts. Substantially all of the Bank's depositors are residents of
the State of Connecticut. Deposits are attracted from within our market area
through the offering of a broad selection of deposit instruments, including NOW,
money market accounts, regular savings accounts and certificates of deposit. We
also utilize brokered certificates of deposits, which at December 31, 2004
amounted to $5.0 million, as an alternate source of funds. Deposit account terms
vary according to the minimum balance required, the time periods the funds must
remain on deposit and the interest rates offered, among other factors. In
determining the terms of our deposit accounts, we consider the rates offered by
our competition, our liquidity needs, profitability to us, matching deposit and
loan products and customer preferences and concerns. We generally review our
deposit mix and pricing weekly. The Bank's current strategy is to offer
competitive rates, and even higher rates on long-term deposits, but not be the
market leader in every account type and maturity.
We also offer a variety of deposit accounts designed for the businesses
operating in our market area. Our business banking deposit products include a
commercial checking account that provides an earnings credit to offset monthly
service charges and a checking account specifically designed for small business
and nonprofit organizations. Additionally, we offer sweep accounts and money
market accounts for businesses. We have sought to increase our commercial
deposits through the offering of these products, particularly to our commercial
borrowers and to local municipalities.
16
The following table sets forth the deposit activity for the periods indicated,
including mortgagors' and investors' escrow accounts and brokered deposits.
Years Ended December 31,
---------------------------------
(Dollars in Thousands) 2004 2003 2002
--------- --------- ---------
Beginning balance $ 417,311 $ 398,315 $ 363,029
Increase before interest credited 36,833 12,389 26,781
Interest credited 6,336 6,607 8,505
--------- --------- ---------
Net increase in deposits 43,169 18,996 35,286
--------- --------- ---------
Ending balance (1) $ 460,480 $ 417,311 $ 398,315
========= ========= =========
----------
(1) Includes mortgagors' and investors' escrow accounts in the amount of
$2.7 million, $2.2 million and $2.0 million at December 31, 2004,
2003 and 2002, respectively. Includes brokered deposits of $5.0
million at December 31, 2004 and 2003.
The following table sets forth the distribution of the Company's deposit
accounts for the dates indicated.
December 31,
------------------------------------------------------------
(Dollars in Thousands) 2004 2003 2002
------------------------------------------------------------
% of % of % of
Balance Total Balance Total Balance Total
--------- ------ --------- ------ --------- ------
Noninterest-bearing demand
deposits $ 46,049 10.00% $ 40,371 9.67% $ 37,624 9.45%
NOW and money market accounts 110,564 24.01 101,852 24.41 90,516 22.72
Savings accounts (1) 95,310 20.70 89,846 21.53 84,201 21.14
Certificates of deposit (2) 208,557 45.29 185,242 44.39 185,974 46.69
--------- ------ --------- ------ --------- ------
Total deposits $ 460,480 100.00% $ 417,311 100.00% $ 398,315 100.00%
========= ====== ========= ====== ========= ======
- ----------
(1) Includes mortgagors' and investors' escrow accounts in the amount of $2.7
million, $2.2 million and $2.0 million at December 31, 2004, 2003 and
2002, respectively.
(2) Includes brokered deposits of $5.0 million at December 31, 2004 and 2003.
The Company had $51.3 million of certificates of deposit of $100,000 or more
outstanding as of December 31, 2004, maturing as follows:
Weighted Average
(Dollars in Thousands) Amount Rate
-------- ----------------
Maturity Period:
----------------
Three months or less $ 12,637 1.89%
Over three through six months 5,096 2.11
Over six through twelve months 6,443 2.03
Over twelve months 27,130 3.73
--------
Total $ 51,306 2.90%
========
17
The following table presents the amount of certificates of deposit accounts
outstanding by the various rate categories, periods to maturity and percent of
total certificate accounts at December 31, 2004.
Amount Due
--------------------------------------------------------------------------
(Dollars in Thousands) More Than More Than Percent of
More Than Two Years Three Years Total
Less Than One Year to to Three to Four More Than Certificate
One Year Two Years Years Years Four Years Total Accounts
--------- ----------- --------- ----------- ---------- --------- -----------
0.00 - 1.00% $ 1,457 $ -- $ -- $ -- $ -- $ 1,457 0.70%
1.01 - 2.00% 61,621 4,111 109 -- -- 65,841 31.57
2.01 - 3.00% 16,762 20,099 7,105 97 4 44,067 21.13
3.01 - 4.00% 9,200 9,858 32,258 6,878 6,038 64,232 30.80
4.01 - 5.00% 3,379 9,387 5,999 95 1,417 20,277 9.72
5.01 - 6.00% 290 2,053 7,992 4 296 10,635 5.10
6.01 - 7.02% 1,828 140 80 -- -- 2,048 0.98
-------- -------- -------- ------- ------- --------- ------
Total $ 94,537 $ 45,648 $ 53,543 $ 7,074 $ 7,755 $ 208,557 100.00%
======== ======== ======== ======= ======= ========= ======
Borrowings. We utilize advances from the FHLB to supplement our supply of
lendable funds and to meet deposit withdrawal requirements. The FHLB functions
as a central reserve bank providing credit for member financial institutions. As
a member, we are required to own capital stock in the FHLB and are authorized to
apply for advances on the security of such stock and certain of our mortgage
loans and other assets (principally securities which are obligations of, or
guaranteed by, the United States), provided certain standards related to
creditworthiness have been met. Advances are made under several different
programs, each having its own interest rate and range of maturities. Depending
on the program, limitations on the amount of advances are based either on a
fixed percentage of an institution's net worth or on the FHLB's assessment of
the institution's creditworthiness. Under its current credit policies, the FHLB
generally limits advances to 25% of a member's assets, and short-term borrowings
of less than one year may not exceed 10% of the institution's assets. The FHLB
determines specific lines of credit for each member institution.
Advances from the FHLB increased $15.5 million, or 27.1%, for the year ended
December 31, 2004. The new advances, which have longer durations, were obtained
to mitigate interest rate risk by matching the durations of the longer-term
mortgage loans in our portfolio. The increased borrowings were used as a
supplement to deposits to fund asset growth.
Junior Subordinated Debt Owed to Unconsolidated Trust. To a lesser extent, the
Company utilizes the proceeds raised from the issuance of trust preferred
securities. In 2002, SI Capital Trust I (the "Trust"), a business trust formed
by SI Bancorp, MHC (formerly SI Bancorp, Inc.), issued $7.0 million of preferred
securities in a private placement and issued approximately $217,000 of common
securities to SI Bancorp, MHC. The Trust used the proceeds of these issuances to
purchase $7.2 million of SI Bancorp, MHC's floating rate junior subordinated
deferrable interest debentures. The interest rate on the debentures and the
trust preferred securities is variable and adjustable quarterly at 3.70% over
the six-month LIBOR. The interest rate on these securities at December 31, 2004
was 6.0%. A rate cap of 11.00% is effective through April 22, 2007. On September
24, 2004, all of the common stock of SI Capital Trust I was contributed to the
Company from SI Bancorp, MHC, at which point, SI Capital Trust I became a
wholly-owned subsidiary of the Company.
The debentures are the sole assets of SI Capital Trust I and are subordinate to
all of the Company's existing and future obligations for borrowed money, its
obligations under letters of credit and certain derivative contracts and any
guarantees by the Company of any such obligations. The trust preferred
securities generally rank equal to the trust common securities in priority of
payment, but rank before the trust common securities if and so long as the
Company fails to make principal or interest payments on the debentures.
Concurrently with the issuance of the debentures and the trust preferred and
common securities, the Company issued a guarantee related to the trust
securities for the benefit of the holders. SI Bancorp, MHC's obligations under
the guarantee and the Company's obligations under the debentures, the related
indenture and the trust agreement relating to the trust securities,
18
constitute a full and unconditional guarantee by the Company of the obligations
of SI Capital Trust I under the trust preferred securities.
The stated maturity of the debentures is April 22, 2032. In addition, the
debentures are subject to redemption at par at the option of the Company,
subject to prior regulatory approval, in whole or in part on any interest
payment date after April 22, 2007. The debentures are also subject to redemption
before April 22, 2007 at a specified price after the occurrence of certain
events that would either have a negative tax effect on SI Capital Trust I or the
Company or would result in SI Capital Trust I being treated as an investment
company that is required to be registered under the Investment Company Act of
1940. Upon repayment of the debentures at their stated maturity or following
their redemption, the Trust will use the proceeds of such repayment to redeem an
equivalent amount of outstanding trust preferred securities and trust common
securities.
Additionally, the Company occasionally utilizes collateralized borrowings, which
represent loans sold that do not meet the criteria for derecognition, due
primarily to recourse and other provisions that could not be measured at the
date of transfer. Such borrowings are derecognized when all recourse and other
provisions that could not be measured at the time of transfer either expire or
become measurable. The Company had no collateralized borrowings at December 31,
2004.
The following table sets forth information regarding the Company's borrowings at
the dates or for the periods indicated.
At or For the Years Ended December 31,
--------------------------------------
(Dollars in Thousands) 2004 2003 2002
----------- ----------- ----------
Maximum amount of advances outstanding at any month-end during
the period:
FHLB advances $ 72,674 $ 57,168 $ 47,718
Subordinated debt 7,217 7,217 7,217
Other borrowings -- 1,951 1,955
Average balance outstanding during the period:
FHLB advances $ 65,154 $ 46,693 $ 40,618
Subordinated debt 7,217 7,217 4,718
Other borrowings -- 1,233 1,378
Weighted average interest rate during the period:
FHLB advances 4.12% 4.66% 5.28%
Subordinated debt 5.14 4.99 6.38
Other borrowings -- 6.00 6.31
Balance outstanding at end of period:
FHLB advances $ 72,674 $ 57,168 $ 43,918
Subordinated debt 7,217 7,217 7,217
Other borrowings -- -- 1,951
Weighted average interest rate at end of period:
FHLB advances 3.80% 4.29% 4.94%
Subordinated debt 5.92 4.85 5.32
Other borrowings -- -- 6.68
19
Trust Services
- --------------
The Bank's trust department primarily provides trust services to individuals,
partnerships, corporations and institutions and also acts as a fiduciary of
estates and conservatorships as a trustee under various wills, trusts and other
plans. Consistent with our operating strategy, we will continue to emphasize the
growth of our trust service operations to grow assets and increase fee-based
income. We have implemented several policies governing the practices and
procedures of the trust department, including policies relating to maintaining
confidentiality of trust records, investment of trust property, handling
conflicts of interest and maintaining impartiality. At December 31, 2004, the
trust department had assets under administration of $118.4 million, representing
277 accounts, the largest of which totaled $9.6 million, or 8.1%, of the trust
department's total assets. For the year ended December 31, 2004 and 2003, trust
services revenue was $631,000 and $596,000, respectively.
Subsidiary Activities
- ---------------------
The Company has one subsidiary other than the Savings Institute Bank and Trust
Company. In 2002, SI Capital Trust I was established as a statutory trust under
Delaware law as a wholly-owned subsidiary of SI Bancorp, MHC for the purpose of
issuing trust preferred securities. SI Capital Trust I issued trust preferred
securities on April 10, 2002. All of the common stock of SI Capital Trust I was
contributed to the Company from SI Bancorp, MHC on September 24, 2004. At that
point, SI Capital Trust I became a wholly-owned subsidiary of the Company. In
accordance with Financial Accounting Standards Board Interpretation No. 46R,
"Consolidation of Variable Interest Entities," SI Capital Trust I is not
consolidated for financial reporting purposes.
The following are descriptions of the Bank's wholly-owned subsidiaries.
803 Financial Corp. 803 Financial Corp. was established in 1995 as a Connecticut
corporation to maintain an ownership interest in a third-party registered
broker-dealer, Infinex Investments, Inc. Infinex operates offices at the Bank
and offers customers a complete range of nondeposit investment products,
including mutual funds, debt, equity and government securities, retirement
accounts, insurance products and fixed and variable annuities. The Bank receives
a portion of the commissions generated by Infinex from sales to customers. For
the years ended December 31, 2004 and 2003, the Bank received fees of $184,000
and $121,000, respectively, through its relationship with Infinex. Due to a
regulatory restriction on federally-chartered thrifts, on December 31, 2004, 803
Financial Corp. sold its interest in Infinex which was subsequently purchased by
SI Financial Group, Inc. As of December 31, 2004, 803 Financial Corp. has no
other holdings.
SI Realty Company, Inc. SI Realty, established in 1999 as a Connecticut
corporation, holds real estate owned by the Bank, including foreclosure
properties. At December 31, 2004, SI Realty had $225,000 in assets.
SI Mortgage Company. In January 1999, the Bank formed SI Mortgage to manage and
hold loans secured by real property. SI Mortgage qualifies as a "passive
investment company," which exempts it from Connecticut income tax under current
law. Income tax savings to the Bank from the use of a passive investment company
was approximately $92,000 and $190,000 for the years ended December 31, 2004 and
2003, respectively.
Personnel
- ---------
At December 31, 2004, the Company had 165 full-time employees and 35 part-time
employees. None of the Company's employees is represented by a collective
bargaining unit. The Company believes its relationship with its employees is
good.
Risk Factors
- ------------
o Additional public company and annual stock employee compensation and
benefit expenses will reduce the Company's profitability and
stockholders' equity. The Company's noninterest expense is likely to
increase as a result of the financial accounting, legal and various
other additional expenses usually associated with operating as a
public company. The Company also will recognize additional annual
employee compensation and benefit
20
expenses stemming from the shares purchased or granted to employees
and executives under new benefit plans. These additional expenses
will adversely affect the Company's profitability and stockholders'
equity. The Company cannot predict the actual amount of the new
stock-related compensation and benefit expenses because applicable
accounting standards require that they be based on the fair market
value of the shares of common stock at specific points in the
future; however, the Company expects them to be material. The
Company will recognize expenses for its employee stock ownership
plan when shares are committed to be released to participants'
accounts and, assuming implementation of any stock-based benefit
plans following the requisite stockholder approval, will recognize
expenses for restricted stock awards and stock options over the
vesting period of awards made to recipients.
o SI Bancorp, MHC's majority control of the Company's common stock
will enable it to exercise voting control over most matters put to a
vote of shareholders, including preventing a sale, a merger or a
second-step conversion transaction. SI Bancorp, MHC owns a majority
of the Company's common stock and, through its Board of Directors,
will be able to exercise voting control over most matters put to a
vote of shareholders. The same directors and officers who manage the
Company and the Bank also manage SI Bancorp, MHC. As a
federally-chartered mutual holding company, the Board of Directors
of SI Bancorp, MHC must ensure that the interests of depositors of
the Bank are represented and considered in matters put to a vote of
shareholders of the Company. Therefore, the votes cast by SI
Bancorp, MHC may not be in your personal best interests as a
shareholder. For example, SI Bancorp, MHC may exercise its voting
control to prevent a sale or merger transaction in which
shareholders could receive a premium for their shares or to defeat a
shareholder nominee for election to the Board of Directors of the
Company. In addition, SI Bancorp, MHC may exercise its voting
control to prevent a second-step conversion transaction. Preventing
a second-step conversion transaction may result in a lower value of
the Company's stock price than otherwise could be achieved as,
historically, fully-converted institutions trade at higher multiples
than mutual holding companies. The matters as to which shareholders,
other than SI Bancorp, MHC, will be able to exercise voting control
are limited and include any proposal to implement a stock-based
incentive plan.
o Due to the time it will take to deploy the offering proceeds into
higher-yielding assets, the Company expects that its return on
equity initially will decline after the offering. Return on equity,
which equals net income divided by average equity, is a ratio used
by many investors to compare the performance of a particular company
with other companies. Over time, the Company intends to deploy the
net proceeds from the offering, which were initially invested into
investment securities, into higher-yielding assets with the goal of
increasing earnings per share and book value per share, without
assuming undue risk, and achieving a return on equity that is
competitive with other publicly held subsidiaries of mutual holding
companies. This goal could take a number of years to achieve, and
the Company cannot assure you that it will be attained.
Consequently, you should not expect a competitive return on equity
in the near future. Failure to achieve a competitive return on
equity might make an investment in the Company's common stock
unattractive to some investors and might cause the Company's common
stock to trade at lower prices than comparable companies with higher
returns on equity.
o The Company's increased emphasis on commercial lending may expose it
to increased lending risks. At December 31, 2004, $141.3 million, or
31.4%, of the Company's loan portfolio consisted of commercial real
estate and commercial business loans. The Company intends to
continue to emphasize these types of lending. These types of loans
generally expose a lender to greater risk of non-payment and loss
than one- to four-family residential mortgage loans because
repayment of the loans often depends on the successful operation of
the property and the income stream of the borrowers. Such loans
typically involve larger loan balances to single borrowers or groups
of related borrowers compared to one- to four-family residential
mortgage loans. Also, many of the Company's commercial borrowers
have more than one loan outstanding with the Company. Consequently,
an adverse development with respect to one loan or one credit
relationship can expose the Company to a significantly greater risk
of loss compared to an adverse development with respect to a one- to
four-family residential mortgage loan.
21
o The Company's inability to achieve profitability on new branches may
negatively impact its earnings. The Company considers its primary
market area to consist of Hartford, New London, Tolland and Windham
counties. However, the majority of the Company's facilities are
located in and a substantial portion of the Company's business is
derived from Windham county, which has a lower median household
income and a higher unemployment rate than other counties in the
Company's market area and the rest of Connecticut. To address this,
in recent years, the Company has expanded its presence throughout
its market area and the Company intends to pursue further expansion
through the establishment of additional branches in Hartford, New
London, Tolland and Middlesex counties, each of which has more
favorable economic conditions than Windham County. The profitability
of the Company's expansion policy will depend on whether the income
that it generates from the additional branches it establishes will
offset the increased expenses resulting from operating new branches.
The Company expects that it may take a period of time before new
branches can become profitable, especially in areas in which it does
not have an established presence. During this period, operating
these new branches may negatively impact the Company's net income.
o Rising interest rates may hurt the Company's profits. Interest rates
were recently at historically low levels. The recent increase in
interest rates has negatively affected the Company's net interest
income. If interest rates continue to rise, the Company's net
interest income and the value of its assets likely would be reduced
if interest paid on interest-bearing liabilities, such as deposits
and borrowings, increased more quickly than interest received on
interest-earning assets, such as loans and investments. If there is
an increasing interest rate environment, the Company's interest rate
spread and net interest margin could be compressed, which would have
a negative effect on its profitability.
o Strong competition within the Company's market area could hurt the
Company's profits and slow growth. The Company faces intense
competition both in making loans and attracting deposits. This
competition has made it more difficult for the Company to make new
loans and at times has forced the Company to offer higher deposit
rates. Price competition for loans and deposits might result in the
Company earning less on its loans and paying more on its deposits,
which reduces net interest income. As of June 30, 2004, the Company
held 0.79% of the deposits in Hartford, New London, Tolland and
Windham counties in Connecticut, which represented the 14th market
share of deposits out of 37 financial institutions in these
counties. Some of the institutions with which the Company competes
have substantially greater resources and lending limits than the
Company has and may offer services that the Company does not
provide. The Company expects competition to increase in the future
as a result of legislative, regulatory and technological changes and
the continuing trend of consolidation in the financial services
industry. The Company's profitability depends upon its continued
ability to compete successfully in its market area.
o The Company has broad discretion in allocating the proceeds of the
offering. Its failure to effectively utilize such proceeds would
reduce its profitability. The Company contributed approximately 50%
of the net proceeds of the offering to Savings Institute Bank and
Trust Company. It may use the remaining net proceeds to repurchase
common stock, purchase investment securities, finance the
acquisition of other financial institutions or other businesses that
are related to banking or for other general corporate purposes. The
Company used a portion of the net proceeds to fund the purchase by
the employee stock ownership plan of shares in the offering. Savings
Institute Bank and Trust Company may use the proceeds it received to
fund new loans, purchase investment securities, establish or acquire
new branches, acquire financial institutions or other businesses
that are related to banking or for general corporate purposes.
Savings Institute Bank and Trust Company has not allocated specific
amounts of proceeds for any of these purposes and has significant
flexibility in determining how much of the net proceeds it applies
to different uses and the timing of such applications. Its failure
to utilize these funds effectively would reduce its profitability.
o Office of Thrift Supervision policy on remutualization transactions
could prohibit acquisition of the Company, which may adversely
affect its stock price. Current Office of Thrift Supervision
regulations permit a mutual holding company to be acquired by a
mutual institution in a remutualization transaction. The possibility
of a
22
remutualization transaction has recently resulted in a degree of
takeover speculation for mutual holding companies that is reflected
in the per share price of mutual holding companies' common stock.
However, the Office of Thrift Supervision has issued a policy
statement indicating that it views remutualization transactions as
raising significant issues concerning disparate treatment of
minority stockholders and mutual members of the target entity and
raising issues concerning the effect on the mutual members of the
acquiring entity. Under certain circumstances, the Office of Thrift
Supervision intends to give these issues special scrutiny and reject
applications providing for the remutualization of a mutual holding
company unless the applicant can clearly demonstrate that the Office
of Thrift Supervision's concerns are not warranted in the particular
case. Should the Office of Thrift Supervision prohibit or otherwise
restrict these transactions in the future, the Company's per share
stock price may be adversely affected.
o The Company operates in a highly regulated environment and it may be
adversely affected by changes in laws and regulations. The Company
is subject to extensive regulation, supervision and examination by
the Office of Thrift Supervision, the Company's chartering authority
and the Federal Deposit Insurance Corporation, as insurer of the
Bank's deposits. SI Bancorp, MHC, the Company and the Bank are all
subject to regulation and supervision by the Office of Thrift
Supervision. Such regulation and supervision governs the activities
in which an institution and its holding company may engage, and are
intended primarily for the protection of the insurance fund and
depositors. Regulatory authorities have extensive discretion in
their supervisory and enforcement activities, including the
imposition of restrictions on the Company's operations, the
classification of its assets and determination of the level of the
Bank's allowance for loan losses. Any change in such regulation and
oversight, whether in the form of regulatory policy, regulations,
legislation or supervisory action, may have a material impact on the
Company's operations.
REGULATION AND SUPERVISION
- --------------------------
General
- -------
The Bank is subject to extensive regulation, examination and supervision by the
Office of Thrift Supervision, as its primary federal regulator, and the FDIC, as
its deposits insurer. The Bank is a member of the Federal Home Loan Bank System
and its deposit accounts are insured up to applicable limits by the Bank
Insurance Fund managed by the FDIC. The Bank must file reports with the OTS and
the FDIC concerning its activities and financial condition in addition to
obtaining regulatory approvals before entering into certain transactions such as
mergers with, or acquisitions of, other financial institutions. There are
periodic examinations by the OTS and, under certain circumstances, the FDIC, to
evaluate the Bank's safety and soundness and compliance with various regulatory
requirements. This regulatory structure is intended primarily for the protection
of the insurance fund and depositors. The regulatory structure also gives the
regulatory authorities extensive discretion in connection with their supervisory
and enforcement activities and examination policies, including policies with
respect to the classification of assets and the establishment of adequate loan
loss reserves for regulatory purposes. Any change in such policies, whether by
the OTS, the FDIC or Congress, could have a material adverse impact on the
Company, SI Bancorp, MHC and the Bank and their operations. The Company and SI
Bancorp, MHC, as savings and loan holding companies, are required to file
certain reports with, are subject to examination by, and otherwise must comply
with the rules and regulations of the OTS. The Company is also subject to the
rules and regulations of the Securities and Exchange Commission (the "SEC")
under the federal securities laws.
Certain of the regulatory requirements that are applicable to the Bank, the
Company and SI Bancorp, MHC are described below. This description of statutes
and regulations is not intended to be a complete explanation of such statutes
and regulations and their effects on the Bank, the Company and SI Bancorp, MHC
are qualified in their entirety by reference to the actual statutes and
regulations.
Regulation of Federal Savings Associations
- ------------------------------------------
Business Activities. Federal law and regulations, primarily the Home Owners'
Loan Act and the regulations of the OTS, govern the activities of federal
savings banks, such as the Bank. These laws and regulations delineate the nature
and extent of the activities in which federal savings banks may engage. In
particular, certain lending
23
authority for federal savings banks, e.g., commercial, non-residential real
property loans and consumer loans, is limited to a specified percentage of the
institution's capital or assets. At December 31, 2004, the Bank believes that it
complied with all lending limits imposed by the OTS.
Branching. Federal savings banks are authorized to establish branch offices in
any state or states of the United States and its territories, subject to the
approval of the OTS.
Capital Requirements. The OTS's capital regulations require federal savings
institutions to meet three minimum capital standards:
o a tangible capital ratio requirement of 1.5% of adjusted total
assets;
o a leverage ratio of 4% of Tier 1 (core) capital to adjusted total
assets (3% for institutions receiving the highest rating on the
CAMELS examination rating system); and
o a risk-based capital ratio requirement of 8% of total capital (core
and supplementary capital) to total risk-weighted assets of which at
least half must be core capital
In addition, the prompt corrective action standards discussed below also
established, in effect, a minimum 2% tangible capital standard, a 4% leverage
ratio standard (3% for institutions receiving the highest rating on the CAMELS
examination rating system) and, together with the risk-based capital standard
itself, a 4% Tier 1 risk-based capital standard. The OTS regulations also
require that, in meeting the tangible, leverage and risk-based capital
standards, institutions must generally deduct investments in and loans to
subsidiaries engaged in activities as principal that are not permissible for a
national bank.
In determining compliance with the risk-based capital requirement, savings
institutions must compute its risk-weighted assets by multiplying its assets,
including certain off-balance sheet assets, recourse obligations, residual
interests and direct credit substitutes, by risk-weight factors ranging from 0%
for cash and obligations of the United States Government or its agencies to 100%
for consumer and commercial loans, as assigned by the OTS capital regulation
based on the risks believed inherent in the type of asset.
Core (Tier 1) capital is defined as common stockholders' equity (including
retained earnings), certain noncumulative perpetual preferred stock and related
surplus and minority interests in equity accounts of consolidated subsidiaries,
less intangibles (other than certain mortgage servicing rights) and credit card
relationships. The components of supplementary capital currently include
cumulative preferred stock, long-term perpetual preferred stock, mandatory
convertible securities, subordinated debt and intermediate preferred stock, the
allowance for loan and lease losses limited to a maximum of 1.25% of
risk-weighted assets and up to 45% of unrealized gains on available-for-sale
equity securities with readily determinable fair market values. Overall, the
amount of supplementary capital included as part of total capital cannot exceed
100% of core capital.
The OTS also has authority to establish individual minimum capital requirements
in appropriate cases upon a determination that an institution's capital level is
or may become inadequate in light of the particular circumstances. At December
31, 2004, the Bank exceeded each of these capital requirements.
Prompt Corrective Regulatory Action. The OTS is required to take certain
supervisory actions against undercapitalized institutions, the severity of which
depends upon the institution's degree of undercapitalization. Generally, a
savings institution that has a ratio of total capital to risk weighted assets of
less than 8%, a ratio of Tier 1 (core) capital to risk-weighted assets of less
than 4% or a ratio of core capital to total assets of less than 4% (3% or less
for institutions with the highest examination rating) is considered to be
"undercapitalized." A savings institution that has a total risk-based capital
ratio less than 6%, a Tier 1 capital ratio of less than 3% or a leverage ratio
that is less than 3% is considered to be "significantly undercapitalized" and a
savings institution that has a tangible capital to assets ratio equal to or less
than 2% is deemed to be "critically undercapitalized." Subject to a narrow
exception, the OTS is required to appoint a receiver or conservator within
specified time frames for an institution that is "critically undercapitalized."
An institution must file a capital restoration plan with the OTS within 45 days
of the date it receives notice that it is "undercapitalized," "significantly
undercapitalized" or "critically undercapitalized." Compliance with the plan
must be guaranteed by any parent holding company. In addition, numerous
mandatory supervisory actions become immediately applicable to an
undercapitalized
24
institution, including, but not limited to, increased monitoring by regulators
and restrictions on growth, capital distributions and expansion. "Significantly
undercapitalized" and "critically undercapitalized" institutions are subject to
more extensive mandatory regulatory actions. The OTS could also take any one of
a number of discretionary supervisory actions, including the issuance of a
capital directive and the replacement of senior executive officers and
directors.
Loans to One Borrower. Federal law provides that savings institutions are
generally subject to the limits on loans to one borrower applicable to national
banks. A savings institution may not make a loan or extend credit to a single or
related group of borrowers in excess of 15% of its unimpaired capital and
surplus. An additional amount may be lent, equal to 10% of unimpaired capital
and surplus, if secured by specified readily-marketable collateral. See "Item 1.
Business. Lending Activities - Loans to One Borrower."
Standards for Safety and Soundness. As required by statute, the federal banking
agencies have adopted Interagency Guidelines prescribing Standards for Safety
and Soundness. The guidelines set forth the safety and soundness standards that
the federal banking agencies use to identify and address problems at insured
depository institutions before capital becomes impaired. If the OTS determines
that a savings institution fails to meet any standard prescribed by the
guidelines, the OTS may require the institution to submit an acceptable plan to
achieve compliance with the standard. The Bank has not received any notice from
the OTS that it has failed to meet any standard prescribed by the guidelines.
Limitation on Capital Distributions. OTS regulations impose limitations upon all
capital distributions by a savings institution, including cash dividends,
payments to repurchase its shares and payments to shareholders of another
institution in a cash-out merger. Under the regulations, an application to and
the prior approval of the OTS is required before any capital distribution if the
institution does not meet the criteria for "expedited treatment" of applications
under OTS regulations (i.e., generally, examination and Community Reinvestment
Act ratings in the two top categories), the total capital distributions for the
calendar year exceed net income for that year plus the amount of retained net
income for the preceding two years, the institution would be undercapitalized
following the distribution or the distribution would otherwise be contrary to a
statute, regulation or agreement with the OTS. If an application is not
required, the institution must still provide prior notice to the OTS of the
capital distribution if, like the Bank, it is a subsidiary of a holding company.
If the Bank's capital were ever to fall below its regulatory requirements or the
OTS notified it that it was in need of increased supervision, its ability to
make capital distributions could be restricted. In addition, the OTS could
prohibit a proposed capital distribution that would otherwise be permitted by
the regulation, if the agency determines that such distribution would constitute
an unsafe or unsound practice.
Qualified Thrift Lender Test. Federal law requires savings institutions to meet
a qualified thrift lender test. Under the test, a savings association is
required to either qualify as a "domestic building and loan association" under
the Internal Revenue Code or maintain at least 65% of its "portfolio assets" in
certain "qualified thrift investments" (primarily residential mortgages and
related investments, including certain mortgage-backed securities) in at least 9
months out of each 12-month period. "Portfolio assets" represent, in general,
total assets less the sum of:
o specified liquid assets up to 20% of total assets;
o goodwill and other intangible assets; and
o the value of property used to conduct business
A savings institution that fails the qualified thrift lender test is subject to
certain operating restrictions and may be required to convert to a bank charter.
Recent legislation has expanded the extent to which education loans, credit card
loans and small business loans may be considered "qualified thrift investments."
As of December 31, 2004, the Bank maintained 80.34% of its portfolio assets in
qualified thrift investments and, therefore, met the qualified thrift lender
test.
Transactions with Related Parties. Federal law limits the Bank's authority to
lend to, and engage in certain other transactions with (collectively, "covered
transactions"), "affiliates" (e.g., any company that controls or is under common
control with an institution, including the Company, SI Bancorp, MHC and their
non-savings institution subsidiaries). The aggregate amount of covered
transactions with any individual affiliate is limited to 10% of the
25
capital and surplus of the savings institution. The aggregate amount of covered
transactions with all affiliates is limited to 20% of the savings institution's
capital and surplus. Loans and other specified transactions with affiliates are
required to be secured by collateral in an amount and of a type described in
federal law. The purchase of low quality assets from affiliates is generally
prohibited. Transactions with affiliates must be on terms and under
circumstances that are at least as favorable to the institution as those
prevailing at the time for comparable transactions with non-affiliated
companies. In addition, savings institutions are prohibited from lending to any
affiliate that is engaged in activities that are not permissible for bank
holding companies and no savings institution may purchase the securities of any
affiliate other than a subsidiary.
The Sarbanes-Oxley Act of 2002 generally prohibits a company from making loans
to its executive officers and directors. However, that act contains a specific
exception for loans by a depository institution to its executive officers and
directors in compliance with federal banking laws. Under such laws, the Bank's
authority to extend credit to executive officers, directors and 10% shareholders
("insiders"), as well as entities in which such persons control, is limited. The
law restricts both the individual and aggregate amount of loans the Bank may
make to insiders based, in part, on the Bank's capital position and requires
certain board approval procedures to be followed. Such loans must be made on
terms substantially the same as those offered to unaffiliated individuals and
not involve more than the normal risk of repayment. There is an exception for
loans made pursuant to a benefit or compensation program that is widely
available to all employees of the institution and does not give preference to
insiders over other employees. In addition, loans made to a director or
executive officer in an amount that, when aggregated with the amount of all
other loans to the person and his or her related interest, are in excess of the
greater of $25,000, or 5% of the Bank's capital and surplus, and in any event
any loans totaling $500,000 or more, must be approved in advance by a majority
of the disinterested members of the Board of Directors.
Enforcement. The OTS has primary enforcement responsibility over federal savings
institutions and has the authority to bring actions against the institution and
all institution-affiliated parties, including stockholders, and any attorneys,
appraisers and accountants who knowingly or recklessly participate in wrongful
action likely to have an adverse effect on an insured institution. Formal
enforcement action may range from the issuance of a capital directive or cease
and desist order for removal of officers and/or directors to institution of
receivership, conservatorship or termination of deposit insurance. Civil
penalties cover a wide range of violations and can amount to $25,000 per day, or
even $1.0 million per day in especially egregious cases. The FDIC has authority
to recommend to the Director of the OTS that enforcement action be taken with
respect to a particular savings institution. If action is not taken by the
Director, the FDIC has authority to take such action under certain
circumstances. Federal law also establishes criminal penalties for certain
violations.
Assessments. Federal savings banks are required to pay assessments to the OTS to
fund its operations. The general assessments, paid on a semi-annual basis, are
based upon the savings institution's total assets, including consolidated
subsidiaries, as reported in the institution's latest quarterly thrift financial
report.
Insurance of Deposit Accounts. The Bank is a member of the Bank Insurance Fund.
The FDIC maintains a risk-based assessment system by which institutions are
assigned to one of three categories based on their capitalization and one of
three subcategories based on examination ratings and other supervisory
information. An institution's assessment rate depends upon the categories to
which it is assigned. Assessment rates for Bank Insurance Fund member
institutions are determined semi-annually by the FDIC and currently range from
zero basis points of assessable deposits for the healthiest institutions to 27
basis points of assessable deposits for the riskiest.
The FDIC has authority to increase insurance assessments. A material increase in
Bank Insurance Fund insurance premiums would likely have an adverse effect on
the operating expenses and results of operation of the Bank. Management cannot
predict what insurance assessment rates will be in the future.
In addition to the assessment for deposit insurance, institutions are required
to make payments on bonds issued in the late 1980s by the Financing Corporation
to recapitalize the predecessor to the Savings Association Insurance Fund.
During the calendar year ended December 31, 2004, Financing Corporation payments
for Bank Insurance Fund members averaged 1.51 basis points of assessable
deposits. At December 31, 2004, the Bank had paid all fees and assessments for
deposit insurance.
26
The FDIC may terminate an institution's insurance of deposits upon a finding
that the institution has engaged in unsafe or unsound practices, is in an unsafe
or unsound condition to continue operations or has violated any applicable law,
regulation, rule, order or condition imposed by the FDIC or the OTS. The
management of the Bank does not know of any practice, condition or violation
that might lead to termination of deposit insurance.
Federal Home Loan Bank System. The Bank is a member of the Federal Home Loan
Bank System, which consists of twelve regional Federal Home Loan Banks. The FHLB
provides a central credit facility primarily for member institutions. The Bank,
as a member of the FHLB, is required to acquire and hold shares of capital stock
in FHLB. The Bank was in compliance with this requirement with an investment in
FHLB at December 31, 2004 of $4.3 million.
The Federal Home Loan Banks are required to provide funds for the resolution of
insolvent thrifts in the late 1980s and to contribute funds for affordable
housing programs. These requirements could reduce the amount of dividends that
the Federal Home Loan Banks pay to their members and could also result in the
Federal Home Loan Banks imposing a higher rate of interest on advances to their
members. If dividends were reduced, or interest on future FHLB advances
increased, our net interest income would be negatively impacted.
Community Reinvestment Act. Under the Community Reinvestment Act, 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 Community Reinvestment Act 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 Community
Reinvestment Act. The Community Reinvestment Act requires the OTS, in connection
with its examination of a savings association, to assess the institution's
record of meeting the credit needs of its community and to take such record into
account in its evaluation of certain applications by such institution.
The Community Reinvestment Act requires public disclosure of an institution's
rating and requires the OTS to provide a written evaluation of an association's
Community Reinvestment Act performance utilizing a four-tiered descriptive
rating system.
The Bank received an "outstanding" rating, which is the highest possible rating,
as a result of its most recent Community Reinvestment Act assessment.
Holding Company Regulation
- --------------------------
General. The Company and SI Bancorp, MHC are savings and loan holding companies
within the meaning of federal law. As such, they are registered with the OTS and
are subject to OTS regulations, examinations, supervision, reporting
requirements and regulations concerning corporate governance and activities. In
addition, the OTS has enforcement authority over the Company, SI Bancorp, MHC
and their non-savings institution subsidiaries. Among other things, this
authority permits the OTS to restrict or prohibit activities that are determined
to be a serious risk to the Bank.
Restrictions Applicable to Mutual Holding Companies. According to federal law
and OTS regulations, a mutual holding company, such as SI Bancorp, MHC, may
generally engage in the following activities: (1) investing in the stock of a
bank; (2) acquiring a mutual association through the merger of such association
into a bank subsidiary of such holding company or an interim bank subsidiary of
such holding company; (3) merging with or acquiring another holding company, one
of whose subsidiaries is a bank; and (4) any activity approved by the Federal
Reserve Board for a bank holding company or financial holding company or
previously approved by OTS for multiple savings and loan holding companies.
Recent legislation, which authorized mutual holding companies to engage in
activities permitted for financial holding companies, expanded the authorized
activities. Financial holding companies may engage in a broad array of financial
service activities including insurance and securities.
27
Federal law prohibits a savings and loan holding company, including a federal
mutual holding company, from directly or indirectly, or through one or more
subsidiaries, acquiring more than 5% of the voting stock of another savings
institution, or its holding company, without prior written approval of the OTS.
Federal law also prohibits a savings and loan holding company from acquiring
more than 5% of a company engaged in activities other than those authorized for
savings and loan holding companies by federal law; or acquiring or retaining
control of a depository institution that is not insured by the FDIC. In
evaluating applications by holding companies to acquire savings institutions,
the OTS must consider the financial and managerial resources and future
prospects of the company and institution involved, the effect of the acquisition
on the risk to the insurance funds, the convenience and needs of the community
and competitive factors.
The OTS is prohibited from approving any acquisition that would result in a
multiple savings and loan holding company controlling savings institutions in
more than one state, except: (1) the approval of interstate supervisory
acquisitions by savings and loan holding companies, and (2) the acquisition of a
savings institution in another state if the laws of the state of the target
savings institution specifically permit such acquisitions. The states vary in
the extent to which they permit interstate savings and loan holding company
acquisitions.
If the savings institution subsidiary of a savings and loan holding company
fails to meet the qualified thrift lender test, the holding company must
register with the Federal Reserve Board as a bank holding company within one
year of the savings institution's failure to so qualify.
Stock Holding Company Subsidiary Regulation. The OTS has adopted regulations
governing the two-tier mutual holding company form of organization and
subsidiary stock holding companies that are controlled by mutual holding
companies. We have adopted this form of organization. The Company is the stock
holding company subsidiary of SI Bancorp, MHC. The Company is permitted to
engage in activities that are permitted for SI Bancorp, MHC subject to the same
restrictions and conditions.
Waivers of Dividends by SI Bancorp, MHC. OTS regulations require SI Bancorp, MHC
to notify the OTS if it proposes to waive receipt of dividends from the Company.
The OTS reviews dividend waiver notices on a case-by-case basis, and, in
general, does not object to any such waiver if: (i) the mutual holding company's
Board of Directors determines that such waiver is consistent with such
directors' fiduciary duties to the mutual holding company's members; (ii) for as
long as the savings association subsidiary is controlled by the mutual holding
company, the dollar amount of dividends waived by the mutual holding company is
considered as a restriction on the retained earnings of the savings association,
which restriction, if material, is disclosed in the public financial statements
of the savings association as a note to the financial statements; (iii) the
amount of any dividend waived by the mutual holding company is available for
declaration as a dividend solely to the mutual holding company, and, in
accordance with Statement of Financial Accounting Standards No. 5, "Accounting
for Contingencies" ("SFAS 5"), where the savings association determines that the
payment of such dividend to the mutual holding company is probable, an
appropriate dollar amount is recorded as a liability; and (iv) the amount of any
waived dividend is considered as having been paid by the savings association in
evaluating any proposed dividend under OTS capital distribution regulations. SI
Bancorp, MHC may seek to waive dividends that the Company may pay, if any.
Acquisition of Control. Under the federal Change in Bank Control Act, a notice
must be submitted to the OTS if any person (including a company), or group
acting in concert, seeks to acquire "control" of a savings and loan holding
company or savings association. An acquisition of "control" can occur upon the
acquisition of 10% or more of the voting stock of a savings and loan holding
company or savings institution or as otherwise defined by the OTS. Under the
Change in Bank Control Act, the OTS has 60 days from the filing of a complete
notice to act, taking into consideration certain factors, including the
financial and managerial resources of the acquirer and the anti-trust effects of
the acquisition. Any company that so acquires control would then be subject to
regulation as a savings and loan holding company.
28
Federal Securities Laws
- -----------------------
The Company filed with the Securities and Exchange Commission a registration
statement under the Securities Act of 1933 for the registration of the Company's
common stock. The Company's common stock continues to be registered with the
Securities and Exchange Commission under the Securities Exchange Act of 1934.
The Company is subject to the information, proxy solicitation, insider trading
restrictions and other requirements under the Securities Exchange Act of 1934.
The registration, under the Securities Act of 1933, of the shares of common
stock issued in the offering does not cover the resale of those shares. Shares
of common stock purchased by persons who are not affiliates of the Company may
be resold without registration. Shares purchased by an affiliate of the Company
will be subject to the resale restrictions of Rule 144 under the Securities Act
of 1933. If the Company meets the current public information requirements of
Rule 144, each affiliate of the Company that complies with the other conditions
of Rule 144, including those that require the affiliate's sale to be aggregated
with those of other persons, would be able to sell in the public market, without
registration, a number of shares not to exceed, in any three-month period, the
greater of 1% of the outstanding shares of the Company, or the average weekly
volume of trading in the shares during the preceding four calendar weeks. In the
future, the Company may permit affiliates to have their shares registered for
sale under the Securities Act of 1933.
Sarbanes-Oxley Act of 2002
- --------------------------
The Sarbanes-Oxley Act of 2002 implemented legislative reforms intended to
address corporate and accounting fraud. The Sarbanes-Oxley Act restricts the
scope of services that may be provided by accounting firms to their public
company audit clients and any non-audit services being provided to a public
company audit client will require pre-approval by the company's audit committee.
In addition, the Sarbanes-Oxley Act requires chief executive officers and chief
financial officers, or their equivalent, to certify to the accuracy of periodic
reports filed with the Securities and Exchange Commission, subject to civil and
criminal penalties if they knowingly or willingly violate this certification
requirement.
Under the Sarbanes-Oxley Act, bonuses issued to top executives before
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 (other than loans by financial institutions
permitted by federal rules and regulations) are restricted. The legislation
accelerates the time frame for disclosures by public companies of changes in
ownership in a company's securities by directors and executive officers.
The Sarbanes-Oxley 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." Among other
requirements, companies must disclose whether at least one member of the audit
committee is a "financial expert" (as such term is defined by the Securities and
Exchange Commission) and if not, why not. Although the Company anticipates that
it will incur additional expense in complying with the provisions of the
Sarbanes-Oxley Act and the resulting regulations, management does not expect
that such compliance will have a material impact on our results of operation or
financial condition.
Privacy Requirements of the Gramm-Leach Bliley Act of 1999
- ----------------------------------------------------------
The Gramm-Leach-Bliley Act of 1999 (the "GLBA") provided for sweeping financial
modernization for commercial banks, savings banks, securities firms, insurance
companies and other financial institutions operating in the United States. Among
other provisions, the GLBA places limitations on the sharing of consumer
financial information with unaffiliated third parties. Specifically, the GLBA
requires all financial institutions offering financial products or services to
retail customers to provide such customers with the financial institution's
privacy policy and provide such customers the opportunity to "opt out" of the
sharing of personal financial information with unaffiliated third parties.
29
Anti-Money Laundering
- ---------------------
The Uniting and Strengthening America by Providing Appropriate Tools Required to
Intercept and Obstruct Terrorism Act of 2001 (referred to as the "USA PATRIOT
Act") significantly expands the responsibilities of financial institutions,
including savings and loan associations, in preventing the use of the U.S.
financial system to fund terrorist activities. Title III of the USA PATRIOT Act
provides for a significant overhaul of the U.S. anti-money laundering regime.
Among other provisions, it requires financial institutions operating in the
United States to develop new anti-money laundering compliance programs, due
diligence policies and controls to ensure the detection and reporting of money
laundering. Such required compliance programs are intended to supplement
existing compliance requirements, also applicable to financial institutions,
under the Bank Secrecy Act and the Office of Foreign Assets Control Regulations.
Other Regulations
- -----------------
Interest and other charges collected or contracted for by the Bank are subject
to state usury laws and federal laws concerning interest rates. The Bank's loan
operations are also subject to federal laws applicable to credit transactions,
such as the:
o Truth-In-Lending Act, governing disclosures of credit terms to
consumer borrowers;
o Home Mortgage Disclosure Act of 1975, requiring financial
institutions to provide information to enable the public and public
officials to determine whether a financial institution is fulfilling
its obligation to help meet the housing needs of the community it
serves;
o Equal Credit Opportunity Act, prohibiting discrimination on the
basis of race, creed or other prohibited factors in extending
credit;
o Fair Credit Reporting Act of 1978, governing the use and provision
of information to credit reporting agencies;
o Fair Debt Collection Act, governing the manner in which consumer
debts may be collected by collection agencies; and
o Rules and regulations of the various federal agencies charged with
the responsibility of implementing such federal laws.
The deposit operations of the Bank also are subject to the:
o Right to Financial Privacy Act, which imposes a duty to maintain
confidentiality of consumer financial records and prescribes
procedures for complying with administrative subpoenas of financial
records;
o Electronic Funds Transfer Act and Regulation E promulgated
thereunder, which governs automatic deposits to and withdrawals from
deposit accounts and customers' rights and liabilities arising from
the use of automated teller machines and other electronic banking
services; and
o Check Clearing for the 21st Century Act (also known as "Check 21"),
which gives "substitute checks," such as digital check images and
copies made from that image, the same legal standing as the original
paper check.
Federal Income Taxation
- -----------------------
General. The Company reports its income on a calendar year basis using the
accrual method of accounting. The federal income tax laws apply to us in the
same manner as to other corporations with some exceptions, including
particularly our reserve for bad debts discussed below. 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 its
subsidiaries. Our federal income tax returns have been either audited or closed
under the statute of limitations through tax year 1996. For its 2004 year, the
Company's maximum federal income tax rate was 34%.
Bad Debt Reserves. For fiscal years beginning before June 30, 1996, thrift
institutions that qualified under certain definitional tests and other
conditions of the Internal Revenue Code were permitted to use certain favorable
provisions to calculate their deductions from taxable income for annual
additions to their bad debt reserve. A reserve could be established for bad
debts on qualifying real property loans, generally secured by interests in real
property improved or to be improved, under the percentage of taxable income
method or the experience method.
30
The reserve for nonqualifying loans was computed using the experience method.
Federal legislation enacted in 1996 repealed the reserve method of accounting
for bad debts for institutions with assets in excess of $500.0 million and the
percentage of taxable income method for all institutions for tax years beginning
after 1995 and require savings institutions to recapture or take into income
certain portions of their accumulated bad debt reserves. Approximately $3.7
million of our accumulated tax-based bad debt reserves would not be recaptured
into taxable income unless the Bank makes a "non-dividend distribution" to the
Company as described below.
Distributions. If the Bank makes "non-dividend distributions" to the Company,
the distributions will be considered to have been made from the Bank's
unrecaptured tax bad debt reserves, including the balance of its reserves as of
December 31, 1987, to the extent of the "non-dividend distributions," and then
from the Bank's supplemental reserve for losses on loans, to the extent of those
reserves, and an amount based on the amount distributed, but not more than the
amount of those reserves, will be included in the Bank's taxable income.
Non-dividend distributions include distributions in excess of the Bank's current
and accumulated earnings and profits, as calculated for federal income tax
purposes, 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 will not be so included in the Bank's taxable income.
The amount of additional taxable income triggered by a non-dividend is an amount
that, when reduced by the tax attributable to the income, is equal to the amount
of the distribution. Therefore, if the Bank makes a non-dividend distribution to
the Company, approximately one and one-half times the amount of the distribution
not in excess of the amount of the reserves would be includable in income for
federal income tax purposes, assuming a 34% federal corporate income tax rate.
The Bank does not intend to pay non-dividend distributions that would result in
a recapture of any portion of its bad debt reserves.
State Taxation
- --------------
The Company and its subsidiaries are subject to the Connecticut corporation
business tax. The Company and its subsidiaries will be eligible to file a
combined Connecticut income tax return and will pay the regular corporation
business tax.
The Connecticut corporation business tax is based on the federal taxable income
before net operating loss and special deductions of the Company and its
subsidiaries and makes certain modifications to federal taxable income to arrive
at Connecticut taxable income. Connecticut taxable income is multiplied by the
state tax rate (9.375% for fiscal year 2004) to arrive at Connecticut income
tax.
In May 1998, the State of Connecticut enacted legislation permitting the
formation of passive investment company subsidiaries by financial institutions.
This legislation exempts qualifying passive investment companies from the
Connecticut corporation business tax and excludes dividends paid from a passive
investment company from the taxable income of the parent financial institution.
The Bank's formation of a passive investment company in January 1999 is expected
to substantially eliminate the state income tax expense of the Company and its
subsidiaries. See Item 1. Business. "Subsidiary Activities - SI Mortgage
Company" for discussion of the Bank's passive investment company.
31
Executive Officers of the Registrant
- ------------------------------------
Certain executive officers of the Bank also serve as executive officers of the
Company. The day-to-day management duties of the executive officers of the
Company and the Bank relate primarily to their duties as to the Bank. The
executive officers of the Company currently are as follows:
Name Age (1) Position
---- ------- --------
Rheo A. Brouillard 50 President and Chief Executive Officer of SI Financial Group, SI
Bancorp, MHC and Savings Institute Bank and Trust Company
Brian J. Hull 44 Executive Vice President, Chief Financial Officer and Treasurer of SI
Financial Group, SI Bancorp, MHC and Savings Institute Bank and
Trust Company
Sonia M. Dudas 53 Senior Vice President and Senior Trust Officer of Savings Institute
Bank and Trust Company
Michael J. Moran 55 Senior Vice President and Senior Credit Officer of Savings Institute
Bank and Trust Company
William E. Anderson, Jr. 35 Vice President and Retail Banking Officer of Savings Institute Bank
and Trust Company
Laurie L. Gervais 40 Vice President and Director of Human Resources of Savings Institute
Bank and Trust Company
----------
(1) Ages presented are as of December 31, 2004.
Biographical Information:
Rheo A. Brouillard has been the President and Chief Executive Officer of Savings
Institute Bank and Trust Company, SI Bancorp, MHC and SI Financial Group since
1995, 2000 and 2004, respectively. He has been a director of the Company since
1995.
Brian J. Hull has been Executive Vice President since 2002 and Chief Financial
Officer and Treasurer since he joined Savings Institute Bank and Trust Company
in 1997. Mr. Hull has served as Chief Financial Officer and Treasurer of SI
Bancorp, MHC and SI Financial Group since 2000 and 2004, respectively.
Sonia M. Dudas has been Senior Vice President and Senior Trust Officer since
1999. Ms. Dudas oversees our wealth management group, which includes our trust,
investment and insurance operations since she joined Savings Institute Bank and
Trust Company in 1992.
Michael J. Moran has been Senior Vice President and Senior Credit Officer since
2001. Mr. Moran joined Savings Institute Bank and Trust Company in 1995.
William E. Anderson, Jr. has been Vice President and Retail Banking Officer
since 2002 and 2004, respectively. Mr. Anderson joined Savings Institute Bank
and Trust Company in 1995.
Laurie L. Gervais has been Vice President and Director of Human Resources since
2003 and 2001, respectively. Ms. Gervais joined Savings Institute Bank and Trust
Company in 1983.
32
Item 2. Properties.
- --------------------
We conduct our business through our main office and branch offices. The
following table sets forth certain information relating to these facilities as
of December 31, 2004.
Net Book Value
Date of as of
Year Square Lease Owned/ December 31,
Location Opened Footage Expiration Leased 2004
- -------- ------ ------- ---------- ------ ----------------------
(Dollars in thousands)
Main Office:
- ------------
803 Main Street 1870 26,210 -- Owned $ 2,134
Willimantic, Connecticut 06226
Branches:
- ---------
115 Main Street 1974 2,400 -- Owned 64
Hebron, Connecticut 06248
554 Exeter Road, Route 207 1978 2,128 -- Owned 256
Lebanon, Connecticut 06249
530 Stonington Road, Route 1 1987 1,960 2006(1) Leased 13
Stonington, Connecticut 06378
9 Proulx Street 1990 1,538 2010 Leased 208
Brooklyn, Connecticut 06234
85 Freshwater Boulevard 1992 4,365 2007(1) Leased 26
Enfield, Connecticut 06082
Bell Park Plaza, 563 Hartford Pike 1996 2,460 2006(1) Leased 7
Dayville, Connecticut 06241
971 Poquonnock Road 1997 3,373 2007(2) Leased 16
Groton, Connecticut 06340
Big Y, 224 Salem Turnpike 1998 575 2008(2) Leased --
Norwich, Connecticut 06360
344 Prospect Street 1998 2,160 2008(2) Leased 281
Moosup, Connecticut 06354
Shaw's, 60 Cantor Drive 1998 421 2010(1) Leased 4
Willimantic, Connecticut 06226
180 Westminster Road, Route 14 1998 1,781 2008(2) Leased 40
Canterbury, Connecticut 06331
Walmart, 474 Boston Post Road 2000 540 2010(1) Leased 79
North Windham, Connecticut 06256
180 River Road, Route 12 2001 656 2006(2) Leased 135
Lisbon, Connecticut 06351
East Brook Mall 2002 2,325 2022(3) Leased 540
Mansfield Center, Connecticut 06250
33
1000-1006 Sullivan Avenue 2005(4) 2,955 2025(2) Leased --
South Windsor, Connecticut 06074
80 Stonington Road, Mystic Plaza 2005(4) 3,436 2014(3) Leased --
Stonington, Connecticut 06378
Meetinghouse Commons, Merrow Road 2005(4) 2,870 2015(2) Leased --
Tolland, Connecticut 06084
Other Properties:
- -----------------
66 Routes 32 and 87 1983 2,380 -- Owned(5) 258
Franklin, Connecticut 06254
5 Westminster Road 1990 1,374 2008(2) Leased 83
Routes 14 and 169
Canterbury, Connecticut 06331
190 Main Street 1990 4,990 -- Owned(6) 300
Danielson, Connecticut 06239
7 Ledgebrook Drive 1990 4,554 2007 Leased(7) 10
Mansfield, Connecticut 06250
779 Main Street 1999 8,182 -- Owned(8) 224
Willimantic, Connecticut 06226
Riverbridge Court Condo Association 2000 3,884 -- Owned(9) 154
720 Main Street
Willimantic, Connecticut 06226
-------
Total: $ 4,832
=======
- ----------
(1) We have an option to renew this lease for one additional five-year period.
(2) We have an option to renew this lease for two additional five-year
periods.
(3) We have an option to renew this lease for four additional five-year
periods.
(4) Anticipate opening Stonington and Tolland branches in April 2005 and South
Windsor branch in July 2005.
(5) A portion of this property has been leased to a tenant under a lease that
expires in 2006. The tenant has an option to renew this lease for one
additional three-year period.
(6) Includes the parking lot located at 39 Academy Street, Danielson,
Connecticut. A portion of this property has been leased to a tenant under
a lease that expires in September 2009. The tenant has the option to renew
this lease for ten additional one-year periods.
(7) This facility houses our trust operations.
(8) A portion of this property includes a parking lot for our main office. The
remainder of this property has been leased to a subtenant under a lease
that expires in December 2007. The subtenant has an option to renew this
lease for three additional five-year periods.
(9) We use a portion of this facility for our employee training center. The
remainder of this property has been leased to a subtenant under a lease
that expires in November 2005. The subtenant has an option to renew this
lease for one additional five-year period.
Item 3. Legal Proceedings.
- --------------------------
Periodically, there have been various claims and lawsuits against us, such as
claims to enforce liens, condemnation proceedings on properties in which we hold
security interest, claims involving the making and servicing of real property
loans and other issues incident to our business. The Company is not a party to
any pending legal proceedings that we believe would have a material adverse
effect on our financial condition, results of operation or cash flows.
34
Item 4. Submission of Matters to a Vote of Security Holders.
- ------------------------------------------------------------
None.
PART II.
- --------
Item 5. Market for the Registrant's Common Equity, Related Stockholder Matters
- ------------------------------------------------------------------------------
and Issuer Purchases of Equity Securities.
- ------------------------------------------
The Company's common stock is listed on the Nasdaq National Market ("NASDAQ")
under the trading symbol "SIFI." The Company completed its initial public
offering on September 30, 2004 and commenced trading on October 1, 2004. The
following table sets forth the high and low sales prices of the common stock for
the fourth quarter of 2004, as reported by NASDAQ. The Company has not paid any
dividends to date to its shareholders. See Item 1. Business. " Regulation and
Supervision - Limitation on Capital Distributions" and Note 18 in the Notes to
the Consolidated Financial Statements for more information relating to
restrictions on dividends.
Dividends High Low
--------- ------- -------
2004:
First Quarter N/A N/A N/A
Second Quarter N/A N/A N/A
Third Quarter N/A N/A N/A
Fourth Quarter N/A $ 12.40 $ 10.70
As of March 14, 2005, the Company had approximately 1,074 holders of record of
the Company's common stock.
The Company did not repurchase any of its common stock during the fourth quarter
of 2004.
Item 6. Selected Financial Data.
- ---------------------------------
We have derived the following selected consolidated financial and other data of
the Company in part from our Consolidated Financial Statements and Notes
appearing elsewhere in this Form 10-K.
Selected Financial Condition Data: At December 31,
- ------------------------------------ ---------------------------------------------------------
(Dollars in Thousands) 2004 2003 2002 2001 2000
--------- --------- --------- --------- ---------
Total assets $ 624,649 $ 518,141 $ 484,944 $ 427,522 $ 373,815
Cash and cash equivalents 30,775 29,577 37,517 30,077 19,418
Securities held to maturity -- 1,728 9,463 13,197 9,366
Securities available for sale 120,557 77,693 87,914 78,697 67,053
Loans receivable, net 447,957 386,924 334,598 293,111 264,553
Deposits (1) 460,480 417,311 398,315 363,029 321,822
FHLB advances 72,674 57,168 43,918 35,183 25,731
Subordinated debt 7,217 7,217 7,217 -- --
Other borrowings -- -- 1,951 -- --
Total equity 80,809 34,099 31,408 27,816 25,273
35
Selected Operating Data: For the Years Ended December 31,
- -------------------------------------------- ----------------------------------------------------
(Dollars in Thousands) 2004 2003 2002 2001 2000
-------- -------- -------- -------- --------
Interest and dividend income $ 28,603 $ 27,930 $ 28,330 $ 27,607 $ 25,330
Interest expense 9,400 9,346 11,014 13,154 12,127
-------- -------- -------- -------- --------
Net interest income 19,203 18,584 17,316 14,453 13,203
Provision for loan losses 550 1,602 537 440 290
-------- -------- -------- -------- --------
Net interest income after provision for loan
losses 18,653 16,982 16,779 14,013 12,913
Noninterest income 4,185 4,722 3,284 3,362 3,139
Noninterest expense 21,031 16,606 15,394 14,470 13,062
-------- -------- -------- -------- --------
Income before income tax provision 1,807 5,098 4,669 2,905 2,990
Income tax provision 519 1,713 1,587 989 1,053
-------- -------- -------- -------- --------
Net income $ 1,288 $ 3,385 $ 3,082 $ 1,916 $ 1,937
======== ======== ======== ======== ========
Selected Operating Ratios: At of For the Years Ended December 31,
- ----------------------------------------------- -----------------------------------------------
2004 2003 2002 2001 2000
------- ------- ------- ------- -------
Performance Ratios:
- -------------------
Return on average assets 0.23% 0.67% 0.68% 0.48% 0.55%
Return on average equity 2.77 10.34 10.46 7.19 8.26
Interest rate spread (2) 3.41 3.81 3.79 3.48 3.49
Net interest margin (3) 3.64 3.98 4.04 3.86 3.87
Noninterest expense to average assets (4) 3.71 3.30 3.39 3.64 3.68
Efficiency ratio (5) 89.29 71.62 73.80 81.91 80.29
Average interest-earning assets to average
interest-bearing liabilities 112.93 108.70 110.03 110.76 110.43
Average equity to average assets 8.21 6.51 6.49 6.71 6.60
Regulatory Capital Ratios:
- --------------------------
Total capital to risk-weighted assets 18.03 12.45 12.12 11.51 13.18
Tier 1 capital to risk-weighted assets 17.12 11.50 11.00 10.38 11.93
Tier 1 capital to total assets (6) 9.99 6.81 6.46 6.29 6.69
Tangible equity ratio 9.99 n/a n/a n/a n/a
Asset Quality Ratios:
- ---------------------
Allowance for loan losses as a percent of total
loans 0.71 0.69 0.91 0.97 0.97
Allowance for loan losses as a percent of
nonperforming loans 338.98 207.57 166.50 130.64 170.15
Net charge-offs (recoveries) to average
outstanding loans during the period 0.01 0.55 0.11 0.07 (0.01)
- ----------
(1) Includes mortgagors' and investors' escrow accounts.
(2) Represents the difference between the weighted average yield on
average interest-earning assets and the weighted average cost of
interest-bearing liabilities.
(3) Represents net interest income as a percent of average
interest-earning assets.
(4) The noninterest expense to average assets ratio, excluding the
effect of the contribution expense to SI Financial Group Foundation,
was 3.27% for the year ended December 31, 2004.
(5) Represents noninterest expense divided by the sum of net interest
income and noninterest income, excluding gains or losses on the sale
of securities. The efficiency ratio, excluding the effect of the
contribution to SI Financial Group Foundation, was 78.62% for the
year ended December 31, 2004.
(6) Represents tier 1 capital to total assets as required by OTS
regulations at December 31, 2004 and tier 1 capital to total average
assets at December 31, 2003, 2002, 2001 and 2000 as required by FDIC
regulations.
36
Item 7. Management's Discussion and Analysis of Financial Condition and Results
- -------------------------------------------------------------------------------
of Operation.
- -------------
General
- -------
The Company's results of operation are dependent primarily on net interest
income, which is the difference between the interest income earned on the
Company's interest-earning assets, such as loans and investments, and the
interest expense on its interest-bearing liabilities, such as deposits and
borrowings. The Company also generates noninterest income such as gains on
securities and loan sales, fees from deposit and trust and investment management
services, insurance commissions and other fees. The Company's noninterest
expenses primarily consist of employee compensation and benefits, occupancy,
computer services, furniture and equipment, outside professional services,
electronic banking fees, marketing and other general and administrative
expenses. The Company's results of operations are also significantly affected by
general economic and competitive conditions, particularly changes in market
interest rates, governmental policies and actions of regulatory agencies.
The following analysis discusses changes in the financial condition as of
December 31, 2004 and 2003 and the results of operations for the years ended
December 31, 2004, 2003 and 2002 and should be read in conjunction with the
Consolidated Financial Statements and the Notes thereto, appearing in Part IV,
Item 15 of this document.
Management Strategy
- -------------------
Our mission is to operate and grow a profitable community-oriented financial
institution. We plan to achieve this by continuing our strategy of:
o offering a full range of financial services;
o expanding our branch network into new market areas;
o pursuing opportunities to increase commercial lending in our market
area;
o applying conservative underwriting practices to maintain the high
quality of our loan portfolio;
o managing our net interest margin and net interest spread by seeking
to increase lending levels;
o managing our investment and borrowing portfolios to provide
liquidity, enhance income and manage interest rate risk; and
o increasing deposits by continuing to offer exceptional customer
service and emphasizing our commercial deposit offerings.
Offering a full range of financial services. The Bank has a long tradition of
focusing on the needs of consumers and small and medium-sized businesses in our
community and being an active corporate citizen. We deliver personalized service
and respond with flexibility to customer needs. We believe our community
orientation is attractive to our customers and distinguishes us from the large
regional banks that operate in our market area and we intend to maintain this
focus as we grow. In this context, we are striving to become a true financial
services company offering our customers one-stop shopping for all of their
financial needs through our banking, investments, insurance and trust products
and services. While we have no current plans or agreements, we may use a portion
of the proceeds from our recent offering for strategic acquisitions to broaden
our products and services. We hope that our broad array of product offerings
will deepen our relationships with our current customers and entice new
customers to begin banking with us, ultimately increasing our fee income and our
profitability.
Expand our branch network into new market areas. Since 2000, we have opened a
new branch office in each of North Windham, Lisbon and Mansfield Center,
Connecticut. In late 2004 and early 2005, the Company signed three lease
agreements for locations in Tolland in Tolland County and South Windsor in
Hartford County and for a new location into which we intend to relocate our
existing Stonington office. The Bank anticipates the opening of these branch
offices during the second and third quarters of 2005. We intend to continue to
pursue expansion in Hartford, New London, Tolland and Windham Counties in future
years, whether through de novo branching or acquisition, and we also may
consider exploring expansion opportunities in Middlesex County.
Pursue opportunities to increase commercial lending. Commercial real estate and
commercial business loans increased $17.2 million and $36.0 million for the
years ended December 31, 2004 and 2003, respectively, and at December 31, 2004
comprised approximately 31.4% of total loans. There are many multi-family and
commercial properties
37
and businesses located in our market area and we may pursue the larger lending
relationships associated with these commercial opportunities, while continuing
to originate any such loans in accordance with what we believe are our
conservative underwriting guidelines. Toward this end, during 2004, we hired
additional seasoned commercial lenders and added new products to increase our
ability to serve the market.
Apply conservative underwriting practices and maintain high quality loan
portfolio. We believe that high asset quality is a key to long-term financial
success. We have sought to maintain a high level of asset quality and moderate
credit risk by using underwriting standards which we believe are conservative,
and by diligent monitoring and collection efforts. At December 31, 2004, our
nonperforming loans (loans which are 90 or more days delinquent) were only 0.21%
of our total loan portfolio and 0.15% of our total assets. Although we intend to
increase our multi-family and commercial real estate and commercial business
lending, we intend to continue our philosophy of managing large loan exposures
through our conservative approach to lending.
Manage net interest margin and net interest spread. We intend to continue to
manage our net interest margin and net interest spread by seeking to increase
lending levels. Loans secured by multi-family and commercial real estate are
generally larger and involve a greater degree of risk than one-to four-family
residential mortgage loans. Consequently, multi-family and commercial real
estate loans typically have higher yields, which increase our net interest
margin and net interest spread.
Manage investment and borrowing portfolios. Our liquidity, income and interest
rate risk are affected by the management of our investment and borrowing
portfolios. We may continue to leverage the additional capital from the offering
by borrowing funds from the Federal Home Loan Bank and investing the funds in
loans and investment securities in a manner consistent with our current
portfolio. This leverage strategy, if implemented and assuming favorable market
conditions, will provide us with additional liquidity, enhance earnings and help
to manage our interest rate risk.
Increase deposits. Our primary source of funds is retail deposit accounts. Since
December 31, 2001, deposits have increased by 26.8%, primarily due to
competitive interest rates and the movement of customer funds out of riskier
investments, including the stock market. We intend to continue to increase our
deposits by continuing to offer exceptional customer service and by focusing on
increasing our commercial deposits from small and medium-sized businesses
through additional business banking products.
Critical Accounting Policies
- ----------------------------
The Company considers accounting policies involving significant judgments and
assumptions by management that have, or could have, a material impact on the
carrying value of certain assets or on income to be critical accounting
policies. We consider the allowance for loan losses and the impairment of
long-lived assets to be our critical accounting policies.
Allowance for Loan Losses. Determining the amount of allowance for loan losses
necessarily involves a high degree of judgment. Management reviews the level of
the allowance on a regular basis and establishes the provision for loan losses
based on the size and the composition of the loan portfolio, delinquency levels,
loss experience, economic conditions, and other factors related to the
collectibility of the loan portfolio. The level of the allowance for loan losses
fluctuates primarily due to changes in the size and composition of the loan
portfolio and in the level of nonperforming loans, classified assets and
charge-offs. A portion of the allowance is established by segregating the loans
by loan category and assigning allocation percentages based on our historical
loss experience and delinquency trends. The applied loss factors are
re-evaluated annually to ensure their relevance in the current real estate
environment. Accordingly, increases in the size of the loan portfolio and the
increased emphasis on commercial real estate and commercial business loans,
which carry a higher degree of risk of default and, thus, a higher allocation
percentage, increases the allowance. Additionally, a portion of the allowance is
established based on the level of specific nonperforming loans, classified
assets or charged-off loans.
Although we believe that we use the best information available to establish the
allowance for loan losses, future additions to the allowance may be necessary
based on estimates that are susceptible to change as a result of
38
changes in economic conditions and other factors. In addition, the OTS, as an
integral part of its examination process, periodically reviews our allowance for
loan losses. Such agency may require us to recognize adjustments to the
allowance based on its judgments about information available to it at the time
of its examination. See Part I. Item 1. Business. "Lending Activities -
Allowance for Loan Losses" and Notes 1 and 4 in the Notes to the Consolidated
Financial Statements for additional information.
Impairment of Long-Lived Assets. The Company is required to record certain
assets we have acquired, including identifiable intangible assets such as core
deposit intangibles, and certain liabilities that we have assumed at fair value,
which may involve making estimates based on third party valuations, such as
appraisals, or internal valuations based on discounted cash flow analyses or
other valuation techniques. Further, long-lived assets, including intangible
assets and premises and equipment, that are held and used by us, are presumed to
have a useful life. The determination of the useful lives of intangible assets
is subjective, as is the appropriate amortization period for such intangible and
long-lived assets. Additionally, long-lived assets are reviewed for impairment
whenever events or changes in circumstances indicate that the carrying amount of
the asset may not be recoverable. If impairment is indicated by that review, the
asset is written down to its estimated fair value through a charge to
noninterest expense. Testing for impairment is a subjective process, the
application of which could result in different evaluations of impairment. See
Notes 1, 4, 6 and 7 in the Notes to the Consolidated Financial Statements for
additional information.
Analysis of Net Interest Income
- -------------------------------
Average Balance Sheet. The following table presents information regarding
average balances of assets and liabilities, the total dollar amounts of interest
income and dividends from average interest-earning assets, the total dollar
amounts of interest expense on average interest-bearing liabilities and the
resulting average yields and costs. The yields and costs for the periods
indicated are derived by dividing income or expense by the average balances of
assets or liabilities, respectively, for the periods presented. For purposes of
this table, average balances have been calculated using average daily balances.
39
2004 2003 2002
--------------------------------- -------------------------------- --------------------------------
Average Average Average
(Dollars in Thousands) Average Interest & Yield/ Average Interest & Yield/ Average Interest & Yield/
Balance Dividends Rate Balance Dividends Rate Balance Dividends Rate
---------- ---------- ------- --------- ---------- ------- --------- ---------- -------
ASSETS:
- -------
INTEREST-EARNING ASSETS:
Loans (1)(2) $ 412,415 $ 24,545 5.95% $ 360,655 $ 23,840 6.61% $ 313,803 $ 23,033 7.34%
Investment securities
(3) 97,021 3,826 3.94 92,353 3,944 4.27 99,416 5,024 5.05
Other interest-earning
assets 18,309 240 1.31 14,166 155 1.09 15,002 274 1.83
---------- ---------- --------- -------- --------- --------
TOTAL INTEREST-EARNING
ASSETS 527,745 28,611 5.42 467,174 27,939 5.98 428,221 28,331 6.62
---------- ---------- --------- -------- --------- --------
Noninterest-earning assets 38,478 35,926 25,903
---------- --------- ---------
TOTAL ASSETS $ 566,223 $ 503,100 $ 454,124
========== ========= =========
LIABILITIES AND EQUITY:
- -----------------------
INTEREST-BEARING
LIABILITIES:
Deposits:
NOW and money market $ 108,678 384 0.35 $ 98,543 424 0.43 $ 86,293 685 0.79
Savings (4) 91,721 625 0.68 87,904 666 0.76 77,817 1,071 1.38
Certificates of
deposit 194,569 5,337 2.74 185,181 5,507 2.97 178,379 6,724 3.77
---------- ---------- --------- -------- --------- --------
Total interest-
bearing deposits 394,968 6,346 1.61 371,628 6,597 1.78 342,489 8,480 2.48
FHLB advances 65,154 2,683 4.12 49,693 2,315 4.66 40,618 2,146 5.28
Subordinated debt 7,217 371 5.14 7,217 360 4.99 4,718 301 6.38
Other borrowings -- -- -- 1,233 74 6.00 1,378 87 6.31
---------- ---------- --------- -------- --------- --------
TOTAL INTEREST-BEARING
LIABILITIES 467,339 9,400 2.01 429,771 9,346 2.17 389,203 11,014 2.83
Noninterest-bearing
liabilities 52,392 40,601 35,461
---------- --------- ---------
TOTAL LIABILITIES 519,731 470,372 424,664
TOTAL STOCKHOLDERS' EQUITY 46,492 32,728 29,460
---------- --------- ---------
TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY $ 566,223 $ 503,100 $ 454,124
========== ========= =========
NET INTEREST-EARNING
ASSETS $ 60,406 $ 37,403 $ 39,018
========== ========= =========
TAX EQUIVALENT NET
INTEREST INCOME (3) 19,211 18,593 17,317
TAX EQUIVALENT INTEREST
RATE SPREAD (5) 3.41% 3.81% 3.79%
TAX EQUIVALENT NET
INTEREST MARGIN AS A
PERCENTAGE OF INTEREST-
EARNING ASSETS (6) 3.64% 3.98% 4.04%
AVERAGE OF INTEREST-
EARNING ASSETS TO
AVERAGE INTEREST-
BEARING LIABILITIES 112.93% 108.70% 110.03%
LESS: TAX EQUIVALENT
ADJUSTMENT (3) (8) (9) (1)
---------- -------- --------
NET INTEREST INCOME PER
STATEMENTS OF INCOME $ 19,203 $ 18,584 $ 17,316
========== ======== ========
- ----------
(1) Amount is net of deferred loan origination fees and costs. Average
balances include nonaccrual loans and loans held for sale.
(2) Loan fees are included in interest income and are insignificant.
40
(3) Municipal securities income and net interest income are presented on
a tax equivalent basis using a tax rate of 34%. The tax equivalent
adjustment is deducted from tax equivalent net interest income to
agree to the amount reported in the statements of income.
(4) Includes mortgagors' and investors' escrow accounts.
(5) Tax equivalent net interest rate spread represents the difference
between the weighted average yield on interest-earning assets and
the weighted average cost of interest-bearing liabilities.
(6) Tax equivalent net interest margin represents tax equivalent net
interest income divided by average interest-earning assets.
Rate/Volume Analysis. The following table sets forth the extent to which changes
in interest rates and changes in volume of interest-earning assets and
interest-bearing liabilities have on the Company's interest income and interest
expense for the periods presented. The rate column shows the effects
attributable to changes in rate (changes in rate multiplied by prior volume).
The volume column shows the effects attributable to changes in volume (changes
in volume multiplied by prior rate). The net column represents the sum of the
rate and volume columns. For purposes of this table, changes attributable to
both changes in rate and volume that cannot be segregated have been allocated
proportionately based on the changes due to rate and the changes due to volume.
2004 Compared to 2003 2003 Compared to 2002
---------------------------- ------------------------------
(Dollars in Thousands) Increase (Decrease) Increase (Decrease)
Due To Due To
------------------- -------------------
Rate Volume Net Rate Volume Net
-------- -------- ------ -------- ------- --------
INTEREST-EARNING ASSETS:
Interest and Dividend Income:
Loans (1)(2) $ (2,515) $ 3,220 $ 705 $ (2,427) $ 3,234 $ 807
Investment securities (3) (311) 193 (118) (740) (340) (1,080)
Other interest-earning assets 45 40 85 (105) (14) (119)
-------- ------- ------ -------- ------- --------
TOTAL INTEREST-EARNING ASSETS (2,781) 3,453 672 (3,272) 2,880 (392)
INTEREST-BEARING LIABILITIES:
Interest Expense:
Deposits (4) (591) 340 (251) (2,343) 460 (1,883)
FHLB advances (292) 660 368 (273) 442 169
Subordinated debt 11 -- 11 (76) 135 59
Other borrowings (37) (37) (74) (4) (9) (13)
-------- ------- ------ -------- ------- --------
TOTAL INTEREST-BEARING
LIABILITIES (909) 963 54 (2,696) 1,028 (1,668)
-------- ------- ------ -------- ------- --------
CHANGE IN NET INTEREST INCOME $ (1,872) $ 2,490 $ 618 $ (576) $ 1,852 $ 1,276
======== ======= ====== ======== ======= ========
- ----------
(1) Amount is net of deferred loan origination fees and costs. Average
balances include nonaccrual loans and loans held for sale.
(2) Loans fees are included in interest income and are insignificant.
(3) Municipal securities income and net interest income are presented on
a tax equivalent basis using a tax rate of 34%. The tax equivalent
adjustment is deducted from tax equivalent net interest income to
agree to the amount reported in the statements of income.
(4) Includes mortgagors' and investors' escrow accounts.
Comparison of Financial Condition at December 31, 2004 and December 31, 2003
- ----------------------------------------------------------------------------
Assets. The Company's total assets increased $106.5 million, or 20.6%, to $624.6
million at December 31, 2004, as compared to $518.1 million at December 31,
2003, primarily due to increases in cash and cash equivalents, investment
securities, loans receivable, FHLB stock and deferred tax asset, net. Cash and
cash equivalents increased $1.2 million, or 4.1%, mainly as a result of the
investment of the net proceeds from the initial public offering in September
2004. Net loans receivable increased $61.0 million, or 15.8%, to $448.0 million
at December 31, 2004. All categories of the loan portfolio contributed to the
increase in net loans receivable with one- to four-family residential loans,
commercial real estate and business loans and construction loans yielding the
largest increases. In 2004, loan originations for commercial real estate and
business loans increased 45.5% which reflects
41
the Company's emphasis on the commercial loan market in order to enhance
earnings and diversify the loan portfolio. Securities available-for-sale
increased $42.9 million, or 55.2%, to $120.6 million as a significant amount of
the proceeds from the stock offering were invested in U.S. government and agency
obligations and mortgage-backed securities. FHLB stock increased $1.5 million,
or 50.9%, to $4.3 million at December 31, 2004, resulting from the
implementation of FHLB's new capital plan and to support a higher level of
borrowings. The deferred tax asset, net, increased $1.4 million from 2003 to
2004 primarily as a result of the charitable contribution to SI Financial Group
Foundation (the "Foundation") of $2.5 million. The Company is only permitted to
deduct for tax purposes, in accordance with the Internal Revenue Code, an amount
equal to 10% of taxable income annually. The remaining balance of the
contribution can be deducted over the next five years provided the Company has
adequate taxable income annually.
Liabilities. Total liabilities increased $59.8 million, or 12.4%, from December
31, 2003 to December 31, 2004 primarily as a result of increases in deposits and
FHLB advances. Deposits, including mortgagors' and investors' escrow accounts,
increased $43.2 million, or 10.3%, to $460.5 million at December 31, 2004. The
Company experienced increases in interest-bearing accounts, such as certificates
of deposit, NOW and money market and savings accounts due to competitive pricing
and marketing efforts. In addition, noninterest-bearing deposits increased as a
result of commercial and personal checking deposit volume. FHLB advances
increased $15.5 million, or 27.1%, to $72.7 million at December 31, 2004. The
FHLB borrowing increases were longer-term fixed-rate advances used to fund loan
demand and to manage interest rate risk.
Equity. Total stockholders' equity increased $46.7 million to $80.8 million at
December 31, 2004. The increase in equity was primarily attributable to the
initial public offering, which resulted in the issuance of common stock and the
receipt of additional paid-in capital during the third quarter of approximately
$51.1 million and net income of $1.3 million, offset by reductions in equity
resulting from the establishment of the Bank's Employee Stock Ownership Plan
("ESOP") of $4.8 million and increased net unrealized holding losses on
available for sale securities aggregating $807,000, net of taxes.
Comparison of Operating Results for the Years Ended December 31, 2004 and
- -------------------------------------------------------------------------
December 31, 2003
- -----------------
General. The Company recorded net income of $1.3 million, a decrease of $2.1
million, or 61.9%, for the year ended December 31, 2004 compared to $3.4 million
for the year ended December 31, 2003. The decrease was primarily attributable to
a $4.4 million increase in noninterest expense and a $537,000 decrease in
noninterest income, offset by an increase of $619,000 in net interest income and
decreases of $1.1 million for the provision for loan losses and $1.2 million for
the provision for income taxes. An increase in net interest income in 2004
resulted from an increase in average assets and a decrease in the average cost
of deposits and borrowings, offset by declining yields on interest-earning
assets and an increase in average liabilities. For the year ended December 31,
2004, noninterest expenses included a $2.5 million contribution of common stock
to SI Financial Group Foundation, resulting in a charge to earnings of $1.7
million after taxes. The Company established SI Financial Group Foundation, a
charitable foundation, dedicated to community activities and the promotion of
charitable causes in the areas in which the Bank operates. In connection with
the offering, the Foundation was funded with 2%, or 251,275 shares, of the
Company's common stock.
Interest and Dividend Income. Total interest and dividend income increased
$672,000 (on a tax equivalent basis), or 2.4%, for 2004, despite a decrease in
the average yield on interest-earning assets from 5.98% to 5.42%, as a result of
an increase in the average balance of interest-earning assets from $467.2
million to $527.7 million. Interest on investment securities decreased in 2004
due to a 33 basis point decrease in the average yield to 3.94%, as a result of
the unfavorable interest rate environment, offset by an increase in the average
balance of investment securities. Although the average yield declined in 2004,
interest on loans increased due to an increase in the average amount of loans
outstanding.
Interest Expense. Interest expense increased $54,000, or 0.6%, to $9.4 million
for 2004 compared to $9.3 million in 2003 as a result of an increase in the
average FHLB debt outstanding during the period, offset by a decrease in
interest expense on interest-bearing deposit accounts. Although average
interest-bearing liabilities increased $37.6
42
million, the cost of funds decreased as the average rate paid declined 16 basis
points to 2.01% due to the prevailing lower interest rate environment.
Provision for Loan Losses. The Company's provision for loan losses decreased
$1.1 million to $550,000 in 2004 from $1.6 million in 2003. Continued
improvements in the real estate market has favorably impacted both our customers
and the quality of our loan portfolio and improved asset quality. A lower
interest rate market, resulting in lower payments on loans, has positively
affected our variable rate borrowers. The decreased provision also reflected
that the Company experienced lower charge-offs for the year ended December 31,
2004 and nonperforming loans were lower at December 31, 2004 as compared to
December 31, 2003. In addition, the higher provision in 2003 was the result of a
$1.6 million write-off of a large commercial real estate loan.
Noninterest Income. Total noninterest income decreased $537,000, or 11.4%, to
$4.2 million in 2004. The following table shows the components of noninterest
income and the dollar and percentage changes from 2004 to 2003.
Year Ended December 31, Change
----------------------- -----------------
(Dollars in Thousands) 2004 2003 Dollars Percent
---------- ---------- ------- -------
Service fees $ 3,244 $ 3,116 $ 128 4.1%
Wealth management fees 942 849 93 11.0
Net gain (loss) on sale of securities (166) 121 (287) (237.2)
Net gain on sale of loans 55 393 (338) (86.0)
Other 110 243 (133) (54.7)
------- ------- ------
TOTAL NONINTEREST INCOME $ 4,185 $ 4,722 $ (537) (11.4)%
======= ======= ======
Increases in electronic banking fees contributed to higher service fees in 2004
as more customers utilize the Bank's electronic banking products. Wealth
management fees increased as a result of greater assets under management and
more favorable portfolio performance than in 2003. The net decrease in gains on
the sales of loans, which was impacted by lower loan sales in 2004 as compared
to 2003, was the primary cause for the decrease in noninterest income.
Noninterest income also decreased due to a loss on the sale of securities
recorded in 2004 compared to a gain on the sale of securities in 2003.
Noninterest Expenses. Noninterest expenses increased by $4.4 million, or 26.6%,
for 2004 as compared to 2003. The following table shows the components of
noninterest expenses and the dollar and percentage changes from 2004 and 2003.
Year Ended December 31, Change
----------------------- -----------------
(Dollars in Thousands) 2004 2003 Dollar Percent
---------- ---------- ------- -------
Salaries and employee benefits $ 9,835 $ 9,090 $ 745 8.2%
Occupancy 2,494 2,059 435 21.1
Furniture and equipment 971 914 57 6.2
Computer services 1,014 857 157 18.3
Electronic banking fees 664 563 101 17.9
Outside professional services 815 500 315 63.0
Marketing 513 387 126 32.6
Supplies 293 266 27 10.2
FDIC deposit insurance and state
assessment 90 75 15 20.0
Impairment charge - other assets 51 36 15 41.7
Contribution to Foundation 2,513 -- 2,513 --
Other real estate operations 11 15 (4) (26.7)
Other 1,767 1,844 (77) (4.2)
-------- -------- -------
TOTAL NONINTEREST EXPENSES $ 21,031 $ 16,606 $ 4,425 26.6%
======== ======== =======
43
The primary reason for the increase in noninterest expenses resulted from the
$2.5 million contribution of the Company's common stock to SI Financial Group
Foundation in connection with the Company's initial public offering during the
third quarter of 2004. Salaries and related benefits and taxes increased
$745,000, or 8.2%, in 2004 over the prior year as the Company increased staffing
levels in preparation for the public offering, expansion of branch facilities
and the commercial lending division as well as normal wage increases. The
expansion initiatives and technological improvements increased occupancy,
furniture and equipment and computer services expenses in 2004. Of the $435,000
increase in occupancy expense for 2004 over 2003, $337,000 was related to an
impairment charge to reduce the carrying value of a former branch facility to
its estimated net market value. Outside professional services, which primarily
includes legal and auditing services, reflects an increase of $315,000 in 2004
compared to 2003 attributable to the Bank's conversion from a state to federal
charter and the additional costs associated with the increased reporting
requirements and regulations of a publicly-held company. Electronic banking fees
continue to rise as a result of greater electronic banking transactions.
Income Tax Provision. The Company's income tax expense decreased $1.2 million to
$519,000 for 2004 compared to $1.7 million in 2003. The decrease in tax expense
was due to a decrease in taxable income which was unfavorably impacted by the
$2.5 million contribution of the Company's common shares to SI Financial Group
Foundation. The effective tax rate was 29% and 34% for 2004 and 2003,
respectively.
Comparison of Operating Results for the Years Ended December 31, 2003 and
- -------------------------------------------------------------------------
December 31, 2002
- -----------------
General. Net income increased due primarily to an increase in net interest
income and noninterest income, offset by an increase in noninterest expense and
the provision for loan losses. Net interest income increased primarily as a
result of a higher volume of interest-earning assets and a decrease in the cost
of funds, offset by a decrease in the yield on interest-earning assets. Net
interest income increased $1.3 million, or 7.3%, to $18.6 million for 2003. The
increase in net interest income for 2003 was primarily attributable to a higher
volume of interest-earning assets and a decrease in the cost of funds.
Interest and Dividend Income. Total interest income decreased $392,000 (on a tax
equivalent basis), or 1.4%, to $27.9 million for 2003, resulting from a decrease
in the average yield, which more than offset an increase in the volume of
interest-earning assets. During 2003, average interest-earning assets increased
by $39.0 million, or 9.1%, to $467.2 million, while the average yield decreased
64 basis points to 5.98%. The composition of interest-earning assets generally
consists of loans and securities. The increase in average interest-earning
assets was primarily due to an increase in the average balance of loans, which
were partially offset by a decrease in investment securities. Interest on
investment securities decreased 21.7% due to the decrease in yields. Interest on
loans receivable increased $807,000, or 3.5%, to $23.8 million for 2003 due to
an increase in the volume of loans, offset by a decrease in yield. During 2003,
we originated loans at lower interest rates due to the prevailing low interest
rate environment.
Interest Expense. Total interest expense decreased $1.7 million, or 15.1%, to
$9.3 million for 2003 due primarily to a decrease in the average rate paid on
deposits, which more than offset an increase in the average balance. The average
interest rate paid on deposits decreased 70 basis points as a result of the
prevailing low interest rate environment. During 2003, we emphasized low cost
transaction accounts and our customers preferred to invest in lower rate,
shorter-term certificates of deposit.
Provision for Loan Losses. Provisions for loan losses increased $1.1 million, or
198.3%, from $537,000 for 2002 to $1.6 million for 2003. The higher provision
reflected significantly higher charge-offs, primarily due to the charge-off in
2003 of a $1.6 million commercial real estate loan, and a larger loan portfolio,
including increased commercial business loans, which carry a higher risk of
default.
44
Noninterest Income. Total noninterest income increased $1.4 million, or 43.8%,
to $4.7 million in 2003 compared to $3.3 million in 2002.
Year Ended December 31, Change
----------------------- -----------------
(Dollars in Thousands) 2003 2002 Dollars Percent
---------- ---------- ------- -------
Service fees $ 3,116 $ 2,579 $ 537 20.8%
Wealth management fees 849 766 83 10.8
Net gain (loss) on sale of securities 121 (258) 379 146.9
Net gain on sale of loans 393 107 286 267.3
Other 243 90 153 170.0
------- ------- -------
TOTAL NONINTEREST INCOME $ 4,722 $ 3,284 $ 1,438 43.8%
======= ======= =======
Service charges increased due to fees from increas ed electronic banking and
deposit services. Wealth management fees increased due to an increase in assets
under management by the trust department and due to increased sales of insurance
products. The increase in the gain on the sale of securities for 2003 was due to
normal repositioning activity in the securities portfolio in 2003 and due to a
loss related to the write-down of interest-only strips in 2002. Net gain on the
sale of loans increased due to additional sales of mortgage loans in the
secondary market due to increased originations in the lower interest rate
environment. The increase in other income in 2003 was due to nonrecurring
credits associated with discontinued employee benefit plans recognized in 2003.
Noninterest Expenses. Noninterest expenses increased by $1.2 million, or 7.9%,
for 2003 as compared to 2002.
Year Ended December 31, Change
----------------------- -----------------
(Dollars in Thousands) 2003 2002 Dollar Percent
---------- ---------- ------- -------
Salaries and employee benefits $ 9,090 $ 8,278 $ 812 9.8%
Occupancy 2,059 1,982 77 3.9
Furniture and equipment 914 1,000 (86) (8.6)
Computer services 857 844 13 1.5
Electronic banking fees 563 387 176 45.5
Outside professional services 500 478 22 4.6
Marketing 387 385 2 0.5
Supplies 266 292 (26) (8.9)
FDIC deposit insurance and state assessment 75 76 (1) (1.3)
Impairment charge - other assets 36 111 (75) (67.6)
Other real estate operations 15 23 (8) (34.8)
Other 1,844 1,538 306 19.9
-------- -------- -------
TOTAL NONINTEREST EXPENSES $ 16,606 $ 15,394 $ 1,212 7.9%
======== ======== =======
Salary and employee benefits increased due to salary increases and additional
compensation related to an increase in employees, higher commissions due to
higher sales volumes and higher pension, insurance and payroll taxes. The
increased electronic banking fees were due to increased transaction activity.
The impairment charges for 2003 and 2002 were recorded against our interest in a
small business investment company limited partnership, which invests in the debt
and equity securities of developing companies for which conventional financing
is not available. The increase in other expenses was primarily due to increased
costs associated with the increased customer use of electronic banking and
additional filing and recording fees in connection with increased mortgage
originations.
Income Tax Provision. Income taxes increased due to a higher level of taxable
income. The effective tax rate for 2003 and 2002 was 34%.
45
Liquidity and Capital Resources
- -------------------------------
Liquidity is the ability to meet current and future financial obligations of a
short-term nature. Our primary sources of funds consist of deposit inflows, loan
repayments and sales, maturities and sales of investment securities and
borrowings from the FHLB. While maturities and scheduled amortization of loans
and securities are predictable sources of funds, deposit flows and mortgage
prepayments are greatly influenced by general interest rates, economic
conditions and competition.
We regularly adjust our investments in liquid assets based upon our assessment
of (1) expected loan demand, (2) expected deposit flows, (3) yields available on
interest-earning deposits and securities and (4) the objectives of our
asset/liability management, funds management and liquidity policies. Our policy
is to maintain liquid assets less short-term liabilities within a range of 12.5%
to 20.0% of total assets. Excess liquid assets are generally invested in
interest-earning deposits and short- and intermediate-term U.S. Government
agency obligations.
Our most liquid assets are cash and cash equivalents and interest-bearing
deposits. The levels of these assets depend on our operating, financing, lending
and investing activities during any given period. At December 31, 2004, cash and
cash equivalents totaled $30.8 million, including interest-bearing deposits of
$9.1 million. Securities classified as available-for-sale, which provide
additional sources of liquidity, totaled $120.6 million at December 31, 2004. In
addition, at December 31, 2004, we had the ability to borrow a total of
approximately $192.0 million from the FHLB, which includes overnight lines of
credit of $6.2 million, before deducting outstanding advances. On that date, we
had advances outstanding of $72.7 million and no overnight advances outstanding.
The Company believes that the Bank's most liquid assets combined with the
available line from the FHLB provides adequate liquidity to meet its current
financial obligations.
At December 31, 2004, we had $84.4 million in loan commitments outstanding,
which included $27.5 million in undisbursed construction loans, $19.4 million in
unused home equity lines of credit, $8.4 million in commercial lines of credit
and $997,000 in standby letters of credit. Certificates of deposit due within
one year of December 31, 2004 totaled $94.5 million, or 20.5%, of total deposits
(including mortgagors' and investors' escrow accounts). Management believes that
the amount of deposits in shorter-term certificates of deposit reflects
customers' hesitancy to invest their funds in long-term certificates of deposit
in the existing low interest rate environment. To compensate, we have increased
the duration of our borrowings with the FHLB. If these maturing certificates of
deposit do not remain with us, we will be required to seek other sources of
funds, including other certificates of deposit and lines of credit. Depending on
market conditions, we may be required to pay higher rates on such deposits or
other borrowings than we currently pay on the certificates of deposit.
Additionally, we maintain a shorter duration in our securities portfolio to
provide necessary liquidity to compensate for any deposit outflows. We believe,
however, based on past experience that a significant portion of our certificates
of deposit will remain with us. We have the ability to attract and retain
deposits by favorably adjusting the interest rates offered to our customers.
Our primary investing activities are the origination of loans and the purchase
of securities. For the year ended December 31, 2004, we originated $178.4
million of loans and purchased $90.7 million of securities. In fiscal 2003, we
originated $207.7 million of loans and purchased $45.1 million of securities.
Financing activities consist primarily of activity in deposit accounts and in
FHLB advances. Asset growth has outpaced deposit growth during the last three
years. The increased liquidity needed to fund asset growth over the last three
years has been provided through increased FHLB borrowings and raising capital
through the issuance of trust preferred securities. We experienced a net
increase in total deposits, including mortgagors' and investors' escrow
accounts, of $43.2 million, $19.0 million and $35.3 million for the years ended
December 31, 2004, 2003 and 2002, respectively. Deposit flows are affected by
the overall level of interest rates, the interest rates and products offered by
us and our local competitors and other factors. We generally manage the pricing
of our deposits to be competitive and to increase core deposit and commercial
banking relationships. Occasionally, we offer promotional rates on certain
deposit products to attract deposits. We experienced increases in FHLB
46
advances of $15.5 million, $13.3 million and $8.7 million for the years ended
December 31, 2004, 2003 and 2002, respectively. Additionally, we generated $7.0
million in net proceeds from the issuance of trust preferred securities in 2002.
Our initial stock offering increased our capital and liquidity. However, over
time, our liquidity will be reduced as net proceeds from the stock offering are
deployed. Our financial condition and results of operation will be enhanced by
the capital from the offering, resulting in increased net interest-earning
assets and net income. However, the large increase in equity resulting from the
capital raised in the offering will, initially, have an adverse impact on our
return on equity. In the future, we may use capital management tools such as
cash dividends and common share repurchases. However, under OTS regulations, we
will not be allowed to repurchase any shares during the first year following the
offering, except to fund the restricted stock awards under any stock-based
benefit plans, unless extraordinary circumstances exist and we receive
regulatory approval.
We are subject to various regulatory capital requirements administered by the
OTS, including a risk-based capital measure. The risk-based capital guidelines
include both a definition of capital and a framework for calculating
risk-weighted assets by assigning balance sheet assets and off-balance sheet
items to broad risk categories. At December 31, 2004, we exceeded all of our
regulatory capital requirements. We are considered "well capitalized" under
regulatory guidelines. As a savings and loan holding company regulated by the
OTS, the Company is not subject to any separate regulatory capital requirements.
See Item 1. Business. "Regulation and Supervision - Regulation of Federal
Savings Associations - Capital Requirements" and Note 15 in the Notes to the
Consolidated Financial Statements for additional information relating to the
Bank's regulatory capital requirements.
Payments Due Under Contractual Obligations
- ------------------------------------------
The following table presents information relating to the Company's payments due
under contractual obligations as of December 31, 2004.
Payments Due by Period
--------------------------------------------------------
One to More
Less Than Three Three to Than Five
(Dollars in Thousands) One Year Years Five Years Years Total
--------- -------- ---------- --------- --------
Long-term debt obligations $ 21,732 $ 28,815 $ 12,127 $ 10,000 $ 72,674
Operating lease obligations (1) 786 1,370 835 3,483 6,474
Other long-term liabilities reflected on the
balance sheet -- -- -- 7,217 7,217
-------- -------- -------- -------- --------
TOTAL CONTRACTUAL OBLIGATIONS $ 22,518 $ 30,185 $ 12,962 $ 20,700 $ 86,365
======== ======== ======== ======== ========
----------
(1) Payments are for lease of real property.
Off-Balance Sheet Arrangements
- ------------------------------
In the normal course of operations, we engage in a variety of financial
transactions that, in accordance with accounting principles generally accepted
in the United States of America, are not recorded in our financial statements.
These transactions involve, to varying degrees, elements of credit, interest
rate, and liquidity risk. Such transactions are used primarily to manage
customers' requests for funding and take the form of loan commitments, lines of
credit and letters of credit.
The contractual amounts of commitments to extend credit represent the amounts of
potential accounting loss should the contract be fully drawn upon, the customer
default and the value of any existing collateral become worthless. The Company
uses the same credit policies in making commitments and conditional obligations
as it does for on-balance sheet instruments. Financial instruments whose
contract amounts represent credit risk at December 31, 2004 and December 31,
2003 are as follows:
47
December 31,
-------------------
(Dollars in Thousands) 2004 2003
-------- --------
Commitments to extend credit: (1)
Future loan commitments (2) $ 27,073 $ 22,224
Undisbursed construction loans 27,527 15,193
Undisbursed home equity lines of credit 19,351 15,577
Undisbursed commercial lines of credit 8,433 7,360
Overdraft protection lines 1,060 1,012
Standby letters of credit (3) 997 718
-------- --------
TOTAL COMMITMENTS $ 84,441 $ 62,084
======== ========
- ----------
(1) Commitments to extend credit are agreements to lend to a customer as
long as there is no violation of any condition established in the
contract. Commitments may require payment of a fee and generally
have fixed expiration dates or other termination clauses.
(2) Includes fixed rate loan commitments of $10.2 million at interest
rates ranging from 4.875% to 7.125% and $16.8 million at interest
rates ranging from 4.375% to 7.0% at December 31, 2004 and 2003,
respectively.
(3) Standby letters of credit are conditional commitments issued to
guarantee the performance of a customer to a third party.
In 1998, the Bank became a limited partner in a Small Business Investment
Corporation ("SBIC") and made a commitment to make a capital investment of $1.0
million in the limited partnership. At December 31, 2004 and 2003, the Bank's
remaining off-balance-sheet commitment for capital investment was approximately
$194,000 and $307,000, respectively.
In 2004, the Bank established an Employee Stock Ownership Plan for the benefit
of its eligible employees. At December 31, 2004, the Bank has repaid principal
payments on the loan to the ESOP of $56,000 and committed to release 8,069
shares held in suspense for allocation to participants in 2005. As of December
31, 2004, the amount of unallocated common shares held in suspense totaled
484,430, with a fair value of $5.9 million, which represents a potential
commitment of the Bank to the ESOP. See Note 11 in the Notes to the Consolidated
Financial Statements.
As of December 31, 2004, we did not engage in any off-balance sheet transactions
reasonably likely to have a material effect on our financial condition, results
of operation or cash flows. See Note 14 in the Notes to the Consolidated
Financial Statements.
Impact of Inflation and Changes in Prices
- -----------------------------------------
The financial statements and financial data presented within this document 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 the
change in the relative purchasing power of money over time due to inflation. The
primary impact of inflation on our operations is reflected in increased
operating costs. Unlike most industrial companies, virtually all the assets and
liabilities of a financial institution are monetary in nature. As a result,
interest rates generally have a more significant impact on a financial
institution's performance than do the effects of general levels of inflation.
Interest rates do not necessarily move in the same direction or to the same
extent as the prices of goods and services.
Impact of Recent Accounting Standards
- -------------------------------------
In November 2002, the Financial Accounting Standards Board ("FASB") issued
Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others," ("FIN 45")
which addresses guarantees such as standby letters of credit, performance
guarantees and direct or indirect guarantees of the indebtedness of others, but
not guarantees of funding. FIN 45 requires a guarantor to recognize, at the
inception of a guarantee, a liability in an amount equal to the fair value of
the obligation undertaken in issuing the guarantee, and requires disclosure
about the maximum potential payments that might be required, as
48
well as the collateral or other recourse obtainable. The recognition and
measurement provisions of FIN 45 were effective on a prospective basis after
December 31, 2002, and its adoption on January 1, 2003 has not had a material
effect on the consolidated financial statements.
In January 2003, the Financial Accounting Standards Board issued Interpretation
No. 46, "Consolidation of Variable Interest Entities," ("FIN 46") which
establishes guidance for determining when an entity should consolidate another
entity that meets the definition of a variable interest entity. FIN 46 requires
a variable interest entity to be consolidated by a company if that company will
absorb a majority of expected losses, will receive a majority of expected
residual returns or both. Transfers to qualified special-purpose entities and
certain other interests in a qualified-special purpose entity are not subject to
the requirements of FIN 46. On December 17, 2003, the FASB revised FIN 46 ("FIN
46R") and deferred the effective date of FIN 46 to no later than the end of the
first reporting period that ends after March 15, 2004. For special-purpose
entities, however, FIN 46 would be required to be applied as of December 31,
2003. SI Capital Trust I issued $7.0 million of trust preferred securities in
2002. As required by FIN 46, the Company deconsolidated SI Capital Trust I at
December 31, 2003 and restated the 2002 statement of financial condition. As a
result, the statement of financial condition at December 31, 2004, 2003 and 2002
(as restated) includes $7.2 million of junior subordinated debt, which was
previously presented in the statement of financial condition as $7.0 million in
trust preferred securities after a consolidation elimination entry of $217,000.
The Company's investment in SI Capital Trust I of $217,000 is included in other
assets. The overall effect on the financial position and operating results as a
result of the deconsolidation was not material.
In April 2003, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities" ("SFAS 149"). This Statement
amends Statement of Financial Accounting Standards No. 133, "Accounting for
Derivative Instruments and Hedging Activities" ("SFAS 133"), and clarifies
accounting for derivative instruments, including certain derivative instruments
embedded in other contracts, and for hedging activities under SFAS 133. This
Statement is effective for contracts entered into or modified after June 30,
2003, except in certain circumstances, and for hedging relationships designated
after June 30, 2003. SFAS 149 did not have a material effect on the consolidated
financial statements.
In May 2003, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity" ("SFAS 150").
This Statement provides new rules on the accounting for certain financial
instruments that, under previous guidance, issuers could account for as equity.
Such financial instruments include mandatorily redeemable shares, instruments
that require the issuer to buy back some of its shares in exchange for cash or
other assets, or obligations that can be settled with shares, the monetary value
of which is fixed. Most of the guidance in SFAS 150 is effective for financial
instruments entered into or modified after May 31, 2003, and otherwise is
effective at the beginning of the first interim period beginning after June 30,
2003. SFAS 150 had no effect on the consolidated financial statements.
In December 2003, the Financial Accounting Standards Board revised Statement of
Financial Accounting Standards No. 132, "Employers' Disclosures about Pensions
and Postretirement Benefits" ("SFAS 132R"). This Statement requires additional
disclosures about the assets, obligations, cash flows and net periodic benefit
cost of defined benefit pension and other postretirement plans. SFAS 132R had no
effect on the consolidated financial statements.
In December 2003, the Accounting Standards Executive Committee of the AICPA
issued Statement of Position No. 03-3, "Accounting for Certain Loans or Debt
Securities Acquired in a Transfer" ("SOP 03-3"). SOP 03-3 addresses the
accounting for differences between contractual cash flows and the cash flows
expected to be collected from purchased loans or debt securities if those
differences are attributable, in part, to credit quality. SOP 03-3 requires
purchased loans and debt securities to be recorded initially at fair value based
on the present value of the cash flows expected to be collected with no
carryover of any valuation allowance previously recognized by the seller.
Interest income should be recognized based on the effective yield from the cash
flows expected to be collected. To the extent that the purchased loans or debt
securities experience subsequent deterioration in credit quality, a valuation
allowance would be established for any additional cash flows that are not
expected to be received.
49
However, if more cash flows subsequently are expected to be received than
originally estimated, the effective yield would be adjusted on a prospective
basis. SOP 03-3 will be effective for loans and debt securities acquired after
December 31, 2004. Management does not expect the adoption of this statement
will have a material impact on the Company's financial statements.
On March 9, 2004, the United States Securities and Exchange Commission (the
"SEC") issued Staff Accounting Bulletin No. 105, "Application of Accounting
Principles to Loan Commitments" ("SAB 105"). SAB 105 summarizes the views of the
SEC staff regarding the application of generally accepted accounting principles
to loan commitments accounted for as derivative instruments. The SEC staff
believes that in recognizing a loan commitment, entities should not consider
expected future cash flows related to the associated servicing of the loan until
the servicing asset has been contractually separated from the underlying loan by
sale or securitization of the loan with the servicing retained. The provisions
of SAB 105 are applicable to all loan commitments accounted for as derivatives
and entered into subsequent to March 31, 2004. The Company may enter into such
commitments in connection with residential mortgage loan applicants. The
adoption of SAB 105 will not have a material impact on the Company's
consolidated results of operations or financial position.
In March 2004, the Emerging Issues Task Force ("EITF") reached a consensus on
the application of EITF Issue 03-1, " The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments," in determining when an
investment is impaired, whether the impairment is other than temporary and the
measurement of the impairment loss. This impairment is applicable to debt and
equity securities that are within the scope of Financial Accounting Standards
Board Statement No. 115, "Accounting for Certain Investments in Debt and Equity
Securities" ("SFAS 115"), Financial Accounting Standards Board Statement No.
124, "Accounting for Certain Investments Held by Not-for-Profit Organizations"
("SFAS 124") and those equity securities outside of the scope of SFAS 115 and
accounted for under the cost method. In October 2004, Emerging Issues Task Force
Issue 03-1-1 was issued to delay the effective date of the measurement and
recognition provisions of EITF Issue 03-1 until the proposed Financial
Accounting Standards Board Staff Position, which provides guidance on the
application of the provisions, is issued in final form. This delay, however,
does not eliminate the need to recognize other-than-temporary impairment losses
as required by applicable authoritative pronouncements. The Company does not
believe that the application of EITF Issue 03-1 will have a material impact on
the Company's consolidated financial statements.
In December 2004, the Financial Accounting Standards Board revised Statement of
Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123R"). This Statement eliminates the alternative intrinsic
value method of accounting, according to APB Opinion No. 25, "Accounting for
Stock Issued to Employees," for recognizing the cost of employee services
received in share-based payment transactions. SFAS 123R requires all entities to
follow the same accounting standard and account for such transactions using the
fair-value-based method. This Statement does not address the accounting for
employee stock ownership plans. At this time, SFAS 123R has no effect on our
consolidated financial statements.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
- --------------------------------------------------------------------
Qualitative Aspects of Market Risk
- ----------------------------------
The primary market risk factor affecting the financial condition and operating
results of the Company is interest rate risk. Interest rate risk is the exposure
of a bank's current and future earnings and capital arising from movements in
interest rates. This risk is managed by periodic evaluation of the interest rate
risk inherent in interest-earning assets and interest-bearing liabilities in an
effort to minimize the adverse effects of changes in the interest rate
environment. Deposit accounts typically react more quickly to changes in market
interest rates than mortgage loans because of the shorter maturities of
deposits. As a result, sharp increases in interest rates may adversely affect
our earnings while decreases in interest rates may beneficially affect our
earnings. To reduce the potential volatility of our earnings, we have sought to
improve the match between asset and liability maturities and rates, while
maintaining an acceptable interest rate spread. Pursuant to this strategy, we
originate adjustable-rate mortgage loans for retention in our loan portfolio.
However, the ability to originate adjustable-rate loans depends, to a great
extent, on market interest rates and borrowers' preferences. As an alternative
to adjustable-rate
50
mortgage loans, we offer fixed-rate mortgage loans with maturities of fifteen
years. This product enables us to compete in the fixed-rate mortgage market
while maintaining a shorter maturity. Fixed-rate mortgage loans typically have
an adverse effect on interest rate sensitivity compared to adjustable-rate
loans. Accordingly, we have sold more long-term fixed-rate mortgage loans in the
secondary market in recent periods to manage interest rate risk. In recent
years, we also have used investment securities with terms of three years or
less, longer-term borrowings from the Federal Home Loan Bank and a 4-year $5.0
million brokered deposit to help manage interest rate risk. We currently do not
participate in hedging programs, interest rate swaps or other activities
involving the use of derivative financial instruments.
We have an Asset/Liability Committee to communicate, coordinate and control all
aspects involving asset/liability management. The committee establishes and
monitors the volume, maturities, pricing and mix of assets and funding sources
with the objective of managing assets and funding sources to provide results
that are consistent with liquidity, growth, risk limits and profitability goals.
Quantitative Aspects of Market Risk
- -----------------------------------
We analyze our interest rate sensitivity position to manage the risk associated
with interest rate movements through the use of interest income simulation. The
matching of assets and liabilities may be analyzed by examining the extent to
which such assets and liabilities are "interest sensitive." 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. Our goal is to manage asset
and liability positions to moderate the effect of interest rate fluctuations on
net interest income. The Company utilizes income simulation to analyze its
interest rate sensitivity.
Income Simulation Analysis. Interest income simulations are completed quarterly
and presented to the Asset/Liability Committee. The simulations provide an
estimate of the impact of changes in interest rates on net interest income under
a range of assumptions. The numerous assumptions used in the simulation process
are reviewed by the Asset/Liability Committee on a quarterly basis. Changes to
these assumptions can significantly affect the results of the simulation. The
simulation incorporates assumptions regarding the potential timing in the
repricing of certain assets and liabilities when market rates change and the
changes in spreads between different market rates. The simulation analysis
incorporates management's current assessment of the risk that pricing margins
will change adversely over time due to competition or other factors.
Simulation analysis is only an estimate of our interest rate risk exposure at a
particular point in time. We continually review the potential effect that
changes in interest rates could have on the repayment of rate sensitive assets
and funding requirements of rate sensitive liabilities.
The tables below set forth an approximation of our exposure as a percentage of
estimated net interest income for the next twelve and twenty-four month periods
using interest income simulation. The simulation uses projected repricing of
assets and liabilities at December 31, 2004 and at December 31, 2003 on the
basis of contractual maturities, anticipated repayments and scheduled rate
adjustments. Prepayment rates can have a significant impact on interest income
simulation. Because of the Company's large percentage of loans and
mortgage-backed securities, rising or falling interest rates have a significant
impact on the prepayment speeds of our earning assets that in turn affect the
rate sensitivity position. The prepayment rates on investment securities are
assumed to fluctuate between 9% and 18% in a flat interest rate environment,
between 6% and 18% in an increasing interest rate environment and between 18%
and 27% in a decreasing interest rate environment, depending on the type of
security. Loan prepayment rates are assumed to fluctuate between 6% and 24% in a
flat interest rate environment, between 6% and 24% in a rising rate environment
and between 6% and 36% in a falling rate environment, depending on the type of
loan. As evidenced by these assumptions, when interest rates rise, prepayments
tend to slow and when interest rates fall, prepayments tend to increase. Our
asset sensitivity would be reduced if prepayments slow and vice versa. Because
prospective effects of hypothetical interest rate changes are based on a number
of assumptions, these computations should not be relied upon as indicative of
actual results. While we believe such assumptions to be reasonable, there can be
no assurance that assumed prepayment rates will approximate actual future
mortgage-backed security, collateralized mortgage obligation and loan repayment
activity. Further, the computations do not reflect any actions that management
may undertake in response to
51
changes in interest rates. Management periodically reviews its rate assumptions
based on existing and projected economic conditions.
The Company's management generally simulates changes to net interest income
using three different interest rate scenarios. The first scenario anticipates
the maximum foreseeable increase in rates over the next twelve months;
management currently assumes this to be 300 basis points. The second scenario
anticipates the maximum foreseeable decrease in rates over the next twelve
months; management's current assumption is 100 basis points. The third scenario
anticipates management's view of the most likely change in interest rates over
the next twelve months; management's current assumption is a 100 basis point
increase in rates. The basis point change in each of the three scenarios is
assumed to occur evenly over both the twelve and twenty-four months presented.
As of December 31, 2004 and 2003, the Company's estimated exposure as a
percentage of estimated net interest margin for the twelve-month and twenty-four
month periods are as follows:
Percent Change in Estimated
As of December 31, 2004: Net Interest Income Over
--------------------------------- ---------------------------
12 Months 24 Months
--------- ---------
300 basis point increase in rates (9.95)% (12.57)%
100 basis point increase in rates (3.20)% (4.25)%
100 basis point decrease in rates (3.70)% (6.35)%
Percent Change in Estimated
As of December 31, 2003: Net Interest Income Over
--------------------------------- ---------------------------
12 Months 24 Months
--------- ---------
300 basis point increase in rates (9.80)% (9.29)%
100 basis point increase in rates 0.84% 3.13%
100 basis point decrease in rates (1.94)% (4.69)%
As of December 31, 2004, based on the scenarios above, net interest income would
be adversely affected in both the twelve and twenty-four month periods if
interest rates rose by 100 or 300 basis points or if interest rates decreased
100 basis points. Using net interest income for the quarter ended December 31,
2004, for each percentage point change in net interest income, the effect on the
Company's annual net income would be $140,000, assuming a 34% income tax rate.
As of December 31, 2003, based on the scenarios above, net interest income would
be adversely affected in both the twelve and twenty-four month periods in a
declining rate environment. In addition, a rise in interest rates by 300 basis
points would negatively impact net interest income over both the twelve and
twenty-four month periods. However, an increase in interest rates of 100 basis
points would slightly increase net interest income in both periods presented.
Using data at December 31, 2003, for each percentage point change in net
interest income, the effect on net income would be $123,000, assuming a 34%
income tax rate.
The change in interest rate sensitivity at December 31, 2004 and December 31,
2003 reflects our continued use of longer-term borrowings.
Item 8. Financial Statements and Supplementary Data.
- ----------------------------------------------------
For the Company's Consolidated Financial Statements, see index on page 57.
52
Item 9. Changes in and Disagreements with Accountants on Accounting and
- -----------------------------------------------------------------------
Financial Disclosure.
- ---------------------
None.
Item 9A. Controls and Procedures.
- ---------------------------------
The Company's management, including the Company's principal executive officer
and principal financial officer, have evaluated the effectiveness of the
Company's "disclosure controls and procedures," as such term is defined in Rule
13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended,
(the "Exchange Act"). Based upon their evaluation, the principal executive
officer and principal financial officer concluded that, as of the end of the
period covered by this report, the Company's disclosure controls and procedures
were effective for the purpose of ensuring that the information required to be
disclosed in the reports that the Company files or submits under the Exchange
Act with the Securities and Exchange Commission (1) is recorded, processed,
summarized and reported within the time periods specified in the SEC's rules and
forms and (2) is accumulated and communicated to the Company's management,
including its principal executive officer and principal financial officer, as
appropriate to allow timely decisions regarding required disclosure.
Item 9B. Other Information.
- ---------------------------
The following disclosures would otherwise have been filed on Form 8-K under the
heading: "Item 1.01. Entry into a Material Definitive Agreement":
On September 30, 2004, the Company and the Bank executed a three-year employment
agreement with each of Rheo A. Brouillard, President and Chief Executive Officer
of the Company and the Bank, and Brian J. Hull, Executive Vice President and
Chief Financial Officer of the Company and the Bank, each of which was effective
as of September 30, 2004. On September 30, 2004, the Bank executed a two-year
change in control agreement with each of Sonia M. Dudas, Senior Vice President
and Senior Trust Officer of the Bank, and Michael J. Moran, Senior Vice
President, Senior Credit Officer of the Bank, each of which was effective as of
September 30, 2004. The terms of the employment agreements and the change in
control agreement were previously disclosed in the Company's Registration
Statement on Form S-1, as amended (File No. 333-116381).
PART III.
- ---------
Item 10. Directors and Executive Officers of the Registrant.
- ------------------------------------------------------------
The information concerning the directors and officers of the Company and
information regarding compliance with Section 16(a) of the Exchange Act is
incorporated herein by reference to the cover page of this Form 10-K, the
Company's Proxy Statement for the 2005 Annual Meeting of Stockholders and to
Part I, Item 1, "Business - Executive Officers of the Registrant" in this
report.
The Company has adopted a Code of Ethics and Business Conduct. See Exhibit 14.0
to this Annual Report on Form 10-K.
Item 11. Executive Compensation.
- --------------------------------
The information regarding executive compensation is incorporated herein by
reference to the Company's Proxy Statement for the 2005 Annual Meeting of
Stockholders.
Item 12. Security Ownership of Certain Beneficial Owners and Management and
- ---------------------------------------------------------------------------
Related Stockholder Matters.
- ----------------------------
The information relating to the security ownership of certain beneficial owners
and management and the equity compensation plan information is incorporated
herein by reference to the Company's Proxy Statement for the 2005 Annual Meeting
of Stockholders.
53
Item 13. Certain Relationships and Related Transactions.
- --------------------------------------------------------
The information relating to certain relationships and related transactions is
incorporated herein by reference to the Company's Proxy Statement for the 2005
Annual Meeting of Stockholders.
Item 14. Principal Accountant Fees and Services.
- ------------------------------------------------
The information relating to the principal accountant fees and expenses is
incorporated herein by reference to the Company's Proxy Statement for the 2005
Annual Meeting of Stockholders.
PART IV.
- --------
Item 15. Exhibits and Financial Statement Schedules.
- ----------------------------------------------------
(1) Financial Statements
The following consolidated financial statements of the Company and its
subsidiaries are filed as part of this report:
o Report of Registered Independent Public Accounting Firm
o Consolidated Statements of Financial Condition as of December 31,
2004 and 2003
o Consolidated Statements of Income for the Years Ended December 31,
2004, 2003 and 2002
o Consolidated Statements of Changes in Stockholders' Equity for the
Years Ended December 31, 2004, 2003 and 2002
o Consolidated Statements of Cash Flows for the Years Ended December
31, 2004, 2003 and 2002
o Notes to Consolidated Financial Statements
(2) Financial Statement Schedules
Financial Statement Schedules have been omitted because they are not applicable
or the required information is shown in the Consolidated Financial Statements or
Notes hereto.
54
(3) Exhibits
3.1 Charter of SI Financial Group, Inc. (1)
3.2 Bylaws of SI Financial Group, Inc. (1)
4.0 Specimen Stock Certificate of SI Financial Group, Inc. (1)
10.1 Employment Agreement by and among SI Financial Group, Inc. and Savings
Institute Bank and Trust Company and Rheo A. Brouillard (2)
10.2 Employment Agreement by and among SI Financial Group, Inc. and Savings
Institute Bank and Trust Company and Brian J. Hull (2)
10.3 Change in Control Agreement by and among SI Financial Group, Inc. and
Savings Institute Bank and Trust Company and Michael J. Moran (2)
10.4 Form of Savings Institute Bank and Trust Company Employee Severance
Compensation Plan (1)
10.5 Savings Institute Directors Retirement Plan (1)
10.6 Form of Savings Institute Bank and Trust Company Supplemental Executive
Retirement Plan (1)
10.7 Savings Institute Group Term Replacement Plan (1)
10.8 Form of Savings Institute Executive Supplemental Retirement Plan -
Defined Benefit (1)
10.9 Form of Savings Institute Director Deferred Fee Agreement (1)
10.10 Form of Savings Institute Director Consultation Plan (1)
10.11 Change in Control Agreement by and among SI Financial Group, Inc.,
Savings Institute Bank and Trust Company and Sonia M. Dudas
14.0 Code of Ethics and Business Conduct
21.0 List of Subsidiaries
23.0 Consent of McGladrey & Pullen, LLP
31.1 Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer
31.2 Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer
32.0 Certification of Chief Executive Officer and Chief Financial Officer
pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906
of the Sarbanes-Oxley Act of 2002
- -----------
(1) Incorporated by reference into this document from the Exhibits filed
with the Securities and Exchange Commission on the Registration
Statement on Form S-1, and any amendments thereto, Registration No.
333-116381.
(2) Incorporated by reference into this document from the Exhibits filed
with Company's Form 10-Q for the quarter ended September 30, 2004,
filed with the Securities and Exchange Commission on November 15,
2004.
55
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.
SI Financial Group, Inc.
By: /s/ Rheo A. Brouillard
-------------------------------------
Rheo A. Brouillard
President and Chief Executive Officer
March 16, 2005
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant in
the capacities and on the dates indicated.
Name Title Date
- --------------------------------- -------------------------------------- --------------
/s/ Rheo A. Brouillard President and Chief Executive March 16, 2005
- --------------------------------- Officer (principal executive officer)
Rheo A. Brouillard
/s/ Brian J. Hull Executive Vice President, Treasurer March 16, 2005
- --------------------------------- and Chief Financial Officer (principal
Brian J. Hull accounting and financial officer)
/s/ Henry P. Hinckley Chairman of the Board March 16, 2005
- ---------------------------------
Henry P. Hinckley
/s/ Robert C. Cushman, Sr. Director March 16, 2005
- ---------------------------------
Robert C. Cushman, Sr.
/s/ Everett Watson Director March 16, 2005
- ---------------------------------
Everett Watson
/s/ Donna M. Evan Director March 16, 2005
- ---------------------------------
Donna M. Evan
/s/ Roger Engle Director March 16, 2005
- ---------------------------------
Roger Engle
/s/ Robert O. Gillard Director March 16, 2005
- ---------------------------------
Robert O. Gillard
/s/ Steven H. Townsend Director March 16, 2005
- ---------------------------------
Steven H. Townsend
56
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
-----------------------------------------
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
Report of Independent Registered Public Accounting Firm 58
Consolidated Statements of Financial Condition as of December 31, 2004 and 2003 59
Consolidated Statements of Income for the Years Ended December 31, 2004, 2003 and 2002 60
Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 2004,
2003 and 2002 62
Consolidated Statements of Cash Flows for the Years Ended December 31, 2004, 2003 and 2002 63
Notes to Consolidated Financial Statements 65
57
Report of Independent Registered Public Accounting Firm
- -------------------------------------------------------
The Board of Directors and Stockholders
SI Financial Group, Inc. and Subsidiaries
Willimantic, Connecticut
We have audited the consolidated statements of financial condition of SI
Financial Group, Inc. and Subsidiaries (the "Company") as of December 31, 2004
and 2003, and the related consolidated statements of income, changes in
stockholders' equity and cash flows for each of the three years in the period
ended December 31, 2004. These consolidated 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 audits to obtain reasonable assurance about whether the
financial statements are free from material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of SI Financial Group,
Inc. and Subsidiaries as of December 31, 2004 and 2003, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2004, in conformity with U.S. generally accepted accounting
principles.
/s/ McGladrey & Pullen, LLP
- ---------------------------
New Haven, Connecticut
February 18, 2005
58
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Dollars in Thousands, Except Share Amounts)
December 31,
---------------------
2004 2003
--------- ---------
ASSETS:
Cash and due from banks:
Noninterest-bearing deposits and cash $ 21,647 $ 20,336
Interest-bearing deposits 8,728 4,441
Federal funds sold 400 4,800
--------- ---------
Cash and cash equivalents (note 2) 30,775 29,577
Available for sale securities, at fair value (note 3) 120,557 77,693
Held to maturity securities, at cost (fair value approximates $1,344) (note 3) -- 1,728
Loans held for sale 200 --
Loans receivable, net (note 4) 447,957 386,924
Accrued interest receivable on loans 1,739 1,580
Accrued interest receivable on investment securities 899 658
Federal Home Loan Bank Stock, at cost (note 9) 4,313 2,858
Cash surrender value of bank-owned life insurance (note 11) 7,561 7,258
Other real estate owned (note 5) -- 328
Premises and equipment, net (note 6) 6,586 6,675
Core deposit intangible (note 7) 292 389
Deferred tax asset, net (note 10) 2,044 601
Other assets (note 9) 1,726 1,872
--------- ---------
TOTAL ASSETS $ 624,649 $ 518,141
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY:
Liabilities:
Deposits: (note 8)
Noninterest-bearing $ 46,049 $ 40,371
Interest-bearing 411,709 374,719
--------- ---------
Total deposits 457,758 415,090
Mortgagors' and investors' escrow accounts 2,722 2,221
Federal Home Loan Bank advances (note 9) 72,674 57,168
Junior subordinated debt owed to unconsolidated trust (note 9) 7,217 7,217
Accrued expenses and other liabilities 3,469 2,346
--------- ---------
TOTAL LIABILITIES 543,840 484,042
--------- ---------
Commitments and contingencies (note 12) -- --
Stockholders' Equity: (note 15)
Preferred stock ($.01 par value; 1,000,000 shares authorized; none
issued or outstanding) -- --
Common stock ($.01 par value; 75,000,000 shares authorized;
12,563,750 shares issued and outstanding at December 31, 2004) 126 --
Additional paid-in capital 50,947 --
Unallocated common shares held by ESOP (note 11) (4,844) --
Retained earnings (including surplus of $1,000 at December 31, 2003) (note 10) 34,870 33,582
Accumulated other comprehensive income (loss) (note 16) (290) 517
--------- ---------
TOTAL STOCKHOLDERS' EQUITY 80,809 34,099
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 624,649 $ 518,141
========= =========
See accompanying notes to consolidated financial statements.
59
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Dollars in Thousands, Except Share Amounts)
Years Ended December 31,
------------------------------
2004 2003 2002
-------- -------- --------
Interest and dividend income:
Loans, including fees $ 24,545 $ 23,840 $ 23,033
Investment securities:
Taxable interest 3,658 3,787 4,894
Tax-exempt interest 24 27 2
Dividends 136 121 127
Other 240 155 274
-------- -------- --------
TOTAL INTEREST AND DIVIDEND INCOME 28,603 27,930 28,330
-------- -------- --------
Interest expense:
Deposits (note 8) 6,346 6,597 8,480
Federal Home Loan advances (note 9) 2,683 2,315 2,146
Subordinated debt (note 9) 371 360 301
Other borrowings -- 74 87
-------- -------- --------
TOTAL INTEREST EXPENSE 9,400 9,346 11,014
-------- -------- --------
NET INTEREST INCOME BEFORE PROVISION FOR LOAN
LOSSES 19,203 18,584 17,316
Provision for loan losses (note 4) 550 1,602 537
-------- -------- --------
NET INTEREST AND DIVIDEND INCOME AFTER PROVISION
FOR LOAN LOSSES 18,653 16,982 16,779
-------- -------- --------
Noninterest income:
Service fees 3,244 3,116 2,579
Wealth management fees 942 849 766
Net gain (loss) on available for sale securities (note 3) (166) 121 (258)
Net gain on sale of loans 55 393 107
Other 110 243 90
-------- -------- --------
TOTAL NONINTEREST INCOME 4,185 4,722 3,284
-------- -------- --------
Noninterest expenses:
Salaries and employee benefits (note 11) 9,835 9,090 8,278
Occupancy 2,494 2,059 1,982
Furniture and equipment 971 914 1,000
Computer services 1,014 857 844
Electronic banking fees 664 563 387
Outside professional services 815 500 478
Marketing 513 387 385
Supplies 293 266 292
FDIC deposit insurance and state assessment 90 75 76
Impairment charge - other asset 51 36 111
Contribution to SI Financial Group Foundation 2,513 -- --
Other real estate operations (note 5) 11 15 23
Other 1,767 1,844 1,538
-------- -------- --------
TOTAL NONINTEREST EXPENSES 21,031 16,606 15,394
-------- -------- --------
60
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME - Continued
(Dollars in Thousands, Except Share Amounts)
Years Ended December 31,
------------------------------
2004 2003 2002
-------- -------- --------
INCOME BEFORE INCOME TAXES 1,807 5,098 4,669
Income tax provision (note 10) 519 1,713 1,587
-------- -------- --------
NET INCOME $ 1,288 $ 3,385 $ 3,082
======== ======== ========
Net income per common share:
Basic N/A N/A N/A
Diluted N/A N/A N/A
Weighted-average common shares outstanding:
Basic N/A N/A N/A
Diluted N/A N/A N/A
See accompanying notes to consolidated financial statements.
61
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002
(Dollars in Thousands, Except Share Amounts)
Common Stock Unallocated Accumulated
-------------------- Additional Common Other Total
Paid-in Shares Held Retained Comprehensive Stockholders'
Shares Dollars Capital by ESOP Earnings Income Equity
---------- ------- ---------- ----------- -------- ------------- -------------
BALANCE AT DECEMBER 31, 2001 -- $ -- $ -- $ -- $ 27,115 $ 701 $ 27,816
Comprehensive income:
Net income -- -- -- -- 3,082 -- 3,082
Change in net unrealized gain on
available for sale securities,
net of taxes (note 16) -- -- -- -- -- 510 510
--------
Total comprehensive income 3,592
---------- ----- -------- -------- -------- ------- --------
BALANCE AT DECEMBER 31, 2002 -- -- -- -- 30,197 1,211 31,408
Comprehensive income:
Net income -- -- -- -- 3,385 -- 3,385
Change in net unrealized loss on
available for sale securities,
net of taxes (note 16) -- -- -- -- -- (694) (694)
--------
Total comprehensive income -- -- -- -- -- -- 2,691
---------- ----- -------- -------- -------- ------- --------
BALANCE AT DECEMBER 31, 2003 -- -- -- -- 33,582 517 34,099
Issuance of common stock for initial
public offering, net of expenses
of $1.8 million 5,025,500 50 48,430 -- -- -- 48,480
Issuance of common stock to SI
Bancorp, MHC 7,286,975 73 (73) -- -- -- --
Issuance of common stock to SI
Financial Group Foundation
including additional tax benefit
of $68.0 thousand due to higher
basis for tax purposes 251,275 3 2,578 -- -- -- 2,581
Shares purchased for ESOP -- -- -- (4,925) -- -- (4,925)
Allocation of ESOP shares -- -- 12 81 -- -- 93
Comprehensive income:
Net income -- -- -- -- 1,288 -- 1,288
Change in net unrealized loss on
available for sale securities,
net of taxes (note 16) -- -- -- -- -- (807) (807)
--------
Total comprehensive income -- -- -- -- -- -- 481
---------- ----- -------- -------- -------- ------- --------
BALANCE AT DECEMBER 31, 2004 12,563,750 $ 126 $ 50,947 $ (4,844) $ 34,870 $ (290) $ 80,809
========== ===== ======== ======== ======== ======= ========
See accompanying notes to consolidated financial statements.
62
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in Thousands)
Years Ended December 31,
----------------------------------
2004 2003 2002
---------- --------- ---------
Cash flows from operating activities:
Net income $ 1,288 $ 3,385 $ 3,082
Adjustments to reconcile net income to net cash provided by
operating activities:
Provision for loan losses 550 1,602 537
Contribution of common stock to charitable foundation 2,513 -- --
Employee stock ownership plan expense 93 -- --
Amortization and accretion of investment premiums and discounts, net 111 466 714
Amortization and accretion of loan premiums and discounts, net 285 192 109
Depreciation and amortization of premises and equipment 1,074 1,039 1,106
Amortization of core deposit intangible 97 97 97
Amortization of deferred debt issuance costs 35 35 26
Amortization of mortgage servicing rights 24 -- --
Deferred income taxes (959) 166 (270)
Net loss (gain) on available for sale securities 166 (121) 258
Loans originated for sale (15,694) (21,000) (12,687)
Proceeds from sale of loans 15,549 22,996 12,795
Net decrease in loans held for sale -- 320 --
Net gain on sale of loans (55) (393) (107)
Net gain on sale of other real estate owned -- (15) (32)
Write-down of other real estate owned 60 -- --
Increase in cash surrender value of bank-owned life insurance (303) (258) --
Impairment charge - long-lived assets 337 -- --
Impairment charge - other assets 51 36 111
Change in operating assets and liabilities:
Deferred loan costs, net of fees (356) (596) (141)
Accrued interest receivable (400) 55 (51)
Other assets 36 (144) (425)
Accrued expenses and other liabilities 1,123 212 640
---------- --------- ---------
NET CASH PROVIDED BY OPERATING ACTIVITIES 5,625 8,074 5,762
---------- --------- ---------
Cash flows from investing activities:
Purchases of available for sale securities (90,693) (45,102) (56,791)
Proceeds from sales of available for sale securities 22,845 11,650 9,956
Proceeds from maturities of and principal repayments on
available for sale securities 23,836 42,323 37,571
Purchases of held to maturity securities -- -- (7,503)
Proceeds from sales of held to maturity securities 1,253 -- --
Proceeds from maturities of and principal repayments on held to
maturity securities 123 7,689 11,085
Net increase in loans (61,512) (55,311) (43,982)
Purchases of Federal Home Loan Bank stock (1,455) (472) (252)
Purchase of bank-owned life insurance policies -- (7,000) --
Purchase of common stock of trust subsidiary -- -- (217)
Proceeds from sales of other real estate owned 268 433 82
Purchases of bank premises and equipment (1,322) (1,619) (1,216)
---------- --------- ---------
NET CASH USED IN INVESTING ACTIVITIES (106,657) (47,409) (51,267)
---------- --------- ---------
Cash flows from financing activities:
Net increase in deposits 42,668 18,740 35,012
Net increase in mortgagors' and investors' escrow accounts 501 256 275
63
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS - Continued
(Dollars in Thousands)
Years Ended December 31,
----------------------------------
2004 2003 2002
---------- --------- ---------
Net increase (decrease) in collateralized borrowings -- (851) 1,951
Proceeds from Federal Home Loan Bank advances 36,370 18,695 15,000
Repayments of Federal Home Loan Bank advances (20,864) (5,445) (6,265)
Proceeds from issuance of junior subordinated debt -- -- 7,217
Debt issuance costs -- -- (245)
Net proceeds from common stock offering 48,480 -- --
Acquisition of common stock by employee stock ownership plan (4,925) -- --
---------- --------- ---------
NET CASH PROVIDED BY FINANCING ACTIVITIES 102,230 31,395 52,945
---------- --------- ---------
NET CHANGE IN CASH AND CASH EQUIVALENTS 1,198 (7,940) 7,440
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 29,577 37,517 30,077
---------- --------- ---------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 30,775 $ 29,577 $ 37,517
========== ========= =========
SUPPLEMENTAL CASH FLOW INFORMATION:
Interest paid $ 9,367 $ 9,367 $ 11,029
========== ========= =========
Income taxes paid $ 1,296 $ 1,848 $ 1,765
========== ========= =========
NONCASH ACTIVITIES:
Unrealized gain (loss) on securities arising during the period $ (1,224) $ (1,050) $ 773
========== ========= =========
Transfer of loans to other real estate owned $ -- $ 703 $ 50
========== ========= =========
Transfer of loans to held for sale $ -- $ -- $ 1,939
========== ========= =========
Derecognition of loans and collateralized borrowings $ -- $ 1,100 $ --
See accompanying notes to consolidated financial statements.
64
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
NOTE 1. NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Business
- ------------------
On August 6, 2004, SI Financial Group, Inc., a federally-chartered mid-tier
stock holding company, was formed. On that date, SI Bancorp, Inc. converted from
a state-chartered mutual holding company to a federally-chartered mutual holding
company operating under the name SI Bancorp, MHC. In addition, Savings Institute
Bank and Trust Company, formerly operating under the name Savings Institute,
completed its conversion from a state-chartered stock savings bank to a
federally-chartered stock savings bank. SI Bancorp, Inc. transferred its
ownership in all of the stock of Savings Institute Bank and Trust Company to SI
Financial Group, Inc. in exchange for all of the outstanding shares of SI
Financial Group, Inc. In addition, SI Financial Group, Inc. received all other
assets and liabilities held by SI Bancorp, Inc., including $7.2 million of
subordinated debt.
On September 30, 2004, the Company sold a total of 5,025,500 shares of its
common stock, representing 40% of the 12,563,750 shares outstanding, at $10.00
per share to eligible account holders and the Employee Stock Ownership Plan of
the Bank in a subscription offering pursuant to a Plan of Reorganization and
Minority Stock Issuance.
In connection with the offering, SI Financial Group, Inc. established SI
Financial Group Foundation, a charitable foundation dedicated to community
activities and the promotion of charitable causes in areas in which the Bank
operates. The Foundation was funded on September 30, 2004 with a contribution of
2%, or 251,275 shares, of the Company's common stock. This contribution resulted
in the recognition of a $2.5 million expense equal to the value of the common
shares contributed by the Company, net of related tax benefits. The Company
recognized an additional tax benefit of $68,000 as an increase to stockholders'
equity resulting from the higher tax basis of the contribution.
Also, as part of the offering, SI Bancorp, MHC was issued 58% of the Company's
common stock in exchange for its ownership of the Bank. SI Bancorp, MHC does not
conduct any business other than owning a majority of the common stock of SI
Financial Group, Inc.
The Bank established an Employee Stock Ownership Plan for the benefit of its
eligible employees. The Bank borrowed the necessary funds from the Company to
purchase 3.92%, or 492,499 shares, of the common shares issued and outstanding.
The Bank intends to make annual contributions adequate to fund the payment of
regular debt service requirements under the ESOP.
The Bank's deposits are insured under the Bank Insurance Fund, which is
administered by the Federal Deposit Insurance Corporation. The Bank provides a
full-range of banking services to consumer and commercial customers through its
main office in Willimantic, Connecticut, and fourteen branches located in
eastern Connecticut.
SI Bancorp, Inc. was organized in 2000 as a Connecticut mutual holding company.
On June 5, 2000, SI Bancorp, Inc. acquired all of the outstanding shares of
SI-Stock Savings Bank, a then newly formed state-chartered capital stock bank.
At that time, Savings Institute, formerly a Connecticut mutual savings bank,
merged with and into SI-Stock Savings Bank to form a Connecticut stock savings
bank operating under the name Savings Institute.
On March 25, 2002, SI Bancorp, Inc. formed SI Capital Trust I for the purpose of
issuing trust preferred securities and investing the proceeds in junior
subordinated debentures issued by SI Bancorp, Inc., and on April 10, 2002, $7.2
million of debt securities were issued. In accordance with Financial Accounting
Standards Board Interpretation No. 46R, "Consolidation of Variable Interest
Entities," the Trust is not included in the Company's consolidated financial
statements.
65
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
Principles of Consolidation
- ---------------------------
The accompanying consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiary, Savings Institute Bank and Trust
Company, and the Bank's wholly-owned subsidiaries, 803 Financial Corp., SI
Mortgage Company and SI Realty Company, Inc. All significant intercompany
accounts and transactions have been eliminated.
Basis of Financial Statement Presentation
- -----------------------------------------
The consolidated financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of America and
general practices within the banking industry. In preparing the consolidated
financial statements, management is required to make estimates and assumptions
that affect the reported amounts of assets and liabilities, and disclosures of
contingent assets and liabilities, as of the date of the statement of financial
condition and reported amounts of revenues and expenses for the periods
presented. Actual results could differ from those estimates. A material estimate
that is particularly susceptible to significant change in the near term relates
to the determination of the allowance for loan losses and the impairment of
long-lived assets.
Significant Group Concentrations of Credit Risk
- -----------------------------------------------
Most of the Company's activities are with customers located within eastern
Connecticut. Refer to Notes 3 and 4, respectively, in the Notes to the
Consolidated Financial Statements for discussions of the Company's investment
securities and lending activities. The Company does not have any significant
concentrations in any one industry or customer.
Cash and Cash Equivalents and Statements of Cash Flows
- ------------------------------------------------------
Cash and due from banks, Federal funds sold and short-term investments with
maturities of less than 90 days are recognized as cash equivalents in the
statements of cash flows. Federal funds sold generally mature in one day. For
purposes of reporting cash flows, the Company considers all highly liquid debt
instruments purchased with a maturity of three months or less to be cash
equivalents. Cash flows from loans and deposits are reported net. The Company
maintains amounts due from banks and Federal funds sold that, at times, may
exceed federally insured limits. The Company has not experienced any losses from
such concentrations.
Investment in Debt and Marketable Equity Securities
- ---------------------------------------------------
Management determines the appropriate classification of securities at the date
individual investment securities are acquired, and the appropriateness of such
classification is reassessed at each statement of financial condition date.
Debt securities that management has the positive intent and ability to hold to
maturity are classified as "held to maturity" and recorded at amortized cost.
Securities purchased and held principally for the purpose of trading in the near
term are classified as "trading securities." These securities are carried at
fair value, with unrealized gains and losses recognized in earnings. Securities
not classified as held to maturity or trading, including equity securities with
readily determinable fair values, are classified as "available for sale" and
recorded at fair value, with unrealized gains and losses excluded from earnings
and reported in other comprehensive income (loss), net of taxes.
Purchase premiums and discounts are recognized in interest income using the
interest method over the terms of the securities. Declines in the fair value of
held to maturity and available for sale securities below their cost that are
deemed to be other than temporary are reported in earnings as realized losses.
In estimating other-than-temporary impairment losses, management considers (1)
the length of time and the extent to which the fair value has been less than
cost, (2) the financial condition and near-term prospects of the issuer and (3)
the intent and ability of the Company to retain its investment in the issuer for
a period of time sufficient to allow for any anticipated recovery in fair value.
Gains and losses on the sale of securities are recorded on the trade date and
are determined using the specific identification method.
66
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
The sale of a held to maturity security within three months of its maturity date
or after collection of at least 85% of the principal outstanding at the time the
security was acquired is considered a maturity for purposes of classification
and disclosure.
Transfers of debt securities into the held to maturity classification from the
available for sale classification are made at fair value on the date of
transfer. The unrealized holding gain or loss on the date of transfer is
retained in accumulated other comprehensive income (loss) and in the carrying
value of the held to maturity securities. Such amounts are amortized over the
remaining contractual lives of the securities by the interest method.
Loans Held for Sale
- -------------------
Loans originated and intended for sale in the secondary market are carried at
the lower of aggregate cost or fair value, as determined by aggregate
outstanding commitments from investors or current investor yield requirements.
Net unrealized losses are recognized through a valuation allowance by charges to
noninterest income.
Mortgage loans held for sale are generally sold with the mortgage servicing
rights retained by the Company. The carrying value of mortgage loans sold is
reduced by the value allocated to the associated mortgage servicing rights.
Gains or losses on sales of mortgage loans are recognized based on the
difference between the selling price and the carrying value of the related
mortgage loans sold on the trade date.
Transfers of Financial Assets
- -----------------------------
Transfers of financial assets are accounted for as sales, when control over the
assets has been surrendered. Control over transferred assets is deemed to be
surrendered when (1) the assets have been isolated from the Company, (2) the
transferee obtains the right to pledge or exchange the transferred assets and no
condition both constrains the transferee from taking advantage of that right and
provides more than a trivial benefit for the transferor and (3) the transferor
does not maintain effective control over the transferred assets through either
(a) an agreement that both entitles and obligates the transferor to repurchase
or redeem the assets before maturity or (b) the ability to unilaterally cause
the holder to return specific assets, other than through a cleanup call.
Servicing
- ---------
Servicing assets are recognized as separate assets when rights are acquired
through purchase or retained through sale of financial assets. Generally,
purchased servicing rights are capitalized at the cost to acquire the rights.
For sales of mortgage loans, a portion of the cost of originating the loan is
allocated to the servicing right based on relative fair value. Fair value is
based on market prices for comparable mortgage servicing contracts, when
available, or alternatively, is based on a valuation model that calculates the
present value of estimated future net servicing income. The valuation model
incorporates assumptions that market participants would use in estimating future
net servicing income, such as the cost to service, the discount rate, the
custodial earnings rate, an inflation rate, ancillary income, prepayment speeds
and default rates and losses. Capitalized servicing rights are reported in other
assets and are amortized into noninterest income in proportion to, and over the
period of, the estimated future net servicing income of the underlying financial
assets.
Servicing assets are evaluated for impairment based upon the fair value of the
rights as compared to amortized cost. Impairment is determined by stratifying
rights into tranches based on predominant risk characteristics, such as interest
rate, loan type and investor type. Impairment is recognized through a valuation
allowance for an individual tranche, to the extent that fair value is less than
the capitalized amount for the tranche. If the Company later determines that all
or a portion of the impairment no longer exists for a particular tranche, a
reduction of the allowance may be recorded as an increase to income.
Servicing fee income is recorded for fees earned for servicing loans. The fees
are based on a contractual percentage of the outstanding principal; or a fixed
amount per loan and are recorded as income when earned. The amortization of
mortgage servicing rights is netted against loan servicing fee income.
67
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
Loans Receivable
- ----------------
Loans receivable are stated at current unpaid principal balances, net of the
allowance for loan losses and deferred loan origination fees and costs.
Management has the ability and intent to hold its loans receivable for the
foreseeable future or until maturity or pay-off.
An impaired loan is measured based on the present value of expected future cash
flows discounted at the loan's effective interest rate or, as a practical
expedient, at the loan's observable market price or the fair value of the
collateral if the loan is collateral dependent. A loan is impaired when it is
probable the Company will be unable to collect all contractual principal and
interest payments due in accordance with the terms of the loan agreement.
A loan is classified as a restructured loan when certain concessions have been
made to the original contractual terms, such as reductions of interest rates or
deferral of interest or principal payments, due to the borrowers' financial
condition.
Management considers all nonaccrual loans and restructured loans to be impaired.
In most cases, loan payments less than ninety days past due, are considered
minor collection delays, and the related loans are generally not considered
impaired.
Allowance for Loan Losses
- -------------------------
The allowance for loan losses, a material estimate which could change
significantly in the near-term, is established as losses are estimated to have
occurred, through provisions for losses charged against operations, and is
maintained at a level that management considers adequate to absorb losses in the
loan portfolio. Loans are charged against the allowance for loan losses when
management believes that the uncollectibility of principal is confirmed.
Subsequent recoveries, if any, are credited to the allowance for loan losses
when received. In connection with the determination of the allowance for loan
losses, management obtains independent appraisals for significant properties,
when considered necessary.
Management's judgment in determining the adequacy of the allowance is inherently
subjective as it requires estimates that are susceptible to significant revision
as more information becomes available. The allowance for loan losses is
evaluated on a regular basis by management and is based on the evaluation of the
known and inherent risk characteristics and size and composition of the loan
portfolio, the assessment of current economic and real estate market conditions,
adverse situations that may affect the borrower's ability to repay, estimated
value of any underlying collateral, historical loan loss experience, regulatory
examination and evaluations of loans and other relevant factors.
The allowance consists of specific, general and unallocated components. The
specific component relates to loans that are classified as doubtful, substandard
or special mention. For such loans that are also classified as impaired, an
allowance is established when the discounted cash flows (or collateral value or
observable market price) of the impaired loan is lower than the carrying value
of that loan. The general component covers non-classified loans and is based on
historical loss experience adjusted for qualitative factors. An unallocated
component is maintained to cover uncertainties that could affect management's
estimate of probable losses. The unallocated component of the allowance reflects
the margin of imprecision inherent in the underlying assumptions used in the
methodologies for estimating specific and general losses in the portfolio.
The majority of the Company's loans are collateralized by real estate located in
eastern Connecticut. Accordingly, the collateral value of a substantial portion
of the Company's loan portfolio and real estate acquired through foreclosure is
susceptible to changes in market conditions.
Management believes that the allowance for loan losses is adequate. While
management uses available information to recognize losses on loans, future
additions to the allowance or write-downs may be necessary based on changes in
economic conditions, particularly in eastern Connecticut. In addition, the
Office of Thrift Supervision, as an integral part of its examination process,
periodically reviews the Company's allowance for loan losses. Such agency
68
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
has the authority to require the Company to recognize additions to the allowance
or write-downs based on the agency's judgments about information available to it
at the time of its examination.
Derivative Financial Instruments
- --------------------------------
On January 1, 2001, the Company adopted Statement of Financial Accounting
Standards No. 133, "Accounting for Derivative Instruments and Hedging
Activities" (SFAS No. 133). This Statement requires that all derivatives be
recognized as assets or liabilities in the statement of financial condition and
measured at fair value.
Interest and Fees on Loans
- --------------------------
Interest on loans is accrued and included in operating income based on
contractual rates applied to principal amounts outstanding. Accrual of interest
is discontinued when loan payments are 90 days or more past due, based on
contractual terms, or when, in the judgment of management, collectibility of the
loan or loan interest becomes uncertain. Subsequent recognition of income occurs
only to the extent payment is received subject to management's assessment of the
collectibility of the remaining interest and principal. A nonaccrual loan is
restored to accrual status when it is no longer delinquent and collectibility of
interest and principal is no longer in doubt. Interest collected on nonaccrual
loans and impaired loans is recognized only to the extent cash payments are
received, and may be recorded as a reduction to principal if the collectibility
of the principal balance of the loan is unlikely.
Loan origination fees and direct loan origination costs are deferred, and the
net amount is recognized as an adjustment of the related loan's yield utilizing
the interest method over the contractual life of the loan.
Rate Lock Commitments
- ---------------------
On March 13, 2002, the Financial Accounting Standards Board determined that loan
commitments related to the origination or acquisition of mortgage loans that
will be held for sale must be accounted for as derivative instruments, effective
for fiscal quarters beginning after April 10, 2002. Accordingly, the Company
adopted such accounting on July 1, 2002.
The Company enters into commitments to originate loans whereby the interest rate
on the loan is determined prior to funding (rate lock commitments). Rate lock
commitments on mortgage loans that are intended to be sold are considered to be
derivatives. Accordingly, such commitments, along with any related fees received
from potential borrowers, are recorded at fair value in derivative assets or
liabilities, with changes in fair value recorded in the net gain or loss on sale
of mortgage loans. Fair value is based on fees currently charged to enter into
similar agreements, and for fixed-rate commitments is also based on the
difference between current levels of interest rates and the committed rates.
Prior to July 1, 2002, such commitments were recorded to the extent of fees
received. Fees received were subsequently included in the net gain or loss on
the sale of mortgage loans.
The Company adopted the provisions of Statement of Financial Accounting
Standards No. 149, "Amendment of Statement 133 on Derivative Instruments and
Hedging Activities," effective July 1, 2003, which applies to the Company's
commitments to fund loans held for sale. As per Staff Accounting Bulletin No.
105, "Application of Accounting Principles to Loan Commitments," the interest
rate lock commitments were valued at zero at inception. The rate locks will
continue to be adjusted for changes in value resulting from changes in market
interest rates.
Collateralized Borrowings
- -------------------------
Collateralized borrowings represent loans sold which do not meet the criteria
for derecognition, due primarily to recourse and other provisions which could
not be measured at the date of transfer. Transferred loans and any related
collateralized borrowings are derecognized when all recourse and other
provisions that could not be measured at the date of transfer either expire or
become measurable.
Other Real Estate Owned
- -----------------------
Other real estate owned consists of properties acquired through, or in lieu of,
loan foreclosure or other proceedings and is initially recorded at the lower of
the related loan balances less any specific allowance for loss, or fair value at
the date of foreclosure, which establishes a new cost basis. Subsequent to
foreclosure, the properties
69
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
are held for sale and are carried at the lower of cost or fair value less
estimated costs of disposal. Any write-down to fair value at the time of
acquisition is charged to the allowance for loan losses. Properties are
evaluated regularly to ensure the recorded amounts are supported by current fair
values, and a charge to operations is recorded as necessary to reduce the
carrying amount to fair value less estimated costs to dispose. Revenue and
expense from the operation of other real estate owned and the provision to
establish and adjust valuation allowances are included in operations. Costs
relating to the development and improvement of the property are capitalized,
subject to the limit of fair value of the collateral. Gains or losses are
included in operations upon disposal.
Income Taxes
- ------------
The Company recognizes income taxes under the asset and liability method. Under
this method, deferred tax assets and liabilities are recognized for the future
tax consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date. Deferred tax assets are reduced by a
valuation allowance when, in the opinion of management, it is more likely than
not that all or some portion of the deferred tax assets will not be realized.
The Company had transactions in which the related tax effect was recorded
directly to stockholders' equity instead of operations. Transactions in which
the tax effect was recorded directly to stockholders' equity included the tax
effects of unrealized gains and losses on available for sale securities and the
tax benefit for the difference between the book and tax basis of the
contribution to SI Financial Group Foundation. At December 31, 2004, the Company
had a net deferred tax asset of $149,000 for unrealized gains and losses on
available for sale securities and a deferred tax asset of $68,000 related to the
difference between the book and tax basis of the SI Financial Group Foundation
contribution.
Premises and Equipment
- ----------------------
Premises and equipment are stated at cost, net of accumulated depreciation and
amortization. Depreciation is charged to operations using the straight-line
method over the estimated useful lives of the related assets. Leasehold
improvements are amortized over the shorter of the improvements' estimated
economic lives or the related lease terms. The estimated useful lives of the
assets are as follows:
Classification Estimated Useful Lives
----------------------- ----------------------
Buildings 5 to 40 years
Furniture and equipment 3 to 10 years
Leasehold improvements 3 to 20 years
Gains and losses on dispositions are recognized upon realization. Maintenance
and repairs are expensed as incurred and improvements are capitalized.
Impairment of Long-lived Assets
- -------------------------------
Long-lived assets, including premises and equipment and certain identifiable
intangible assets that are held and used by the Company, are reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. If impairment is indicated
by that review, the asset is written down to its estimated fair value through a
charge to noninterest expense.
Core Deposit Intangible
- -----------------------
In connection with branch acquisitions that do not represent business
combinations, the excess of deposit liabilities assumed from other banks over
assets acquired is recorded as a core deposit intangible.
70
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
Other Investment
- ----------------
The Company's investment in a Small Business Investment Company is recorded at
cost and is evaluated for impairment annually. Impairment considered by
management to be other than temporary, results in a write-down of the investment
which is recognized in earnings as a realized loss. Write-downs of $51,000,
$36,000 and $111,000 during the years ended December 31, 2004, 2003 and 2002,
respectively, were recognized on this investment. This investment, with a net
book value of $608,000 and $546,000 at December 31, 2004 and 2003, respectively,
is included in other assets. The SBIC is licensed by the Small Business
Administration. It provides mezzanine financing and private equity investments
to small companies which may not otherwise qualify for standard banking
financing.
Trust Assets
- ------------
Assets of the Trust Department, other than trust cash on deposit at the Bank,
are not included in these consolidated financial statements because they are not
assets of the Company. Trust fees are recognized on the accrual basis of
accounting.
Related Party Transactions
- --------------------------
Directors, officers and their affiliates of the Company and the Bank have been
customers of and have had transactions with the Bank, and it is expected that
such persons will continue to have such transactions in the future. Management
believes that all deposit accounts, loans, services and commitments comprising
such transactions were made in the ordinary course of business, on substantially
the same terms, including interest rates and collateral, as those prevailing at
the time for comparable transactions with other customers who are not directors
or officers. In the opinion of management, the transactions with related parties
did not involve more than normal risks of collectibility, favored treatment or
terms or present other unfavorable features. Notes 4, 8 and 13 contain details
regarding related party transactions.
Earnings Per Share
- ------------------
Basic net income per common share is calculated by dividing the net income
available to common stockholders by the weighted-average number of common shares
outstanding during the period. Diluted net income per common share is computed
in a manner similar to basic net income per common share except that the
weighted-average number of common shares outstanding is increased to include the
incremental common shares (as computed using the treasury stock method) that
would have been outstanding if all potentially dilutive common stock (i.e. stock
options) were issued during the period. The Company had no dilutive or
anti-dilutive common shares outstanding for the three years ended December 31,
2004. Anti-dilutive shares are common stock equivalents (i.e. stock options)
with weighted average exercise prices in excess of the weighted average market
value for the period in question. Unallocated common shares held by the ESOP are
not included in the weighted-average number of common shares outstanding for
purposes of calculating both basic and diluted income per common share.
Per common share data is not considered meaningful and, is therefore, not
presented for the years ended December 31, 2004, 2003 and 2002 as the Company
had no shares outstanding prior to the Company's initial public offering on
September 30, 2004.
Comprehensive Income
- --------------------
Accounting principles generally require that recognized revenue, expenses, gains
and losses be included in net income. Although certain changes in assets and
liabilities, such as unrealized gains and losses on available for sale
securities, are reported as a separate component of the capital section in the
statement of financial condition, such items, along with net income, are
components of comprehensive income.
Employee Stock Ownership Plan
- -----------------------------
In 2004, the Company established an Employee Stock Ownership Plan and accounts
for the ESOP shares in accordance with Statement of Position 93-6, "Employers'
Accounting for Employee Stock Ownership Plans" ("SOP 93-6"). Under SOP 93-6,
unearned ESOP shares are not considered outstanding for calculating net income
per common share and are presented as unallocated common shares held by ESOP.
The value of unearned shares to be allocated to ESOP participants for future
services not yet performed is recognized as a reduction to stockholders'
71
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
equity in the Company's statement of financial condition. As ESOP shares are
committed to be released, compensation expense will be recognized with a
corresponding increase to stockholders' equity. The loan to the ESOP will be
repaid principally from the Bank's contributions to the ESOP and dividends
payable on common stock held by the ESOP over a period of fifteen years.
Fair Values of Financial Instruments
- ------------------------------------
The following methods and assumptions were used by the Company in estimating the
fair value of its financial instruments:
o Cash and due from banks, federal funds sold, accrued interest
receivable and mortgagors' and investors' escrow accounts. The
carrying amount is a reasonable estimate of fair value.
o Securities. Fair values, excluding restricted Federal Home Loan Bank
stock, are based on quoted market prices or dealer quotes, if
available. If a quoted market price is not available, fair value is
estimated using quoted market prices for similar securities. The
carrying value of FHLB stock approximates fair value based on the
redemption provisions of the Federal Home Loan Bank.
o Loans held for sale. The fair value of loans held for sale is
estimated using quoted market prices.
o Loans receivable. For variable rate loans which reprice frequently
and have no significant change in credit risk, fair values are based
on carrying values. The fair value of fixed-rate loans are estimated
by discounting the future cash flows using the year-end rates at
which similar loans would be made to borrowers with similar credit
ratings and for the same remaining maturities.
o Servicing assets. The fair value is based on market prices for
comparable mortgage servicing contracts, when available, or
alternatively, is based on a valuation model that calculates the
present value of estimated future net servicing income.
o Deposits. The fair value of demand deposits, negotiable orders of
withdrawal, regular savings and certain money market deposits is the
amount payable on demand at the reporting date. The fair value of
certificates of deposit and other time deposits is estimated using a
discounted cash flow calculation that applies interest rates
currently being offered for deposits of similar remaining maturities
to a schedule of aggregated expected maturities on such deposits.
o Advances from the Federal Home Loan Bank. The fair value of the
advances is estimated using a discounted cash flow calculation that
applies current FHLB interest rates for advances of similar maturity
to a schedule of maturities of such advances.
o Collateralized borrowings. The fair value of collateralized
borrowings is estimated by discounting the future cash flows using
market rates for similar borrowings.
o Junior subordinated debt to unconsolidated trust. Based on the
floating rate characteristic of these instruments, the carrying
value is considered to approximate fair value.
o Off-balance sheet instruments. Fair values for off-balance sheet
lending 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.
72
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
Recent Accounting Pronouncements
- --------------------------------
In November 2002, the Financial Accounting Standards Board issued Interpretation
No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others," which addresses
guarantees such as standby letters of credit, performance guarantees and direct
or indirect guarantees of the indebtedness of others, but not guarantees of
funding. FIN 45 requires a guarantor to recognize, at the inception of a
guarantee, a liability in an amount equal to the fair value of the obligation
undertaken in issuing the guarantee, and requires disclosure about the maximum
potential payments that might be required, as well as the collateral or other
recourse obtainable. The recognition and measurement provisions of FIN 45 were
effective on a prospective basis after December 31, 2002, and its adoption on
January 1, 2003 has not had a material effect on the consolidated financial
statements.
In January 2003, the Financial Accounting Standards Board issued Interpretation
No. 46, "Consolidation of Variable Interest Entities," which establishes
guidance for determining when an entity should consolidate another entity that
meets the definition of a variable interest entity. FIN 46 requires a variable
interest entity to be consolidated by a company if that company will absorb a
majority of expected losses, will receive a majority of expected residual
returns or both. Transfers to qualified special-purpose entities and certain
other interests in a qualified-special purpose entity are not subject to the
requirements of FIN 46. On December 17, 2003, the FASB revised FIN 46 and
deferred the effective date of FIN 46 to no later than the end of the first
reporting period that ends after March 15, 2004. For special-purpose entities,
however, FIN 46 would be required to be applied as of December 31, 2003. SI
Capital Trust I issued $7.0 million of trust preferred securities in 2002. As
required by FIN 46, SI Capital Trust I was deconsolidated at December 31, 2003
and restated the 2002 statement of financial condition. As a result, the
statement of financial condition at December 31, 2004 and 2003 includes $7.2
million of junior subordinated debt, which was previously presented in the
statement of financial condition as $7.0 million in trust preferred securities
after a consolidation elimination entry of $217,000. The Company's investment in
SI Capital Trust I of $217,000 is included in other assets. The overall effect
on the financial position and operating results as a result of the
deconsolidation was not material.
In April 2003, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities" . This Statement amends Statement
of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities" , and clarifies accounting for derivative
instruments, including certain derivative instruments embedded in other
contracts, and for hedging activities under SFAS 133. This Statement is
effective for contracts entered into or modified after June 30, 2003, except in
certain circumstances, and for hedging relationships designated after June 30,
2003. SFAS 149 did not have a material effect on the consolidated financial
statements.
In May 2003, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity". This Statement
provides new rules on the accounting for certain financial instruments that,
under previous guidance, issuers could account for as equity. Such financial
instruments include mandatorily redeemable shares, instruments that require the
issuer to buy back some of its shares in exchange for cash or other assets, or
obligations that can be settled with shares, the monetary value of which is
fixed. Most of the guidance in SFAS 150 is effective for financial instruments
entered into or modified after May 31, 2003, and otherwise is effective at the
beginning of the first interim period beginning after June 30, 2003. SFAS 150
had no effect on the consolidated financial statements.
In December 2003, the Financial Accounting Standards Board revised Statement of
Financial Accounting Standards No. 132, "Employers' Disclosures about Pensions
and Postretirement Benefits". This Statement requires additional disclosures
about the assets, obligations, cash flows and net periodic benefit cost of
defined benefit pension and other postretirement plans. SFAS 132R had no effect
on the consolidated financial statements.
In December 2003, the Accounting Standards Executive Committee of the AICPA
issued Statement of Position No. 03-3, "Accounting for Certain Loans or Debt
Securities Acquired in a Transfer". SOP 03-3 addresses the accounting for
differences between contractual cash flows and the cash flows expected to be
collected from purchased loans or debt securities if those differences are
attributable, in part, to credit quality. SOP 03-3 requires purchased loans
73
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
and debt securities to be recorded initially at fair value based on the present
value of the cash flows expected to be collected with no carryover of any
valuation allowance previously recognized by the seller. Interest income should
be recognized based on the effective yield from the cash flows expected to be
collected. To the extent that the purchased loans or debt securities experience
subsequent deterioration in credit quality, a valuation allowance would be
established for any additional cash flows that are not expected to be received.
However, if more cash flows subsequently are expected to be received than
originally estimated, the effective yield would be adjusted on a prospective
basis. SOP 03-3 will be effective for loans and debt securities acquired after
December 31, 2004. Management does not expect the adoption of this statement
will have a material impact on the Company's financial statements.
On March 9, 2004, the United States Securities and Exchange Commission issued
Staff Accounting Bulletin No. 105, "Application of Accounting Principles to Loan
Commitments". SAB 105 summarizes the views of the SEC staff regarding the
application of generally accepted accounting principles to loan commitments
accounted for as derivative instruments. The SEC staff believes that in
recognizing a loan commitment, entities should not consider expected future cash
flows related to the associated servicing of the loan until the servicing asset
has been contractually separated from the underlying loan by sale or
securitization of the loan with the servicing retained. The provisions of SAB
105 are applicable to all loan commitments accounted for as derivatives and
entered into subsequent to March 31, 2004. The Company may enter into such
commitments in connection with residential mortgage loan applicants. The
adoption of SAB 105 did not have a material impact on the Company's consolidated
results of operations or financial position.
In March 2004, the Emerging Issues Task Force reached a consensus on the
application of EITF Issue 03-1, " The Meaning of Other-Than-Temporary Impairment
and Its Application to Certain Investments," in determining when an investment
is impaired, whether the impairment is other than temporary and the measurement
of the impairment loss. This impairment is applicable to debt and equity
securities that are within the scope of Financial Accounting Standards Board
Statement No. 115, "Accounting for Certain Investments in Debt and Equity
Securities", Financial Accounting Standards Board Statement No. 124, "Accounting
for Certain Investments Held by Not-for-Profit Organizations" and those equity
securities outside of the scope of SFAS 115 and accounted for under the cost
method. In October 2004, Emerging Issues Task Force Issue 03-1-1 was issued to
delay the effective date of the measurement and recognition provisions of EITF
Issue 03-1 until the proposed Financial Accounting Standards Board Staff
Position, which provides guidance on the application of the provisions, is
issued in final form. This delay, however, does not eliminate the need to
recognize other-than-temporary impairment losses as required by applicable
authoritative pronouncements. The Company does not believe that the application
of EITF Issue 03-1 will have a material impact on the Company's consolidated
financial statements.
In December 2004, the Financial Accounting Standards Board revised Statement of
Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation". This Statement eliminates the alternative intrinsic value method
of accounting, according to APB Opinion No. 25, "Accounting for Stock Issued to
Employees," for recognizing the cost of employee services received in
share-based payment transactions. SFAS 123R requires all entities to follow the
same accounting standard and account for such transactions using the
fair-value-based method. This Statement does not address the accounting for
employee stock ownership plans. At this time, SFAS 123R has no effect on our
consolidated financial statements.
Reclassifications
- -----------------
Certain 2003 and 2002 amounts have been reclassified to conform with the
December 31, 2004 presentation, and such reclassifications had no effect on 2003
and 2002 net income.
74
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
NOTE 2. RESTRICTIONS ON CASH AND DUE FROM BANKS
The Bank is required to maintain reserves against its respective transaction
accounts and non-personal time deposits. At December 31, 2004 and December 31,
2003, the Bank maintained cash and liquid asset reserves of approximately $6.2
million and $5.3 million, respectively, and maintained $6.0 million in the
Federal Reserve Bank for clearing purposes, as required.
NOTE 3. INVESTMENT SECURITIES
The carrying and approximate fair values of investment securities at December
31, 2004 and 2003 are as follows:
December 31, 2004
-----------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
(Dollars in Thousands) Cost Gains Losses Value
--------- ---------- ---------- ---------
AVAILABLE FOR SALE SECURITIES:
Debt securities:
U.S. Government and agency obligations $ 73,950 $ 201 $ (475) $ 73,676
Mortgage-backed securities 40,926 86 (418) 40,594
Corporate debt securities 3,498 65 -- 3,563
Obligations of state and political subdivisions 1,499 85 -- 1,584
Tax-exempt securities 560 -- -- 560
Foreign government securities 75 -- -- 75
--------- ----- ------ ---------
TOTAL DEBT SECURITIES 120,508 437 (893) 120,052
Equity securities:
Marketable equity securities 488 17 -- 505
--------- ----- ------ ---------
TOTAL AVAILABLE FOR SALE SECURITIES $ 120,996 $ 454 $ (893) $ 120,557
========= ===== ====== =========
December 31, 2003
----------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
(Dollars in Thousands) Cost Gains Losses Value
--------- ---------- ---------- --------
AVAILABLE FOR SALE SECURITIES:
Debt securities:
U.S. Government and agency obligations $ 38,583 $ 524 $ (108) $ 38,999
Mortgage-backed securities 19,050 87 (773) 18,364
Corporate debt securities 15,540 911 -- 16,451
Obligations of state and political subdivisions 2,499 88 -- 2,587
Tax-exempt securities 630 -- -- 630
Foreign government securities 75 -- -- 75
-------- ------- -------- --------
TOTAL DEBT SECURITIES 76,377 1,610 (881) 77,106
Equity securities:
Marketable equity securities 531 56 -- 587
-------- ------- -------- --------
TOTAL AVAILABLE FOR SALE SECURITIES 76,908 1,666 (881) 77,693
-------- ------- -------- --------
HELD TO MATURITY SECURITIES:
Mortgage-backed securities 1,728 -- (384) 1,344
-------- ------- -------- --------
TOTAL INVESTMENT SECURITIES $ 78,636 $ 1,666 $ (1,265) $ 79,037
======== ======= ======== ========
75
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
The following tables present the Company's available for sale and held to
maturity securities' gross unrealized losses and fair value, aggregated by the
length of time the individual securities have been in a continuous unrealized
loss position at December 31, 2004 and 2003:
(Dollars in Thousands) Less Than 12 Months 12 Months Or More Total
--------------------- -------------------- ---------------------
Fair Unrealized Fair Unrealized Fair Unrealized
December 31, 2004: Value Loss Value Loss Value Loss
- -------------------------------------- -------- ---------- ------- ---------- -------- ----------
U.S. Government and agency obligations $ 51,335 $ 454 $ 490 $ 21 $ 51,825 $ 475
Mortgage-backed securities 23,716 259 4,530 159 28,246 418
-------- ----- ------- ----- -------- -------
TOTAL $ 75,051 $ 713 $ 5,020 $ 180 $ 80,071 $ 893
======== ===== ======= ===== ======== =======
(Dollars in Thousands) Less Than 12 Months 12 Months Or More Total
--------------------- -------------------- ---------------------
Fair Unrealized Fair Unrealized Fair Unrealized
December 31, 2003: Value Loss Value Loss Value Loss
- -------------------------------------- -------- ---------- ------- ---------- -------- ----------
U.S. Government and agency obligations $ 8,351 $ 84 $ 1,291 $ 24 $ 9,642 $ 108
Mortgage-backed securities 11,772 744 2,768 413 14,540 1,157
-------- ----- ------- ----- -------- -------
TOTAL $ 20,123 $ 828 $ 4,059 $ 437 $ 24,182 $ 1,265
======== ===== ======= ===== ======== =======
At December 31, 2004 and 2003, unrealized losses on securities that have existed
for a period of twelve months or more totaled $180,000 and $437,000,
respectively. On this date, sixty-two debt securities with gross unrealized
losses have aggregate depreciation of approximately 1% of the Company's
amortized cost basis. Management believes that none of the unrealized losses on
these securities are other than temporary because all of the unrealized losses
relate to debt and mortgage-backed securities issued by the U.S. Treasury or
government agencies and private issuers that maintain investment grade ratings,
which the Company has both the intent and the ability to hold until maturity or
until the fair value fully recovers. In addition, management considers the
issuers of the securities to be financially sound and believes the Company will
receive all contractual principal and interest related to these investments.
During 2004, a held to maturity security, with an amortized cost of $1.7
million, was sold after being downgraded by various credit agencies to below
investment grade.
The amortized cost and fair value of debt securities at December 31, 2004 by
contractual maturities are presented below. Actual maturities of mortgage-backed
securities may differ from contractual maturities because the mortgages
underlying the securities may be called or repaid without any penalties. Because
mortgage-backed securities are not due at a single maturity date, they are not
included in the maturity categories in the following maturity summary.
76
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
Available for Sale
---------------------
Amortized Fair
(Dollars in Thousands) Cost Value
--------- ---------
Maturity:
Within 1 year $ 16,627 $ 16,660
After 1 but within 5 years 54,205 53,965
After 5 but within 10 years 5,543 5,610
After 10 years 3,207 3,223
--------- ---------
79,582 79,458
Mortgage-backed securities 40,926 40,594
--------- ---------
$ 120,508 $ 120,052
========= =========
At December 31, 2004 and 2003, U.S. Treasury securities with a carrying value of
$4.0 million and a fair value of $4.0 million and $4.1 million, respectively,
were pledged to secure U.S. Treasury tax and loan payments and public deposits.
Proceeds from the sales of available for sale securities during the years ended
December 31, 2004, 2003 and 2002 amounted to $22.8 million, $11.7 million and
$10.0 million, respectively.
The following is a summary of realized gains and losses on the sale or
write-down of securities for the years ended December 31, 2004, 2003 and 2002:
Years Ended December 31,
------------------------
(Dollars in Thousands) 2004 2003 2002
------ ------ ------
Gross gains on sales $ 689 $ 410 $ 414
Gross losses on sales (855) (215) (323)
Impairment charges -- (74) (349)
------ ------ ------
NET GAIN (LOSS) $ (166) $ 121 $ (258)
====== ====== ======
NOTE 4. LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES
General
- -------
The Company's lending activities are conducted principally in eastern
Connecticut. The Company grants single-family and multi-family residential
loans, commercial loans and a variety of consumer loans. In addition, the
Company grants loans for the construction of residential homes, residential
developments and land development projects.
The Company has established credit policies applicable to each type of lending
activity in which it engages. The Company evaluates the creditworthiness of each
customer and, in most cases, extends credit of up to 80% of the market value of
the collateral at the date of the credit extension, depending on the borrowers'
creditworthiness and the type of collateral. The market value of collateral is
monitored on an ongoing basis and additional collateral is obtained when
warranted. Real estate is the primary form of collateral. Other important forms
of collateral are time deposits and marketable securities. While collateral
provides assurance as a secondary source of repayment, the Company ordinarily
requires the primary source of repayment to be based on the borrower's ability
to generate
77
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
continuing cash flows. The Company's policy for collateral requires that,
generally, the amount of the loan may not exceed 95% of the original appraised
value of the property. Private mortgage insurance or additional collateral is
generally required for that portion of the loan in excess of 80% of the
appraised value of the property.
Loan Portfolio
- --------------
The composition of the Company's loan portfolio at December 31, 2004 and 2003 is
as follows:
(Dollars in Thousands) December 31,
---------------------
2004 2003
--------- ---------
Real estate loans:
Residential - 1 to 4 family $ 252,180 $ 226,881
Multi-family and commercial 82,213 73,428
Construction (1) 35,773 20,652
--------- ---------
TOTAL REAL ESTATE LOANS 370,166 320,961
--------- ---------
Commercial business loans 59,123 50,746
--------- ---------
Consumer loans 21,125 17,518
--------- ---------
TOTAL LOANS 450,414 389,225
Deferred loan origination costs, net of deferred
fees 743 387
Allowance for loan losses (3,200) (2,688)
--------- ---------
LOANS, NET $ 447,957 $ 386,924
========= =========
----------
1) Net of undisbursed portion of $27.5 million and $15.2 million at
December 31, 2004 and 2003, respectively.
Mortgage Servicing Rights
- -------------------------
The Company services certain loans that it has sold with and without recourse to
third parties and other loans for which the Company acquired the servicing
rights. The aggregate of loans serviced for others approximated $50.5 million
and $44.7 million at December 31, 2004 and 2003, respectively. As of December
31, 2004 and 2003, the Company was liable under recourse provisions for loans
sold by the Company of approximately $138,000 and $222,000, respectively.
The balance of capitalized servicing rights, included in other assets at
December 31, 2004 and 2003 was $165,000 and $124,000, respectively. The fair
value of the capitalized mortgage servicing rights approximated its carrying
value for the periods presented. No impairment charges related to servicing
rights were recognized during the years ended December 31, 2004, 2003 and 2002.
78
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
A summary of the activity in the balances of capitalized mortgage servicing
rights is as follows:
Years Ended December 31,
------------------------
(Dollars in Thousands) 2004 2003
----------- ----------
BALANCE AT BEGINNING OF PERIOD $ 124 $ --
Additions 65 124
Amortization (24) --
----- -----
BALANCE AT END OF PERIOD $ 165 $ 124
===== =====
Impaired and Nonaccrual Loans
- -----------------------------
At December 31, 2004 and 2003, the unpaid principal balances of loans placed on
nonaccrual status were approximately $944,000 and $1.3 million, respectively. If
nonaccrual loans had been performing in accordance with their original terms,
the Company would have recorded approximately $56,000, $67,000 and $185,000 in
additional interest income during the years ended December 31, 2004, 2003 and
2002, respectively.
The following information relates to impaired loans, which include all
nonaccrual loans and restructured loans, as of and for the years ended December
31, 2004 and 2003.
(Dollars in Thousands) December 31,
-----------------
2004 2003
------- -------
Loans receivable for which there is a related allowance for credit losses determined:
Based on discounted cash flows $ -- $ --
Based on the fair value of collateral -- --
------- -------
$ -- $ --
======= =======
Loans receivable for which there is no related allowance for credit losses determined:
Based on discounted cash flows $ 139 $ 685
Based on the fair value of collateral 887 1,068
------- -------
$ 1,026 $ 1,753
======= =======
Additional information related to impaired loans is as follows:
(Dollars in Thousands) Years Ended December 31,
---------------------------
2004 2003 2002
------- ------- -------
Average recorded investment in impaired loans $ 1,487 $ 1,918 $ 2,191
======= ======= =======
Interest income recognized $ 9 $ -- $ 31
======= ======= =======
Cash interest received $ 12 $ 41 $ 64
======= ======= =======
No additional funds are committed to be advanced to those borrowers whose loans
are impaired.
79
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
Allowance for Loan Losses
- -------------------------
Changes in the allowance for loan losses for the years ended December 31, 2004,
2003 and 2002 are as follows:
Years Ended December 31,
----------------------------
(Dollars in Thousands) 2004 2003 2002
------- -------- -------
BALANCE AT BEGINNING OF YEAR $ 2,688 $ 3,067 $ 2,861
Provision for loan losses 550 1,602 537
Loans charged-off (75) (2,113) (406)
Recoveries of loans previously charged-off 37 132 75
------- -------- -------
BALANCE AT END OF YEAR $ 3,200 $ 2,688 $ 3,067
======= ======== =======
Related Party Loans
- -------------------
In the normal course of business, the Company grants loans to related parties.
Related parties include officers, directors of the Company and its subsidiaries
and their immediate family members and respective affiliates in which they have
a controlling interest. These loans were made on substantially the same terms,
including interest rates and collateral, as those prevailing at the time for
comparable transactions with customers, and did not involve more than the normal
risk of collectibility. For the years ended December 31, 2004 and 2003, all
related party loans were performing.
Changes in loans outstanding to such related parties during the years ended
December 31, 2004 and 2003 are as follows:
Years Ended December 31,
------------------------
(Dollars in Thousands) 2004 2003
----------- ----------
BALANCE AT BEGINNING OF YEAR $ 4,368 $ 4,207
Additional loans 1,295 2,174
Repayments (1,111) (1,765)
Other (1) (168) (248)
----------- ----------
BALANCE AT END OF YEAR $ 4,384 $ 4,368
=========== ==========
----------
(1) Represents the net amount of loans at the beginning of the period,
to individuals who became, or ceased being, related parties during
the period.
NOTE 5. OTHER REAL ESTATE OPERATIONS
A summary of other real estate operations for the years ended December 31, 2004,
2003 and 2002, is as follows:
(Dollars in Thousands) Years Ended December 31,
------------------------
2004 2003 2002
------ ------ ------
Net loss (gain) from sales or write-downs of other real
estate owned $ 60 $ (15) $ (32)
Rental expense (income) of holding other real estate, net (49) 30 55
------ ------ ------
EXPENSE FROM OTHER REAL ESTATE OPERATIONS, NET $ 11 $ 15 $ 23
====== ====== ======
80
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
NOTE 6. PREMISES AND EQUIPMENT
Premises and equipment at December 31, 2004 and 2003 are summarized as follows:
December 31,
------------------
(Dollars in Thousands) 2004 2003
-------- -------
Land $ 207 $ 207
Buildings 6,604 6,440
Furniture and equipment 5,786 5,295
Leasehold improvements 2,512 2,486
Construction in process 160 2
-------- -------
15,269 14,430
Less accumulated depreciation and amortization 8,683 7,755
-------- -------
PREMISES AND EQUIPMENT, NET $ 6,586 $ 6,675
======== =======
Depreciation and amortization expense was $1.1 million, $1.0 million and $1.1
million, respectively, for the years ended December 31, 2004, 2003 and 2002.
During 2004, the Company reduced the carrying value on a former branch facility
to its estimated fair value and, as a result, recognized an impairment charge of
$337,000 which is included in occupancy expense for the period ended December
31, 2004.
NOTE 7. CORE DEPOSIT INTANGIBLE
In 1998, the Bank acquired certain assets and assumed certain deposit
liabilities of a bank located in Canterbury, Connecticut. In consideration of
the assumption of approximately $8.1 million of deposit liabilities, the Bank
received approximately $7.1 million in cash and other assets. The resulting core
deposit premium intangible is being amortized over 10 years using the
straight-line method. The net book value of this asset at December 31, 2004 and
2003 is as follows:
December 31,
-------------
(Dollars in Thousands) 2004 2003
----- -----
Core deposit intangible $ 973 $ 973
Less accumulated amortization 681 584
----- -----
CORE DEPOSIT INTANGIBLE, NET $ 292 $ 389
===== =====
81
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
Amortization expense was $97,000 for each of the years ended December 31, 2004,
2003 and 2002. Expected future amortization expense as of December 31, 2004 is
as follows:
(Dollars in Thousands)
2005 - $ 97
2006 - 97
2007 - 98
-----
$ 292
=====
NOTE 8. DEPOSITS
A summary of deposit balances, by type, at December 31, 2004 and 2003 are as
follows:
December 31,
---------------------
(Dollars in Thousands) 2004 2003
--------- ---------
Noninterest-bearing demand deposits $ 46,049 $ 40,371
Interest-bearing accounts:
NOW and money market accounts 110,564 101,852
Savings accounts 92,588 87,625
Certificates of deposit (1) 208,557 185,242
--------- ---------
Total interest-bearing accounts 411,709 374,719
--------- ---------
TOTAL DEPOSITS $ 457,758 $ 415,090
========= =========
----------
(1) Includes brokered deposits of $5.0 million at December 31, 2004 and
2003 with a maturity date of December 24, 2007.
Certificates of deposit in denominations of $100,000 or more were approximately
$51.3 million and $38.8 million at December 31, 2004 and 2003, respectively.
Deposits in excess of $100,000 are not federally insured.
Contractual maturities of certificates of deposit as of December 31, 2004 and
2003 are summarized below.
December 31,
---------------------
(Dollars in Thousands) 2004 2003
--------- ---------
Within one year $ 94,537 $ 99,016
After one year to two years 45,648 31,310
After two years to three years 53,543 27,182
After three years to four years 7,074 22,324
Over four years 7,755 5,410
--------- ---------
TOTAL CERTIFICATES OF DEPOSIT $ 208,557 $ 185,242
========= =========
82
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
A summary of interest expense by account type for the years ended December 31,
2004, 2003 and 2002 is as follows:
Years Ended December 31,
---------------------------
(Dollars in Thousands) 2004 2003 2002
------- ------- -------
NOW and money market accounts $ 384 $ 424 $ 685
Savings accounts (1) 625 666 1,071
Certificates of deposit (2) 5,337 5,507 6,724
------- ------- -------
TOTAL $ 6,346 $ 6,597 $ 8,480
======= ======= =======
----------
(1) Includes interest expense on mortgagors' and investors' escrow
accounts.
(2) Includes interest expense on brokered deposits.
Related Party Deposits
- ----------------------
Deposit accounts of officers, directors and other related parties aggregated
approximately $326,000 and $551,000 at December 31, 2004 and 2003, respectively.
NOTE 9. LONG-TERM DEBT
Federal Home Loan Bank Borrowings
- ---------------------------------
The Bank is a member of the Federal Home Loan Bank of Boston. At December 31,
2004 and 2003, the Bank had access to a pre-approved secured line of credit with
the FHLB of $6.2 million and the capacity to obtain additional advances up to a
certain percentage of the value of its qualified collateral, as defined in the
FHLB Statement of Credit Policy. In accordance with an agreement with the FHLB,
the qualified collateral must be free and clear of liens, pledges and
encumbrances. At December 31, 2004 and 2003, there were no advances outstanding
under the line of credit. Other outstanding advances from the FHLB aggregated
$72.7 million and $57.2 million at interest rates ranging from 1.87% to 5.84%
and 1.89% to 5.84% at December 31, 2004 and 2003, respectively. At December 31,
2004, the weighted average interest rate on FHLB advances was 3.80%.
The Bank is required to maintain an investment in capital stock of the FHLB, as
collateral, in an amount equal to a percentage of its outstanding residential
first mortgage loans. The carrying value of Federal Home Loan Bank stock
approximates fair value based on the redemption provisions of the FHLB.
Junior Subordinated Debt Owed to Unconsolidated Trust
- -----------------------------------------------------
On March 25, 2002, SI Bancorp, MHC (formerly SI Bancorp, Inc.), formed SI
Capital Trust I, which became its wholly-owned subsidiary when it purchased all
of the Trust's common securities. The Trust has no independent assets or
operations, and exists for the sole purpose of issuing trust securities and
investing the proceeds thereof in an equivalent amount of junior subordinated
debentures issued by SI Bancorp, MHC.
The Trust issued $7.0 million of trust preferred securities in 2002. Pursuant to
FASB Interpretation No. 46R, "Consolidation of Variable Interest Entities"
issued in December 2003, SI Bancorp, MHC deconsolidated the Trust at December
31, 2003. As a result, the statement of financial condition at December 31, 2004
and 2003 includes $7.2 million of junior subordinated debt, which was previously
presented in the statement of financial condition as $7.0 million in trust
preferred securities after a consolidation elimination entry of $217,000. The
Company's investment in the Trust of $217,000 is included in other assets. The
overall effect on the financial position and operating results of the Company as
a result of the deconsolidation was not material. On September 24, 2004, all of
the common stock of SI Capital Trust I was contributed to the Company from SI
Bancorp, MHC. At that point, SI Capital Trust I became a wholly-owned subsidiary
of the Company.
The subordinated debt securities are unsecured obligations of the Company and
are subordinate and junior in right of payment to all present and future senior
indebtedness of the Company. The Company has entered into a
83
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
guarantee, which together with its obligations under the subordinated debt
securities and the declaration of trust governing the Trust, including its
obligations to pay costs, expenses, debts and liabilities, other than trust
securities, provides a full and unconditional guarantee of amounts on the
capital securities. If the Company defers interest payments on the junior
subordinated debt securities, or otherwise is in default of the obligations, the
Company would be prohibited from making dividend payments to its shareholders.
The junior subordinated debentures, which bear interest at six-month LIBOR plus
3.70% (6.0%, 4.92% and 5.32% at December 31, 2004, 2003 and 2002, respectively),
mature on April 22, 2032 and can be redeemed at the Company's option in 2007.
The trust securities also bear interest at six-month LIBOR plus 3.70%. The
duration of the trust is 30 years; however, the trust securities are redeemable
at par at the Trust's option in 2007.
The contractual maturities of long-term debt, by year, at December 31, 2004 is
as follows:
December 31, 2004
--------------------------------------
(Dollars in Thousands) FHLB Subordinated
Advances (1) Debt (2) Total
------------ ------------ --------
2005 (3) $ 21,732 $ -- $ 21,732
2006 (3) 15,486 -- 15,486
2007 (3) 13,329 -- 13,329
2008 (3) 8,127 -- 8,127
2009 4,000 -- 4,000
Thereafter 10,000 7,217 17,217
-------- ------- --------
TOTAL LONG-TERM DEBT $ 72,674 $ 7,217 $ 79,891
======== ======= ========
----------
(1) Interest rates on the FHLB advances are fixed.
(2) Interest rates on the junior subordinated debt are floating based on
the six-month LIBOR plus 3.70%.
(3) Includes amortizing advances that are being repaid in equal monthly
payments of principal and interest.
NOTE 10. INCOME TAXES
The components of the income tax provision for the years ended December 31,
2004, 2003 and 2002 are as follows:
(Dollars in Thousands) December 31,
---------------------------
2004 2003 2002
------- ------- -------
Current tax provision:
Federal $ 1,477 $ 1,546 $ 1,857
State 1 1 --
------- ------- -------
TOTAL CURRENT TAX PROVISION 1,478 1,547 1,857
------- ------- -------
Deferred tax provision (benefit):
Federal (959) 166 (270)
------- ------- -------
TOTAL DEFERRED TAX PROVISION
(BENEFIT) (959) 166 (270)
------- ------- -------
TOTAL PROVISION FOR INCOME TAXES $ 519 $ 1,713 $ 1,587
======= ======= =======
84
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
A reconciliation of the anticipated income tax provision (computed by applying
the Federal statutory income tax rate of 34% to income before income tax
expense), to the provision for income taxes as reported in the statements of
income is as follows:
(Dollars in Thousands) December 31,
--------------------------
2004 2003 2002
------ ------- -------
Provision for income tax at statutory rate $ 614 $ 1,733 $ 1,587
Increase (decrease) resulting from:
Dividends received deduction (7) (11) (11)
Bank-owned life insurance earnings credit (103) (88) --
Tax-exempt income (6) (11) (4)
Nondeductible expenses 6 6 4
Other 15 84 11
------ ------- -------
TOTAL PROVISION FOR INCOME TAXES $ 519 $ 1,713 $ 1,587
====== ======= =======
EFFECTIVE TAX RATE 28.7% 33.6% 34.0%
====== ======= =======
The tax effects of temporary differences that give rise to significant
components of the deferred tax assets and deferred tax liabilities at December
31, 2004 and 2003 are presented below:
(Dollars in Thousands) December 31,
-----------------
2004 2003
------- -------
Deferred tax assets:
Allowance for loan losses $ 1,088 $ 914
Core deposit intangible 108 101
Unrealized losses on securities 149 --
Premises and equipment 178 324
Investment write-downs 84 87
Charitable contribution carry-forward 759 --
Deferred compensation 204 76
Other 241 76
------- -------
TOTAL DEFERRED TAX ASSETS 2,811 $ 1,578
------- -------
Deferred tax liabilities:
Unrealized gains on securities -- 268
Deferred loan costs 759 703
Other 8 6
------- -------
TOTAL DEFERRED TAX LIABILITIES 767 977
------- -------
DEFERRED TAX ASSET, NET $ 2,044 $ 601
======= =======
At December 31, 2004, the Company had a charitable contribution carry-forward
for tax purposes, primarily related to the contribution of the Company's common
stock to SI Financial Group Foundation, Inc., of approximately $2.2 million. The
Company is permitted, under the Internal Revenue Code, to deduct only an amount
equal to 10% of the Company's annual taxable income in any one year. We may
utilize the excess contribution as a deduction over the subsequent five-year
period following the contribution provided that we have
85
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
sufficient earnings. We estimate that all of the contribution will be deductible
prior to the expiration of the carry-forward in the period ending December 31,
2009.
Retained earnings at December 31, 2004 and 2003 includes a contingency reserve
for loan losses of approximately $3.7 million which represents the tax reserve
balance existing at December 31, 1987, and is maintained in accordance with
provisions of the Internal Revenue Code applicable to mutual savings banks.
Amounts transferred to the reserve have been claimed as deductions from taxable
income, and, if the reserve is used for purposes other than to absorb losses on
loans, a Federal income tax liability could be incurred. It is not anticipated
that the Company will incur a Federal income tax liability relating to this
reserve balance, and accordingly, deferred income taxes of approximately $1.3
million at December 31, 2004 and 2003 have not been recognized.
Effective for taxable years commencing after December 31, 1998, financial
services companies doing business in Connecticut are permitted to establish a
"passive investment company" ("PIC") to hold and manage loans secured by real
property. PICs are exempt from Connecticut corporation business tax, and
dividends received by the financial services companies from PICs are not
taxable. In January 1999, the Bank established a PIC, as a wholly-owned
subsidiary, and in June 2000, began to transfer a portion of its residential and
commercial mortgage loan portfolios from the Bank to the PIC. A substantial
portion of the Company's interest income is now derived from the PIC, an entity
whose net income is exempt from State of Connecticut taxes, and accordingly,
state income taxes represent minimum state tax amounts.
The Bank's ability to continue to realize the tax benefits of the PIC is subject
to the PIC continuing to comply with all statutory requirements related to the
operations of the PIC.
NOTE 11. EMPLOYEE BENEFITS
Profit Sharing/401(k) Plan
- --------------------------
The Bank's Profit Sharing and 401(k) Savings Plan (the "Plan") is a tax
qualified defined contribution plan for the benefit of its eligible employees.
The Bank's profit sharing contribution to the Plan is a discretionary amount
authorized by the Board of Directors, based on the financial results of the
Bank. An employee's share of the profit sharing contribution represents the
ratio of the employee's salary to the total salary expense of the Bank.
Contributions to the profit sharing plan were approximately $227,000, $303,000
and $246,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
The Bank's Plan also includes a 401(k) feature. An eligible employee may
contribute up to a certain percentage of his/her compensation, and the Bank
makes a matching contribution of 50% of the first 6% of the employee's
compensation. Bank contributions were approximately $169,000, $146,000 and
$179,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
Group Term Replacement Plan
- ---------------------------
The Bank maintains the Group Term Replacement Plan for the purpose of providing
a death benefit to executives designated by the Compensation Committee of the
Board of Directors. The death benefits are funded through certain insurance
policies, which are owned by the Bank on the lives of the participating
executives. The Bank pays the life insurance premiums which fund the death
benefits from its general assets and is the beneficiary of any death benefits
exceeding any executive's maximum dollar amount specified in his or her split
dollar endorsement policy. The maximum dollar amount of each executive's split
dollar death benefit equals three times the executive's annual compensation less
$50,000 pre-retirement and three times final annual compensation post-retirement
not to exceed a specified dollar amount. For purposes of the plan, annual
compensation includes an executive's base compensation, plus commissions and
cash bonuses earned under the Bank's bonus plan. Participation in the plan
ceases if an executive is terminated for cause or the executive terminates
employment for reasons other than death, disability or retirement. If the Bank
wishes to maintain the insurance after a participant's termination in the plan,
the Bank will be the direct beneficiary of the entire death proceeds of the
insurance policies.
86
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
Executive Supplemental Retirement Plan - Defined Benefit
- --------------------------------------------------------
During the year ended December 31, 2003, the Company adopted unfunded
supplemental defined-benefit retirement plans with its directors and members of
senior management. This plan provides for supplemental retirement benefits to
certain executives based upon average annual compensation and years of service.
Entitlement of benefits commence upon the earlier of executive's termination of
employment (other than for cause), at or after attaining age 65 or, depending on
the executive, on the date when the executive's years of service and age total
80 or 78. Total expenses incurred under this plan for the years ended December
31, 2004 and 2003 were $282,000 and $215,000, respectively.
Director Deferred Fee Agreements
- --------------------------------
During the year ended December 31, 2003, the Company adopted a deferred
compensation plan that provides directors with the option of deferring their
director fees until retirement. The liability related to this plan is being
accrued over the participants' service periods and was $26,000 and $9,000 at
December 31, 2004 and 2003, respectively. Fees charged to expense under these
agreements amounted to $14,000 and $9,000 for the years ended December 31, 2004
and 2003, respectively. Interest expense associated with deferred fees totaled
$3,000 and $0 for the years ended December 31, 2004 and 2003, respectively.
Supplemental Executive Retirement Plan
- --------------------------------------
Effective January 2004, the Company adopted the Supplemental Executive
Retirement Plan in an effort to provide restorative payments to executives,
designated by the Board of Directors, who are prevented from receiving the full
benefits of the Company's Profit Sharing and 401(k) Savings Plan and Employee
Stock Ownership Plan. The supplemental executive retirement plan also provides
supplemental benefits to participants upon a change in control prior to the
complete scheduled repayment of the ESOP loan. As of December 31, 2004, the
President and Chief Executive Officer, Rheo A. Brouillard, has been designated
by the Board of Directors to participate in the plan. Total expense incurred
under this plan was $3,000 for the year ended December 31, 2004.
Employee Stock Ownership Plan
- -----------------------------
In September 2004, in connection with the initial public offering, the Bank
established an Employee Stock Ownership Plan for the benefit of its eligible
employees. The ESOP purchased 492,499 shares of the Company's common shares. The
transaction was financed from the proceeds of a $4.9 million loan from the
Company with an initial interest rate of 4.75%. The loan to the ESOP will be
repaid principally from the Bank's contributions to the ESOP and dividends
payable on the common stock held by the ESOP over the fifteen-year term of the
loan. The loan is secured by the shares purchased by First Bankers Trust
Services, Inc., the ESOP trustee, which are held in a suspense account for
allocation among the participants as the loan is repaid. As the loan is repaid
to the Company, shares will be released from collateral and will be allocated to
the accounts of the participants.
The Company accounts for these ESOP shares in accordance with Statement of
Position 93-6, "Employers' Accounting for Employee Stock Ownership Plans." Under
SOP 93-6, unearned ESOP shares are not considered outstanding for calculating
net income per common share and are presented as unallocated common shares held
by ESOP, as a reduction in shareholders' equity, in the statement of financial
condition. During the period the ESOP shares are committed to be released, the
Company will recognize compensation expense equal to the fair value of the ESOP
shares, unearned common shares held by ESOP will be reduced by the cost of the
ESOP shares and the differential between the fair value and the cost will be
charged to additional paid-in capital. Only ESOP shares that have been allocated
or committed to be released will be considered outstanding for earnings per
share computations.
Shares are released as debt is repaid and common shares held by the ESOP are
allocated among participants on the basis of compensation as of the year end
before the allocation. Benefits become 100% vested upon completion of five years
of service. Forfeitures of nonvested benefits will be reallocated among
remaining participants in the same proportion as contributions.
Dividends on unallocated shares may be used by the ESOP to repay the debt to the
Company and are not reported as dividends in the financial statements but as a
reduction of debt or accrued interest payable if used for debt
87
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
service. Compensation expense is recognized if dividends on unallocated shares
are paid or added to the accounts of participants. Dividends on allocated shares
are charged to retained earnings.
At December 31, 2004, the Bank has repaid principal payments on the loan of
$56,000 and committed to release 8,069 shares held in suspense for allocation to
participants in 2005. As of December 31, 2004, the amount of unallocated common
shares held in suspense totaled 484,430, with a fair value of $5.9 million,
which represents a potential commitment of the Bank to the ESOP. Total
compensation expense recognized in connection with the ESOP was $93,000 for the
year ended December 31, 2004.
Bank-Owned Life Insurance
- -------------------------
The Company has an investment in, and is the beneficiary of, life insurance
policies on the lives of certain officers. The purpose of these life insurance
investments is to provide income through the appreciation in cash surrender
value of the policies, which is used to offset the costs of various benefit and
retirement plans. These policies had aggregate cash surrender values of
approximately $7.6 million and $7.3 million at December 31, 2004 and 2003,
respectively. Income earned on these life insurance policies aggregated $303,000
and $258,000 for the years ended December 31, 2004 and 2003, respectively.
NOTE 12. COMMITMENTS AND CONTINGENCIES
Leases
- ------
The Company leases certain of its branch offices and equipment under operating
lease agreements that expire at various dates through 2025. In addition to
rental payments, the branch leases require payments for property taxes in excess
of base year taxes.
Future minimum rental commitments under the terms of these leases, by year and
in the aggregate, at December 31, 2004, are as follows:
(Dollars in Thousands)
2005 $ 786
2006 792
2007 578
2008 426
2009 409
Thereafter 3,483
-------
$ 6,474
=======
Rental expense charged to operations for cancelable and noncancelable operating
leases approximated $589,000, $576,000 and $556,000 for the years ended December
31, 2004, 2003 and 2002, respectively.
88
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
Subleases
- ---------
The Company subleases excess office space in its premises to various tenants
under noncancelable operating leases, with terms ranging from two to five years.
Future minimum lease payments receivable for noncancelable leases, by year and
in the aggregate, at December 31, 2004, are as follows:
(Dollars in Thousands)
2005 $ 71
2006 57
2007 51
2008 28
2009 19
-----
$ 226
=====
Rental income under noncancelable leases approximated $51,000, $39,000 and
$61,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
Legal Matters
- -------------
The Company is involved in various legal proceedings that have arisen in the
normal course of business. Management believes that resolution of these matters
will not have a material effect on the Company's financial condition or results
of operations.
Other
- -----
In 1998, the Bank became a limited partner in a Small Business Investment
Corporation and made a commitment to make a capital investment of $1.0 million
in the limited partnership. At December 31, 2004 and 2003, the Bank's remaining
off-balance-sheet commitment for capital investment was approximately $194,000
and $307,000, respectively.
Also, the Bank has entered into agreements with certain customers whereby the
Bank, on a nightly basis, transfers to a third party a portion of the customers'
demand deposit account balance above a certain level. The balance of the amounts
so transferred of approximately $17.7 million and $13.5 million at December 31,
2004 and 2003, respectively, has been derecognized and is not reflected in the
statements of financial condition.
NOTE 13. RELATED PARTY TRANSACTIONS
During the years ended December 31, 2004, 2003 and 2002, the Company paid
approximately $27,000, $187,000 and $90,000, respectively, for insurance,
supplies and advertising, to companies related to directors of the Company. In
addition, the Company entered into an agreement to sublease real property to
United Natural Foods, Inc., a company affiliated with one of the Company's
directors, whereas United Natural Foods, Inc. shall pay the Company rental
income totaling $128,000 over the five-year agreement. For the year ended
December 31, 2004, the Company received rental income from United Natural Foods,
Inc. of $6,000. Loans to related parties are discussed in Note 4 and related
party deposits are discussed in Note 8.
SI Bancorp, MHC owns a majority of the Company's common stock and, through its
Board of Directors, will be able to exercise voting control over most matters
put to a vote of shareholders. The same directors and officers who manage the
Company and the Bank also manage SI Bancorp, MHC. As a federally-chartered
mutual holding company, the Board of Directors of SI Bancorp, MHC must ensure
that the interests of depositors of the Bank are represented and considered in
matters put to a vote of shareholders of the Company. Therefore, the votes cast
by SI Bancorp, MHC may not be in the best interest of all shareholders. For
example, SI Bancorp, MHC may exercise its voting control to prevent a sale or
merger transaction, a second-step conversion transaction or defeat a shareholder
nominee for election to the Board of Directors of the Company. The matters as to
which
89
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
shareholders, other than SI Bancorp, MHC, will be able to exercise voting
control are limited and include any proposal to implement a stock-based
incentive plan.
NOTE 14. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
In the normal course of business, the Company is a party to financial
instruments with off-balance-sheet risk to meet the financing needs of its
customers. These financial instruments include commitments to extend credit and
standby letters of credit and involve, to varying degrees, elements of credit
and interest rate risk in excess of the amounts recognized in the statements of
financial condition. The contractual amounts of those instruments reflect the
extent of involvement the Company has in particular classes of financial
instruments.
The contractual amounts of commitments to extend credit represent the amounts of
potential accounting loss should the contract be fully drawn upon, customer
default and the value of any existing collateral be determined as worthless. The
Company uses the same credit policies in making commitments and conditional
obligations as it does for on-balance-sheet instruments. Financial instruments
whose contract amounts represent credit risk are as follows at December 31, 2004
and 2003 were as follows:
(Dollars in Thousands) December 31,
-------------------
2004 2003
-------- --------
Commitments to extend credit:
Future loan commitments (1) $ 27,073 $ 22,224
Undisbursed construction loans 27,527 15,193
Undisbursed home equity lines of credit 19,351 15,577
Undisbursed commercial lines of credit 8,433 7,360
Overdraft protection lines 1,060 1,012
Standby letters of credit 997 718
-------- --------
TOTAL $ 84,441 $ 62,084
======== ========
----------
(1) Includes fixed rate loan commitments of $10.2 million at interest
rates ranging from 4.875% to 7.125% and $16.8 million at interest
rates ranging from 4.375% to 7.0% at December 31, 2004 and 2003,
respectively.
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of any condition established in the contract. Commitments
generally have fixed expiration dates or other termination clauses and may
require payment of a fee. The commitments generally expire as follows:
o Future loan commitments: 90 days or less
o Undisbursed construction loans: 1 year or less
o Undisbursed home equity lines of credit: 5 years or less
o Undisbursed commercial lines of credit: 1 year or less
o Overdraft protection lines: No expiration
o Standby letters of credit: 12 to 24 months
Standby letters of credit are conditional commitments issued by the Company to
guarantee the performance of a customer to a third party. Since these
commitments could expire without being drawn upon, the total commitment amounts
do not necessarily represent future cash requirements.
The Company adopted the provisions of Statement of Financial Accounting
Standards No. 149, "Amendment of Statement 133 on Derivative Instruments and
Hedging Activities," effective July 1, 2003, which includes the Company's
commitments to fund loans held for sale. As per Staff Accounting Bulletin No.
105, "Application of Accounting
90
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
Principles to Loan Commitments," the interest rate lock commitment was valued at
zero at inception. The rate locks will continue to be adjusted for changes in
value resulting from changes in market interest rates.
Effective January 1, 2003, newly issued or modified guarantees, that are not
derivative contracts, are required to be recorded on the Company's consolidated
statement of financial condition at their fair value at the date of inception.
There was no liability related to such guarantees at December 31, 2004 and 2003.
The Company evaluates each customer's creditworthiness on a case-by-case basis.
The amount of collateral obtained, if deemed necessary by the Company upon
extension of credit, is based on management's credit evaluation of the
counterparty. Collateral held varies but may include residential and commercial
property; accounts receivable; inventory; property, plant and equipment;
deposits and securities.
At December 31, 2004 and 2003, the outstanding balance of loans sold with
recourse was approximately $138,000 and $222,000, respectively. Loan repurchase
commitments are agreements to repurchase loans previously sold upon the
occurrence of conditions established in the contract, including default by the
underlying borrower.
NOTE 15. REGULATORY MATTERS
The Bank is subject to various regulatory capital requirements administered by
the Office of Thrift Supervision. Failure to meet minimum capital requirements
can initiate certain mandatory, and possibly additional discretionary, actions
by regulators that, if undertaken, could have a direct material effect on the
Company'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 the 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 in the table
below) of total and Tier I capital (as defined in the regulations) to
risk-weighted assets (as defined), of Tier I capital (as defined) to total
assets (as defined) and tangible capital to tangible assets. Management
believes, as of December 31, 2004 and 2003, that the Bank met all capital
adequacy requirements to which it is subject.
As of December 31, 2003, the most recent notification from the FDIC (the Bank's
primary federal regulatory agency at the time) categorized the Bank as well
capitalized under the regulatory framework for prompt corrective action. To be
categorized as well capitalized, the Bank must maintain minimum total
risk-based, Tier I risk-based, Tier I leverage and tangible equity ratios as set
forth in the table below. There are no conditions or events since then that
management believes have changed the Bank's category.
The Bank's actual capital amounts and ratios at December 31, 2004 and 2003 were:
The Savings Institute Bank and Trust Company at December 31, 2004:
- ------------------------------------------------------------------
To Be Well
For Capital Capitalized Under
Adequacy Prompt Corrective
(Dollars in Thousands) Actual Purposes Action Provisions
---------------- ---------------- ------------------
Amount Ratio Amount Ratio Amount Ratio
-------- ----- -------- ----- -------- -----
Total Capital to Risk Weighted Assets $ 63,459 18.03% $ 28,157 8.00% $ 35,196 10.00%
Tier I Capital to Risk Weighted Assets 60,253 17.12 14,078 4.00 21,117 6.00
Tier I Capital to Total Assets (1) 60,253 9.99 24,125 4.00 30,157 5.00
Tangible Equity Ratio 60,253 9.99 9,047 1.50 N/A N/A
- ----------
(1) Office of Thrift Supervision reporting requirement includes "Total
Assets."
91
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
The Savings Institute Bank and Trust Company at December 31, 2003:
- ------------------------------------------------------------------
(Dollars in Thousands) To Be Well
For Capital Capitalized Under
Adequacy Prompt Corrective
Actual Purposes Action Provisions
----------------- ---------------- ------------------
Amount Ratio Amount Ratio Amount Ratio
-------- ------ -------- ----- -------- -----
Total Capital to Risk Weighted Assets $ 37,529 12.45% $ 24,115 8.00% $ 30,144 10.00%
Tier I Capital to Risk Weighted Assets 34,679 11.50 12,062 4.00 18,093 6.00
Tier I Capital to Total Average Assets (1) 34,679 6.81 20,369 4.00 25,462 5.00
- ----------
(1) FDIC reporting requirement includes "Total Average Assets."
A reconciliation of the Company's total capital to the Bank's regulatory capital
is as follows:
December 31,
--------------------
(Dollars in Thousands) 2004 2003
--------- --------
TOTAL CAPITAL PER FINANCIAL STATEMENTS $ 80,809 $ 34,099
Holding company equity not available for regulatory capital (20,555) 1,467
Accumulated losses (gains) on available for sale
securities 291 (486)
Intangible assets (292) (389)
Disallowed servicing assets -- (12)
--------- --------
TOTAL TIER 1 CAPITAL 60,253 34,679
--------- --------
Adjustments for total capital:
Net unrealized gains on available for sale securities 6 25
Allowance for loan and credit losses 3,200 2,825
--------- --------
TOTAL CAPITAL PER REGULATORY REPORTING $ 63,459 $ 37,529
========= ========
NOTE 16. OTHER COMPREHENSIVE INCOME (LOSS)
Other comprehensive income (loss), which is comprised solely of the change in
unrealized gains and losses on available for sale securities, for the years
ended December 31, 2004 and 2003 is as follows:
December 31, 2004
-------------------------------------
(Dollars in Thousands) Before-Tax Tax Benefit Net of Tax
Amount (Expense) Amount
---------- ----------- ----------
Unrealized holding losses arising during the period $ (1,390) $ 473 $ (917)
Reclassification adjustment for losses recognized in net
income 166 (56) 110
---------- ----- ------
UNREALIZED HOLDING LOSSES ON AVAILABLE FOR SALE
SECURITIES, NET OF TAXES $ (1,224) $ 417 $ (807)
======== ===== ======
92
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
December 31, 2003
------------------------------------
Before-Tax Tax Benefit Net of Tax
(Dollars in Thousands) Amount (Expense) Amount
---------- ----------- ----------
Unrealized holding losses arising during the period $ (1,171) $ 397 $ (774)
Reclassification adjustment for gains recognized in net
income 121 (41) 80
-------- ------ ------
UNREALIZED HOLDING LOSSES ON AVAILABLE FOR SALE
SECURITIES, NET OF TAXES $ (1,050) $ 356 $ (694)
======== ====== ======
December 31, 2002
-------------------------------------
Before-Tax Tax Benefit Net of Tax
(Dollars in Thousands) Amount (Expense) Amount
---------- ----------- ----------
Unrealized holding gains arising during the period $ 515 $ (175) $ 340
Reclassification adjustment for losses recognized in net
income 258 (88) 170
----- ------ -----
UNREALIZED HOLDING GAINS ON AVAILABLE FOR SALE
SECURITIES, NET OF TAXES $ 773 $ (263) $ 510
===== ====== =====
NOTE 17. FAIR VALUE OF FINANCIAL INSTRUMENTS AND INTEREST RATE RISK
Financial Accounting Standards Board Statement No. 107, "Disclosures About Fair
Value of Financial Instruments" ("FAS 107"), requires disclosure of fair value
information about financial instruments, whether or not recognized in the
statements of financial condition, for which it is practicable to estimate that
value. In cases where quoted market prices are not available, fair values are
based on estimates using present value or other valuation techniques. Those
techniques are significantly affected by the assumptions used, including the
discount rates and estimates of future cash flows. In that regard, the derived
fair value estimates cannot be substantiated by comparisons to independent
markets and, in many cases, could not be realized in immediate settlement of the
instrument. FAS 107 excludes certain financial instruments from its disclosure
requirements. Accordingly, the aggregate fair value amounts presented do not
represent the underlying value of the Company.
Management uses its best judgment in estimating the fair value of the Company's
financial instruments; however, there are inherent weaknesses in any estimation
technique. Therefore, for substantially all financial instruments, the fair
value estimates presented herein are not necessarily indicative of the amounts
the Company could have realized in a sales transaction at December 31, 2004 or
2003. The estimated fair value amounts for 2004 and 2003 have been measured as
of their respective year-ends, and have not been reevaluated or updated for
purposes of these consolidated financial statements subsequent to those
respective dates. As such, the estimated fair values of these financial
instruments subsequent to the respective reporting dates may be different than
the amounts reported at each year-end.
The information presented should not be interpreted as an estimate of the fair
value of the entire Company since a fair value calculation is only required for
a limited portion of the Company's assets. Due to the wide range of valuation
techniques and the degree of subjectivity used in making the estimate,
comparisons between the Company's disclosures and those of other banks may not
be meaningful.
93
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
As of December 31, 2004 and 2003, the recorded book balances and estimated fair
values of the Company's financial instruments were:
2004 2003
--------------------- ---------------------
Carrying Fair Carrying Fair
(Dollars in Thousands) Amount Value Amount Value
--------- --------- --------- ---------
Financial Assets:
- -----------------
Cash and due from banks $ 21,647 $ 21,647 $ 20,336 $ 20,336
Interest-bearing deposits 8,728 8,728 4,441 4,441
Federal funds sold 400 400 4,800 4,800
Available for sale securities 120,557 120,557 77,693 77,693
Held to maturity securities -- -- 1,728 1,344
Loans held for sale 200 200 -- --
Loans receivable, net 447,957 446,026 386,924 397,260
FHLB stock 4,313 4,313 2,858 2,858
Accrued interest receivable 2,638 2,638 2,238 2,238
Financial Liabilities:
- ----------------------
Savings deposits 92,588 92,588 87,625 87,625
Demand deposits, negotiable orders of
withdrawal and money market accounts 156,613 156,613 142,223 142,223
Certificates of deposit 208,557 210,294 185,242 187,094
Mortgagors' and investors' escrow accounts 2,722 2,722 2,221 2,221
Advances from FHLB 72,674 72,602 57,168 58,590
Subordinated debt 7,217 7,217 7,217 7,217
Off-Balance Sheet Instruments
- -----------------------------
Loan commitments on which the committed interest rate is less than the current
market rate are insignificant at December 31, 2004 and 2003.
The Company assumes interest rate risk, which represents the risk that general
interest rate levels will change, as a result of its normal operations. As a
result, the fair values of the Company's financial instruments will change when
interest rate levels change and that change may be either favorable or
unfavorable to the Company. Management attempts to match maturities of assets
and liabilities to the extent believed necessary to minimize interest rate risk.
However, borrowers with fixed rate obligations are less likely to prepay in a
rising rate environment and more likely to prepay in a falling rate environment.
Conversely, depositors who are receiving fixed rates are more likely to withdraw
funds before maturity in a rising rate environment and less likely to do so in a
falling rate environment. Management monitors rates and maturities of assets and
liabilities and attempts to minimize interest rate risk by adjusting terms of
new loans and deposits and by investing in securities with terms that mitigate
the Company's overall interest rate risk.
NOTE 18. RESTRICTIONS ON DIVIDENDS, LOANS AND ADVANCES
Federal and state regulations place certain restrictions on dividends paid and
loans or advances made by the Bank to the Company. The total amount of dividends
which may be declared in a given calendar year is generally limited to the net
income of the Bank for that year plus retained net income for the preceding two
years.
94
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
At December 31, 2004 and 2003, the Bank's retained earnings available for
payment of dividends was $9.1 million and $7.9 million, respectively.
Accordingly, $51.1 million and $27.7 million of the Company's equity in the net
assets of the Bank was restricted at December 31, 2004 and 2003, respectively.
In addition, the Company is further restricted, under its junior subordinated
debt obligation, from paying dividends to its shareholders if the Company has
deferred interest payments or has otherwise defaulted on its junior subordinated
debt obligations.
Under federal regulation, the Bank is also limited to the amount it may loan to
the Company, unless such loans are collateralized by specific obligations. Loans
or advances to the Company by the Bank are limited to 10% of the Bank's capital
stock and surplus on a secured basis. In addition, dividends paid by the Bank to
the Company would be prohibited if the effect there of would cause the Bank's
capital to be reduced below applicable minimum capital requirements.
At December 31, 2004, SI Bancorp, MHC owned $7.3 million shares of the Company's
common stock, representing 58% of the total number of the Company's outstanding
shares. Upon regulatory approval, SI Bancorp, MHC may seek to waive receipt of
the dividends from the Company. As of December 31, 2004, the Company had not
declared any dividends and SI Bancorp, MHC has not waived any dividends.
NOTE 19. SI FINANCIAL GROUP, INC. PARENT COMPANY ONLY FINANCIAL INFORMATION
SI Financial Group, Inc.
Condensed Statements of Financial Condition
December 31,
-------------------
2004 2003
-------- --------
(Dollars in Thousands)
Assets:
Cash and due from banks $ 10,878 $ 3,215
Available for sale securities 10,499 2,036
Investment in Savings Institute Bank and Trust Company 60,161 35,566
Other assets 6,750 569
-------- --------
TOTAL ASSETS $ 88,288 $ 41,386
======== ========
Liabilities and Equity:
Other liabilities 7,572 7,287
-------- --------
TOTAL LIABILITIES 7,572 7,287
-------- --------
Equity 80,716 34,099
-------- --------
TOTAL LIABILITIES AND EQUITY $ 88,288 $ 41,386
======== ========
95
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
SI Financial Group, Inc.
Condensed Statements of Income
Years Ended December 31,
------------------------
2004 2003
---------- -----------
(Dollars in Thousands)
Dividends from subsidiary $ -- $ 350
Interest and dividends on investments 141 94
Other income 139 47
--------- --------
TOTAL INCOME 280 491
Operating expenses 2,957 412
--------- --------
INCOME (LOSS) BEFORE INCOME TAXES AND EQUITY
IN UNDISTRIBUTED NET INCOME OF SUBSIDIARY (2,677) 79
Income tax benefit 909 92
--------- --------
(1,768) 171
Equity in undistributed net income of subsidiary 3,056 3,214
--------- --------
NET INCOME $ 1,288 $ 3,385
========= ========
SI Financial Group, Inc.
Condensed Statements of Cash Flows
Years Ended December 31,
------------------------
2004 2003
---------- -----------
(Dollars in Thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 1,288 $ 3,385
Adjustments to reconcile net income to net cash
provided by operating activities:
Equity in undistributed earnings of subsidiary (3,056) (3,214)
Other, net 1,562 (69)
--------- --------
CASH PROVIDED BY OPERATING ACTIVITIES (206) 102
--------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of available for sale securities (9,503) --
Proceeds from maturities of available for sale securities 1,000 --
Investment in subsidiary (32,108) (1,000)
--------- --------
CASH PROVIDED BY INVESTING ACTIVITIES (40,611) (1,000)
--------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from common stock offering 48,480 --
--------- --------
CASH PROVIDED BY FINANCING ACTIVITIES 48,480 --
--------- --------
NET CHANGE IN CASH AND CASH EQUIVALENTS 7,663 (898)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 3,215 4,113
--------- --------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 10,878 $ 3,215
========= ========
96
SI FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------------------------------------------------------
NOTE 20. QUARTERLY DATA (UNAUDITED)
(Dollars in Thousands, 2004 2003
Except Share Amounts) ------------------------------------------- -------------------------------------
Fourth Third Second First Fourth Third Second First
Quarter Quarter(1) Quarter(2) Quarter Quarter Quarter Quarter Quarter
------- ---------- ---------- ------- ------- ------- ------- -------
Interest and dividend income $ 7,766 $ 7,151 $ 6,903 $ 6,783 $ 6,707 $ 7,142 $ 7,086 $ 6,995
Interest expense 2,469 2,374 2,307 2,250 2,218 2,295 2,379 2,454
------- -------- ------- ------- ------- ------- ------- -------
NET INTEREST INCOME 5,297 4,777 4,596 4,533 4,489 4,847 4,707 4,541
Provision for loan losses 150 100 150 150 120 340 967 175
------- -------- ------- ------- ------- ------- ------- -------
NET INTEREST INCOME
AFTER PROVISION FOR
LOAN LOSSES 5,147 4,677 4,446 4,383 4,369 4,507 3,740 4,366
Noninterest income 1,127 754 1,069 1,235 1,162 1,143 1,201 1,216
Noninterest expenses 4,643 6,997 4,958 4,433 4,140 4,167 4,193 4,106
------- -------- ------- ------- ------- ------- ------- -------
INCOME (LOSS) BEFORE
INCOME TAXES 1,631 (1,566) 557 1,185 1,391 1,483 748 1,476
Provision (benefit) for
income taxes 529 (556) 165 381 453 503 231 526
------- -------- ------- ------- ------- ------- ------- -------
NET INCOME (LOSS) $ 1,102 $ (1,010) $ 392 $ 804 $ 938 $ 980 $ 517 $ 950
======= ======== ======= ======= ======= ======= ======= =======
NET INCOME PER COMMON
SHARE:
Basic $ 0.09 N/A N/A N/A N/A N/A N/A N/A
Diluted $ 0.09 N/A N/A N/A N/A N/A N/A N/A
- ----------
(1) Noninterest expenses include a $2.5 million charitable contribution to SI
Financial Group Foundation.
(2) Noninterest expenses include a $337,000 impairment charge for the
reduction in carrying value of a former branch facility to its fair value.
NOTE 21. SUBSEQUENT EVENT
In February 2005, the Company reached an agreement with FTN Financial Capital
Assets Corporation to sell $25.7 million of one- to four-family residential
mortgage loans with servicing rights retained. The proceeds from the sale were
not significantly different than the carrying value of the loans and the
resulting gain and mortgage servicing asset will be recorded by the Company in
the first quarter of 2005.
97