================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
------------------
FORM 10-Q
------------------
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2004
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
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Commission file number 000-23777
PENSECO FINANCIAL SERVICES CORPORATION
Incorporated pursuant to the laws of Pennsylvania
------------------
Internal Revenue Service -- Employer Identification No. 23-2939222
150 North Washington Avenue, Scranton, Pennsylvania 18503-1848
(570) 346-7741
------------------
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No |_|
Indicate by checkmark whether the registrant is an accelerated filer (as defined
in Rule 12b-2 of the Act). |_|
The total number of shares of the registrant's Common Stock, $0.01 par value,
outstanding on October 29, 2004 was 2,148,000.
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PENSECO FINANCIAL SERVICES CORPORATION
Page
Part I -- FINANCIAL INFORMATION
Item 1. Financial Statements - Consolidated
Balance Sheets:
September 30, 2004........................................ 3
December 31, 2003......................................... 3
Statements of Income:
Three Months Ended September 30, 2004..................... 4
Three Months Ended September 30, 2003..................... 4
Nine Months Ended September 30, 2004...................... 5
Nine Months Ended September 30, 2003...................... 5
Statements of Cash Flows:
Nine Months Ended September 30, 2004...................... 6
Nine Months Ended September 30, 2003...................... 6
Notes to Financial Statements................................ 7
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations.................................... 13
Item 3. Quantitative and Qualitative Disclosures About Market Risk..... 24
Item 4. Controls and Procedures........................................ 25
Part II -- OTHER INFORMATION
Item 1. Legal Proceedings.............................................. 25
Item 2. Changes in Securities and Use of Proceeds...................... 25
Item 3. Defaults Upon Senior Securities................................ 25
Item 4. Submission of Matters to a Vote of Security Holders............ 25
Item 5. Other Information.............................................. 25
Item 6. Exhibits and Reports on Form 8-K............................... 25
Signatures............................................................. 26
Certifications......................................................... 27
PART I. FINANCIAL INFORMATION, Item 1 -- Financial Statements
PENSECO FINANCIAL SERVICES CORPORATION
CONSOLIDATED BALANCE SHEETS
(unaudited)
(in thousands of dollars)
September 30, December 31,
2004 2003
---------------- ----------------
ASSETS
Cash and due from banks $ 10,409 $ 10,062
Interest bearing balances with banks 5,255 4,693
Federal funds sold 3,275 23,600
---------------- ----------------
Cash and Cash Equivalents 18,939 38,355
Investment securities:
Available-for-sale, at fair value 189,772 179,600
Held-to-maturity (fair value of $101,201
and $115,672, respectively) 98,637 113,525
---------------- ----------------
Total Investment Securities
288,409 293,125
Loans, net of unearned income 263,980 240,382
Less: Allowance for loan losses 3,600 3,500
---------------- ----------------
Loans, Net 60,380 236,882
Bank premises and equipment 9,404 9,935
Other real estate owned 44 121
Accrued interest receivable 3,437 3,298
Other assets 3,197 2,874
---------------- ----------------
Total Assets $ 583,810 $ 584,590
================ ================
LIABILITIES
Deposits:
Non-interest bearing $ 90,341 $ 79,726
Interest bearing 316,056 328,218
---------------- ----------------
Total Deposits 406,397 407,944
Other borrowed funds:
Repurchase agreements 25,904 19,454
Short-term borrowings 611 823
Long-term borrowings 86,875 93,523
Accrued interest payable 840 1,158
Other liabilities 1,183 881
---------------- ----------------
Total Liabilities 521,810 523,783
---------------- ----------------
STOCKHOLDERS' EQUITY
Common stock ($ .01 par value, 15,000,000 shares
authorized, 2,148,000 shares issued and outstanding) 21 21
Surplus 10,819 10,819
Retained earnings 50,321 48,131
Accumulated other comprehensive income 839 1,836
---------------- ----------------
Total Stockholders' Equity 62,000 60,807
---------------- ----------------
Total Liabilities and Stockholders' Equity $ 583,810 $ 584,590
================ ================
PENSECO FINANCIAL SERVICES CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
(in thousands of dollars)
Three Months Ended Three Months Ended
September 30, 2004 September 30, 2003
---------------------- ----------------------
INTEREST INCOME
Interest and fees on loans $ 3,468 $ 3,401
Interest and dividends on investments:
U.S. Treasury securities and U.S. Agency obligations 1,976 2,141
States & political subdivisions 947 645
Other securities 21 33
Interest on Federal funds sold 14 147
Interest on balances with banks 16 28
---------------------- ----------------------
Total Interest Income
6,442 6,395
---------------------- ----------------------
INTEREST EXPENSE
Interest on time deposits of $100,000 or more 164 202
Interest on other deposits 790 975
Interest on other borrowed funds 897 972
---------------------- ----------------------
Total Interest Expense 1,851 2,149
---------------------- ----------------------
Net Interest Income 4,591 4,246
Provision for loan losses 114 1
---------------------- ----------------------
Net Interest Income After Provision for Loan Losses 4,477 4,245
---------------------- ----------------------
OTHER INCOME
Trust department income 372 345
Service charges on deposit accounts 271 283
Merchant transaction income 1,698 1,729
Other fee income 289 328
Other operating income 200 549
Realized gains (losses) on securities, net - -
---------------------- ----------------------
Total Other Income 2,830 3,234
---------------------- ----------------------
OTHER EXPENSES
Salaries and employee benefits 2,235 2,219
Expense of premises and fixed assets 556 607
Merchant transaction expenses 1,344 1,378
Other operating expenses 1,251 1,218
---------------------- ----------------------
Total Other Expenses 5,386 5,422
---------------------- ----------------------
Income before income taxes 1,921 2,057
Applicable income taxes 306 454
---------------------- ----------------------
Net Income 1,615 1,603
Other comprehensive income, net of taxes:
Unrealized securities gains (losses) 1,915 (610)
---------------------- ----------------------
Comprehensive Income $ 3,530 $ 993
====================== ======================
Earnings per Common Share
(Based on 2,148,000 shares outstanding) $ .75 $ .75
Cash Dividends Declared Per Common Share $ .30 $ .30
PENSECO FINANCIAL SERVICES CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
(in thousands of dollars)
Nine Months Ended Nine Months Ended
September 30, 2004 September 30, 2003
---------------------- ----------------------
INTEREST INCOME
Interest and fees on loans $ 9,816 $ 11,443
Interest and dividends on investments:
U.S. Treasury securities and U.S. Agency obligations 6,188 6,062
States & political subdivisions 2,675 1,927
Other securities 72 88
Interest on Federal funds sold 57 236
Interest on balances with banks 53 68
---------------------- ----------------------
Total Interest Income
18,861 19,824
---------------------- ----------------------
INTEREST EXPENSE
Interest on time deposits of $100,000 or more 501 676
Interest on other deposits 2,453 3,286
Interest on other borrowed funds 2,737 2,199
---------------------- ----------------------
Total Interest Expense
5,691 6,161
---------------------- ----------------------
Net Interest Income
13,170 13,663
Provision for loan losses 135 456
---------------------- ----------------------
Net Interest Income After Provision for Loan Losses
13,035 13,207
---------------------- ----------------------
OTHER INCOME
Trust department income 1,014 981
Service charges on deposit accounts 810 848
Merchant transaction income 4,097 4,141
Other fee income 848 923
Other operating income 481 1,432
Realized gains (losses) on securities, net - -
---------------------- ----------------------
Total Other Income
7,250 8,325
---------------------- ----------------------
OTHER EXPENSES
Salaries and employee benefits 6,792 6,619
Expense of premises and fixed assets 1,837 1,929
Merchant transaction expenses 3,281 3,437
Other operating expenses 3,618 3,546
---------------------- ----------------------
Total Other Expenses
15,528 15,531
---------------------- ----------------------
Income before income taxes
4,757 6,001
Applicable income taxes 634 1,254
---------------------- ----------------------
Net Income
4,123 4,747
Other comprehensive income, net of taxes:
Unrealized securities (losses) gains (997) (828)
---------------------- ----------------------
Comprehensive Income $ 3,126 $ 3,919
====================== ======================
Earnings per Common Share
(Based on 2,148,000 shares outstanding) $ 1.92 $ 2.21
Cash Dividends Declared Per Common Share $ .90 $ .90
PENSECO FINANCIAL SERVICES CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(in thousands of dollars)
Nine Months Ended Nine Months Ended
September 30, 2004 September 30, 2003
--------------------- ---------------------
OPERATING ACTIVITIES
Net Income $ 4,123 $ 4,747
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation 624 891
Provision for loan losses 114 456
Deferred income tax provision (benefit) 60 20
Amortization of securities, (net of accretion) 1,191 694
Net realized losses (gains) on securities - -
Loss (gain) on other real estate - 13
(Increase) decrease in interest receivable (139) 325
(Increase) decrease in other assets (323) 297
Increase (decrease) in income taxes payable 183 55
(Decrease) increase in interest payable (318) (324)
Increase (decrease) in other liabilities 573 160
--------------------- ---------------------
Net cash provided by operating activities
6,088 7,334
--------------------- ---------------------
INVESTING ACTIVITIES
Purchase of investment securities available-for-sale (49,543) (37,383)
Proceeds from investment securities available-for-sale 23,015 17,756
Purchase of investment securities to be held-to-maturity - (103,031)
Proceeds from repayments of investment securities available-for-sale 14,108 4,386
Proceeds from repayments of investment securities held-to-maturity 14,434 16,069
Net loans (originated) repaid (23,656) 46,865
Proceeds from other real estate 121 143
Investment in premises and equipment (93) (1,064)
--------------------- ---------------------
Net cash (used) provided by investing activities (21,614) (56,259)
--------------------- ---------------------
FINANCING ACTIVITIES
Net increase (decrease) in demand and savings deposits 11,181 8,729
Net (payments) proceeds on time deposits (12,728) (10,926)
Increase (decrease) in federal funds purchased - -
Increase (decrease) in repurchase agreements 6,450 5,775
Net (decrease) increase in short-term borrowings (212) (662)
Proceeds from long-term borrowings - 100,000
Repayments of long-term borrowings (6,648) (4,299)
Cash dividends paid (1,933) (1,933)
--------------------- ---------------------
Net cash (used) provided by financing activities (3,890) 96,684
--------------------- ---------------------
Net (decrease) increase in cash and cash equivalents
(19,416) 47,759
Cash and cash equivalents at January 1 38,355 54,619
--------------------- ---------------------
Cash and cash equivalents at September 30 $ 18,939 $ 102,378
===================== =====================
The Company paid interest and income taxes of $6,009 and $432 and $6,485 and
$1,518, for the nine month periods ended September 30, 2004 and 2003,
respectively.
Notes to CONSOLIDATED Financial Statements
For the Quarter Ended September 30, 2004
(unaudited)
These Notes to Financial Statements reflect events subsequent to December 31,
2003, the date of the most recent Report of Independent Auditors, through the
date of this Quarterly Report on Form 10-Q for the quarter ended September 30,
2004. These Notes to Financial Statements should be read in conjunction with
Financial Information and Other Information required to be furnished as part of
this Report, in particular, (1) Management's Discussion and Analysis of
Financial Condition and Results of Operations for the three months ended
September 30, 2004 and September 30, 2003 and for the nine months ended
September 30, 2004 and September 30, 2003, with respect to the Company's net
interest income, capital requirements and liquidity, (2) Part II, Item 6,
Exhibits and Reports on Form 8-K and (3) the Company's Annual Report - Form 10-K
for the year ended December 31, 2003, incorporated herein by reference.
NOTE 1 -- Principles of Consolidation
Penseco Financial Services Corporation (Company) is a financial holding company,
incorporated under the laws of Pennsylvania. It is the parent company of Penn
Security Bank and Trust Company (Bank), a Pennsylvania state chartered bank.
Intercompany transactions have been eliminated in preparing the consolidated
financial statements.
The accounting policies of the Company conform with accounting principles
generally accepted in the United States of America and with general practices
within the banking industry.
NOTE 2 -- Basis of Presentation
The unaudited consolidated financial statements have been prepared in accordance
with generally accepted accounting principles for interim financial information.
In the opinion of management, all adjustments that are of a normal recurring
nature and are considered necessary for a fair presentation have been included.
They are not, however, necessarily indicative of the results of consolidated
operations for a full year.
For further information, refer to the consolidated financial statements and
accompanying notes included in the Company's Annual Report - Form 10-K for the
year ended December 31, 2003.
NOTE 3 -- Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change
relate to the determination of the allowance for losses on loans and the
valuation of real estate acquired in connection with foreclosures or in
satisfaction of loans. In connection with the determination of the allowances
for losses on loans and foreclosed real estate, management obtains independent
appraisals for significant properties.
NOTE 4 -- Investment Securities
Investments in securities are classified in two categories and accounted for as
follows:
Securities Held-to-Maturity Bonds, notes, debentures and mortgage-backed
securities for which the Company has the positive intent and ability to hold to
maturity are reported at cost, adjusted for amortization of premiums and
accretion of discounts computed on the straight-line basis, which approximates
the interest method, over the remaining period to maturity.
Securities Available-for-Sale Bonds, notes, debentures, mortgage-backed
securities and certain equity securities not classified as securities to be held
to maturity are carried at fair value with unrealized holding gains and losses,
net of tax, reported as a net amount in a separate component of stockholders'
equity until realized.
The amortization of premiums on mortgage-backed securities is done based on
management's estimate of the lives of the securities, adjusted, when necessary,
for advanced prepayments in excess of those estimates.
Realized gains and losses on the sale of securities available-for-sale are
determined using the specific identification
method and are reported as a separate component of other income in the
Statements of Income. Unrealized gains and losses are included as a separate
item in computing comprehensive income.
The amortized cost and fair value of investment securities at September 30, 2004
and December 31, 2003 are as follows:
Available-for-Sale
Gross Gross
Amortized Unrealized Unrealized Fair
September 30, 2004 Cost Gains Losses Value
- --------------------------------------------------------------------------------
U.S. Treasury securities $ 4,999 $ 101 $ - $ 5,100
U.S. Agency securities 70,953 485 160 71,278
Mortgage-backed securities 57,635 51 86 57,600
States & political subdivisions 48,751 792 229 49,314
- --------------------------------------------------------------------------------
Total Debt Securities 182,338 1,429 475 183,292
Equity securities 6,163 317 - 6,480
- --------------------------------------------------------------------------------
Total Available-for-Sale $ 188,501 $ 1,746 $ 475 $ 189,772
===============================================================================
Available-for-Sale
Gross Gross
Amortized Unrealized Unrealized Fair
December 31, 2003 Cost Gains Losses Value
- --------------------------------------------------------------------------------
U.S. Treasury securities $ 15,008 $ 379 $ - $ 15,387
U.S. Agency securities 63,568 1,435 - 65,003
Mortgage-backed securities 71,975 147 107 72,015
States & political subdivisions 20,158 683 - 20,841
- --------------------------------------------------------------------------------
Total Debt Securities 170,709 2,644 107 173,246
Equity securities 6,109 245 - 6,354
- --------------------------------------------------------------------------------
Total Available-for-Sale $ 176,818 $ 2,889 $ 107 $ 179,600
================================================================================
Held-to-Maturity
Gross Gross
Amortized Unrealized Unrealized Fair
September 30, 2004 Cost Gains Losses Value
- --------------------------------------------------------------------------------
Mortgage-backed securities $ 69,388 $ 8 $ 267 $ 69,129
States & political subdivisions 29,249 2,823 - 32,072
- --------------------------------------------------------------------------------
Total Held-to-Maturity $ 98,637 $ 2,831 $ 267 $ 101,201
================================================================================
Held-to-Maturity
Gross Gross
Amortized Unrealized Unrealized Fair
December 31, 2003 Cost Gains Losses Value
- --------------------------------------------------------------------------------
Mortgage-backed securities $ 84,138 $ 8 $ 580 $ 83,566
States & political subdivisions 29,387 2,719 - 32,106
- --------------------------------------------------------------------------------
Total Held-to-Maturity $ 113,525 $ 2,727 $ 580 $ 115,672
================================================================================
The amortized cost and fair value of debt securities at September 30, 2004 by
contractual maturity are shown below. Expected maturities will differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties.
September 30, 2004 Available-for-Sale Held-to-Maturity
- --------------------------------------------------------------------------------------
Amortized Fair Amortized Fair
Cost Value Cost Value
- --------------------------------------------------------------------------------------
Due in one year or less:
U.S. Treasury securities $ 4,999 $ 5,100 $ - $ -
U.S. Agency securities 15,015 15,457 - -
After one year through five years:
U.S. Agency securities 55,938 55,821 - -
After ten years:
States & political subdivisions 48,751 49,314 29,249 32,072
- --------------------------------------------------------------------------------------
Subtotal 124,703 125,692 29,249 32,072
Mortgage-backed securities 57,635 57,600 69,388 69,129
- --------------------------------------------------------------------------------------
Total Debt Securities $ 182,338 $ 183,292 $ 98,637 $ 101,201
======================================================================================
The gross fair value and unrealized losses of the Company's investments,
aggregated by investment category and length of time that individual securities
have been in a continuous unrealized loss position, at September 30, 2004 are as
follows:
Less than twelve months Twelve months or more Totals
------------------------------ ------------------------------ ------------------------------
Fair Unrealized Fair Unrealized Fair Unrealized
Value Losses Value Losses Value Losses
------------- ------------- ------------- ------------- ------------- -------------
U.S. Agency securities $ 40,665 $ 160 $ - $ - $ 40,665 $ 160
Mortgage-backed securities 39,086 86 68,807 267 107,893 353
States & political
subdivisions 17,517 229 - - 17,517 229
------------- ------------- ------------- ------------- ------------- -------------
Total $ 97,268 $ 475 $ 68,807 $ 267 $ 166,075 $ 742
============= ============= ============= ============= ============= =============
The above table includes forty-nine (49) securities that have unrealized losses
for less than twelve months and one (1) mortgaged-backed security that has been
in an unrealized loss position for twelve or more months. The unrealized losses
in each case are related to interest rate fluctuations. Because the decline in
market value is attributable to changes in interest rates and not credit quality
and because the Company has the ability and intent to hold these investments
until a market price recovery, which may be maturity, the Company does not
consider these investments to be other-than-temporarily impaired at September
30, 2004.
NOTE 5 -- Loan Portfolio
Details regarding the Company's loan portfolio:
September 30, December 31,
As Of: 2004 2003
- --------------------------------------------------------------------------------
Real estate - construction and land development $ 5,737 $ 3,078
Real estate mortgages 187,217 172,964
Commercial 37,137 30,056
Credit card and related plans 2,451 2,403
Installment 25,459 25,855
Obligations of states & political subdivisions 5,979 6,026
- --------------------------------------------------------------------------------
Loans, net of unearned income 263,980 240,382
Less: Allowance for loan losses 3,600 3,500
- --------------------------------------------------------------------------------
Loans, net $ 260,380 $ 236,882
- --------------------------------------------------------------------------------
NOTE 6 -- Loan Servicing
The Company generally retains the right to service mortgage loans sold to
others. The cost allocated to the mortgage servicing rights retained has been
recognized as a separate asset and is being amortized in proportion to and over
the period of estimated net servicing income.
Mortgage servicing rights are evaluated for impairment based on the fair value
of those rights. Fair values are estimated using discounted cash flows based on
current market rates of interest and current expected future prepayment rates.
For purposes of measuring impairment, the rights must be stratified by one or
more predominant risk characteristics of the underlying loans. The Company
stratifies its capitalized mortgage servicing rights based on the product type,
interest rate and term of the underlying loans. The amount of impairment
recognized is the amount, if any, by which the amortized cost of the rights for
each stratum exceed the fair value.
NOTE 7 -- Long-Term Debt
During the quarter ended March 31, 2003, the Bank borrowed $100,000 from the
Federal Home Loan Bank, in four loans with various maturity dates, to finance
the purchase of a mortgaged-backed security.
The loans are secured by a general collateral pledge of the Company.
A summary of the long-term debt at September 30, 2004 is as follows:
Note payable, due in monthly installments of $161, including
principal and interest at a fixed rate of 2.73%, maturing March, 2008. $ 6,427
Note payable, due in monthly installments of $253, including
principal and interest at a fixed rate of 3.22%, maturing March, 2010. 15,281
Note payable, due in monthly installments of $430, including
principal and interest at a fixed rate of 3.74%, maturing March, 2013. 37,528
Note payable, due in monthly installments of $186, including
principal and interest at a fixed rate of 4.69%, maturing March, 2023. 27,639
--------
Total long-term debt $ 86,875
========
The Company has agreed to maintain sufficient qualifying collateral to fully
secure the above borrowings.
Aggregate maturities of long-term debt at September 30, 2004 are as follows:
September 30, Principal
------------- ---------
2005 $ 9,139
2006 9,464
2007 9,801
2008 9,181
2009 8,533
Thereafter 40,757
---------
$ 86,875
=========
NOTE 8 -- Employee Benefit Plans
The components of the net periodic benefit costs are as follows:
Pension Benefits Other Benefits
------------------ -----------------
Nine months ended September 30, 2004 2003 2004 2003
- -----------------------------------------------------------------------------
Service cost $ 297 $ 289 $ 1 $ 1
Interest cost 493 476 4 4
Expected return on plan assets (525) (468) - -
Amortization of prior service cost - - 2 2
Amortization of net (gain) loss 93 131 - -
- -----------------------------------------------------------------------------
Net periodic pension cost $ 358 $ 428 $ 7 $ 7
- -----------------------------------------------------------------------------
Contributions
The Company previously disclosed in its financial statements for the year ended
December 31, 2003, that it expected to contribute $318 to its pension plan and
$12 to its postretirement plan in 2004. As of September 30, 2004, $190 has been
contributed to the pension plan. The Company presently anticipates contributing
$381 to fund its pension plan in 2004. The postretirement plan estimate has not
changed since December 31, 2003.
NOTE 9 -- Regulatory Matters
The Company and the Bank are subject to various regulatory capital requirements
administered by the Federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory--and possibly additional
discretionary--actions by regulators that, if undertaken, could have a direct
material effect on the Company and the Bank's Consolidated Financial Statements.
Under capital adequacy guidelines and the regulatory framework for prompt
corrective action, the Company and the Bank must meet specific capital
guidelines that involve quantitative measures of their assets, liabilities, and
certain off-balance sheet items as calculated under regulatory accounting
practices. The Company and the Bank's capital amounts and classifications are
also subject to qualitative judgements by the regulators about components, risk
weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Company and the Bank to maintain minimum amounts and ratios (set
forth in the Capital Adequacy table below) of Tier I and Total Capital to
risk-weighted assets and of Tier I Capital to average assets (Leverage ratio).
The table also presents the Company's actual capital amounts and ratios. The
Bank's actual capital amounts and ratios are substantially identical to the
Company's. Management believes, as of September 30, 2004, that the Company and
the Bank meet all capital adequacy requirements to which they are subject.
As of September 30, 2004, the most recent notification from the Federal Deposit
Insurance Corporation (FDIC) categorized the Company as "well capitalized" under
the regulatory framework for prompt corrective action. To be categorized as
"well capitalized", the Company must maintain minimum Tier I Capital, Total
Capital and Leverage ratios as set forth in the Capital Adequacy table. There
are no conditions or events since that notification that management believes
have changed the Company's categorization by the FDIC.
The Company and Bank are also subject to minimum capital levels, which could
limit the payment of dividends, although the Company and Bank currently have
capital levels, which are in excess of minimum capital level ratios required.
The Pennsylvania Banking Code restricts capital funds available for payment of
dividends to the Retained Earnings of the Bank. Accordingly, at September 30,
2004, the balances in the Capital Stock and Surplus accounts totalling $10,840
are unavailable for dividends.
In addition, the Bank is subject to restrictions imposed by Federal law on
certain transactions with the Company's affiliates. These transactions include
extensions of credit, purchases of or investments in stock issued by the
affiliate, purchases of assets subject to certain exceptions, acceptance of
securities issued by an affiliate as collateral for loans, and the issuance of
guarantees, acceptances, and letters of credit on behalf of affiliates. These
restrictions
prevent the Company's affiliates from borrowing from the Bank unless the loans
are secured by obligations of designated amounts. Further, the aggregate of such
transactions by the Bank with a single affiliate is limited in amount to 10
percent of the Bank's Capital Stock and Surplus, and the aggregate of such
transactions with all affiliates is limited to 20 percent of the Bank's Capital
Stock and Surplus. The Federal Reserve System has interpreted "Capital Stock and
Surplus" to include undivided profits.
Actual Regulatory Requirements
- ---------------------------------------------- --------------------------------------------
For Capital To Be
Adequacy Purposes "Well Capitalized"
As of September 30, 2004 Amount Ratio Amount Ratio Amount Ratio
- ----------------------------------------------------------------------------------------------
Total Capital
(to Risk Weighted Assets) $ 64,269 19.95% > $ 25,774 > 8.0% > $ 32,217 > 10.0%
- - - -
Tier 1 Capital
(to Risk Weighted Assets) $ 60,669 18.83% > $ 12,887 > 4.0% > $ 19,330 > 6.0%
- - - -
Tier 1 Capital
(to Average Assets) $ 60,669 10.39% > $ * > * > $ 29,185 > 5.0%
- - - -
*3.0% ($17,511), 4.0% ($23,348) or 5.0% ($29,185) depending on the bank's CAMELS
Rating and other regulatory risk factors.
Actual Regulatory Requirements
- ---------------------------------------------- --------------------------------------------
For Capital To Be
Adequacy Purposes "Well Capitalized"
As of December 31, 2003 Amount Ratio Amount Ratio Amount Ratio
- ----------------------------------------------------------------------------------------------
Total Capital
(to Risk Weighted Assets) $ 61,824 21.99% > $ 22,490 > 8.0% > $ 28,112 > 10.0%
- - - -
Tier I Capital
(to Risk Weighted Assets) $ 58,324 20.75% > $ 11,245 > 4.0% > $ 16,867 > 6.0%
- - - -
Tier I Capital
(to Average Assets) $ 58,324 10.21% > * > * > $ 28,556 > 5.0%
- - - -
* 3.0% ($17,134), 4.0% ($22,845) or 5.0% ($28,556) depending on the bank's
CAMELS Rating and other regulatory risk factors.
PART 1. FINANCIAL INFORMATION, Item 2 --
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following commentary provides an overview of the financial condition and
significant changes in the results of operations of Penseco Financial Services
Corporation and it's subsidiary, Penn Security Bank and Trust Company, for the
three months ended September 30, 2004 and September 30, 2003 and for the nine
months ended September 30, 2004 and September 30, 2003. Throughout this review,
the subsidiary of Penseco Financial Services Corporation, Penn Security Bank and
Trust Company, is referred to as the "Company". All intercompany accounts and
transactions have been eliminated in preparing the consolidated financial
statements. All information is presented in thousands of dollars, except as
indicated.
Critical Accounting Policies
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
Provision (allowance) for possible loan losses - The provision for loan losses
is based on past loan loss experience, management's evaluation of the potential
loss in the current loan portfolio under current economic conditions and such
other factors as, in management's best judgement, deserve current recognition in
estimating loan losses. The annual provision for loan losses charged to
operating expense is that amount which is sufficient to bring the balance of the
allowance for possible loan losses to an adequate level to absorb anticipated
losses.
Actuarial assumptions associated with pension, post-retirement and other
employee benefit plans - These assumptions include discount rate, rate of future
compensation increases and expected return on plan assets.
Provision for income taxes - Management believes that the assumptions and
judgements used to record tax related assets or liabilities have been
appropriate.
Fair value of certain investment securities - Fair value of investment
securities are based on quoted market prices.
Loan servicing rights - Mortgage servicing rights are evaluated for impairment
based on the fair value of those rights. Fair values are estimated using
discounted cash flows based on current market rates of interest and current
expected future prepayment rates. For purposes of measuring impairment, the
rights must be stratified by one or more predominant risk characteristics of the
underlying loans. The Company stratifies its capitalized mortgage servicing
rights based on the product type, interest rate and term of the underlying
loans. The amount of impairment recognized is the amount, if any, by which the
amortized cost of the rights for each stratum exceed the fair value.
Premium amortization - The amortization of premiums on mortgage-backed
securities is done based on management's estimate of the lives of the
securities, adjusted, when necessary, for advanced prepayments in excess of
those estimates.
Executive Summary
Net income for the three months ended September 30, 2004 remained basically
unchanged at $1,615 or $.75 per share compared with $1,603 or $.75 per share for
the three months ended September 30, 2003. Net interest income, before provision
for loan losses, increased $345 or 8.1% to $4,591 for the three months ended
September 30, 2004 compared to $4,246 for the same period of 2003. The growth
partially came from increases in the investment securities portfolio along with
increased loans, and lower interest expense on time deposits and long-term
borrowings. The provision for loan losses increased $113 from the year ago
period due to growth in the Company's loan portfolio based upon the analysis
methodology of valuating the reserve for bad debts and as an act of prudence by
management. Other income decreased $404 or 12.5% mostly due to a reduction of
$367 in gains on the sale of mortgage loans to the secondary market which peaked
during the third quarter of 2003. Also, the Company experienced reduced fee
income of $25 from income on sold mortgages serviced for others. Other expenses
decreased slightly by $36 to $5,386 compared to $5,422 from the year ago period.
Applicable income taxes decreased $148 mainly due to increased tax-free income.
For the nine months ended September 30, 2004, net income decreased $624 or 13.1%
to $4,123 or $1.92 per share compared with the 2003 year to date period of
$4,747 or $2.21 per share. Net interest income before provision for loan losses
decreased $493 or 3.6% to $13,170 for the nine months ended September 30, 2004
from $13,663 for the same period of 2003. Provision for loan losses decreased to
$135 in 2004 from $456 for the same period of 2003. Net interest income after
provision for loan losses decreased $172 or 1.3% to $13,035 from $13,207 for the
nine months ended September 30, 2003. Other income decreased $1,075 or 12.9% of
which $1,036 is attributed to a reduction in gains on the sale of mortgage loans
to the secondary market which peaked during the third quarter of 2003. Other
expenses were relatively unchanged at $15,528 compared to $15,531 from the year
ago period. Applicable income taxes decreased $620 mainly from increased
tax-free income along with lower net income.
Net Interest Income and Net Interest Margin
Net interest income, the largest contributor to the Company's earnings, is
defined as the difference between interest income on assets and the cost of
funds supporting those assets. Earning assets are composed primarily of loans
and investments while deposits, short-term and long-term borrowings represent
interest-bearing liabilities. Variations in the volume and mix of these assets
and liabilities, as well as changes in the yields earned and rates paid, are
determinants of changes in net interest income.
Net interest income after provision for loan losses increased $232 or 5.5% to
$4,477 for the three months ended September 30, 2004 compared to $4,245 for the
three months ended September 30, 2003. Earning assets increased 19 basis points,
largely due to the increases in investments and loans, along with lower interest
expense on time deposits and long-term borrowings. Offsetting this increase was
an increase in the provision for loan losses from $1 in 2003 to $114 in 2004.
The net interest margin represents the Company's net yield on its earning assets
and is calculated as net interest income divided by average earning assets. In
the three months ended September 30, 2004, net interest margin was 3.28%
increasing 35 basis points from 2.93% in the same period of 2003.
Total average earning assets and average interest bearing funds decreased in the
three months ended September 30, 2004 as compared to 2003. Average earning
assets decreased $19.3 million or 3.3%, from $579.7 million in 2003 to $560.4
million in 2004 and average interest bearing funds decreased $22.9 million, or
5.0%, from $459.4 million to $436.5 million for the same period, mainly due to a
reduction of time deposits from September 2003. As a percentage of average
assets, earning assets increased to 96.3% for the three months ended September
30, 2004 from 96.0% for the year ago period.
Changes in the mix of both earning assets and funding sources also impacted net
interest income in the three months ended September 30, 2004 and 2003. Average
loans as a percentage of average earning assets increased from 42.8% in 2003 to
46.0% in 2004, due largely to the increase in commercial and real estate loans.
Average investments increased $37.6 million from 44.1% to 52.3% of average
assets but at lower yields than 2003. Average short-term investments, federal
funds sold and interest bearing balances with banks, decreased $66.6 million to
$9.3 from $75.9 and also decreased as a percentage of average earning assets
from 13.1% in 2003 to 1.7% in 2004 as the Company invested in tax-free
securities. Average time deposits decreased $19.0 million or 13.7% from 30.1% of
interest bearing liabilities in 2003 to 27.4% in 2004. Average long-term
borrowings decreased $8.9.
Shifts in the interest rate environment and competitive factors affected the
rates paid for funds as well as the yields earned on assets. The investment
securities tax equivalent yield decreased 25 basis points from 4.93% in the
three months ended September 30, 2003 to 4.68% for 2004. Also, average loan
yields decreased 10 basis points, from 5.48% in the three months ended September
30, 2003 to 5.38% in 2004.
The average time deposit costs decreased 28 basis points from 2.56% in 2003 to
2.28% in 2004; however money market accounts increased 4 basis points from .74%
in 2003 to .78% in 2004.
The most significant change in net interest income has been from increases in
our loan portfolio along with increased tax-free income from the investment
portfolio.
In 2003, the Company purchased a FHLMC (Freddie Mac) pool of new twenty year
residential mortgages, with a 5 1/2% coupon and a face value of $100 million.
The Company financed the purchase by borrowing $100 million from the Federal
Home Loan Bank with maturities ranging from 5 to 20 years. The interest spread
will vary depending on various interest rate scenarios which affect prepayment
speeds.
Distribution of Assets, Liabilities and Stockholders' Equity / Interest Rates
and Interest Differential
The table below presents average balances, interest income on a fully taxable
equivalent basis and interest expense, as well as average rates earned and paid
on the Company's major asset and liability items for the three months ended
September 30, 2004 and September 30, 2003.
- ----------------------------------------------------------------------------------------------------------
September 30, 2004 September 30, 2003
ASSETS Average Revenue/ Yield/ Average Revenue/ Yield/
Balance Expense Rate Balance Expense Rate
- ----------------------------------------------------------------------------------------------------------
Investment Securities
Available-for-sale:
U.S. Treasury securities $ 5,200 $ 86 6.62% $ 31,034 $ 326 4.20%
U.S. Agency obligations 134,351 1,094 3.26% 72,719 871 4.79%
States & political subdivisions 47,062 538 6.93% 20,994 265 7.65%
Federal Home Loan Bank stock 5,894 19 1.29% 6,113 31 2.03%
Other 567 2 1.41% 448 2 1.79%
Held-to-maturity:
U.S. Agency obligations 70,867 796 4.49% 94,711 944 3.99%
States & political
subdivisions 29,248 409 8.47% 29,540 380 7.79%
Loans, net of unearned income:
Real estate mortgages 187,013 2,571 5.50% 183,014 2,554 5.58%
Commercial 37,090 465 5.01% 30,660 394 5.14%
Consumer and other 33,826 432 5.11% 34,607 453 5.24%
Federal funds sold 3,519 14 1.59% 62,615 147 0.94%
Interest on balances with banks 5,787 16 1.11% 13,236 28 0.85%
- ----------------------------------------------------------------------------------------------------------
Total Earning Assets/Total Interest
Income 560,424 $ 6,442 4.60% 579,691 $ 6,395 4.41%
- ----------------------------------------------------------------------------------------------------------
Cash and due from banks 8,816 9,053
Bank premises and equipment 9,502 10,214
Accrued interest receivable 3,391 3,014
Other assets 3,309 5,324
Less: Allowance for loan losses 3,498 3,504
- ----------------------------------------------------------------------------------------------------------
Total Assets $ 581,944 $ 603,792
- ----------------------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Demand-Interest bearing $ 32,484 $ 26 0.32% $ 29,581 $ 24 0.32%
Savings 82,997 73 0.35% 77,896 97 0.50%
Money markets 89,365 174 0.78% 92,805 172 0.74%
Time - Over $100 27,886 164 2.35% 32,605 202 2.48%
Time - Other 91,478 517 2.26% 105,774 682 2.58%
Federal funds purchased - - - - - -
Repurchase agreements 23,876 44 0.74% 23,518 43 0.73%
Short-term borrowings 525 2 1.52% 444 1 0.90%
Long-term borrowings 87,851 851 3.87% 96,754 928 3.84%
- ----------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities/
Total Interest Expense 436,462 $ 1,851 1.70% 459,377 $ 2,149 1.87%
- ----------------------------------------------------------------------------------------------------------
Demand - Non-interest bearing 85,225 80,405
All other liabilities 349 2,739
Stockholders' equity 59,908 61,271
- ----------------------------------------------------------------------------------------------------------
Total Liabilities and
Stockholders' Equity $ 581,944 $ 603,792
- ----------------------------------------------------------------------------------------------------------
Interest Spread 2.90% 2.54%
- ----------------------------------------------------------------------------------------------------------
Net Interest Income $ 4,591 $ 4,246
- ----------------------------------------------------------------------------------------------------------
FINANCIAL RATIOS
Net interest margin 3.28% 2.93%
Return on average assets 1.11% 1.06%
Return on average equity 10.78% 10.46%
Average equity to average assets 10.29% 10.15%
Dividend payout ratio 38.87% 40.13%
- ----------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses decreased $172 or 1.3% to
$13,035 for the nine months ended September 30, 2004 compared to $13,207 for the
nine months ended September 30, 2003. Earning assets repriced downward 42 basis
points, largely due to the reduction in our average loan portfolio for the nine
months of 2004 versus 2003, due to the refinancing of residential portfolio
mortgage loans with lower fixed-rate obligations, which then were sold to the
secondary market and peaked during the third quarter of 2003. Offsetting this
decrease was increased securities portfolio income and a reduction in the
provision for loan losses from $456 in 2003 to $135 in 2004.
The net interest margin represents the Company's net yield on its earning assets
and is calculated as net interest income divided by average earning assets. In
the nine months of 2004, net interest margin was 3.12% decreasing 25 basis
points from 3.37% in the same period of 2003.
Total average earning assets and average interest bearing funds increased in the
nine months ended September 30, 2004 as compared to 2003. Average earning assets
increased $21.7 million or 4.0%, from $540.9 million in 2003 to $562.6 million
in 2004 and average interest bearing funds increased $13.4 million, or 3.2%,
from $425.1 million to $438.5 million for the same period. As a percentage of
average assets, earning assets increased to 96.4% for the nine months ended
September 30 of 2004 from 95.9% for the year ago period.
Changes in the mix of both earning assets and funding sources also impacted net
interest income in the nine months ended September 30, 2004 and 2003. Average
loans as a percentage of average earning assets decreased from 49.8% in 2003 to
44.6% in 2004, due in part to the sale of all new and refinanced fixed rate
mortgages in the secondary market, which peaked during the third quarter of
2003; also, the increase in total assets caused by the leveraged transaction
noted below during 2003; average investments increased $66.9 million from 42.5%
to 52.8%. Average short-term investments, federal funds sold and interest
bearing balances with banks decreased $26.4 million to $15.0 from $41.4 and also
decreased as a percentage of average earning assets from 7.7% in 2003 to 2.7% in
2004 as the Company invested in tax-free securities. Average time deposits
decreased $17.2 million or 12.2% from 33.1% of interest bearing liabilities in
2003 to 28.2% in 2004. However, average short-term borrowings, long-term
borrowings and repurchase agreements increased $20.5 from 21.7% in 2003 to 25.7%
in 2004, as a percentage of funding sources, principally related to the
leveraged transaction described below.
Shifts in the interest rate environment and competitive factors affected the
rates paid for funds as well as the yields earned on assets. The investment
securities tax equivalent yield decreased 63 basis points from 5.26% for the
nine months ended September 30, 2003 to 4.63% for 2004. Also, average loan
yields decreased 44 basis points, from 5.66% for the nine months ended September
30, 2003 to 5.22% in 2004.
The average time deposit costs decreased 47 basis points from 2.75% in 2003 to
2.28% in 2004, along with money market accounts decreasing 15 basis points from
..88% in 2003 to .73% in 2004. These reductions are offset by the interest on new
fixed-rate, long-term borrowings.
The most significant change in net interest income has been the reduction in our
loan portfolio during 2003 due to the refinancing of higher rate, long-term,
fixed-rate real estate loans, which were sold to the secondary market. A gain on
the sale of mortgage loans partially offset the decline in net interest income,
during 2003.
During 2004 net loans increased to $260 from $237, an increase of $23 or 9.7%
In 2003, the Company purchased a FHLMC (Freddie Mac) pool of new twenty year
residential mortgages, with a 5 1/2% coupon and a face value of $100 million.
The Company financed the purchase by borrowing $100 million from the Federal
Home Loan Bank with maturities ranging from 5 to 20 years. The interest spread
will vary depending on various interest rate scenarios which affect prepayment
speeds.
Distribution of Assets, Liabilities and Stockholders' Equity / Interest Rates
and Interest Differential
The table below presents average balances, interest income on a fully taxable
equivalent basis and interest expense, as well as average rates earned and paid
on the Company's major asset and liability items for the nine months ended
September 30, 2004 and September 30, 2003.
- ----------------------------------------------------------------------------------------------------------
September 30, 2004 September 30, 2003
ASSETS Average Revenue/ Yield/ Average Revenue/ Yield/
Balance Expense Rate Balance Expense Rate
- ----------------------------------------------------------------------------------------------------------
Investment Securities
Available-for-sale:
U.S. Treasury securities $ 6,575 $ 285 5.78% $ 32,900 $ 1,013 4.11%
U.S. Agency obligations 135,161 3,322 3.28% 70,231 2,650 5.03%
States & political subdivisions 43,127 1,470 6.89% 20,358 705 7.00%
Federal Home Loan Bank stock 5,714 62 1.45% 4,550 80 2.34%
Other 537 10 2.48% 414 8 2.58%
Held-to-maturity:
U.S. Agency obligations 76,519 2,581 4.50% 71,674 2,399 4.46%
States & political subdivisions 29,294 1,205 8.31% 29,840 1,222 8.27%
Loans, net of unearned income:
Real estate mortgages 181,477 7,228 5.31% 200,403 8,832 5.88%
Commercial 35,041 1,274 4.85% 31,367 1,150 4.89%
Consumer and other 34,214 1,314 5.12% 37,803 1,461 5.15%
Federal funds sold 7,161 57 1.06% 31,812 236 0.99%
Interest on balances with banks 7,790 53 0.91% 9,550 68 0.95%
- ----------------------------------------------------------------------------------------------------------
Total Earning Assets/Total Interest
Income 562,610 $ 18,861 4.47% 540,902 $ 19,824 4.89%
- ----------------------------------------------------------------------------------------------------------
Cash and due from banks 8,576 8,473
Bank premises and equipment 9,683 9,965
Accrued interest receivable 3,172 3,177
Other assets 3,165 4,902
Less: Allowance for loan losses 3,498 3,383
- ----------------------------------------------------------------------------------------------------------
Total Assets $ 583,708 $ 564,036
- ----------------------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Demand-Interest bearing $ 31,312 $ 76 0.32% $ 28,298 $ 109 0.51%
Savings 81,928 274 0.45% 76,124 372 0.65%
Money markets 89,071 490 0.73% 87,784 579 0.88%
Time - Over $100 28,936 501 2.31% 33,150 676 2.72%
Time - Other 94,605 1,613 2.27% 107,523 2,226 2.76%
Federal funds purchased - - - - - -
Repurchase agreements 22,144 121 0.73% 21,031 134 0.85%
Short-term borrowings 476 4 1.12% 820 10 1.63%
Long-term borrowings 90,072 2,612 3.87% 70,348 2,055 3.89%
- ----------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities/
Total Interest Expense 438,544 $ 5,691 1.73% 425,078 $ 6,161 1.93%
- ----------------------------------------------------------------------------------------------------------
Demand - Non-interest bearing 82,517 75,829
All other liabilities 1,580 2,849
Stockholders' equity 61,067 60,280
- ----------------------------------------------------------------------------------------------------------
Total Liabilities and
Stockholders' Equity $ 583,708 $ 564,036
- ----------------------------------------------------------------------------------------------------------
Interest Spread 2.74% 2.96%
- ----------------------------------------------------------------------------------------------------------
Net Interest Income $ 13,170 $ 13,663
- ----------------------------------------------------------------------------------------------------------
FINANCIAL RATIOS
Net interest margin 3.12% 3.37%
Return on average assets 0.94% 1.12%
Return on average equity 9.00% 10.50%
Average equity to average assets 10.46% 10.69%
Dividend payout ratio 46.88% 40.68%
- ----------------------------------------------------------------------------------------------------------
Investments
The Company's investment portfolio consists primarily of two functions: One to
provide liquidity and two to contribute to earnings. To provide liquidity the
Company may invest in short-term securities such as Federal funds sold, interest
bearing deposits with banks, U.S. Treasury securities and U.S. Agency securities
all with maturities of one year or less. These funds are invested short-term to
ensure the availability of funds to meet customer demand for credit needs. The
Company enhances interest income by securing long-term investments within its
investment portfolio, by means of U.S. Treasury securities, U.S. Agency
securities, municipal securities and mortgage-backed securities generally with
maturities greater than one year.
Investments in securities are classified in two categories and accounted for as
follows:
Securities Held-to-Maturity Bonds, notes, debentures and mortgage-backed
securities for which the Company has the positive intent and ability to hold to
maturity are reported at cost, adjusted for amortization of premiums and
accretion of discounts computed on the straight-line basis, which approximates
the interest method, over the remaining period to maturity.
Securities Available-for-Sale Bonds, notes, debentures, mortgage-backed
securities and certain equity securities not classified as securities to be held
to maturity are carried at fair value with unrealized holding gains and losses,
net of tax, reported as a net amount in a separate component of stockholders'
equity until realized.
The amortization of premiums on mortgage-backed securities is determined based
on management's estimate of the lives of the securities, adjusted, when
necessary, for advanced prepayments in excess of those estimates.
Gains and losses on the sale of securities available-for-sale are determined
using the specific identification method and are reported as a separate
component of other income in the Statements of Income.
During 2003, the Company experienced accelerated pre-payments of its fixed-rate
mortgage-backed securities portfolio, due to the historically low-rate interest
environment. Additionally, amortization of the bond premium was also accelerated
relative to the increased pre-payments of principal on the mortgage-backed
securities, which impacted earnings on a negative basis. The proceeds of the
pre-payments have been reinvested in long-term municipal securities at tax
equivalent yields higher than the Company was receiving on the mortgage-backed
securities.
Deposits
The Company is largely dependent on its core deposit base to fund operations.
Management has competitively priced its deposit products in checking, savings,
money market and time deposits to provide a stable source of funding.
As the economy shows strength and improves, migration of some deposits may
return to the equity markets as consumers become more prone to increased yields.
Historically, such changes in the Company's deposit base have been minimal.
Provision for Loan Losses
The provision for loan losses represents management's determination of the
amount necessary to bring the allowance for loan losses to a level that
management considers adequate to reflect the risk of future losses inherent in
the Company's loan portfolio. The process of determining the adequacy of the
allowance is necessarily judgmental and subject to changes in external
conditions. The allowance for loan losses reflects management's judgment as to
the level considered appropriate to absorb such losses based upon a review of
many factors, including historical loss experience, adverse situations that may
affect the borrower's ability to repay (including the timing of future
payments), economic conditions and trends, loan portfolio volume and mix, loan
performance trends, the value and adequacy of collateral, and the Company's
internal credit review process. Accordingly, there can be no assurance that
existing levels of the allowance will ultimately prove adequate to cover actual
loan losses. The quarterly provision for loan losses charged to operating
expense is that amount which is sufficient to bring the balance of the allowance
for possible loan losses to an adequate level to absorb anticipated losses.
Based on this ongoing evaluation, management determines the provision necessary
to maintain an appropriate allowance.
For the three months ended September 30, 2004, the provision for loan losses
increased to $114 from $1 in the three months ended September 30, 2003. Loans
charged off totaled $15 and recoveries were $1 for the three months ended
September 30, 2004. In the same period of 2003, loans charged off were $29 and
recoveries were $28. In the
nine months ended September 30, 2004, the provision for loan losses was $135, a
decrease from $456 in the nine months ended September 30, 2003. Loans
charged-off totaled $43 and recoveries of $8 for the nine months ended September
30, 2004. In the same period of 2003 loans charged off were $334, offset by
recoveries of $31. At September 30, 2004 the allowance for loan losses was set
at $3,600 or 1.36% of loans based upon the bank's analysis methodology as an act
of prudence by management.
Other Income
The following table sets forth information by category of other income for the
Company for three months ended September 30, 2004 and September 30, 2003,
respectively:
September 30, September 30,
Three Months Ended: 2004 2003
- ------------------------------------------------------------------------
Trust department income $ 372 $ 345
Service charges on deposit accounts 271 283
Merchant transaction income 1,698 1,729
Other fee income 289 328
Other operating income 200 549
Realized gains (losses) on securities, net - -
- ------------------------------------------------------------------------
Total Other Income $ 2,830 $ 3,234
- ------------------------------------------------------------------------
Other income decreased $404 or 12.5% to $2,830 for the three months ended
September 30, 2004 compared with $3,234 for the similar period of 2003. Trust
income increased $27 or 7.8% largely due to new business. Other fee income
decreased $39 or 11.9% mainly from reduced income from mortgage loans serviced
for others. Other operating income decreased $349 or 63.6%, primarily due to a
reduction in gains on the sale of loans in the secondary market of $367, which
peaked during the third quarter of 2003, offset by increased brokerage income of
$22 largely due to new business.
The following table sets forth information by category of other income for the
Company for nine months ended September 30, 2004 and September 30, 2003,
respectively:
September 30, September 30,
Nine Months Ended: 2004 2003
- ------------------------------------------------------------------------
Trust department income $ 1,014 $ 981
Service charges on deposit accounts 810 848
Merchant transaction income 4,097 4,141
Other fee income 848 923
Other operating income 481 1,432
Realized gains (losses) on securities, net - -
- ------------------------------------------------------------------------
Total Other Income $ 7,250 $ 8,325
- ------------------------------------------------------------------------
Other income decreased $1,075 or 12.9% to $7,250 for the nine months ended
September 30, 2004 from $8,325 for the same period of 2003. Trust income
increased $33 or 3.4%. Other fee income decreased $75 or 8.8% mainly due to
reduced cardholder discounts and income from sold mortgages serviced for others.
Other operating income decreased $951 or 66.4%, primarily due to a reduction in
gains on the sale of loans in the secondary market of $1,036, which peaked
during the third quarter of 2003, offset by increased brokerage income of $83 or
26.1% largely due to new business.
Other Expenses
The following table sets forth information by category of other expenses for the
Company for the three months ended September 30, 2004 and September 30, 2003,
respectively:
September 30, September 30,
Three Months Ended: 2004 2003
- ------------------------------------------------------------------------
Salaries and employee benefits $ 2,235 $ 2,219
Expense of premises and fixed assets 556 607
Merchant transaction expenses 1,344 1,378
Other operating expenses 1,251 1,218
- ------------------------------------------------------------------------
Total Other Expenses $ 5,386 $ 5,422
- ------------------------------------------------------------------------
Total other expenses decreased $36 to $5,386 in the three months ended September
30, 2004 compared with $5,422 for the same period of 2003.
Applicable income taxes decreased $148 due to increased tax-free income.
The following table sets forth information by category of other expenses for the
Company for the nine months ended September 30, 2004 and September 30, 2003,
respectively:
September 30, September 30,
Nine Months Ended: 2004 2003
- ------------------------------------------------------------------------
Salaries and employee benefits $ 6,792 $ 6,619
Expense of premises and fixed assets 1,837 1,929
Merchant transaction expenses 3,281 3,437
Other operating expenses 3,618 3,546
- ------------------------------------------------------------------------
Total Other Expenses $ 15,528 $ 15,531
- ------------------------------------------------------------------------
Total other expenses decreased $3 to $15,528 during the nine months ended
September 30, 2004 compared with $15,531 for the same period of 2003. Salaries
and employment benefits expense increased $173 or 2.6%, mainly from increases in
salaries of $100, employee hospitalization of $35 and employee education costs
of $25, offset by decreased merchant transaction expense of $156 or 4.5%.
Applicable income taxes decreased $620 mainly due to increased tax-free income
along with lower net income.
Loan Portfolio
Details regarding the Company's loan portfolio:
September 30, December 31,
As Of: 2004 2003
- --------------------------------------------------------------------------------
Real estate - construction and land development $ 5,737 $ 3,078
Real estate mortgages 187,217 172,964
Commercial 37,137 30,056
Credit card and related plans 2,451 2,403
Installment 25,459 25,855
Obligations of states & political subdivisions 5,979 6,026
- --------------------------------------------------------------------------------
Loans, net of unearned income 263,980 240,382
Less: Allowance for loan losses 3,600 3,500
- --------------------------------------------------------------------------------
Loans, net $ 260,380 $ 236,882
- --------------------------------------------------------------------------------
Loan Quality
The comprehensive lending policy established by the Board of Directors guides
the lending activities of the Company. Loans must meet criteria, which include
consideration of the character, capacity and capital of the borrower, collateral
provided for the loan, and prevailing economic conditions.
Regardless of credit standards, there is risk of loss inherent in every loan
portfolio. The allowance for loan losses is an amount that management believes
will be adequate to absorb possible losses on existing loans that may become
uncollectible, based on evaluations of the collectibility of the loans. The
evaluations take into consideration such factors as change in the nature and
volume of the loan portfolio, overall portfolio quality, review of specific
problem loans, industry experience, collateral value and current economic
conditions that may affect the borrower's ability to pay. Management believes
that the allowance for loan losses is adequate. While management uses available
information to recognize losses on loans, future additions to the allowance may
be necessary based on changes in economic conditions. In addition, various
regulatory agencies, as an integral part of their examination process,
periodically review the Company's allowance for loan losses. Such agencies may
require the Company to recognize additions to the allowance based on their
judgment of information available to them at the time of their examination.
The allowance for loan losses is increased by periodic charges against earnings
as a provision for loan losses, and decreased periodically by charge-offs of
loans (or parts of loans) management has determined to be uncollectible, net of
actual recoveries on loans previously charged-off.
Non-Performing Assets
Non-performing assets consist of non-accrual loans, loans past due 90 days or
more and still accruing interest and other real estate owned. The following
table sets forth information regarding non-performing assets as of the dates
indicated:
September 30, December 31, September 30,
As Of: 2004 2003 2003
- ----------------------------------------------------------------------------------------------
Non-accrual loans $ 2,253 $ 1,533 $ 2,192
Loans past due 90 days or more and accruing:
Guaranteed student loans 245 169 227
Credit card and home equity loans 2 3 24
- ----------------------------------------------------------------------------------------------
Total non-performing loans 2,500 1,705 2,443
Other real estate owned 44 121 278
- ----------------------------------------------------------------------------------------------
Total non-performing assets $ 2,544 $ 1,826 $ 2,721
- ----------------------------------------------------------------------------------------------
Loans are generally placed on a non-accrual status when principal or interest is
past due 90 days or when payment in full is not anticipated. When a loan is
placed on non-accrual status, all interest previously accrued but not collected
is charged against current income. Loans are returned to accrual status when
past due interest is collected and the collection of principal is probable.
Loans on which the accrual of interest has been discontinued or reduced amounted
to $2,253 and $2,192 at September 30, 2004 and September 30, 2003, respectively.
If interest on those loans had been accrued, such income would have been $265
and $195 for the nine months ended September 30, 2004 and September 30, 2003,
respectively. Interest income on those loans, which is recorded only when
received, amounted to $27 and $34 for September 30, 2004 and September 30, 2003,
respectively. There are no commitments to lend additional funds to individuals
whose loans are in non-accrual status.
The management process for evaluating the adequacy of the allowance for loan
losses includes reviewing each month's loan committee reports, which list all
loans that do not meet certain internally developed criteria as to collateral
adequacy, payment performance, economic conditions and overall credit risk.
These reports also address the current status and actions in process on each
listed loan. From this information, adjustments are made to the allowance for
loan losses. Such adjustments include both specific loss allocation amounts and
general provisions by loan category based on present and past collection
experience, nature and volume of the loan portfolio, overall quality, and
current economic conditions that may affect the borrower's ability to pay. As of
September 30, 2004 there are no significant loans as to which management has
serious doubt about their collectibility other than what is included above.
At September 30, 2004 and December 31, 2003, the Company did not have any loans
specifically classified as impaired.
Most of the Company's lending activity is with customers located in the
Company's geographic market area and repayment thereof is affected by economic
conditions in this market area.
Loan Loss Experience
The following tables present the Company's loan loss experience during the
periods indicated:
September 30, September 30,
Three Months Ended: 2004 2003
- --------------------------------------------------------------------------
Balance at beginning of period $ 3,500 $ 3,500
Charge-offs:
Real estate mortgages - -
Commercial and all others - 13
Credit card and related plans 10 15
Installment loans 5 1
- --------------------------------------------------------------------------
Total charge-offs 15 29
- --------------------------------------------------------------------------
Recoveries:
Real estate mortgages - 24
Commercial and all others - -
Credit card and related plans - -
Installment loans 1 4
- --------------------------------------------------------------------------
Total recoveries 1 28
- --------------------------------------------------------------------------
Net charge-offs (recoveries) 14 1
- --------------------------------------------------------------------------
Provision charged to operations 114 1
- --------------------------------------------------------------------------
Balance at End of Period $ 3,600 $ 3,500
- --------------------------------------------------------------------------
Ratio of net charge-offs (recoveries)
to average loans outstanding 0.005% 0.001%
- --------------------------------------------------------------------------
September 30, September 30,
Nine Months Ended: 2004 2003
- --------------------------------------------------------------------------
Balance at beginning of period $ 3,500 $ 3,347
Charge-offs:
Real estate mortgages - 6
Commercial and all others 12 289
Credit card and related plans 23 35
Installment loans 8 4
- --------------------------------------------------------------------------
Total charge-offs 43 334
- --------------------------------------------------------------------------
Recoveries:
Real estate mortgages 3 24
Commercial and all others - -
Credit card and related plans 2 2
Installment loans 3 5
- --------------------------------------------------------------------------
Total recoveries 8 31
- --------------------------------------------------------------------------
Net charge-offs (recoveries) 35 303
- --------------------------------------------------------------------------
Provision charged to operations 135 456
- --------------------------------------------------------------------------
Balance at End of Period $ 3,600 $ 3,500
- --------------------------------------------------------------------------
Ratio of net charge-offs (recoveries)
to average loans outstanding 0.014% 0.112%
- --------------------------------------------------------------------------
Due to the continuing economic uncertainties, management believes the allowance
for loan losses is considered adequate based on its methodology. The allowance
for loan losses, as a percentage of total loans, stands at 1.36% at September
30, 2004 and 1.45% at September 30, 2003.
The allowance for loan losses is allocated as follows:
As Of: September 30, 2004 December 31, 2003 September 30, 2003
- -----------------------------------------------------------------------------------------------
Amount %* Amount %* Amount %*
- -----------------------------------------------------------------------------------------------
Real estate mortgages $ 1,100 73% $ 1,100 73% $ 1,400 73%
Commercial and all others 2,070 16% 1,970 15% 1,575 15%
Credit card and related plans 180 1% 180 1% 175 1%
Personal installment loans 250 10% 250 11% 350 11%
- -----------------------------------------------------------------------------------------------
Total $ 3,600 100% $ 3,500 100% $ 3,500 100%
- -----------------------------------------------------------------------------------------------
* Percent of loans in each category to total loans
Liquidity
The objective of liquidity management is to maintain a balance between sources
and uses of funds in such a way that the cash requirements of customers for
loans and deposit withdrawals are met in the most economical manner. Management
monitors its liquidity position continuously in relation to trends of loans and
deposits for short-term as well as long-term requirements. Liquid assets are
monitored on a daily basis to assure maximum utilization. Management also
manages its liquidity requirements by maintaining an adequate level of readily
marketable assets and access to short-term funding sources. Management does not
foresee any adverse trends in liquidity.
The Company remains in a highly liquid condition both in the short and long
term. Sources of liquidity include the Company's U.S. Treasury and U.S. Agency
bond portfolios, additional deposits, earnings, overnight loans to and from
other companies (Federal funds) and lines of credit at the Federal Reserve Bank
and the Federal Home Loan Bank. The Company is not a party to any commitments,
guarantees or obligations that could materially affect its liquidity.
The Company offers collateralized repurchase agreements that have a one day
maturity, as an alternative deposit option for its customers. The Company also
has long-term debt outstanding to the FHLB, which was used to purchase a Freddie
Mac pool of residential mortgages, as described earlier in this report. The
Company continues to have $180,530 of available borrowing capacity with the
FHLB.
Commitments and Contingent Liabilities
In the normal course of business, there are outstanding commitments and
contingent liabilities, created under prevailing terms and collateral
requirements such as commitments to extend credit, financial guarantees and
letters of credit, which are not reflected in the accompanying Financial
Statements. The Company does not anticipate any losses as a result of these
transactions. These instruments involve, to varying degrees, elements of credit
and interest rate risk in excess of the amount recognized in the Balance Sheets.
The contract or notional amounts of those instruments reflect the extent of
involvement the Company has in particular classes of financial instruments.
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of any condition established in the contract. Commitments
generally have expiration dates of one year or less or other termination clauses
and may require payment of a fee. Since many of the commitments are expected to
expire without being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements.
Standby letters of credit are conditional commitments issued to guarantee the
performance of a customer to a third party. The credit risk involved in issuing
letters of credit is essentially the same as that involved in extending loan
facilities to customers.
Related Parties
The Company does not have any material transactions involving related persons or
entities, other than traditional banking transactions, which are made on the
same terms and conditions as those prevailing at the time for comparable
transactions with unrelated parties. The Bank has issued standby letters of
credit for the account of a related party in the amount of $6,853.
Capital Resources
A strong capital position is important to the continued profitability of the
Company and promotes depositor and investor confidence. The Company's capital
provides a basis for future growth and expansion and also provides additional
protection against unexpected losses.
Additional sources of capital would come from retained earnings from the
operations of the Company and from the sale of additional common stock.
Management has no plans to offer additional common stock at this time.
The Company's total risk-based capital ratio was 19.95% at September 30, 2004.
The Company's risk-based capital ratio is more than the 10.00% ratio that
Federal regulators use as the "well capitalized" threshold. This is the current
criteria which the FDIC uses in determining the lowest insurance rate for
deposit insurance. The Company's risk-based capital ratio is more than double
the 8.00% limit, which determines whether a company is "adequately capitalized".
Under these rules, the Company could significantly increase its assets and still
comply with these capital requirements without the necessity of increasing its
equity capital.
Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act, enacted in July of 2002, continues to impact the
Company. A recalculation of our public float as of June 30, 2003 and 2004
determined that the Company is not subject to the accelerated filing deadlines
of the Securities and Exchange Commission (SEC) which reduced the number of days
accelerated filers have to issue the 2004 Annual Report (Form 10-K) from 75 to
60 days. Similarly, for accelerated filers, the quarterly reports for 2004 have
to be filed within 40 days of the end of each quarter from 45 days in prior
years. In 2005, accelerated filers will lose another 5 days and quarterly
reports will need to be filed within 35 days of the end of each quarter.
Although not subject to the accelerated filing dates we do intend to file our
quarterly reports this year within 40 days of the end of each quarter.
Section 404 of the Act requires that, for the Company, commencing with the
Annual Report for year 2005, which must be filed with the SEC by March 1, 2006,
and for each year thereafter, the report must include an internal control report
that contains management's assertions regarding the effectiveness of the
Company's internal control structure and procedures over financial reporting.
The Company's auditors must also provide an opinion about whether management's
assessment of the effectiveness of its internal control over financial reporting
is fairly stated in all material respects. This provision will require
management to document each type of transaction that occurs in the Company, the
risks involved in the transaction, the internal controls established to mitigate
such risks, information and communication of the results and finally a
monitoring of the controls. Affecting all of this is the control environment
within the Company. All of this must be accomplished by December 31, 2005, and
due to this, management is already spending an enormous amount of time
documenting the internal control processes within the Company.
PART 1. FINANCIAL INFORMATION, Item 3 --
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss from adverse changes in market prices and rates.
The Company's market risk arises principally from interest rate risk inherent in
its lending, deposit and borrowing activities. Management actively monitors and
manages its interest rate risk exposure. Although the Company manages other
risks, such as credit quality and liquidity risk in the normal course of
business, management considers interest rate risk to be its most significant
market risk and the risk that could potentially have the largest material effect
on the Company's financial condition and results of operations. Other types of
market risks such as foreign currency exchange risk and commodity price risk do
not arise in the normal course of community banking activities.
Achieving consistent growth in net interest income is the primary goal of the
Company's asset/liability function. The Company attempts to control the mix and
maturities of assets and liabilities to achieve consistent growth in net
interest income despite changes in market interest rates. The Company seeks to
accomplish this goal while maintaining adequate liquidity and capital. A
continuation of historically low interest rates will most likely affect
negatively the Company's net interest income. The Company continues to evaluate
its mix of assets and liabilities in response to the changing economy.
PART 1. FINANCIAL INFORMATION, Item 4 --
CONTROLS AND PROCEDURES
Based on the evaluations by the Company's principal executive officer, Otto P.
Robinson, Jr., President and the Company's principal financial officer, Patrick
Scanlon, Controller, of the Company's Disclosure Controls and Procedures as of
September 30, 2004, they have concluded that the Company's disclosure controls
are effective, reasonably ensure that material information relating to the
Company and its consolidated subsidiaries is made known to them by others within
those entities, particularly during the period in which this report is being
prepared, and identify significant deficiencies or material weaknesses in
internal controls which could adversely affect the Company's ability to record,
process, summarize and report financial data.
Based on information available to them, they are not aware of significant
deficiencies or material weaknesses in the Company's internal control system.
Based on information available to them, they are not aware of any changes made
in internal controls or in other factors during the reporting period that could
materially affect or is reasonably likely to materially affect the Company's
internal controls over financial reporting.
Based on information available to them, they are not aware of any fraud that
involves management or other employees of the Company.
Despite these and other controls and procedures, the Company's two hundred or so
employees process over 10 million financial transactions every year. The
Company's computer systems consist of some 17 million lines of code used in the
processing of this financial information. Financial accounting rules encompass
thousands of pages of instructions and contain many confusing and "gray" areas.
From time to time honest errors in the entry, processing, or reporting of this
information are discovered or a dishonest or disloyal employee surfaces.
Fortunately, in the past any such errors or discoveries have not been material
and therefore we have never had to restate the Company's financial results. The
probability is that we won't in the future, but the possibility does exist and
the certifications marked as exhibits 31 and 32 are made subject to these
contingencies.
PART II. OTHER INFORMATION
Item 1 -- Legal Proceedings
None.
Item 2 -- Changes in Securities and Use of Proceeds
None.
Item 3 -- Defaults Upon Senior Securities
None.
Item 4 -- Submission of Matters to a Vote of Security Holders
None.
Item 5 -- Other Information
None.
Item 6 -- Exhibits and Reports on Form 8-K
a. Exhibits
31 Certifications required under Section 302 of the Sarbanes-Oxley Act
of 2002
32 Certifications required under Section 906 of the Sarbanes-Oxley Act
of 2002
b. Reports on Form 8-K
An 8-K was filed on August 18, 2004, reporting the impending retirement
of the Company's President Otto P. Robinson, Jr.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
PENSECO FINANCIAL SERVICES CORPORATION
By /s/ RICHARD E. GRIMM
------------------------------
Richard E. Grimm
Executive Vice-President
Dated: October 29, 2004
By /s/ PATRICK SCANLON
------------------------------
Patrick Scanlon
Controller
Dated: October 29, 2004