Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
GENERAL
The principal objective of this discussion is to provide an overview of the
financial condition and results of operations of Financial Institutions, Inc.
and its subsidiaries for the periods covered in this quarterly report. This
discussion and tabular presentations should be read in conjunction with the
accompanying consolidated financial statements and accompanying notes.
Income. The Company's results of operations are dependent primarily on net
interest income, which is the difference between the income earned on loans and
securities and the cost of funds, consisting of the interest paid on deposits
and borrowings. Results of operations are also affected by the provision for
loan losses, service charges on deposits, financial services group fees and
commissions, mortgage banking activities, gain or loss on the sale or call of
investment securities and other miscellaneous income.
Expenses. The Company's noninterest expenses primarily consist of salaries and
employee benefits, occupancy and equipment, supplies and postage, amortization
of intangible assets, computer and data processing, professional fees, other
miscellaneous expense and income tax expense. Results of operations are also
significantly affected by general economic and competitive conditions,
particularly changes in interest rates, government policies and the actions of
regulatory authorities.
OVERVIEW
Net income was $5.1 million, or $0.42 per share (diluted), and $4.1 million, or
$0.33 per share (diluted), for the quarter ended September 30, 2004 and 2003,
respectively. Return on average common equity (annualized) for the quarter ended
September 30, 2004 was 11.36%, compared to 8.70% for the same period a year ago.
Return on average assets (annualized) for the three months ended September 30,
2004 was 0.94%, compared to 0.75% for the same period a year ago.
Net income was $13.3 million, or $1.08 per share (diluted), and $12.0 million,
or $0.97 per share (diluted), for the nine months ended September 30, 2004 and
2003, respectively. Return on average common equity (annualized) for the nine
months ended September 30, 2004 was 9.79%, compared to 8.73% for the same period
a year ago. Return on average assets (annualized) for the nine months ended
September 30, 2004 was 0.81%, compared to 0.74% for the same period a year ago.
The improved earnings during 2004 is due primarily to a decrease in the
provision for loan losses, which was $2.1 million for the third quarter of 2004
and $9.5 million for the nine months ended September 30, 2004 compared to $5.6
million for the third quarter 2003 and $14.2 million for the nine months ended
September 30, 2003.
Net interest income, the principal source of the Company's earnings, was $19.2
million for the third quarter of 2004 compared to $18.5 million for the same
quarter last year. Net interest margin was 3.98% for the three months ended
September 30, 2004, an increase of 12 basis points from the 3.86% level for the
same quarter last year. Net interest income was $56.4 million for the nine
months ended September 30, 2004 compared to $56.6 million for the same period
last year. Net interest margin for the nine months ended September 30, 2004 was
3.88%, a drop of 7 basis points from 3.95% for the nine months ended
September 30, 2003.
As the Company has been actively working to reduce credit risk in the loan
portfolio and implement more stringent underwriting requirements, its loan
origination processes have slowed. The Company has made investments in people
and processes to provide for a stronger credit and sales culture within the
organization. The Company is in the process of expanding its loan origination
staff, providing additional training on the new credit processes and increasing
sales training activities in an effort to grow the loan portfolio. On October
13, 2004, the Company announced the appointment of James T. Rudgers as Senior
Vice President and Chief of Community Banking. In that position, Mr. Rudgers
will oversee and support the management of the Company's four banking
subsidiaries.
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CRITICAL ACCOUNTING POLICIES
The Company's consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States and are consistent
with predominant practices in the financial services industry. Application of
critical accounting policies, those policies that Management believes are the
most important to the Company's financial position and results, requires
Management to make estimates, assumptions, and judgments that affect the amounts
reported in the consolidated financial statements and accompanying notes and are
based on information available as of the date of the financial statements.
Future changes in information may affect these estimates, assumptions, and
judgments, which, in turn, may affect amounts reported in the financial
statements.
The Company has numerous accounting policies, of which the most significant are
presented in Note 1 of the Notes to Consolidated Financial Statements included
in the Company's Annual Report on Form 10-K as of December 31, 2003, dated
March 12, 2004, as filed with the Securities and Exchange Commission. These
policies, along with the disclosures presented in the other financial statement
notes and in this discussion, provide information on how significant assets,
liabilities, revenues and expenses are reported in the financial statements and
how those reported amounts are determined. Based on the sensitivity of financial
statement amounts to the methods, assumptions, and estimates underlying those
amounts, Management has determined that the accounting policies with respect to
the allowance for loan losses and goodwill require particularly subjective or
complex judgments important to the Company's financial position and results of
operations, and, as such, are considered to be critical accounting policies as
discussed below.
Allowance for Loan Losses: Arriving at an appropriate level of allowance
involves a high degree of judgment. The Company's allowance for loan losses
represents management's estimate of probable credit losses inherent in the loan
portfolio. Management uses historical information to assess the adequacy of the
allowance for loan losses and considers the prevailing business environment, as
it is affected by changing economic conditions and various external factors,
which may impact the loan portfolio. Management also uses a loan risk rating
system as well as current portfolio performance to determine the allowance. The
allowance is increased by provisions for loan losses and by recoveries of loans
previously charged-off and reduced by loans charged-off.
Goodwill: SFAS No. 141 requires that the purchase method of accounting be used
for all business combinations and further clarifies the criteria for the initial
recognition and measurement of intangible assets separate from goodwill. SFAS
No. 142 prescribes the accounting for goodwill and intangible assets subsequent
to initial recognition. The provisions of SFAS No. 142 discontinue the
amortization of goodwill and intangible assets with indefinite lives. Instead,
these assets are subject to at least an annual impairment review, and more
frequently if certain impairment indicators are in evidence. Changes in the
estimates and assumptions used to evaluate impairment may have a material impact
on the Company's consolidated financial statements or results of operations.
SFAS No. 142 also requires that reporting units be identified for the purpose of
assessing impairment of goodwill.
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FORWARD LOOKING STATEMENTS
This report contains certain forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended (the "Securities Act"),
and Section 21E of the Securities Exchange Act of 1934, as amended (the
"Exchange Act"), that involve substantial risks and uncertainties. When used in
this report, or in the documents incorporated by reference herein, the words
"anticipate", "believe", "estimate", "expect", "intend", "may", "project",
"plan", "seek" and similar expressions identify such forward-looking statements.
Actual results, performance or achievements could differ materially from those
contemplated, expressed or implied by the forward-looking statements contained
herein. These forward-looking statements are based on the current expectations
of the Company or the Company's management and are subject to a number of risks
and uncertainties, including but not limited to, economic, competitive,
regulatory, and other factors affecting the Company's operations, markets,
products and services, as well as expansion strategies and other factors
discussed elsewhere in this report filed by the Company with the Securities and
Exchange Commission. Many of these factors are beyond the Company's control.
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SELECTED FINANCIAL DATA
The following tables present certain information and ratios that management of
the Company considers important in evaluating performance:
At or For the Three Months Ended September 30,
2004 2003 $ Change % Change
Per common share data:
Net income - basic $ 0.42 $ 0.33 $ 0.09 27 %
Net income - diluted $ 0.42 $ 0.33 $ 0.09 27 %
Cash dividends declared $ 0.16 $ 0.16 $ - - %
Book value $ 15.21 $ 14.78 $ 0.43 3 %
Common shares outstanding:
Weighted average shares - basic 11,196,646 11,159,433
Weighted average shares - diluted 11,253,282 11,265,904
Period end 11,197,075 11,162,209
Performance ratios, annualized:
Return on average assets 0.94 % 0.75 %
Return on average common equity 11.36 % 8.70 %
Common dividend payout ratio 38.10 % 48.48 %
Net interest margin (tax-equivalent) 3.98 % 3.86 %
Efficiency ratio * 60.82 % 55.30 %
Asset quality data:
Past due over 90 days and accruing $ 1,179 $ 1,723
Restructured loans - 3,098
Nonaccrual loans 46,471 46,352
Other real estate owned 2,089 756
Total nonperforming assets $ 49,739 $ 51,929
Asset quality ratios:
Nonperforming loans to total loans 3.76 % 3.73 %
Nonperforming assets to total loans and other
real estate 3.92 % 3.78 %
Allowance for loan losses to total loans 2.46 % 2.12 %
Allowance for loan losses to nonperforming loans 65 % 57 %
Net loan charge-offs to average loans 0.60 % 0.89 %
Capital ratios:
Average common equity to average total assets 7.64 % 7.78 %
Leverage ratio 7.30 % 7.00 %
Tier 1 risk based capital ratio 11.21 % 9.99 %
Risk-based capital ratio 12.47 % 11.25 %
* The efficiency ratio represents noninterest expense less other real estate expense and amortization of intangibles divided by net interest income (tax
equivalent) plus other noninterest income less gain (loss) on sale of securities and gain on sale of credit card portfolio, calculated using the following
detail:
Noninterest expense $ 16,359 $ 14,896
Less: Other real estate expense 1 146
Amortization of intangibles 132 309
Net expense (numerator) $ 16,226 $ 14,441
Net interest income $ 19,227 $ 18,540
Plus: Tax equivalent adjustment 1,107 1,096
Net interest income (tax equivalent) 20,334 19,636
Plus: Noninterest income 6,360 7,059
Less: Gain on sale of securities 14 581
Net revenue (denominator) $ 26,680 $ 26,114
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SELECTED FINANCIAL DATA (CONTINUED)
At or For the Nine Months Ended September 30,
2004 2003 $ Change % Change
Per common share data:
Net income - basic $ 1.09 $ 0.98 $ 0.11 11 %
Net income - diluted $ 1.08 $ 0.97 $ 0.11 11 %
Cash dividends declared $ 0.48 $ 0.48 $ - - %
Common shares outstanding:
Weighted average shares - basic 11,183,651 11,142,055
Weighted average shares - diluted 11,248,307 11,244,866
Performance ratios, annualized:
Return on average assets 0.81 % 0.74 %
Return on average common equity 9.79 % 8.73 %
Common dividend payout ratio 44.04 % 48.98 %
Net interest margin (tax-equivalent) 3.88 % 3.95 %
Efficiency ratio * 60.49 % 55.87 %
Asset quality data and ratios:
Net loan charge-offs $ 7,355 $ 6,806
Net loan charge-offs to average loans 0.75 % 0.67 %
* The efficiency ratio represents noninterest expense less other real estate expense and amortization of intangibles divided by net interest income (tax
equivalent) plus other noninterest income less gain (loss) on sale of securities and gain on sale of credit card portfolio, calculated using the following
detail:
Noninterest expense $ 47,931 $ 45,419
Less: Other real estate expense 98 781
Amortization of intangibles 676 926
Net expense (numerator) $ 47,157 $ 43,712
Net interest income $ 56,380 $ 56,574
Plus: Tax equivalent adjustment 3,365 3,372
Net interest income (tax equivalent) 59,745 59,946
Plus: Noninterest income 19,477 19,321
Less: Gain on sale of securities 88 1,023
Gain on sale of credit card portfolio 1,177 -
Net revenue (denominator) $ 77,957 $ 78,244
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NET INCOME ANALYSIS
Average Balance Sheets
The tables on the following pages set forth certain information relating to the
Company's consolidated statements of financial condition and reflects the
average yields earned on interest-earning assets, as well as the average rates
paid on interest-bearing liabilities as of and for the periods presented.
Dividing interest income or interest expense by the average balances of
interest-earning assets or interest-bearing liabilities, respectively, derived
such yields and rates. Tax equivalent adjustments have been made. All average
balances are average daily balances. Nonaccrual loan balances are included in
the yield calculations in these tables.
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For The Three Months Ended September 30,
2004 2003
Average Interest Annualized Average Interest Annualized
Outstanding Earned/ Yield/ Outstanding Earned/ Yield/
(Dollars in thousands) Balance Paid Rate Balance Paid Rate
Interest-earning assets:
Federal funds sold and interest-bearing
deposits $ 14,320 $ 51 1.42 % $ 65,723 $ 171 1.03 %
Investment securities (1):
Taxable 494,475 5,081 4.11 % 348,650 3,477 3.99 %
Non-taxable 247,496 3,163 5.11 % 230,435 3,130 5.43 %
Total investment securities 741,971 8,244 4.44 % 579,085 6,607 4.56 %
Loans (2):
Commercial and agricultural 787,284 11,549 5.84 % 874,278 12,747 5.78 %
Residential real estate 249,736 4,182 6.70 % 259,537 4,638 7.15 %
Consumer and home equity 247,726 3,711 5.96 % 244,898 4,243 6.87 %
Total loans 1,284,746 19,442 6.03 % 1,378,713 21,628 6.23 %
Total interest-earning assets 2,041,037 27,737 5.42 % 2,023,521 28,406 5.58 %
Allowance for loans losses (31,290 ) (26,375 )
Other non-interest earning assets 166,161 160,262
Total assets $ 2,175,908 $ 2,157,408
Interest-bearing liabilities:
Savings and money market 420,514 659 0.62 % 401,828 833 0.82 %
Interest-bearing checking 386,588 681 0.70 % 387,250 794 0.81 %
Certificates of deposit 748,916 4,552 2.42 % 753,866 5,517 2.90 %
Borrowings 125,152 1,079 3.43 % 136,487 1,206 3.51 %
Guaranteed preferred beneficial interests in
Corporation's junior subordinated debentures - - - 16,200 420 10.35 %
Junior subordinated debentures issued to
unconsolidated subsidiary trust 16,702 432 10.35 % - - -
Total interest-bearing liabilities 1,697,872 7,403 1.73 % 1,695,631 8,770 2.05 %
Non-interest bearing demand deposits 277,192 254,528
Other non-interest-bearing liabilities 16,971 21,677
Total liabilities 1,992,035 1,971,836
Shareholders' equity (3) 183,873 185,572
Total liabilities and shareholders' equity $ 2,175,908 $ 2,157,408
Net interest income - tax equivalent 20,334 19,636
Less: tax equivalent adjustment 1,107 1,096
Net interest income $ 19,227 $ 18,540
Net interest rate spread 3.69 % 3.53 %
Net earning assets $ 343,165 $ 327,890
Net interest income as a percentage of
average interest-earning assets 3.98 % 3.86 %
Ratio of average interest-earning assets to
average interest-bearing liabilities 120.21 % 119.34 %
(1) Amounts shown are amortized cost for held to maturity securities and fair
value for available for sale securities. In order to make pre-tax income and
resultant yields on tax-exempt securities comparable to those on taxable
securities and loans, a tax-equivalent adjustment to interest earned from
tax-exempt securities has been computed using a federal rate of 35%.
(2) Net of deferred loan fees and costs, and loan discounts and premiums.
(3) Includes unrealized gains/(losses) on securities available for sale.
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For The Nine Months Ended September 30,
2004 2003
Average Interest Annualized Average Interest Annualized
Outstanding Earned/ Yield/ Outstanding Earned/ Yield/
(Dollars in thousands) Balance Paid Rate Balance Paid Rate
Interest-earning assets:
Federal funds sold and interest-bearing
deposits $ 34,593 $ 274 1.06 % $ 46,598 $ 397 1.14 %
Investment securities (1):
Taxable 462,867 14,174 4.08 % 391,979 12,385 4.22 %
Non-taxable 248,303 9,614 5.16 % 230,011 9,635 5.59 %
Total investment securities 711,170 23,788 4.46 % 621,990 22,020 4.72 %
Loans (2):
Commercial and agricultural 816,915 34,922 5.71 % 857,233 38,554 6.01 %
Residential real estate 246,175 12,364 6.70 % 257,267 14,053 7.28 %
Consumer and home equity 244,407 11,378 6.22 % 241,683 12,949 7.16 %
Total loans 1,307,497 58,664 5.99 % 1,356,183 65,556 6.46 %
Total interest-earning assets 2,053,260 82,726 5.38 % 2,024,771 87,973 5.80 %
Allowance for loans losses (30,292 ) (24,068 )
Other non-interest earning assets 164,927 156,474
Total assets $ 2,187,895 $ 2,157,177
Interest-bearing liabilities:
Savings and money market 424,431 2,058 0.65 % 410,619 3,224 1.05 %
Interest-bearing checking 390,420 1,987 0.68 % 386,805 2,805 0.97 %
Certificates of deposit 766,999 14,291 2.49 % 748,428 16,914 3.02 %
Borrowings 125,997 3,349 3.55 % 148,654 3,826 3.44 %
Guaranteed preferred beneficial interests in
Corporation's junior subordinated debentures - - - 16,200 1,258 10.35 %
Junior subordinated debentures issued to
unconsolidated subsidiary trust 16,702 1,296 10.35 % - - -
Total interest-bearing liabilities 1,724,549 22,981 1.78 % 1,710,706 28,027 2.19 %
Non-interest bearing demand deposits 263,736 239,843
Other non-interest-bearing liabilities 15,355 22,365
Total liabilities 2,003,640 1,972,914
Shareholders' equity (3) 184,255 184,263
Total liabilities and shareholders' equity $ 2,187,895 $ 2,157,177
Net interest income - tax equivalent 59,745 59,946
Less: tax equivalent adjustment 3,365 3,372
Net interest income $ 56,380 $ 56,574
Net interest rate spread 3.60 % 3.61 %
Net earning assets $ 328,711 $ 314,065
Net interest income as a percentage of
average interest-earning assets 3.88 % 3.95 %
Ratio of average interest-earning assets to
average interest-bearing liabilities 119.06 % 118.36 %
(1) Amounts shown are amortized cost for held to maturity securities and fair
value for available for sale securities. In order to make pre-tax income and
resultant yields on tax-exempt securities comparable to those on taxable
securities and loans, a tax-equivalent adjustment to interest earned from
tax-exempt securities has been computed using a federal rate of 35%.
(2) Net of deferred loan fees and costs, and loan discounts and premiums.
(3) Includes unrealized gains/(losses) on securities available for sale.
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Net Interest Income
Net interest income, the principal source of the Company's earnings, increased
$0.7 million or 4% in the third quarter of 2004 to $19.2 million compared to
$18.5 million in the third quarter of 2003. Net interest margin was 3.98% for
the third quarter of 2004, an increase of 12 basis points from 3.86% for the
same period last year. The increase in net interest income is the result of a
$0.7 million drop in interest income being more than offset by a $1.4 million
decline in interest expense. The change in interest income is a result of
decreases attributed to changes due to rate of $0.8 million with only a $0.1
million increase in changes due to volume offsetting the rate changes. The
change in interest expense is a result of decreases attributed to changes in
rate of $1.3 million and decreases attributed to changes in volume of $0.1
million.
Net interest income for the nine months ending September 30, 2004 was $56.4
million compared to $56.6 million for the nine months ending September 30, 2003.
Net interest margin was 3.88% for the nine months ended September 30, 2004, a
drop of 7 basis points from 3.95% for the same period last year. Interest income
declined $5.2 million while interest expense declined $5.0 million when
comparing the first nine months of 2004 with 2003. The change in interest income
is a result of decreases attributed to changes due to rate of $5.5 million with
only a $0.3 million increase in changes due to volume offsetting the rate
changes. The change in interest expense is a result of decreases attributed to
changes in rate of $4.9 million and decreases attributed to changes in volume of
$0.2 million.
Increases in market interest rates during the third quarter of 2004 have had a
positive effect on net interest margin, as the increase in rates had a favorable
impact on earning asset yields without increasing funding costs. However, the
recent market rate increase is expected to have a greater impact on funding
costs in the future. Comparing the third quarter of 2004 with the third quarter
of 2003, the Company's average loans declined $94.0 million and average deposits
increased $35.7 million, the principal factors leading to the $111.5 million
increase in average investment securities and federal funds sold. Yields on loan
assets are generally higher than yields on investment securities and federal
funds sold, so the shift in earning asset mix to a lower percentage of loans and
higher percentage of investment securities and federal funds sold had an adverse
effect on earning asset yields. This change in mix together with the overall
drop in market interest rates resulted in a decline in earning asset yields of
16 basis points from 5.58% in the third quarter of 2003 to 5.42% in the third
quarter of 2004. Offsetting this decline was a drop of 32 basis points in the
cost of interest bearing liabilities. The 16 basis point drop in earning asset
yield coupled with the 32 basis point drop in the cost of interest bearing
liabilities resulted in net interest spread improving 16 basis points to 3.69%
in the third quarter of 2004 compared to 3.53% in the third quarter of 2003.
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Rate/Volume Analysis
The following table presents the extent to which changes in interest rates and
changes in the volume of interest-earning assets and interest-bearing
liabilities have affected the Company's interest income and interest expense
during the periods indicated. Information is provided in each category with
respect to: (i) changes attributable to changes in volume (changes in volume
multiplied by current year rate); (ii) changes attributable to changes in rate
(changes in rate multiplied by prior volume); and (iii) the net change. The
changes attributable to the combined impact of volume and rate have been
allocated proportionately to the changes due to volume and the changes due to
rate.
Three Months ended September 30, Nine Months ended September 30,
2004 vs. 2003 2004 vs. 2003
Increase/(Decrease) Total Increase/(Decrease) Total
Due To Due To
------------------------------ Increase/ ------------------------------ Increase/
(Dollars in thousands) Volume Rate (Decrease) Volume Rate (Decrease)
Interest-earning assets:
Federal funds sold and
interest-bearing deposits $ (184 ) $ 64 $ (120 ) $ (95 ) $ (28 ) $ (123 )
Investment securities:
Taxable 1,499 105 1,604 2,205 (416 ) 1,789
Non-taxable 256 (223 ) 33 266 (287 ) (21 )
Total investment securities 1,755 (118 ) 1,637 2,471 (703 ) 1,768
Loans:
Commercial and agricultural (1,332 ) 134 (1,198 ) (1,698 ) (1,934 ) (3,632 )
Residential real estate (171 ) (285 ) (456 ) (553 ) (1,136 ) (1,689 )
Consumer and home equity 32 (564 ) (532 ) 138 (1,709 ) (1,571 )
Total loans (1,471 ) (715 ) (2,186 ) (2,113 ) (4,779 ) (6,892 )
Total interest-earning assets 100 (769 ) (669 ) 263 (5,510 ) (5,247 )
Interest-bearing liabilities:
Savings and money market 27 (201 ) (174 ) 62 (1,228 ) (1,166 )
Interest-bearing checking (3 ) (110 ) (113 ) 13 (831 ) (818 )
Certificates of deposit (44 ) (921 ) (965 ) 303 (2,926 ) (2,623 )
Borrowed funds (100 ) (27 ) (127 ) (595 ) 118 (477 )
Junior subordinated debentures
issued to unconsolidated subsidiary
trust 12 - 12 38 - 38
Total interest-bearing liabilities (108 ) (1,259 ) (1,367 ) (179 ) (4,867 ) (5,046 )
Net interest income $ 208 $ 490 $ 698 $ 442 $ (643 ) $ (201 )
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Provision for Loan Losses
The provision for loan losses for the third quarter of 2004 totaled $2.1
million, a decrease of $3.5 million compared to the $5.6 million provision for
loan losses for the third quarter of 2003. The provision for the nine months
ended September 30, 2004 totaled $9.5 million, a decrease of $4.7 million
compared to the $14.2 million provision for the same period last year. The
decrease in the provision for loan losses on both a quarter-to-date and
year-to-date basis is primarily a result of a reduced level of impaired loans
requiring specific allocations. See further discussion of the Analysis of the
Allowance for Loan Losses.
Noninterest Income
Noninterest income decreased 10% in the third quarter of 2004 to $6.4 million
from $7.1 million for the third quarter of 2003, and increased 1% in the first
nine months of 2004 to $19.5 million from $19.3 million for the same period last
year. The third quarter decline was partially attributed to the lower volume of
residential mortgage loans sold in the current quarter relative to the
historically high levels of refinancing activity in 2003. Higher income from
service fees reflects FII's expanding portfolio of products provided to its
customers throughout its four-bank service territory. This increase in income
from service fees, financial services group fees and commissions and other
income mostly offset the decline in gain on securities compared with last year's
third quarter.
Noninterest Expense
Noninterest expense for the third quarter of 2004 totaled $16.4 million compared
with $14.9 million for the third quarter of 2003. Noninterest expense for the
nine months ended September 30, 2004 increased to $47.9 million compared to
$45.4 million for the same period last year. The primary component of
noninterest expense is salaries and benefits, which totaled $9.2 million for the
third quarter of 2004 and $8.5 million for the third quarter of 2003. Salaries
and benefits for the nine months ended September 30, 2004 increased to
$27.4 million compared to $25.4 million for the same period last year. The
increase in salaries and benefits relates primarily to additional lending and
credit administration staff. The company also experienced an increase in
professional fees during the current year. Professional fees totaled $1.0
million and $0.4 million for the three months ended September 30, 2004 and 2003,
respectively. Professional fees totaled $2.1 million and $1.5 million for the
nine months ended September 30, 2004 and 2003, respectively. The increases were
primarily attributable to consulting fees surrounding the reorganization of loan
operations and compliance with the Sarbanes-Oxley Act of 2002, as well as higher
legal fees related to credit collection. The additional noninterest expenses,
coupled with a slowing of revenue growth, were the principal factors in the rise
in the Company's efficiency ratio to 60.82% for the quarter ended September 30,
2004, compared to 55.30% for the same quarter last year, and 60.49% for the nine
months ended September 30, 2004, compared to 55.87% for the same period a year
ago.
Income Tax Expense
The provision for income taxes provides for Federal and New York State income
taxes and amounted to $2.0 million and $1.1 million for the third quarter of
2004 and 2003, respectively. The provision amounted to $5.1 million and $4.3
million for the nine months ended September 30, 2004 and 2003. The effective tax
rate increased during the third quarter of 2004 to 27.7%, compared to 20.7% for
the third quarter of 2003. The third quarter of 2003 effective tax rate of 20.7%
was lower than normal due primarily to lower net income before income taxes,
which resulted primarily from the increase in provision for loan losses. The
effective tax rates are more comparable on a year-to-date basis at 27.8% for the
first nine months of 2004, versus 26.3% for the first nine months of 2003.
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ANALYSIS OF FINANCIAL CONDITION
Lending Activities
Loan Portfolio Composition Set forth below is selected information regarding the
composition of the Company's loan portfolio at the dates indicated.
September 30, December 31, September 30,
(Dollars in thousands) 2004 2003 2003
Commercial $ 213,722 16.9 % $ 248,313 18.4 % $ 260,033 18.9 %
Commercial real estate 348,901 27.5 369,712 27.5 366,250 26.7
Agricultural 197,710 15.6 235,199 17.5 247,272 18.0
Residential real estate 254,991 20.1 251,502 18.7 250,983 18.3
Consumer and home equity 252,072 19.9 240,591 17.9 248,917 18.1
Total loans 1,267,396 100.0 1,345,317 100.0 1,373,455 100.0
Allowance for loan losses (31,168 ) (29,064 ) (29,052 )
Total loans, net $ 1,236,228 $ 1,316,253 $ 1,344,403
Total gross loans decreased $77.9 million to $1.267 billion at September 30,
2004 from $1.345 billion at December 31, 2003. Commercial loans decreased
$34.6 million to $213.7 million or 16.9% of the portfolio at September 30, 2004
from $248.3 million or 18.4% at December 31, 2003. Agricultural loans decreased
$37.5 million, to $197.7 million at September 30, 2004 from $235.2 million at
December 31, 2003. The decline in loans relates to decreased loan production
coupled with loan charge-offs, pay-offs and refinances with other institutions a
result of the Company working to reduce credit risk in the loan portfolio. The
expansion of the loan origination staff and additional training on the new
credit processes combined with expanded sales training activities is expected to
contribute to future growth of the loan portfolio. Included in agricultural
loans were $100.1 million in loans to dairy farmers, or 7.9% of the total loan
portfolio at September 30, 2004 compared to $119.3 million or 8.9% of the total
loan portfolio at December 31, 2003. Loans held for sale totaled $1.9 million at
September 30, 2004, comprised of residential mortgages of $1.4 million and
student loans of $0.5 million. Loans held for sale totaled $4.9 million as of
December 31, 2003, comprised of residential mortgages of $3.1 million and
student loans of $1.8 million.
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Nonaccruing Loans and Nonperforming Assets
The following table provides information regarding nonaccruing loans and other
nonperforming assets at the dates indicated.
September 30, December 31, September 30,
(Dollars in thousands) 2004 2003 2003
Nonaccruing loans (1)
Commercial $ 19,069 $ 12,983 $ 18,910
Commercial real estate 11,478 11,745 10,387
Agricultural 13,818 18,870 14,550
Residential real estate 1,593 2,496 2,005
Consumer and home equity 513 578 500
Total nonaccruing loans 46,471 46,672 46,352
Troubled debt restructured loans - 3,069 3,098
Accruing loans 90 days or more delinquent 1,179 1,709 1,723
Total nonperforming loans 47,650 51,450 51,173
Other real estate owned 2,089 653 756
Total nonperforming assets $ 49,739 $ 52,103 $ 51,929
Total nonperforming loans to total loans 3.76 % 3.82 % 3.73 %
Total nonperforming assets to total loans and other real estate 3.92 % 3.87 % 3.78 %
(1) Although loans are generally placed on nonaccrual status when they become
90 days or more past due, they may be placed on nonaccrual status earlier if
they have been identified by the Company as presenting uncertainty with
respect to the collectibility of interest or principal.
Nonperforming assets at September 30, 2004 declined to $49.7 million, compared
with $52.1 million at December 31, 2003 and compared to $51.9 million at
September 30, 2003. During the third quarter of 2004, the Company received
$3.0 million in payments on nonaccrual loans and $0.5 million of nonaccrual
loans were returned to accruing status. Also during the third quarter, the
Company charged-off $1.9 million in loans that were on nonaccrual status at
June 30, 2004 and transferred $6.2 million in loans to nonaccrual status. The
Company has focused considerable resources on working to reduce the level of
nonperforming assets in the most cost effective manner. The Company has also
made investments in people and processes to provide for a stronger credit and
sales culture within the organization.
The following table details nonaccrual loan activity for the periods indicated.
Three Months Ended
September 30, June 30, March 31,
(Dollars in thousands) 2004 2004 2004
Nonaccruing loans, beginning of period $ 47,333 $ 44,324 $ 46,672
Additions 6,199 13,538 4,906
Payments (3,032 ) (4,512 ) (3,033 )
Charge-offs (1,916 ) (1,532 ) (3,775 )
Returned to accruing status (538 ) (4,110 ) (59 )
Transferred to other real estate (1,575 ) (375 ) (387 )
Nonaccruing loans, end of period $ 46,471 $ 47,333 $ 44,324
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Potential problem loans are loans that are currently performing, but information
known about possible credit problems of the borrowers causes management to have
doubt as to the ability of such borrowers to comply with the present loan
payment terms and may result in disclosure of such loans as nonperforming at
some time in the future. Management evaluates loans classified as substandard,
which continue to accrue interest, to be potential problem loans. The Company
identified $114.5 million and $104.8 million in loans that continued to accrue
interest which were classified as substandard as of September 30, 2004 and
June 30, 2004, respectively. These loans remain in a performing status due to a
variety of factors, including payment history, the value of collateral
supporting the credits, and personal or government guarantees.
Analysis of the Allowance for Loan Losses
The allowance for loan losses represents the estimated amount of probable credit
losses inherent in the Company's loan portfolio. The Company performs periodic,
systematic reviews of each Banks' loan portfolios to estimate probable losses in
the respective loan portfolios. In addition, the Company regularly evaluates
prevailing economic and business conditions, industry concentrations, changes in
the size and characteristics of the portfolio and other pertinent factors. The
process used by the Company to determine the overall allowance for loan losses
is based on this analysis, taking into consideration management's judgment.
Allowance methodology is reviewed on a periodic basis and modified as
appropriate. Based on this analysis the Company believes the allowance for loan
losses is adequate at September 30, 2004.
The following table sets forth the activity in the allowance for loan losses for
the periods indicated.
Three Months Ended Nine Months Ended
September 30, September 30,
(Dollars in thousands) 2004 2003 2004 2003
Balance at beginning of period $ 30,961 $ 26,518 $ 29,064 $ 21,660
Charge-offs:
Commercial 709 1,600 3,116 4,099
Commercial real estate 489 687 1,412 1,594
Agricultural 475 - 2,378 27
Residential real estate 139 26 162 97
Consumer and home equity 386 897 1,297 1,652
Total charge-offs 2,198 3,210 8,365 7,469
Recoveries:
Commercial 181 63 486 419
Commercial real estate 1 6 102 18
Agricultural 3 1 37 3
Residential real estate 1 1 3 10
Consumer and home equity 72 83 382 212
Total recoveries 258 154 1,010 662
Net charge-offs 1,940 3,056 7,355 6,807
Provision for loan losses 2,147 5,590 9,459 14,199
Balance at end of period $ 31,168 $ 29,052 $ 31,168 $ 29,052
Ratio of net loan charge-offs to average loans
(annualized) 0.60 % 0.89 % 0.75 % 0.67 %
Ratio of allowance for loan losses to total loans 2.46 % 2.12 % 2.46 % 2.12 %
Ratio of allowance for loan losses to nonperforming
loans 65 % 57 % 65 % 57 %
Net loan charge-offs were $1.9 million for the third quarter of 2004 or 0.60%
(annualized) of average loans compared to $3.1 million or 0.89% (annualized) of
average loans in the same period last year. The ratio of the allowance for loan
losses to nonperforming loans was 65% at September 30, 2004, compared
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to 56% at December 31, 2003 and 57% at September 30, 2003. The ratio of the
allowance for loan losses to total loans increased to 2.46% at September 30,
2004, compared to 2.16% at December 31, 2003 and 2.12% a year ago.
Investing Activities
The Company's total investment security portfolio increased $109.9 million to
$762.0 million as of September 30, 2004 compared to $652.1 million as of
December 31, 2003. The largest increase was in mortgage-backed securities, which
increased $75.7 million as detailed below. The investment security increase
corresponds with the increase in deposits and decrease in loans since year-end,
as the Company invested excess cash and cash equivalents in investment
securities. Further detail regarding the Company's investment portfolio follows.
U.S. Treasury and Agency Securities
At September 30, 2004, the U.S. Treasury and Agency securities portfolio totaled
$239.4 million, all of which was classified as available for sale. The portfolio
is comprised entirely of U. S. federal agency securities of which approximately
90% are callable securities. These callable securities provide higher yields
than similar securities without call features. At September 30, 2004 included in
callable securities are $104.7 million of structured notes all of which are step
callable agency debt issues. The step callable bonds step-up in rate at
specified intervals and are periodically callable by the issuer. At
September 30, 2004, the structured notes had a current average coupon of 4.06%
that adjust on average to 6.40% within four years. At December 31, 2003, the
U.S. Treasury and Agency securities portfolio totaled $211.9 million, all of
which was classified as available for sale.
State and Municipal Obligations
At September 30, 2004, the portfolio of state and municipal obligations totaled
$250.3 million, of which $209.5 million was classified as available for sale. At
that date, $40.8 million was classified as held to maturity, with a fair value
of $41.5 million. At December 31, 2003, the portfolio of state and municipal
obligations totaled $242.5 million, of which $195.4 million was classified as
available for sale. At that date, $47.1 million was classified as held to
maturity, with a fair value of $48.1 million.
Mortgage-Backed Securities
Mortgage-backed securities, all of which were classified as available for sale,
totaled $268.4 million and $192.7 million at September 30, 2004 and December 31,
2003, respectively. The portfolio was comprised of $187.1 million of
mortgage-backed pass-through securities, $70.6 million of collateralized
mortgage obligations (CMOs) and $10.7 million of other asset-backed securities
at September 30, 2004. The mortgage backed pass-through securities were
predominantly issued by government sponsored enterprises (FNMA, FHLMC, or GNMA).
Approximately 87% of the mortgage-backed pass-through securities were in fixed
rate securities that were most frequently formed with mortgages having an
original balloon payment of five or seven years. The adjustable rate agency
mortgage-backed securities portfolio is principally indexed to the one-year
Treasury bill. The CMO portfolio consists of government agency issues and
privately issued AAA rated securities. The other asset-backed securities are
primarily Student Loan Marketing Association (SLMA) floaters, which are
securities backed by student loans. At December 31, 2003 the portfolio consisted
of $138.5 million of mortgage-backed pass-through securities, $45.1 million of
CMOs and $9.1 million of other asset-backed securities. The mortgage-backed
portfolio at December 31, 2003 was primarily agency issued (FNMA, FHLMC, GNMA)
obligations, but also included privately issued AAA rated securities and SLMA
floaters to further diversify the portfolio.
Corporate Bonds
The corporate bond portfolio, all of which was classified as available for sale,
totaled $1.0 million and $4.1 million at September 30, 2004 and December 31,
2003, respectively. The portfolio was purchased to further diversify the
investment portfolio and increase investment yield. The Company's investment
policy limits investments in corporate bonds to no more than 10% of total
investments and to bonds rated as Baa or better by Moody's Investors Service,
Inc. or BBB or better by Standard & Poor's Ratings Services at the time of
purchase.
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Equity Securities
Available for sale equity securities totaled $2.9 million at September 30, 2004
and $0.9 million at December 31, 2003.
Funding Activities
Deposits
The Banks offer a broad array of core deposit products including checking
accounts, interest-bearing transaction accounts, savings and money market
accounts and certificates of deposit under $100,000. These core deposits totaled
$1.644 billion or 88.3% of total deposits of $1.862 billion at September 30,
2004 compared to core deposits of $1.552 billion or 85.3% of total deposits of
$1.819 billion at December 31, 2003. The core deposit base consists almost
exclusively of in-market customer accounts. The Company had total public
deposits of $418.5 million at September 30, 2004 compared to $355.6 million at
December 31, 2003. Included in total deposits are certificates of deposit over
$100,000, which amounted to $218.2 million and $267.1 million as of
September 30, 2004 and December 31, 2003, respectively. The decline in
certificates of deposit over $100,000 is mainly due to a decline in brokered
certificates of deposit, which totaled $68.0 million and $125.4 million as of
September 30, 2004 and December 31, 2003, respectively. A portion of the cash
available from increases in core deposits and declines in loans outstanding has
been utilized to reduce brokered certificates of deposit.
Non-Deposit Sources of Funds
The Company's most significant source of non-deposit funds is FHLB borrowings.
FHLB advances outstanding amounted to $66.4 million and $89.0 million as of
September 30, 2004 and December 31, 2003, respectively. These FHLB borrowings
include both short and long-term advances maturing on various dates through
2014. The decline in FHLB borrowings is also reflective of the deployment of
cash generated from core deposit growth and the decline in loans outstanding.
The Company had approximately $53.7 million of immediate credit available under
lines of credit with the FHLB at September 30, 2004, collateralized by FHLB
stock and real estate mortgage loans. The Company also has lines of credit with
the Federal Agricultural Mortgage Corp. (Farmer Mac) permitting borrowings to a
maximum of $25.0 million. No advances were outstanding against the Farmer Mac
lines as of September 30, 2004. The Company also has cancelable overnight
Federal funds purchased lines of credit with other commercial banks that totaled
$60.0 million and $71.3 million as of September 30, 2004 and December 31, 2003.
No advances were outstanding against the overnight lines of credit as of
September 30, 2004. The Company also utilizes securities sold under agreements
to repurchase as a source of funds. These short-term repurchase agreements
amounted to $28.9 million and $22.5 million as of September 30, 2004 and
December 31, 2003, respectively.
During 2003, FII expanded the terms of an existing credit agreement with M&T
Bank. Proceeds of the loan were principally used to infuse capital to the NBG
and BNB subsidiaries allowing those banks to meet higher capital ratios required
in agreements imposed by their regulators. The credit agreement includes a
$25.0 million term loan facility and a $5.0 million revolving loan facility. The
term loan requires monthly payments of interest only, at a variable interest
rate of London Interbank Offered Rate ("LIBOR") plus 1.75%, which was 3.27% as
of September 30, 2004. The $25.0 million term loan is included in long-term
borrowings on the consolidated statements of financial condition as principal
installments are due as follows: $5.0 million in December 2006, $10.0 million in
December 2007 and $10.0 million in December 2008. The $5.0 million revolving
loan accrues interest at a rate of LIBOR plus 1.50%. There were no advances
outstanding on the revolving loan as of September 30, 2004. The credit agreement
includes affirmative financial covenants, all of which were met as of
September 30, 2004. FII pledged the stock of its subsidiary banks as collateral
for the credit facility.
During 2001 FISI Statutory Trust I (the "Trust") was established and issued 30
year guaranteed preferred beneficial interests in junior subordinated debentures
of the Company ("capital securities") in the aggregate amount of $16.2 million
at a fixed rate of 10.2%. The Company used the net proceeds from the sale of the
capital securities to partially fund the acquisition of BNB. As of September 30,
2004, all of the capital securities qualified as Tier I capital under regulatory
definitions. Effective December 31, 2003, the provisions of FASB Interpretation
No. 46 (Revised), "Consolidation of Variable Interest Entities,"
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resulted in the deconsolidation of the Company's wholly-owned Trust. The
deconsolidation resulted in the derecognition of the $16.2 million in trust
preferred securities and the recognition of $16.7 million in junior subordinated
debentures and a $502,000 investment in the subsidiary trust recorded in other
assets in the Company's consolidated statements of financial condition.
Equity Activities
Total shareholders' equity amounted to $188.0 million at September 30, 2004, an
increase of $4.9 million from $183.1 million at December 31, 2003. The increase
in shareholders' equity results from the $13.3 million in year-to-date net
income partially offset by $6.5 million in dividends declared and $2.5 million
in unrealized gain on securities.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity
The objective of maintaining adequate liquidity is to assure the ability of the
Company and its subsidiaries to meet their financial obligations. These
obligations include the payment of interest on deposits, borrowings and junior
subordinated debentures, as well as, withdrawal of deposits on demand or at
their contractual maturity, the repayment of borrowings as they mature, the
ability to fund new and existing loan commitments and the ability to take
advantage of new business opportunities. The Company and its subsidiaries
achieve liquidity by maintaining a strong base of core customer funds, maturing
short-term assets, the ability to sell securities, lines of credit, and access
to capital markets.
Liquidity at the subsidiary bank level is managed through the monitoring of
anticipated changes in loans, the investment portfolio, core deposits and
wholesale funds. The strength of the subsidiary banks' liquidity position is a
result of its base of core customer deposits. These core deposits are
supplemented by wholesale funding sources, including credit lines with the other
banking institutions, the FHLB, Farmer Mac and the Federal Reserve Bank.
The primary sources of liquidity for the Company are dividends from its
subsidiaries, lines of credit, and access to capital markets. Dividends from
subsidiaries are limited by various regulatory requirements related to capital
adequacy and earnings trends. On September 4, 2003 the Boards of Directors of
NBG and BNB entered into agreements with the Office of the Comptroller of the
Currency ("OCC") one of the terms of which required NBG and BNB to adopt
dividend policies that would permit them to declare dividends only when they are
in compliance with their approved capital plan and the provisions of 12 U.S.C.
Section 56 and 60, and upon prior written notice to (but not consent of) the
Assistant Deputy Comptroller. Neither bank has had their respective capital plan
approved by the OCC or declared a dividend since entering into the agreements.
The Boards of both NBG and BNB have recently adopted resolutions providing that
no dividends will be declared without the prior written approval of the OCC, and
the Board of the Company has adopted a parallel resolution pursuant to which it
has agreed not to request a dividend from either bank until their respective
capital plans and proposed dividend declarations have been approved by the OCC.
The banks are important sources of funds to the Company and, if they are unable,
or limited in their ability, to pay dividends to the Company, that may adversely
affect the liquidity of the Company and, over time, could adversely affect the
Company's ability to pay dividends to its shareholders and meet its obligations
on borrowings and junior subordinated debentures.
The Company's cash and cash equivalents were $88.3 million at September 30,
2004, an increase of $2.7 million from the balance of $85.6 million at December
31, 2003. The Company has $197.0 million in unpledged investment securities at
September 30, 2004 compared to $89.6 million at December 31, 2003.
Capital Resources
The Federal Reserve Board has adopted a system using risk-based capital
guidelines to evaluate the capital adequacy of bank holding companies. The
guidelines require a minimum total risk-based capital ratio of 8.0%. Leverage
ratio is also utilized in assessing capital adequacy with a minimum requirement
that can range from 3.0% to 5.0%.
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The Company's Tier 1 leverage ratio was 7.30% and 7.03% at September 30, 2004
and December 31, 2003, respectively, both of which are well above minimum
regulatory capital requirements. Total Tier 1 capital of $155.5 million at
September 30, 2004 increased $7.8 million from $147.7 million at December 31,
2003.
The Company's total risk-based capital ratio was 12.47% at September 30, 2004
and 11.44% at December 31, 2003, respectively, both well above minimum
regulatory capital requirements. Total risk-based capital was $173.1 million at
September 30, 2004, an increase of $7.1 million from $166.0 million at
December 31, 2003.
In addition, the formal agreements entered into by NBG and BNB with their
primary regulator requires both banks to maintain a Tier 1 leverage capital
ratio equal to 8%, a Tier 1 risk-based capital ratio equal to 10%, and a total
risk-based capital ratio of 12%. The following table details the capital ratios
for each of the banks as of September 30, 2004.
NBG BNB
Tier 1 leverage ratio 8.93 % 8.83 %
Tier 1 risk-based capital ratio 13.37 % 14.89 %
Total risk-based capital ratio 14.64 % 16.14 %
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