FIDELITY D & D BANCORP INC - Quarter Report: 2006 March (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 31, 2006

 

OR

 

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                 to                

 

Commission file number: 333-90273

 

FIDELITY D & D BANCORP, INC.

 

 

Address of principal executive offices:

BLAKELY & DRINKER ST.

DUNMORE, PENNSYLVANIA 18512

 

TELEPHONE:

570-342-8281

 

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 subjected to such filing requirements for the past 90 days.

 

ý  YES    o  NO

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer o

Accelerated filer o

Non-accelerated filer ý

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

o  YES    ý  NO

 

The number of outstanding shares of Common Stock of Fidelity D & D Bancorp, Inc. at April 28, 2006, the latest practicable date, was 2,044,802 shares.

 

 

FIDELITY D & D BANCORP, INC.

 

Form 10-Q March 31, 2006

 

Index

 

Part I. Financial Information
Item 1.	Financial Statements:
	Consolidated Balance Sheets as of March 31, 2006 and December 31, 2005
	Consolidated Statements of Income for the three months ended March 31, 2006 and 2005
	Consolidated Statements of Changes in Shareholders’ Equity for the three months ended March 31, 2006 and 2005
	Consolidated Statements of Cash Flows for the three months ended March 31, 2006 and 2005
	Notes to Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosure about Market Risk
Item 4.	Controls and Procedures
Part II. Other Information
Item 1.	Legal Proceedings
Item 1A.	Risk Factors
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.	Defaults Upon Senior Securities
Item 4.	Submission of Matters to a Vote of Security Holders
Item 5.	Other Information
Item 6.	Exhibits
Signatures
Exhibit index

 

2

 

PART I – Financial Information

 

Item 1: Financial Statements

 

FIDELITY D & D BANCORP, INC.

Consolidated Balance Sheets

As of March 31, 2006 and December 31, 2005

 

		March 31, 2006			December 31, 2005
		(unaudited)			(audited)
ASSETS
Cash and due from banks		$	10,380,049		$	12,525,723
Interest-bearing deposits with financial institutions		106,846			68,817
Total cash and cash equivalents		10,486,895			12,594,540
Available-for-sale securities		114,294,790			95,681,654
Held-to-maturity securities		1,911,062			1,996,919
Federal Home Loan Bank Stock		4,699,000			4,628,200
Loans and leases, net (allowance for loan losses of $5,716,473 in 2006; $5,984,649 in 2005)		410,379,842			403,144,095
Loans available-for-sale (fair value $964,715 in 2006; $434,272 in 2005)		953,252			428,584
Bank premises and equipment, net		11,543,777			11,683,148
Cash surrender value of bank owned life insurance		7,962,307			7,891,898
Other assets		4,776,255			4,033,132
Accrued interest receivable		2,186,604			1,959,826
Foreclosed assets held for sale		92,999			18,702
Total assets		$	569,286,783		$	544,060,698
LIABILITIES
Deposits
Non-interest-bearing		$	67,692,897		$	70,361,086
Certificates of deposit of $100,000 or more		69,369,516			76,257,553
Other interest-bearing deposits		271,441,861			232,880,001
Total deposits		408,504,274			379,498,640
Accrued interest payable and other liabilities		3,396,492			3,238,844
Short-term borrowings		27,422,536			28,772,997
Long-term debt		81,029,348			83,704,188
Total liabilities		520,352,650			495,214,669
COMMITMENTS AND CONTINGENCIES
SHAREHOLDERS’ EQUITY
Preferred stock authorized 5,000,000 shares with no par value; none issued		—			—
Capital stock authorized 10,000,000 shares with no par value; issued and outstanding 2,044,802 shares in 2006; 2,039,639 shares in 2005		18,268,245			10,594,901
Retained earnings		32,476,484			39,363,461
Accumulated other comprehensive loss		(1,810,596		)	(1,112,333		)
Total shareholders’ equity		48,934,133			48,846,029
Total liabilities and shareholders’ equity		$	569,286,783		$	544,060,698

 

See Notes to Consolidated Financial Statements

 

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FIDELITY D & D BANCORP, INC.

Consolidated Statements of Income

(unaudited)

 

		Three Months Ended
		March 31, 2006			March 31, 2005
Interest income
Interest and fees on loans and leases:
Taxable		$	6,498,618		$	5,682,968
Nontaxable		132,158			98,410
Interest-bearing deposits with financial institutions		2,537			2,688
Investment securities:
U.S. Government agency and corporations		885,182			910,157
States and political subdivisions (nontaxable)		141,044			112,455
Other securities		198,410			126,815
Federal funds sold		35,488			40,792
Total interest income		7,893,437			6,974,285
Interest expense
Certificates of deposit of $100,000 or more		666,409			676,023
Other deposits		1,730,497			880,216
Securities sold under repurchase agreements		135,449			196,809
Other short-term borrowings and long-term debt		1,125,363			940,851
Other		5,410			4,582
Total interest expense		3,663,128			2,698,481
Net interest income		4,230,309			4,275,804
Provision for loan losses		75,000			80,000
Net interest income, after provision for loan losses		4,155,309			4,195,804
Other income:
Service charges on deposit accounts		631,727			598,321
Gain (loss) on:
Investment securities		(168		)	—
Loans		14,985			(11,442		)
Leased assets		15,054			(34,873		)
Foreclosed assets held for sale		405			405
Write-down lease residual		—			(220,000		)
Fees and other service charges		465,262			415,202
Total other income		1,127,265			747,613
Other expenses:
Salaries and employee benefits		2,006,814			1,742,921
Premises and equipment		800,851			734,455
Advertising		128,373			131,209
Professional fees and services		282,489			382,043
Other		702,663			575,284
Total other expenses		3,921,190			3,565,912
Income before provision for income taxes		1,361,384			1,377,505
Provision for income taxes		329,753			358,116
Net income		$	1,031,631		$	1,019,389
Per share data:
Net income - basic		$	0.51		$	0.50
Net income - diluted		$	0.50		$	0.50
Dividends		$	0.22		$	0.20

 

See Notes to Consolidated Financial Statements

 

4

 

FIDELITY D & D BANCORP, INC.

Consolidated Statements of Changes in Shareholders’ Equity

For the Three Months Ended March 31, 2006 and 2005

 

										Accumulated other
		Capital stock					Retained			comprehensive
		Shares *		Amount			earnings			(loss)			Total
Balance, December 31, 2004 (audited)		2,023,529		$	10,072,134		$	36,396,027		$	(101,401	)	$	46,366,760
Total comprehensive income:
Net income							1,019,389						1,019,389
Change in net unrealized holding gains (losses) on available-for-sale securities, net of reclassification adjustment and tax effects										(906,950		)	(906,950		)
Comprehensive income													112,439
Issuance of common stock through Employee Stock Purchase Plan		1,134		31,671									31,671
Dividends reinvested through Dividend Reinvestment Plan		3,733		120,572									120,572
Cash dividend declared							(404,932		)				(404,932		)
Balance, March 31, 2005 (unaudited)		2,028,396		$	10,224,377		$	37,010,484		$	(1,008,351	)	$	46,226,510

 

* The number of shares has been adjusted to reflect the retroactive effect of a 10% stock dividend paid on February 15, 2006.

 

										Accumulated other
		Capital stock					Retained			comprehensive
		Shares		Amount			earnings			(loss)			Total
Balance, December 31, 2005 (audited)		1,854,217		$	10,594,901		$	39,363,461		$	(1,112,333	)	$	48,846,029
Total comprehensive income:
Net income							1,031,631						1,031,631
Change in net unrealized holding gains (losses) on available-for-sale securities, net of reclassification adjustment and tax effects										(698,263		)	(698,263		)
Comprehensive income													333,368
Issuance of common stock through Employee Stock Purchase Plan		1,571		48,151									48,151
Dividends reinvested through Dividend Reinvestment Plan		3,620		141,180									141,180
Stock-based compensation expense				21,913									21,913
Cash dividend declared							(449,060		)				(449,060		)
Stock dividend declared		185,394		7,462,100			(7,462,100		)				—
Cash paid for fractional shares on stock dividend							(7,448		)				(7,448		)
Balance, March 31, 2006 (unaudited)		2,044,802		$	18,268,245		$	32,476,484		$	(1,810,596	)	$	48,934,133

 

See Notes to Consolidated Financial Statements

 

5

 

FIDELITY D & D BANCORP, INC.

Consolidated Statements of Cash Flows

(unaudited)

 

		Three Months Ended
		March 31, 2006			March 31, 2005
Cash flows from operating activities:
Net income		$	1,031,631		$	1,019,389
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		294,860			285,546
Net amortization of securities		26,505			108,079
Provision for loan losses		75,000			80,000
Deferred income tax expense (benefit)		91,443			(105,682		)
Stock-based compensation expense		21,913			—
Amortization of investment in limited partnership		22,500			22,500
Proceeds from sale of loans available-for-sale		1,777,954			404,963
Originations of loans available for sale		(2,287,637		)	(240,019		)
Write-down of foreclosed assets held for sale		—			28,603
Write-down lease residual		—			220,000
Increase in cash surrender value of life insurance		(70,409		)	(57,792		)
Loss on sale of investment securities		168			—
(Gain) loss on sale of loans		(14,985		)	11,442
Gain on sale of foreclosed assets held-for-sale		(405		)	(405		)
Loss on sale of leased assets		—			34,873
Amortization of loan servicing rights		18,813			27,952
Change in:
Accrued interest receivable		(226,778		)	(355,499		)
Other assets		(516,168		)	(459,472		)
Accrued interest payable and other liabilities		158,053			570,995
Net cash provided by operating activities		402,458			1,595,473
Cash flows from investing activities:
Held-to-maturity securities:
Proceeds from maturities, calls and principal pay-downs		85,055			164,184
Available-for-sale securities:
Proceeds from sales		1,537,336			—
Proceeds from maturities, calls and principal pay-downs		1,542,173			4,376,627
Purchases		(22,776,490		)	(1,454,954		)
Net (increase) decrease in FHLB stock		(70,800		)	737,500
Net (increase) decrease in loans and leases		(7,385,044		)	3,478,773
Proceeds from sale of leased assets		—			210,671
Acquisition of bank premises and equipment		(155,489		)	(77,537		)
Proceeds from sale of foreclosed assets held-for-sale		—			5,817
Net cash (used in) provided by investing activities		(27,223,259		)	7,441,081
Cash flows from financing activities:
Net (decrease) increase in non-interest-bearing deposits		(2,668,189		)	485,776
Net decrease in certificates of deposit of $100,000 or more		(6,888,037		)	(1,484,239		)
Net increase in other interest-bearing deposits		38,561,860			15,408,496
Net decrease in short-term borrowings		(1,350,461		)	(11,463,224		)
Repayments of long-term debt		(2,674,840		)	(192,758		)
Dividends paid, net of dividend reinvestment		(307,880		)	(284,360		)
Proceeds from employee stock purchase plan		48,151			31,671
Cash payments in lieu of fractional shares on stock dividend		(7,448		)	—
Net cash provided by financing activities		24,713,156			2,501,362
Net (decrease) increase in cash and cash equivalents		(2,107,645		)	11,537,916
Cash and cash equivalents, beginning		12,594,540			10,216,394
Cash and cash equivalents, ending		$	10,486,895		$	21,754,310

 

See Notes to Consolidated Financial Statements

 

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FIDELITY D & D BANCORP, INC.

 

Notes to Consolidated Financial Statements

(unaudited)

 

1.                                      Nature of operations and critical accounting policies

 

Principles of consolidation

 

The accompanying unaudited consolidated financial statements of Fidelity D & D Bancorp, Inc., and its wholly-owned subsidiary, The Fidelity Deposit and Discount Bank (the Bank or collectively, the Company) have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to this Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnote disclosures required by GAAP for complete financial statements. In the opinion of management, all normal recurring adjustments necessary for a fair presentation of the financial condition and results of operations for the periods have been included. All significant inter-company balances and transactions have been eliminated in consolidation. Prior period amounts are reclassified when necessary to conform to the current period’s presentation. During the fourth quarter of 2005, the Company changed its classification, within the consolidated statements of cash flows, of the activity associated with loans available-for-sale from investing activities to operating activities. Accordingly, the cash flows for the quarter ended March 31, 2005 have been reclassified to conform to the current year’s quarter presentation. The effect of the change increased operating cash flows by $165,000 and decreased investing cash flows by $165,000. The Company believes the change in classification of loans available-for-sale is preferable because it better reflects the primary business purpose of these transactions and complies with the requirements of SFAS 102, Statement of Cash Flows—Exemption of Certain Enterprises and Classification of Cash Flows from Certain Securities Acquired for Resale. On January 17, 2006, the Board of Directors declared a 10% stock dividend. The new common shares were distributed on February 15, 2006 to shareholders of record at the close of business on January 30, 2006. All common stock and per-share data, presented in the prior period, has been adjusted to reflect the retroactive effect of the 10% stock dividend.

 

 The preparation of financial statements in conformity with GAAP 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 reported periods. Actual results could differ from those estimates. For additional information and disclosures required under GAAP, refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

 

Nature of operations

 

The Bank is a commercial bank chartered in the Commonwealth of Pennsylvania and a wholly-owned subsidiary of the Company. Having commenced operations in 1903, the Bank is committed to provide superior customer service, while offering a full range of banking products and financial and trust services, to both our consumer and commercial customers from its main office located in Dunmore and other branches throughout Lackawanna and Luzerne counties.

 

Management is responsible for the fairness, integrity and objectivity of the unaudited financial statements included in this report. Management prepared the unaudited financial statements in accordance with GAAP. In meeting its responsibility for the financial statements, Management depends on the Company’s accounting systems and related internal controls. These systems and controls are designed to provide reasonable, but not absolute, assurance that the financial records accurately reflect the transactions of the Company, the Company’s assets are safeguarded and that financial statements present fairly the financial condition and results of operations of the Company.

 

In the opinion of Management, the consolidated balance sheets as of March 31, 2006 and December 31, 2005 and the related consolidated statements of income for each of the three month periods ended March 31, 2006 and March 31, 2005 and changes in shareholders’ equity and cash flows for each of the three month periods ended March 31, 2006 and March 31, 2005 present fairly the financial condition and results of operations of the Company. All material adjustments required for a fair presentation have been made. These adjustments are of a normal recurring nature. As indicated in Note 3, “Stock Plans”, included herein, the Company adopted Statement of Financial Accounting Standard 123R, Share-Based Payment, during the first quarter of 2006. There have been no other material changes in accounting principles and practices or in the method of application. Other than the retroactive adjustment of 2005 common stock and the related per-share data, as a result of the 10% stock dividend noted above,

 

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there have been no other retroactive adjustments during these periods. The results of operations for interim periods are not necessarily indicative of the results of operations for the entire year.

 

This Quarterly Report on Form 10-Q should be read in conjunction with the Company’s audited financial statements for the year ended December 31, 2005 and the notes included therein, included within the Company’s Annual Report filed on Form 10-K.

 

Critical accounting policies

 

The presentation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect many of the reported amounts and disclosures. Actual results could differ from these estimates.

 

A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses (the allowance). Management believes that the allowance, as of March 31, 2006, is adequate and reasonable. Given the subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make materially different assumptions, and could, therefore calculate a materially different allowance value. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in the future. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance. Such agencies may require the Company to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.

 

Another material estimate is the calculation of fair values of the Company’s investment securities. The Company receives estimated fair values of investment securities from an independent valuation service. In developing these fair values, the valuation service uses estimates of cash flows, based on historical performance of similar instruments in similar interest rate environments. Based on experience, Management is aware that estimated fair values of investment securities tend to vary among valuation services. Accordingly, when selling investment securities, Management may obtain price quotes from more than one source. Available-for-sale (“AFS”) securities are carried at fair value on the consolidated balance sheet, with unrealized gains and losses, net of income tax, reported separately within shareholders’ equity through accumulated other comprehensive income (loss).

 

The fair value of residential mortgage loans, classified as AFS, is obtained from the Federal National Mortgage Association (“FNMA”). To determine the fair value of student loans, classified as AFS, the Bank uses the pricing obtained from the most recent student loans sold from its AFS portfolio. From time-to-time, the Bank may originate Small Business Administration (“SBA”) loans AFS. The fair value of SBA loans, classified as AFS, is obtained from an outside pricing source. The market to which the Bank sells mortgage and other loans is restricted and price quotes from other sources are not typically obtained. As of March 31, 2006 and December 31, 2005, the AFS loan portfolio consisted of residential mortgage and student loans.

 

2.                                      Earnings per share

 

Basic earnings per share (EPS) is computed by dividing income available to common shareholders by the weighted-average number of common stock outstanding for the period. Diluted EPS is computed in the same manner as basic EPS but reflects the potential dilution that could occur if stock options to issue additional common stock were exercised, which would then result in additional stock outstanding to share or dilute the earnings of the Company. The Company maintains two share-based compensation plans that may generate additional potential dilutive common shares. Generally, dilution would occur if Company-issued stock options were exercised and converted into common stock.

 

In the computation of diluted EPS, the Company uses the treasury stock method to determine the dilutive effect of its granted but unexercised stock options. Under this method, the assumed proceeds received from shares issued, in a hypothetical stock option exercise, are assumed to be used to purchase treasury stock. Pursuant to the guidance of Statement of Financial Accounting Standard (“SFAS”) No. 128, Earning Per Share, proceeds include: proceeds from the exercise of outstanding stock options; compensation cost for future service that the Company has not yet recognized; and any “windfall” tax benefits that would be credited directly to shareholders’ equity when the grant generates a tax deduction (or a reduction in proceeds if there is a charge to equity). For a further discussion on the Company’s stock option plans, see note 3, below.

 

The following table illustrates the data used in computing basic EPS and a reconciliation to derive at the components

 

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of diluted EPS for the periods indicated:

 

Three months ended March 31,		2006			2005
Basic EPS:
Net income available to common shareholders		$	1,031,631		$	1,019,389
Weighted-average common shares outstanding		2,041,979			2,025,425
Basic EPS		$	0.51		$	0.50
Diluted EPS:
Net income available to common shareholders		$	1,031,631		$	1,019,389
Weighted-average common shares outstanding		2,041,979			2,025,425
Dilutive potential common shares		2,321			580
Weighted-average common shares and dilutive potential shares		2,044,300			2,026,005
Diluted EPS		$	0.50		$	0.50

 

3.                                      Stock plans

 

In December 2004, the Financial Accounting Standard Board, (the “FASB”) issued SFAS 123R, Share-Based Payment, which replaces SFAS 123, Accounting for Stock-Based Compensation, and supersedes Accounting Principles Bulletin Opinion 25, Accounting for Stock Issued to Employees. SFAS 123R requires that the cost of share-based payment transactions (including those with employees and non-employees) be recognized in the financial statements. SFAS 123R applies to all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share options, or other equity instruments (except for those held by an ESOP) or by incurring liabilities (1) in amounts based (even in part) on the price of the entity’s shares or other equity instruments, or (2) that require (or may require) settlement by the issuance of an entity’s shares or other equity instruments.

 

On January 1, 2006, the Company implemented the provisions SFAS 123R using the Modified Prospective Application transition method (the “MPA”). The MPA requires the Company to apply the provisions of SFAS 123R to: (a) new awards granted after its adoption; (b) any awards that were granted after the first fiscal year beginning after December 15, 1994 that have not vested by the date the Company adopts SFAS 123R; and (c) any outstanding liability awards. Under the MPA, the Company is not required to adjust prior years’ financial statements. In addition, as of December 31, 2005, all of the Bank’s stock option awards granted, prior to that date, were fully vested and therefore the Bank is not required to apply the provisions of SFAS 123R to these previously granted share-based awards. Therefore, the following discussion will be most applicable to share-based awards issued during the first quarter of 2006.

 

The Company has two stock-based compensation plans (the “plans”). The plans were shareholder-approved and permit the grant of share-based compensation awards to its directors, key officers and certain other employees. The Company believes that these plans better align the interest of its directors, key officers and employees with the interest of its shareholders. The Company further believes that the granting of share-based awards, under the provisions of the plans, is necessary to retain the knowledge base, continuity and expertise of its directors, key officers and certain employees.

 

The Company established the 2000 Independent Directors Stock Option Plan and has reserved 55,000 shares of its un-issued capital stock for issuance under the plan. Under the 2000 Independent Directors Stock Option Plan, each outside director is awarded stock options to purchase 500 shares of the Company’s common stock on the first business day of January, each year, at the fair market value on date of grant. No stock options were awarded during the first quarter of 2006 or for each of the years ended December 31, 2005, 2004 and 2003 due to the directors’ voluntary election to forego the award. At March 31, 2006 and December 31, 2005, there were 14,850 unexercised stock options outstanding under this plan.

 

The Company has also established the 2000 Stock Incentive Plan and has reserved 55,000 shares of its un-issued capital stock for issuance under the plan. Under the 2000 Stock Incentive Plan, key officers and certain other

 

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employees are eligible to be awarded qualified stock options to purchase the Company’s common stock at the fair market value on the date of grant. During the first quarter of 2006, 2,200 shares were issued under the 2000 Stock Incentive plan. No stock options were awarded for each of the years ended December 31, 2005, 2004 and 2003. As of March 31, 2006 and December 31, 2005, there were 5,830 and 5,280, respectively, unexercised stock options outstanding under this plan.

 

Under both plans, options are granted with an exercise price equal to the market price of the Company’s stock at the date of grant. The awards vest based on six months of continuous service from the date of grant and have 10-year contractual terms. Generally, all shares that are granted become fully vested.

 

The Company does not have stock options that are traded on organized capital exchanges. As such, the estimated fair value of options awarded under its plans is determined, on the date of grant, using the Black-Scholes Option Pricing Valuation Model. For the options granted during the first quarter of 2006, the model incorporated the assumptions noted in the following table:

 

Expected volatility		16.00	%
Expected dividend		2.41	%
Risk-free interest rate		4.35	%
Expected term		5.25	years

 

The expected volatility was determined based on the daily five-year historical volatility of the Company’s stock. Management believes the five-year historical volatility measurement closely resembles the fluctuation of its stock under most economic conditions and cycles. Because of the relatively short vesting period, the model assumes that all options granted will fully vest. The risk-free rate is for the period within the expected term of the options based on the U.S. Treasury yield curve. The Company used the simplified method to determine the term in which options are expected to be outstanding.

 

A summary of the status of the Company’s stock option plans as of March 31, 2006, December 31, 2005 and December 31, 2004 and changes during the periods is presented below:

 

							Weighted-
				Weighted-			average
				average			remaining		Aggregate
				exercise			contractual		intrinsic
		Options		price *			term (yrs)		value
Outstanding, December 31, 2004		20,570		$	32.29		5.7
Granted		—
Exercised		—
Forfeited or expired		(440	)	34.09
Outstanding, December 31, 2005		20,130		32.25			4.7
Granted		2,200		36.59
Exercised		—
Forfeited or expired		(1,650	)	33.07
Outstanding, March 31, 2006		20,680		$	32.64		5.0		$	102,482
Exercisable, March 31, 2006		18,480		$	32.17		4.4		$	100,260

 

* Includes options with exercise prices ranging from $28.18 to $36.59 per share.

 

 

No options have been granted under the 2000 Independent Directors Stock Option Plan since 2002 and all options previously granted and outstanding are fully vested. As of March 31, 2006, no options have been exercised under the provisions of this plan.

 

Under the 2000 Stock Incentive Plan, the grant-date fair value of the options granted during the three months ended March 31, 2006 was determined to be $6.21 per share. Approximately $6,800 of stock-based compensation expense was recorded during the quarter ended March 31, 2006 and is included as a component of salaries and employee benefits in the consolidated income statement. Since the plan is a qualified option plan under the Internal Revenue Code, no tax benefit will be recorded until the shares are exercised by the recipients. No options were exercised

 

10

 

during the periods presented. Since the Company adopted SFAS 123R on January 1, 2006, under the MPA, the comparable data for the previous periods is not required to be reported. As of March 31, 2006, there were 2,200 non-vested shares with a grant-date fair value of $6.21 per share. Therefore, there was approximately $6,800 of unrecognized compensation expense related to the non-vested share-based compensation agreements granted under the plan as of March 31, 2006. The non-vested shares and related unrecognized compensation are expected to fully vest and be recognized during the second quarter of 2006.

 

In addition to the two stock option plans above, the Company has established the 2002 Employee Stock Purchase Plan (the “ESPP”) and has reserved 110,000 shares of its un-issued capital stock for issuance under the plan. The plan was designed to promote broad-based employee ownership of the Company’s stock. Under the 2002 ESPP, employees may have automatic payroll deductions to purchase the Company’s capital stock at a discounted price based on the fair market value of the Company’s capital stock on either the commencement date or termination date. At March 31, 2006, 6,051 shares have been issued under the plan. The ESPP is considered a compensatory plan and, as such, is required to comply with the provisions of SFAS 123R. The Company recognizes compensation expense on its ESPP Plan on the date the shares are purchased. For the three months ended March 31, 2006, compensation expense related to the ESPP amounted to approximately $15,000 and is included as a component of salaries and employee benefits in the consolidated income statement.

 

Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following is Management’s discussion and analysis of the significant changes in the consolidated financial condition of the Company as of March 31, 2006 compared to December 31, 2005 and the results of operations for the three months ended March 31, 2006 and March 31, 2005. Current performance may not be indicative of future results. This discussion should be read in conjunction with the Company’s 2005 Annual Report filed on Form 10-K.

 

Forward looking statements

 

This Interim Report on Form 10-Q contains a number of forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. These statements may be identified by the use of the words “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “outlook,” “plan,” “potential,” “predict,” “project,” “should,” “will,” “would” and similar terms and phrases, including references to assumptions. Forward looking statements include risks and uncertainties.

 

Forward-looking statements are based on various assumptions and analyses made by us in light of Management’s experience and its perception of historical trends, current conditions and expected future developments, as well as other factors Management believes are appropriate under the circumstances. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors (many of which are beyond our control) that could cause actual results to differ materially from future results expressed or implied by such forward-looking statements. These factors include, without limitation, the following:

 

•                  the timing and occurrence or non-occurrence of events may be subject to circumstances beyond our control;

 

•                  there may be increases in competitive pressure among financial institutions or from non-financial institutions;

 

•                  changes in the interest rate environment may reduce interest margins;

 

•                  changes in deposit flows, loan demand or real estate values may adversely affect our business;

 

•                  changes in accounting principles, policies or guidelines may cause our financial condition to be perceived differently;

 

•                  general economic conditions, either nationally or locally in some or all areas in which we do business, or conditions in the securities markets or the banking industry may be less favorable than we currently anticipate;

 

•                  legislative or regulatory changes may adversely affect our business;

 

•                  technological changes may be more rapid, difficult or expensive than we anticipate;

 

11

 

•                  success or consummation of new business initiatives may be more difficult or expensive than we anticipate;

 

•                  acts of war or terrorism; or

 

•                  natural disaster.

 

Management cautions readers not to place undue reliance on forward-looking statements, which reflect analyses only as of the date of this document. We have no obligation to update any forward-looking statements to reflect events or circumstances after the date of this document. Readers should review the risk factors described in other documents that we file or furnish, from time to time, with the Securities and Exchange Commission, including Annual Reports to Shareholders, Annual Reports filed on Form 10-K and other current reports filed or furnished on Form 8-K.

 

General

 

The Company’s principal revenues are derived from interest, dividends and fees earned on its interest-earning assets, which are comprised of loans, securities and other short-term investments. The Company’s principal expenses consist of interest paid on its interest-bearing liabilities, which are comprised of deposits, short-and long-term borrowings and operating and general expenses. The Company’s profitability depends primarily on its net interest income, which is the difference between interest income generated from its interest-earning assets and the interest expense incurred on its interest-bearing liabilities. Net interest income is dependent upon the interest-rate spread, which is the difference between the average yield earned on interest-earning assets and the average rate paid on interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, any positive rate spread will generate net interest income. The interest rate spread is significantly impacted by changes in interest rates and market yield curves and their related impact on cash flows, customer deposit flows and loan demand. The interest rate spread is further influenced by the composition and characteristics of interest-earning assets and interest-bearing liabilities and by the competition in our marketplace. The interest rate spread and the changes in the interest rate spread, from period-to-period, is also affected by differences in the maturity and re-pricing characteristics of the assets compared to the maturity and re-pricing characteristics of the liabilities that fund them.

 

The Company’s profitability is also affected by the level of its non-interest income and expenses, provision for loan losses and provision for income taxes. Non-interest income consists mostly of service charges on the Bank’s loan and deposit products, trust and asset management service fees, increases in the cash surrender value of the bank owned life insurance (“BOLI”), net gains or losses from sales of leases, securities and loans AFS and from the sale of other real estate (“ORE”) properties. Non-interest expense consists of compensation and related employee benefit expenses, occupancy, equipment, data processing, advertising, marketing, professional fees, insurance and other operating overhead.

 

The Company’s profitability is significantly affected by general economic and competitive conditions, changes in market interest rates, government policies and actions of regulatory authorities. The Company’s loan portfolio is comprised principally of commercial and commercial real estate loans. The properties underlying the Company’s mortgages are concentrated in Northeastern Pennsylvania. Credit risk, which represents the possibility of the Company not recovering amounts due from its borrowers, is significantly related to local economic conditions in the areas the properties are located as well as the Company’s underwriting standards. Economic conditions affect the market value of the underlying collateral as well as the levels of adequate cash flow and revenue generation from income-producing commercial and multi-family properties.

 

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COMPARISON OF RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED

MARCH 31, 2006 AND MARCH 31, 2005

 

Overview

 

Net income for the first quarter of 2006 was $1,032,000, an increase of $13,000 or 1%, from the $1,019,000 recorded in the same quarter in 2005. Diluted earnings per share for each of the respective periods was $0.50.

 

The improvement in net income was primarily the result of an increase in total interest income and an increase in non-interest income. These items were partially offset by increases in interest expense and other operating expenses.

 

The change in net income resulted in marginal variances in return on average assets (“ROA”) and return on average shareholders’ equity (“ROE”) at 0.75% and 8.81%, respectively, for the three months ended March 31, 2006 compared to 0.77% and 8.85%, respectively, for the same period in 2005.

 

Net interest income and interest sensitive assets / liabilities

 

Net interest income decreased $46,000, or 1%, to $4,230,000 for the first quarter of 2006, from $4,276,000 recorded in the same period of 2005. The decrease was principally due to the effect rising interest rates had on the rates paid on average interest-bearing liabilities compared to the effect rising interest rates had on our interest-earning assets. Rates paid increased 78 basis points, to 3.36%, for the three months ended March 31, 2006 compared to 2.58% for the same 2005 period. In addition to the increase in rates paid, there was an increase in the average interest-bearing liabilities of $17,531,000 during the same comparable periods. To be competitive in our marketplace, Management has endeavored to attract and retain core deposits by aggressively pursing these products via various marketing and rate enhancing techniques. From these efforts, average core deposits, which excludes time deposits of greater than $100,000, increased approximately $42,157,000 during the first quarter of 2006 compared to the fourth quarter of 2005 and increased $51,586,000 from the quarter ended March 31, 2005. As a result, interest expense on deposits increased $841,000, or 54%, during the first quarter of 2006 compared to the same quarter of 2005. Interest expense on borrowings increased $124,000, or 11%, due predominantly to increases in market rates. Average balances of non-interest bearing deposits (“DDAs”) remained stable from year-end December 31, 2005. DDAs are an important funding source as they have the effect of reducing the cost of money that is used to fund interest-earning assets. Management has committed to continue the campaign to attract and retain these core-deposits and will further implement deposit-gathering strategies throughout 2006.

 

Partially offsetting the increase in interest expense was a $919,000, or 13%, increase in interest income. The increase was due primarily to a 49 basis point increase on the rates earned on its average interest-earning assets which also increased in the first quarter of 2006 compared to the first quarter of 2005. During this period, the loan portfolio increased $28,556,000 on average and yielded 41 basis points more during the current year quarter than in the same quarter of 2005. The increase in the loan portfolio was from the successful implementation of various sales campaigns programs targeted at mortgage and home equity lending products and increased production in commercial lending. Both the increase in yield and average interest-earning assets supported net interest income, but to a lesser degree than the effect higher rates paid on interest-bearing liabilities.

 

During the first quarter of 2006, the Bank’s tax-equivalent margin and spread both decreased 14 and 27 basis points, respectively, compared to the first quarter of 2005. The decline in margin and spread is the result of the rates paid on the Bank’s interest-bearing liabilities increasing at a faster pace than the increase in the yields earned on interest-earning assets.

 

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The following table sets forth, a comparison of average balance sheet amounts and their corresponding tax-equivalent interest income and expense and annualized tax-equivalent yield and cost for the periods indicated (dollars in thousands):

 

		Three months ended						Year ended
		March 31,						December 31,
		2006			2005			2005
Average interest-earning assets:
Loans and leases		$	414,410		$	385,854		$	391,854
Investments		114,098			118,421			113,562
Federal funds sold		3,385			6,369			1,866
Interest-bearing deposits		280			642			540
Total		$	532,173		$	511,286		$	507,822
Average interest-bearing liabilities:
Other interest-bearing deposits		$	172,856		$	116,709		$	126,481
Certificates of deposit		157,446			182,905			174,688
Borrowed funds		87,158			76,300			82,114
Repurchase agreements		24,786			48,801			35,106
Total		$	442,246		$	424,715		$	418,389
Interest income:
Loans and leases		$	6,699		$	5,832		$	24,514
Investments		1,306			1,211			4,979
Federal funds sold		35			40			49
Interest-bearing deposits		3			3			14
Total		$	8,043		$	7,086		$	29,556
Interest expense:
Other interest-bearing deposits		$	1,050		$	232		$	1,573
Certificates of deposit		1,347			1,324			5,355
Borrowed funds		1,131			945			4,159
Repurchase agreements		135			197			634
Total		$	3,663		$	2,698		$	11,721
Net interest income		$	4,380		$	4,388		$	17,835
Yield on average interest-earning assets		6.13		%	5.62		%	5.82		%
Rate on average interest-bearing liabilities		3.36		%	2.58		%	2.80		%
Net interest spread		2.77		%	3.04		%	3.02		%
Net interest margin		3.34		%	3.48		%	3.51		%

 

In the table above, interest income was adjusted to a tax-equivalent basis to recognize the income from the various tax-exempt assets as if the interest was fully taxable. This treatment allows a uniform comparison among the yields on interest-earning assets. The calculations were computed on a fully tax-equivalent basis using the corporate federal tax rate of 34%. Net interest spread represents the difference between the yield on interest-earning assets and the rate on interest-bearing liabilities. Net interest margin represents the ratio of net interest income to total average interest-earning assets.

 

Provision for loan losses

 

The provision for loan losses represents the necessary amount to charge against current earnings, the purpose of which is to increase the allowance for loan losses to a level that represents Management’s best estimate of known and inherent losses in the Bank’s loan and lease portfolio. Loans and leases determined to be uncollectible are charged-off against the allowance for loan losses.

 

The required amount of the provision for loan losses, based upon the adequate level of the allowance for loan losses, is subject to ongoing analysis of the loan portfolio. The Bank’s Special Asset Committee meets periodically to review problem loans and leases. The committee is comprised of Bank Management, including the chief risk officer, loan

 

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workout officers and collection personnel. The committee reports quarterly to the Credit Administration Committee of the Board of Directors.

 

Management continuously reviews the risks inherent in the loan and lease portfolio. Specific factors used to evaluate the adequacy of the loan loss provision during the formal process include:

 

•                  Specific loans that could have loss potential

•                  Levels of and trends in delinquencies and non-accrual loans

•                  Levels of and trends in charge-offs and recoveries

•                  Trends in volume and terms of loans

•                  Changes in risk selection and underwriting standards

•                  Changes in lending policies, procedures and practices

•                  Experience, ability and depth of lending management

•                  National and local economic trends and conditions

•                  Changes in credit concentrations

 

The provision for loan losses was $75,000, for the three months ended March 31, 2006, compared to $80,000 for the three months ended March 31, 2005. As a result, the allowance was $5,716,000 at March 31, 2006 compared to $6,001,000 at March 31, 2005. The decrease in the provision for loan losses was driven by a decrease in non-performing loans, which consist of loans past due 90 days or more and non-accrual loans. The balance of non-performing loans declined $654,000 to $8,996,000 at March 31, 2006, compared to $9,650,000 at December 31, 2005. The decrease was mainly attributable to the collection and pay-offs of non-accrual loans. Our Special Assets Department continues to aggressively manage and pursue the collection and resolution of non-accruing loans which has resulted in these reductions.

 

Other income

 

Total other (non-interest) income increased $380,000, or 51%, for the three months ended March 31, 2006 compared to the same period in 2005. During the 2005 quarter, the Bank recognized an estimated impairment charge of $220,000 in anticipation of projected realized losses from the future sales of its leased vehicles. The Bank’s automobile lease finance business concluded in 2005, and similar impairment charges from this activity will not recur. Service charges on deposit accounts increased $33,000 or 6%, due primarily to growth in debit card activity. Fees, other service charges and other non-interest related income increased $50,000 or 12%, from increases in trust and financial service fees and an increase in the cash surrender value of BOLI during the first quarter of 2006 compared to the same period of 2005.

 

Other operating expenses

 

Other (non-interest) expenses increased $355,000, or 10%, for the three months ended March 31, 2006 compared to the same period in 2005. Salary and employee benefits increased $264,000, or 15%, due to pay increases, increased number of full-time equivalent employees, one-time voluntary separation benefit payments and stock-based compensation expense (see footnote 3, “Stock Plans”, of the consolidated financial statements, included herein for a discussion on the Company’s adoption of SFAS 123R). The increase in premises and equipment was caused by increased repair and maintenance associated with maintenance agreement renewal costs. The decrease in professional service fees was caused mostly by non-recurring expenses associated with the 2005 Bank-wide participation in management skills development and sales training programs as well as a decrease in outside consulting fees for Sarbanes-Oxley compliance documentation procedures.

 

Income tax provision

 

Compared to the first quarter of 2005, income before provision for income taxes for the first quarter of 2006 was relatively unchanged. The effective federal income tax rate was 26.0% for 2005 and 24.2% for 2006. The effective tax rate decrease is attributable to an increased portion of combined tax-free interest income from municipal securities, tax-free loans and tax-free earnings from the BOLI, collectively representing a larger portion of pre-tax earnings.

 

15

 

COMPARISON OF FINANCIAL CONDITION AT

MARCH 31, 2006 AND DECEMBER 31, 2005

 

Overview

 

Consolidated assets increased $25,226,000, or 5%, during the three months ended March 31, 2006 to $569,287,000. The asset increase resulted from an increase in deposits of $29,006,000, partially offset by a decrease in combined short-and long-term borrowings of $4,025,000. Total investments and net loans increased $18,527,000 and $7,760,000, respectively, since December 31, 2005. Shareholders’ equity increased modestly with increases from net income, stock issuance from the Company sponsored employee stock purchase and the dividend reinvestment plans and recognition of stock-based compensation, partially offset by an increase in the unrealized loss on AFS securities and an increase in cash dividends declared. The decline in the market value of securities AFS is due to the predominant increasing interest rate environment which largely began in 2004.

 

Investment securities

 

At the time of purchase, the Bank classifies investment securities into one of three categories: trading, AFS or held-to- maturity (“HTM”). To date, Management has not purchased any securities for trading purposes. Management classifies most securities as AFS even though it has no immediate intent to sell them. The AFS designation affords Management the flexibility to sell securities and adjust the balance sheet in response to capital levels, liquidity needs, structuring strategies and/or changes in market conditions. Securities AFS are carried at net fair market value in the consolidated balance sheet with an adjustment to stockholders’ equity, net of tax, which is presented under the caption “Accumulated other comprehensive income (loss).”  Securities designated as HTM are carried at amortized cost.

 

At March 31, 2006, the carrying value of investment securities totaled $116,206,000, or 20%, of total assets compared to $97,679,000 or 18%, as of December 31, 2005. The increase in investments was due to the deployment of deposit inflow, mostly into short-term U.S. government agency securities, to meet regulatory requirements. At March 31, 2006, approximately 35% of the carrying value of the investment portfolio was comprised of mortgage-backed securities that amortize and provide monthly cash flow. Also, as March 31, 2006, agency and municipal bonds comprised 44% and 13%, respectively, of the investment portfolio.

 

As illustrated in the following table of amortized cost and fair market value of investment securities, the portfolio is comprised of HTM and AFS securities with carrying values of $1,911,000 and $114,295,000, respectively. At March 31, 2006, the AFS debt securities were recorded with a net unrealized loss in the amount of $2,925,000 and equity securities were recorded with an unrealized gain of $182,000:

 

		Amortized			Gross unrealized			Gross unrealized			Fair
(dollars in thousands)		cost			gains			losses			value
Held-to-maturity securities:
Mortgage-backed securities		$	1,911		$	30		$	—		$	1,941
Available-for-sale securities:
U.S. government agencies and corporations		$	51,907		$	—		$	1,212		$	50,695
Obligations of states and municipal subdivisions		14,726			34			172			14,588
Corporate bonds		10,015			63			—			10,078
Mortgage-backed securities		40,111			—			1,638			38,473
Total debt		116,759			97			3,022			113,834
Equity securities		279			182			—			461
Total available-for-sale		$	117,038		$	279		$	3,022		$	114,295

 

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The amortized cost and fair value of debt securities at March 31, 2006 by contractual maturity are as follows (dollars in thousands):

 

 

Expected maturities will differ from contractual maturities because issuers and borrowers may have the right to call or repay obligations with or without call or prepayment penalty. Federal agency and municipal securities are included based on their original stated maturity. Mortgage-backed securities, which are based on weighted-average lives and subject to monthly principal pay-downs, are listed in total.

 

Management evaluates securities for other-than-temporary impairment on a quarterly basis or more frequently when economic conditions or market conditions warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

 

At March 31, 2006, the AFS debt securities portfolio was carried at a net unrealized loss $2,925,000 compared to $1,859,000 at December 31, 2005. The U.S. government or its agencies guarantee most of the debt and mortgage-backed securities. In analyzing an issuer’s financial condition, Management considers whether the securities are issued by the U.S. government, its agencies or other governments, whether downgrades by bond rating agencies have occurred and the results of reviews of the issuer’s financial condition. Because the decline in market values is attributable to changes in interest rates and not credit quality, and the Company has the ability and intent to hold those securities until a recovery of fair value, which may be maturity, Management does not consider those securities to be other-than-temporarily impaired.

 

Loans available - for- sale (“AFS”)

 

Generally, upon origination, certain residential mortgages, the guaranteed portions of Small Business Administration loans and student loans are classified as AFS. In the event of market rate increases, fixed-rate loans and loans not immediately scheduled to re-price would no longer produce yields consistent with the current market. In a declining interest rate environment, the Bank would be exposed to prepayment risk and, as rates on adjustable rate loans decrease, interest income would be negatively affected. To better manage prepayment and interest rate risk, loans that meet these conditions may be considered for sale in the secondary market. Consideration is also given to the Company’s current liquidity position and expected future liquidity needs. Loans AFS are carried at the lower of cost or estimated fair value. If the fair market values of these loans fall below their amortized cost, the loan is written down by the difference with a corresponding charge to current earnings. Subsequent appreciation, if any, is credited to current earnings but only to the extent of previous write-downs.

 

At March 31, 2006, loans AFS amounted to $953,000 with a corresponding fair value of $965,000, compared to $429,000 and $434,000, respectively, at December 31, 2005. For the first quarter of 2006, residential mortgage and student loans with principal balances of $1,769,000 were sold into the secondary market with combined net gains of approximately $15,000 recognized.

 

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Loans and leases

 

The Bank originates commercial and industrial (commercial) and commercial real estate loans, residential, consumer, home equity and construction loans. The relative volume of originations is dependent upon customer demand, current interest rates and the perception and duration of future interest levels. The Bank continues to focus its efforts on the expansion of variable-rate commercial loan portfolios and fixed-rate residential mortgage and consumer loans. The broad spectrum of products provides diversification which helps manage, to an extent, interest rate risk and credit concentration risk. Credit risk is further managed through underwriting policies and procedures and loan monitoring practices. Interest rate risk is managed using various asset/liability modeling techniques and analyses. The interest rates on most commercial loans are adjustable with reset intervals of five years or less.

 

The majority of our loan portfolio is collateralized, at least in part, by real estate in the greater Lackawanna and Luzerne Counties of Pennsylvania. Commercial lending activities generally involve a greater degree of credit risk than residential lending because they typically have larger balances and are more affected by adverse conditions in the economy. Because payments on commercial loans depend upon the successful operation and management of the properties and the businesses which operate from within them, repayment of such loans may be affected by factors outside the borrower’s control. Such factors may include adverse conditions in the real estate market, the economy, the industry or changes in government regulations. As such, commercial loans require more ongoing evaluation and monitoring which occurs with the Bank’s credit administration and outsourced loan review functions.

 

Gross loans, of $416,096,000 at March 31, 2006 increased from $409,129,000 at December 31, 2005. Strength in origination activity has boosted the commercial and residential real estate portfolios. Residential real estate loan growth was reasonably strong due to the demand generated from a relatively low interest rate environment and efforts of advertising and marketing campaigns. The increase in commercial and commercial real estate lending is principally due to the addition of experienced senior lenders to the commercial lending team and the team’s focus on providing outstanding service and value-added proposals to the Bank’s customer base.

 

The composition of the loan portfolio at March 31, 2006 and December 31, 2005, is summarized as follows:

 

		March 31, 2006					December 31, 2005
		Amount			%		Amount			%
Commercial and commercial real estate		$	219,743,485		52.8		$	216,288,597		52.9
Residential real estate		107,573,042			25.8		103,920,613			25.4
Consumer and home equity		74,463,688			17.9		74,070,328			18.1
Real estate construction		13,681,138			3.3		14,198,858			3.4
Direct financing leases		634,962			0.2		650,348			0.2
Gross loans		416,096,315			100.0		409,128,744			100.0
Allowance for loan losses		(5,716,473		)			(5,984,649		)
Net loans		$	410,379,842				$	403,144,095

 

Allowance for loan losses

 

Management continually evaluates the credit quality of the Bank’s loan and lease portfolio and performs a formal review of the adequacy of the allowance for loan losses (the “allowance”), on a quarterly basis. The allowance reflects Management’s best estimate of the amount of credit losses in the loan portfolio. Management’s judgment is based on the evaluation of individual loans, past experience, the assessment of current economic conditions and other relevant factors including the amounts and timing of cash flows expected to be received on impaired loans. Those estimates may be susceptible to significant change. The provision for loan losses represents the amount necessary to maintain an appropriate allowance. Loan losses are charged directly against the allowance when loans are deemed to be uncollectible. Recoveries from previously charged-off loans are added to the allowance when received.

 

Management applies two primary components during the loan review process to determine proper allowance levels. The two levels are specific loan loss allocation for loans that are deemed impaired and a general loan loss allocation for those loans not specifically allocated. The methodology to analyze the adequacy of the allowance for loan losses is as follows:

 

18