UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

FORM 10-K

 

ý   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2005

 

OR

 

o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)

 

For the transition period from                                    to

 

Commission file number 0-17077

 

PENNS WOODS BANCORP, INC.

(exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code     (570) 322-1111

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities to be registered pursuant to Section 12(g) of the Act:

 

Common Stock, par value $8.33 per share

(Title of Class)

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

o Yes  ý No

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

o Yes  ý No

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes                                                               ý         No        o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.      ý

 

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  ý  Non-accelerated filer o

 

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

 

State the aggregate market value of the voting stock held by non-affiliates of the registrant $124,212,908 at June 30, 2005.

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s definitive proxy statement prepared in connection with its annual meeting of shareholders to be held on April 26, 2006 are incorporated by reference in Part III hereof.

 

 

PART I

 

ITEM 1   BUSINESS

 

A. General Development of Business and History

 

On January 7, 1983, Penns Woods Bancorp, Inc. (the “Company”) was incorporated under the laws of the Commonwealth of Pennsylvania as a bank holding company. The Jersey Shore State Bank (the “Bank”) became a wholly owned subsidiary of the Company, and each outstanding share of Bank common stock was converted into one share of Company common stock. This transaction was approved by the shareholders of the Bank on April 11, 1983 and was officially effective on July 12, 1983. The Company’s business has consisted primarily of managing and supervising the Bank, and its principal source of income has been dividends paid by the Bank. The Company’s two other wholly-owned subsidiaries are Woods Real Estate Development Co, Inc. and Woods Investment Co., Inc.

 

The Bank is engaged in commercial and retail banking and the taking of time and regular savings and demand deposits, the making of commercial and consumer loans and mortgage loans, and safe deposit services. Auxiliary services, such as cash management, are provided to commercial customers. The Bank operates full banking services with twelve branch offices in Northcentral Pennsylvania.

 

In October 2000, the Bank acquired The M Group, Inc. D/B/A The Comprehensive Financial Group (“The M Group”). The M Group, which operates as a subsidiary of the Bank, offers insurance and securities brokerage services. Securities are offered by The M Group through ING Financial Partners, Inc., a registered broker-dealer.

 

Neither the Company nor the Bank anticipates that compliance with environmental laws and regulations will have any material effect on capital expenditures, earnings, or on its competitive position. The Bank is not dependent on a single customer or a few customers, the loss of whom would have a material effect on the business of the Bank.

 

The Bank employed approximately 189 persons as of December 31, 2005 in either a full-time or part-time capacity. The Company does not have any employees. The principal officers of the Bank also serve as officers of the Company.

 

A copy of the Code of Ethics and Code of Conduct for the Corporation can be requested from Brian Knepp, Vice President of Finance, at 300 Market Street, Williamsport, PA 17701. A link with access to the Corporation’s SEC 10K filings, annual reports, and quarterly filings can be found at www.jssb.com.

 

B. Regulation and Supervision

 

The Company is also subject to the provisions of the Bank Holding Company Act of 1956, as amended (the “BHCA”) and to supervision and examination by the Board of Governors of the Federal Reserve System (the “FRB”). The Bank is subject to the supervision and examination by the Federal Deposit Insurance Corporation (the “FDIC”), as its primary federal regulator and as the insurer of the Bank’s deposits. The Bank is also regulated and examined by the Pennsylvania Department of Banking (the “Department”).

 

The insurance activities of The M Group are subject to regulation by the insurance departments of the various states in which The M Group conducts business including principally the Pennsylvania Department of Insurance. The securities brokerage activities of The M Group are subject to regulation by federal and state securities commissions.

 

The FRB has issued regulations under the BHCA that require a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. As a result, the FRB, pursuant to such regulations, may require the Company to stand ready to use its resources to provide adequate capital funds to the Bank during periods of financial stress or adversity. The BHCA requires the Company to secure the prior approval of the FRB before it can acquire all or substantially all of the assets of any bank, or acquire ownership or control of 5% or more of any voting shares of any bank. Such a transaction would also require approval of the Department.

 

A bank holding company is prohibited under the BHCA from engaging in, or acquiring direct or indirect control of, more than 5% of the voting shares of any company engaged in non-banking activities unless the FRB, by order or regulation, has found such activities to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.

 

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Under the BHCA, the FRB has the authority to require a bank holding company to terminate any activity or relinquish control of a non-bank subsidiary (other than a non-bank subsidiary of a bank) upon the FRB’s determination that such activity or control constitutes a serious risk to the financial soundness and stability of any bank subsidiary of the bank holding company.

 

Bank holding companies are required to comply with the FRB’s risk-based capital guidelines. The risk-based capital rules are designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks and bank holding companies and to minimize disincentives for holding liquid assets. Currently, the required minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) is 8%. At least half of the total capital is required to be Tier 1 capital, consisting principally of common shareholders’ equity, less certain intangible assets. The remainder (“Tier 2 capital”) may consist of certain preferred stock, a limited amount of subordinated debt, certain hybrid capital instruments and other debt securities, 45% of net unrealized gains on marketable equity securities, and a limited amount of the general loan loss allowance. The risk-based capital guidelines are required to take adequate account of interest rate risk, concentration of credit risk, and risks of nontraditional activities.

 

In addition to the risk-based capital guidelines, the FRB requires each bank holding company to comply with the leverage ratio, under which the bank holding company must maintain a minimum level of Tier 1 capital to average total consolidated assets of 3% for those bank holding companies which have the highest regulatory examination ratings and are not contemplating or experiencing significant growth or expansion. All other bank holding companies are expected to maintain a leverage ratio of at least 4% to 5%. The Bank is subject to similar capital requirements adopted by the FDIC.

 

C. Regulation of the Bank

 

From time to time, various types of federal and state legislation have been proposed that could result in additional regulation of, and restrictions of, the business of the Bank. It cannot be predicted whether any such legislation will be adopted or how such legislation would affect the business of the Bank. As a consequence of the extensive regulation of commercial banking activities in the United States, the Bank’s business is particularly susceptible to being affected by federal legislation and regulations that may increase the costs of doing business.

 

Prompt Corrective Action - The FDIC has specified the levels at which an insured institution will be considered “well- capitalized,” “adequately capitalized,” “undercapitalized,” and “critically undercapitalized.” In the event an institution’s capital deteriorates to the “undercapitalized” category or below, the Federal Deposit Insurance Act (the “FDIA”) and FDIC regulations prescribe an increasing amount of regulatory intervention, including: (1) the institution of a capital restoration plan by a bank and a guarantee of the plan by a parent institution; and (2) the placement of a hold on increases in assets, number of branches, or lines of business. If capital has reached the significantly or critically undercapitalized levels, further material restrictions can be imposed, including restrictions on interest payable on accounts, dismissal of management and (in critically undercapitalized situations) appointment of a receiver. For well-capitalized institutions, the FDIA provides authority for regulatory intervention where the institution is deemed to be engaging in unsafe or unsound practices or receives a less than satisfactory examination report rating for asset quality, management, earnings or liquidity.

 

Deposit Insurance - There are presently two deposit insurance funds administered by the FDIC - the Savings Association Insurance Fund (“SAIF”) and the Bank Insurance Fund (“BIF”). The Bank’s deposits are insured under the BIF; however, the deposits assumed by the Bank in connection with the merger of Lock Haven Savings Bank are treated and assessed as SAIF-insured deposits. The FDIC has implemented a risk-related premium schedule for all insured depository institutions that results in the assessment of premiums based on capital and supervisory measure. Under the risk-related premium schedule, the FDIC assigns, on a semiannual basis, each institution to one of three capital groups (well-capitalized, adequately capitalized or undercapitalized) and further assigns such institution to one of three subgroups within a capital group. The institution’s subgroup assignment is based upon the FDIC’s judgment of the institution’s strength in light of supervisory evaluations, including examination reports, statistical analyses, and other information relevant to gauging the risk posed by the institution. Only institutions with a total capital to risk-adjusted assets ratio of 10.0% or greater, a Tier 1 capital to risk-adjusted assets ratio of 6.0% or greater and a Tier 1 leverage ratio of 5.0% or greater, are assigned to the well-capitalized group. As of December 31, 2005, the Bank’s ratios were well above required minimum ratios.

 

The BIF and SAIF assessment rates range from zero for those institutions with the least risk, to $0.27 for every $100 of insured deposits for institutions deemed to have the highest risk. The Bank is in the category of institutions that presently pay nothing for deposit insurance. While the Bank presently pays no premiums for deposit insurance, it is subject to

 

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assessments to pay the interest on Financing Corporation (“FICO”) bonds. FICO was created by Congress to issue bonds to finance the resolution of failed thrift institutions. The current annual FICO assessment for the Bank (and all banks) is $.0132 per $100 of BIF deposits.

 

In February 2006, deposit insurance modernization legislation was enacted. When the new law becomes effective ( different sections to take effect in the third and fourth quarters of 2006), it will merge the BIF and SAIF into a single Deposit Insurance Fund, increase deposit insurance coverage for IRAs to $250,000, provide for the future increase of deposit insurance on all accounts by authorizing the FDIC to index the coverage to the rate of inflation, authorize the FDIC to set the reserve ratio of the combined Deposit Insurance Fund at a level between 1.15% and 1.50%, and permit the FDIC to establish assessments to be paid by insured banks to maintain the minimum ratios. New deposit insurance assessment rates will not be known until the FDIC conducts extensive research and issues new assessment rates. While the possible assessment rates are unknown, the FDIC has stated that it expects that all banks will be assessed some amount for deposit insurance based upon present expectations. Banks in existence prior to 1996 will receive a partial credit for past deposit insurance premiums paid, but the amount of the credit for a specific bank will not be known until new regulations implementing the assessments and the credits are adopted.

 

Other Legislation

 

The Fair and Accurate Credit Transactions Act (“FACT”) was signed into law on December 4, 2003. This law extends the previously existing Fair Credit Reporting Act. New provisions added by FACT address the growing problem of identity theft. Consumers will be able to initiate a fraud alert when they are victims of identity theft, and credit reporting agencies will have additional duties. Consumers will also be entitled to obtain free credit reports, and will be granted certain additional privacy rights.

 

The Sarbanes-Oxley Act of 2002 was enacted to enhance penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures under the federal securities laws. The Sarbanes-Oxley Act generally applies to all companies, including the Company, that file or are required to file periodic reports with the Securities and Exchange Commission under the Securities Exchange Act of 1934, or the Exchange Act. The legislation includes provisions, among other things, governing the services that can be provided by a public company’s independent auditors and the procedures for approving such services, requiring the chief executive officer and principal accounting officer to certify certain matters relating to the company’s periodic filings under the Exchange Act, requiring expedited filings of reports by insiders of their securities transactions and containing other provisions relating to insider conflicts of interest, increasing disclosure requirements relating to critical financial accounting policies and their application, increasing penalties for securities law violations, and creating a new public accounting oversight board, a regulatory body subject to SEC jurisdiction with broad powers to set auditing, quality control, and ethics standards for accounting firms. In response to the legislation, the national securities exchanges and NASDAQ have adopted new rules relating to certain matters, including the independence of members of a company’s audit committee as a condition to listing or continued listing.

 

In addition, Congress is often considering some financial industry legislation. The Company cannot predict how any new legislation, or new rules adopted by the federal banking agencies, may affect its business in the future.

 

In addition to federal banking law, the Bank is subject to the Pennsylvania Banking Code. The Banking Code was amended in late 2000 to provide more complete “parity” in the powers of state-chartered institutions compared to national banks and federal savings banks doing business in Pennsylvania. Pennsylvania banks have the same ability to form financial subsidiaries authorized by the Gramm-Leach-Bliley Act, as do national banks.

 

Environmental Laws

 

Environmentally related hazards have become a source of high risk and potential liability for financial institutions relating to their loans. Environmentally contaminated properties owned by an institution’s borrowers may result in a drastic reduction in the value of the collateral securing the institution’s loans to such borrowers, high environmental clean up costs to the borrower affecting its ability to repay the loans, the subordination of any lien in favor of the institution to a state or federal lien securing clean up costs, and liability to the institution for clean up costs if it forecloses on the contaminated property or becomes involved in the management of the borrower. The Company is not aware of any borrower who is currently subject to any environmental investigation or clean up proceeding which is likely to have a material adverse effect on the financial condition or results of operations of the Company.

 

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Effect of Government Monetary Policies

 

The earnings of the Company are and will be affected by domestic economic conditions and the monetary and fiscal policies of the United States Government and its agencies. The monetary policies of the FRB have had, and will likely continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to curb inflation or combat a recession. The FRB has a major effect upon the levels of bank loans, investments, and deposits through its open market operations in the United States Government securities and through its regulation of, among other things, the discount rate on borrowing of member banks and the reserve requirements against member bank deposits. It is not possible to predict the nature and impact of future changes in monetary and fiscal policies.

 

DESCRIPTION OF BANK

 

History and Business

 

Jersey Shore State Bank (“Bank”) was incorporated under the laws of the Commonwealth of Pennsylvania as a state bank in 1934 and became a wholly owned subsidiary of the Company on July 12, 1983.

 

As of December 31, 2005, the Bank had total assets of $552,631,000; total shareholders’ equity of $57,170,000 and total deposits of $352,860,000. The Bank’s deposits are insured by the Federal Deposit Insurance Corporation for the maximum amount provided under current law.

 

The Bank engages in business as a commercial bank, doing business at several locations in Lycoming, Clinton, and Centre Counties, Pennsylvania. The Bank offers insurance and securities brokerage services through its wholly owned subsidiary, The M Group, Inc. D/B/A The Comprehensive Financial Group.

 

Services offered by the Bank include accepting time, demand and savings deposits including Super NOW accounts, regular savings accounts, money market accounts, investment certificates, fixed rate certificates of deposit, and club accounts. Its services also include making secured and unsecured commercial and consumer loans, financing commercial transactions, making construction and mortgage loans, and the renting of safe deposit facilities. Additional services include making residential mortgage loans, revolving credit loans with overdraft protection, small business loans, etc. Business loans include seasonal credit collateral loans and term loans.

 

The Bank’s loan portfolio mix can be classified into four principal categories of real estate, agricultural, commercial, and consumer.

 

Real estate loans can be further segmented into construction and land development, farmland, one-to-four family residential, multi-family, and commercial or industrial. Qualified borrowers are defined by policy or by industry underwriting standards. Owner provided equity requirements range from 20% to 30% with a first lien status required. Terms are restricted to between 10 and 20 years with the exception of construction and land development, which is limited to one to five years. Appraisals, verifications, and visitations comply with industry standards.

 

Financial information that is required on all commercial mortgages includes the most current three years balance sheets and income statements and projections on income to be developed through the project. In the case of corporations and partnerships, the principals are often asked to indebt themselves personally as well. Residential mortgages, repayment ability is determined from information contained in the application and recent income tax returns. Emphasis is on credit, employment, income, and residency verification. Broad hazard insurance is always required and flood insurance where applicable. In the case of construction mortgages, builders risk insurance is requested.

 

Agricultural loans for the purchase or improvement of real estate must meet the Bank’s real estate underwriting criteria. The only permissible exception is when a Farmers Home Loan Administration guaranty is obtained. Agricultural loans made for the purchase of equipment are usually payable in five years, but never more than seven, depending upon the useful life of the purchased asset. Minimum borrower equity ranges from 20% to 30%. Livestock financing criteria depends upon the nature of the operation. A dairy herd could be financed over three years, but a feeder operation would require cleanup in intervals of less than one year. Agricultural loans are also made for crop production purposes. Such loans are structured to repay within the production cycle and not carried over into a subsequent year. General purpose working capital loans are also a possibility with repayment expected within one year. It is also a general policy to collateralize non-real estate loans

 

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with not only the asset purchased but also junior liens on all other available assets. Insurance and credit criteria is the same as mentioned previously. In addition, annual visits are made to our agricultural customers to determine the general condition of assets. Personal credit requirements are handled as consumer loans.

 

Commercial loans are made for the acquisition and improvement of real estate, purchase of equipment, and for working capital purposes on a seasonal or revolving basis. Criteria were discussed under real estate financing for such loans, but it is important to note that such loans may be made in conjunction with the Pennsylvania Industrial Development Authority. Caution is also exercised in taking industrial property for collateral by requiring, on a selective basis, environmental audits.

 

Equipment loans are generally amortized over three to seven years, with an owner equity contribution required of at least 20% of the purchase price. Unusually expensive pieces may be financed for a longer period depending upon the asset’s useful life. The increased cash flow resulting from the additional piece, through improved income or greater depreciation expense, serves in establishing the terms. Insurance coverage with the Bank as loss payee is required, especially in the case where the equipment is rolling stock.

 

Seasonal and revolving lines of credit are offered for working capital purposes. Collateral for such a loan includes the pledge of inventory and/or receivables. Drawing availability is usually 50% of inventory and 75% of eligible receivables. Eligible receivables are defined as invoices less than 90 days delinquent. Exclusive reliance is very seldom placed on such collateral; therefore, other lienable assets are also taken into the collateral pool. Where reliance is placed on inventory and accounts receivable, the applicant must provide financial information including agings on a monthly basis. In addition, the guaranty of the principals is usually obtained.

 

It is unusual for the Bank to make unsecured commercial loans. But when such a loan is a necessity, credit information in the file must support that decision.

 

Letter of Credit availability is limited to standbys where the customer is well known to the Bank. Credit criteria is the same as that utilized in making a direct loan and collateral is obtained in most cases, and whenever the expiration date is for more than one year.

 

Consumer loan products include second mortgages, automobile financing, small loan requests, overdraft check lines, and PHEAA referral loans. Our policy includes standards used in the industry on debt service ratios and terms are consistent with prudent underwriting standards and the use of proceeds. Verifications are made of employment and residency, along with credit history. Second mortgages are confined to equity borrowing and home improvements. Terms are generally ten years or less and rates are fixed. Loan to collateral value criteria is 80% or less and verifications are made to determine values. Automobile financing is generally restricted to five years and done on a direct basis. The Bank, as a practice, does not floor plan and therefore does not discount dealer paper. Small loan requests are to accommodate personal needs such as the purchase of small appliances or for the payment of taxes. Overdraft check lines are limited to $5,000 or less.

 

The Bank’s investment portfolio is analyzed and priced on a monthly basis. Investments are made in U.S. Treasuries, U.S. Agency issues, bank qualified municipal bonds, corporate bonds, and corporate stocks which consist of Pennsylvania bank stocks. Bonds with BAA or better ratings are used, unless a local issue is purchased that has a lesser or no rating.

 

Factors taken into consideration when investments are made include liquidity, the Company’s tax position, and the policies of the Asset/Liability Committee.

 

Although the Bank has regular opportunities to bid on pools of funds of $100,000 or more in the hands of municipalities, hospitals, and others, it does not rely on these monies to fund loans on intermediate or longer-term investments. Minor seasonal growth in deposits is experienced at or near the year-end.

 

The Bank operates twelve full service offices in Lycoming, Clinton, and Centre Counties, Pennsylvania. The economic base of the region is developed around service, light manufacturing industries, and agriculture. The banking environment in Lycoming, Clinton, and Centre Counties, Pennsylvania is highly competitive. The Bank competes for loans and deposits with commercial banks, savings and loan associations, and other financial institutions.

 

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The Bank has a relatively stable deposit base and no material amount of deposits is obtained from a single depositor or group of depositors (including federal, state, and local governments). The Bank has not experienced any significant seasonal fluctuations in the amount of its deposits.

 

Supervision and Regulation

 

The earnings of the Bank are affected by the policies of regulatory authorities including the FDIC and the FRB. An important function of the FRB is to regulate the money supply and interest rates. Among the instruments used to implement these objectives are open market operations in U.S. Government Securities, changes in reserve requirements against member bank deposits, and limitations on interest rates that member banks may pay on time and savings deposits. These instruments are used in varying combinations to influence overall growth and distribution of bank loans, investments on deposits, and their use may also affect interest rates charged on loans or paid for deposits.

 

The policies and regulations of the FRB have had and will probably continue to have a significant effect on the Bank’s deposits, loans and investment growth, as well as the rate of interest earned and paid, and are expected to affect the Bank’s operation in the future. The effect of such policies and regulations upon the future business and earnings of the Bank cannot accurately be predicted.

 

ITEM 1A – RISK FACTORS

 

The following sets forth several risk factors that are unique to the Company.

 

Changes in interest rates could reduce our income, cash flows and asset values.

 

Our income and cash flows and the value of our assets depend to a great extent on the difference between the interest rates we earn on interest-earning assets, such as loans and investment securities, and the interest rates we pay on interest-bearing liabilities such as deposits and borrowings. These rates are highly sensitive to many factors which are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Board of Governors of the Federal Reserve System. Changes in monetary policy, including changes in interest rates, will influence not only the interest we receive on our loans and investment securities and the amount of interest we pay on deposits and borrowings but will also affect our ability to originate loans and obtain deposits and the value of our investment portfolio. If the rate of interest we pay on our deposits and other borrowings increases more than the rate of interest we earn on our loans and other investments, our net interest income, and therefore our earnings, could be adversely affected. Our earnings also could be adversely affected if the rates on our loans and other investments fall more quickly than those on our deposits and other borrowings.

 

Economic conditions either nationally or locally in areas in which our operations are concentrated may adversely affect our business.

 

Deterioration in local, regional, national or global economic conditions could cause us to experience a reduction in deposits and new loans, an increase in the number of borrowers who default on their loans and a reduction in the value of the collateral securing their loans, all of which could adversely affect our performance and financial condition. Unlike larger banks that are more geographically diversified, we provide banking and financial services locally. Therefore, we are particularly vulnerable to adverse local economic conditions.

 

Our financial condition and results of operations would be adversely affected if our allowance for loan losses is not sufficient to absorb actual losses or if we are required to increase our allowance.

 

Despite our underwriting criteria, we may experience loan delinquencies and losses. In order to absorb losses associated with nonperforming loans, we maintain an allowance for loan losses based on, among other things, historical experience, an evaluation of economic conditions, and regular reviews of delinquencies and loan portfolio quality. Determination of the allowance inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. At any time there are likely to be loans in our portfolio that will result in losses but that have not been identified as nonperforming or potential problem credits. We cannot be sure that we will be able to identify deteriorating credits before they become nonperforming assets or that we will be able to limit losses on those loans that are identified. We may be required to increase our allowance for loan losses for any of several reasons. Federal regulators, in reviewing our loan portfolio as part of a regulatory examination, may request that we increase our allowance for loan losses. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in our allowance. In addition, if charge-offs in future periods exceed our allowance for loan losses, we will need additional increases in our allowance for loan losses. Any increases in our allowance for loan losses will result in

 

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a decrease in our net income and, possibly, our capital, and may materially affect our results of operations in the period in which the allowance is increased.

 

Many of our loans are secured, in whole or in part, with real estate collateral which is subject to declines in value.

 

In addition to considering the financial strength and cash flow characteristics of a borrower, we often secure our loans with real estate collateral. Real estate values and the real estate market are generally affected by, among other things, changes in local, regional or national economic conditions, fluctuations in interest rates and the availability of loans to potential purchasers, changes in tax laws and other governmental statutes, regulations and policies, and acts of nature. The real estate collateral provides an alternate source of repayment in the event of default by the borrower. If real estate prices in our markets decline, the value of the real estate collateral securing our loans could be reduced. If we are required to liquidate real estate collateral securing loans during a period of reduced real estate values to satisfy the debt, our earnings and capital could be adversely affected.

 

Competition may decrease our growth or profits.

 

We face substantial competition in all phases of our operations from a variety of different competitors, including commercial banks, savings and loan associations, mutual savings banks, credit unions, consumer finance companies, factoring companies, leasing companies, insurance companies and money market mutual funds. There is very strong competition among financial services providers in our principal service area. Our competitors may have greater resources, higher lending limits or larger branch systems than we do. Accordingly, they may be able to offer a broader range of products and services as well as better pricing for those products and services than we can.

 

In addition, some of the financial services organizations with which we compete are not subject to the same degree of regulation as is imposed on federally insured financial institutions. As a result, those nonbank competitors may be able to access funding and provide various services more easily or at less cost than we can, adversely affecting our ability to compete effectively.

 

We may be adversely affected by government regulation.

 

The banking industry is heavily regulated. Banking regulations are primarily intended to protect the federal deposit insurance funds and depositors, not shareholders. Changes in the laws, regulations, and regulatory practices affecting the banking industry may increase our costs of doing business or otherwise adversely affect us and create competitive advantages for others. Regulations affecting banks and financial services companies undergo continuous change, and we cannot predict the ultimate effect of these changes, which could have a material adverse effect on our profitability or financial condition.

 

We rely on our management and other key personnel, and the loss of any of them may adversely affect our operations.

 

We are and will continue to be dependent upon the services of our executive management team. In addition, we will continue to depend on our ability to retain and recruit key commercial loan officers. The unexpected loss of services of any key management personnel or commercial loan officers could have an adverse effect on our business and financial condition because of their skills, knowledge of our market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.

 

Environmental liability associated with lending activities could result in losses.

 

In the course of our business, we may foreclose on and take title to properties securing our loans. If hazardous substances were discovered on any of these properties, we could be liable to governmental entities or third parties for the costs of remediation of the hazard, as well as for personal injury and property damage. Many environmental laws can impose liability regardless of whether we knew of, or were responsible for, the contamination. In addition, if we arrange for the disposal of hazardous or toxic substances at another site, we may be liable for the costs of cleaning up and removing those substances from the site even if we neither own nor operate the disposal site. Environmental laws may require us to incur substantial expenses and may materially limit use of properties we acquire through foreclosure, reduce their value or limit our ability to sell them in the event of a default on the loans they secure. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability.

 

Failure to implement new technologies in our operations may adversely affect our growth or profits.

 

The market for financial services, including banking services and consumer finance services, is increasingly affected by advances in technology, including developments in telecommunications, data processing, computers, automation, Internet-

 

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based banking and telebanking. Our ability to compete successfully in our markets may depend on the extent to which we are able to exploit such technological changes. However, we can provide no assurance that we will be able properly or timely to anticipate or implement such technologies or properly train our staff to use such technologies. Any failure to adapt to new technologies could adversely affect our business, financial condition or operating results.

 

An investment in our common stock is not an insured deposit.

 

Our common stock is not a bank deposit and, therefore, is not insured against loss by the Federal Deposit Insurance Corporation, commonly referred to as the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is subject to the same market forces that affect the price of common stock in any company.

 

ITEM 1B – UNRESOLVED STAFF COMMENTS

 

None.

 

ITEM  2    PROPERTIES

 

The Company owns and leases its properties. Listed herewith are the locations of properties owned or leased, in which the banking offices are located; all properties are in good condition and adequate for the Bank’s purposes:

 

Office		Address
Main		115 South Main Street P.O. Box 5098 Jersey Shore, Pennsylvania 17740		Owned
Bridge Street		112 Bridge Street Jersey Shore, Pennsylvania 17740		Owned
DuBoistown		2675 Euclid Avenue Williamsport, Pennsylvania 17702		Owned
Williamsport		300 Market Street P.O. Box 967 Williamsport, Pennsylvania 17703-0967		Owned
Montgomery		9094 Rt 405 Highway Montgomery, Pennsylvania 17752		Under Lease
Lock Haven		4 West Main Street Lock Haven, Pennsylvania 17745		Owned
Mill Hall		(Inside Wal-Mart), 173 Hogan Boulevard Mill Hall, Pennsylvania 17751		Under Lease
Spring Mills		3635 Penns Valley Road, P.O. Box 66 Spring Mills, Pennsylvania 16875		Owned
Centre Hall		2842 Earlystown Road Centre Hall, Pennsylvania 16828		Land Under Lease
Zion		100 Cobblestone Road Bellefonte, Pennsylvania 16823		Under Lease
State College		(Inside Wal-Mart), 1665 North Atherton Place State College, Pennsylvania 16803		Under Lease
State College		2050 North Atherton Street State College, Pennsylvania 16803		Land Under Lease
The M Group, Inc. D/B/A The		705 Washington Boulevard Williamsport, Pennsylvania 17701		Under Lease

 

9

 

Comprehensive Financial Group

 

ITEM  3    LEGAL PROCEEDINGS

 

The Company is subject to lawsuits and claims arising out of its business. In the opinion of management, after review and consultation with counsel, any proceedings that may be assessed will not have a material adverse effect on the consolidated financial position of the Company.

 

ITEM  4    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

No matters were submitted to a vote of security holders during the fourth quarter of 2005.

 

ITEM 4A  EXECUTIVE OFFICERS OF THE REGISTRANT:

 

NAME		AGE		FIVE-YEAR ANALYSIS OF DUTIES
Ronald A. Walko		59		President and Chief Executive Officer of the Company; the Bank; The M Group; and Woods Investment Company, Inc.; President of Woods Real Estate Development Co, Inc.; and Federal Bank examiner prior to 1986 for an eighteen-year period.
Thomas A. Donofrio		51		Executive Vice President and Chief Administrative Officer of the Company and Bank; Vice President of Woods Real Estate Development Co, Inc.; Executive Vice President of Woods Investment Company, Inc. and President of a bank data processing company prior to 2005 for a period of three years.

 

10

 

PART II

 

ITEM  5    MARKET FOR THE REGISTRANT’S COMMON STOCK, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES

 

The Common Stock is listed on the Nasdaq National Market under the symbol “PWOD”. The following table sets forth (1) the quarterly high and low prices for a share of the Company’s Common Stock during the periods indicated, and (2) quarterly dividends on a share of the Common Stock with respect to each quarter since January 1, 2003. The following quotations represent prices between buyers and sellers and do not include retail markup, markdown or commission. They may not necessarily represent actual transactions.

 

								Dividends
		HIGH			LOW			Declared
2003
First quarter		$	34.39		$	27.38		$	0.23
Second quarter		39.53			31.43			0.23
Third quarter		35.27			32.20			0.23
Fourth quarter		39.93			34.04			0.57
2004
First quarter		$	40.33		$	35.92		$	0.29
Second quarter		39.09			35.39			0.29
Third quarter		42.29			36.80			0.29
Fourth quarter		41.77			37.72			0.60
2005
First quarter		$	41.67		$	38.58		$	0.38
Second quarter		41.58			37.08			0.38
Third quarter		38.30			36.76			0.39
Fourth quarter		39.76			36.67			0.41

 

The Bank has paid cash dividends since 1941. The Company has paid dividends since the effective date of its formation as a bank holding company. It is the present intention of the Registrant’s Board of Directors to continue the dividend payment policy; however, further dividends must necessarily depend upon earnings, financial condition, appropriate legal restrictions and other factors relevant at the time the Board of Directors of the Registrant considers dividend policy. Cash available for dividend distributions to shareholders of the Registrant must initially come from dividends paid by the Bank to the Company. Therefore, the restrictions on the Bank’s dividend payments are directly applicable to the Company.  See also the information appearing in Note 17 to the Consolidated Financial Statements included elsewhere in the Annual Report for additional information related to dividend restrictions.

 

Under the Pennsylvania Business Corporation Law of 1988 a corporation may not pay a dividend, if after giving effect thereto, the corporation would be unable to pay its debts as they become due in the usual course of business and after giving effect thereto the total assets of the corporation would be less than the sum of its total liabilities plus the amount that would be needed, if the corporation were to be dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution of the shareholders whose preferential rights are superior to those receiving the dividend.

 

As of March 7, 2006, the Registrant had approximately 1,255 shareholders of record.

 

11

 

Following is a schedule of the shares of the Company’s common stock purchased by the Company during the fourth quarter of 2005.

 

							Total Number of		Maximum Number (or
							Shares (or Units)		Approximate Dollar Value)
		Total Number of		Average Price Paid			Purchased as Part		of Shares (or Units) that
		Shares (or Units)		per Share (or Units)			of Publicly Announced		May Yet Be Purchased
Period		Purchased		Purchased			Plans or Programs		Under the Plans or Programs
Month#1(October 1- October 31, 2005)		—		$	—		—		—
Month#2 (November 1- November 30, 2005)		7,000		39.20			7,000		39,693
Month#3 (December 1,- December 31, 2005)		4,000		38.95			4,000		35,693

 

12

 

ITEM  6    SELECTED FINANCIAL DATA

 

The following table sets forth certain financial data as of and for each of the years in the five-year period ended December 31, 2005.

 

(In Thousands, Except Per Share Data)		2005			2004			2003			2002			2001
Consolidated Statement of Income Data:
Interest income		$	30,903		$	29,845		$	28,384		$	28,465		$	27,893
Interest expense		10,381			8,768			9,265			10,846			12,481
Net interest income		20,522			21,077			19,119			17,619			15,412
Provision for loan losses		720			465			255			365			372
Net interest income after provision for loan losses		19,802			20,612			18,864			17,254			15,040
Noninterest income		9,431			8,918			9,150			5,965			5,829
Noninterest expense		15,108			14,184			13,137			12,086			11,149
Income before income taxes		14,125			15,346			14,877			11,133			9,720
Applicable income taxes		3,224			4,263			3,703			2,247			1,978
Net Income		$	10,901		$	11,083		$	11,174		$	8,886		$	7,742
Consolidated Balance Sheet at End of Period:
Total assets		$	568,668		$	546,703		$	527,381		$	472,206		$	424,810
Loans		338,438			324,505			275,828			257,845			251,623
Allowance for loan losses		(3,679		)	(3,338		)	(3,069		)	(2,953		)	(2,927		)
Deposits		352,529			356,836			334,318			339,848			305,150
Long-term debt — other		84,478			75,878			70,878			51,778			41,778
Shareholders’ equity		73,919			73,165			69,769			63,142			55,252
Per Share Data:
Earnings per share - Basic		$	2.75		$	2.78		$	2.79		$	2.22		$	1.92
Earnings per share - Diluted		2.74			2.78			2.79			2.22			1.92
Cash dividends declared		1.56			1.47			1.24			1.03			0.93
Book value		18.59			18.36			17.50			15.78			13.78
Number of shares outstanding, at end of period		3,975,787			3,985,832			3,985,872			3,637,595			3,647,508
Average number of shares outstanding-basic		3,971,926			3,990,008			3,996,702			4,003,575			4,046,214
Selected financial ratios:
Return on average shareholders’ equity		14.54		%	15.49		%	16.60		%	15.00		%	14.38		%
Return on average total assets		1.97		%	2.06		%	2.24		%	2.01		%	1.95		%
Net interest income to average interest earning assets		4.30		%	4.33		%	4.36		%	4.25		%	4.16		%
Dividend payout ratio		57.10		%	52.72		%	44.76		%	46.40		%	48.17		%
Average shareholders’ equity to average total assets		13.56		%	13.30		%	13.51		%	13.39		%	13.54		%
Loans to deposits, at end of period		96.00		%	90.94		%	82.50		%	75.87		%	82.46		%

 

Per share data and number of shares outstanding have been adjusted in each reporting period to give retroactive effect to a 10% stock dividend issued November 13, 2003 and a six for five stock split issued November 18, 2005.

 

13

 

ITEM 7     MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

 

RESULTS OF OPERATIONS

 

NET INTEREST INCOME

 

Net interest income is determined by calculating the difference between the yields earned on interest-earning assets and the rates paid on interest-bearing liabilities. To compare the tax-exempt asset yields to taxable yields, amounts are adjusted to taxable equivalents based on the marginal corporate federal tax rate of 34%. The tax equivalent adjustments to net interest income for 2005, 2004, and 2003 were $1,764,000, $906,000, and $1,367,000, respectively.

 

2005 vs 2004

 

Reported net interest income decreased $555,000 or 2.6 % from the year ended December 31, 2004 to 2005. Total interest income increased $1,058,000 and is attributed to the increase of $27,940,000 in the average balance of the loan portfolio coupled with an increase of the tax equivalent yield on investment securities of 46 basis points offset partially by a decrease in the average balance of the investment securities of $17,608,000.

 

On a tax equivalent basis, net interest income increased to $22,286,000 from $21,983,000 for the year ended December 31, 2004. The tax equivalent interest income on the investment portfolio remained stable despite a decrease in the average balance of the investment portfolio of $17,608,000. Offsetting the decline in average balance of the portfolio was a shift in the portfolio to tax-exempt bonds from taxable. This repositioning was undertaken to provide portfolio call protection, strategic investment at the community level, and as part of the Company’s tax strategy. The net growth in the volume of the loan portfolio has generated additional interest income that has offset the 3 basis point increase in the overall yield of the portfolio.

 

For the year ended December 31, 2005, reported interest expense increased $1,613,000 over the same period of 2004. Over half of the increased level of interest expense was due to market driven increases in the rates paid on deposit accounts. The increases are primarily the result of the continued rate increases enacted by the Federal Open Markets Committee (FOMC) coupled with aggressive pricing competition for deposits. In addition, deposit dollars have shifted from lower rate transaction based accounts to higher rate time deposits over the past year. This shift has resulted in the average balance of time deposits increasing $16,051,000 in 2005 as compared to 2004. The shift in dollars and the FOMC rate increases resulted in the average rate paid on deposits increasing to 1.98% from 1.65% for the year ended December 31, 2004 with the time deposit portfolio average rate increasing 40 basis points over the time period.

 

The Company increased long-term borrowing during 2005 through the FHLB to minimize future borrowing costs and to enhance liability positioning. These additional borrowings were utilized by management to replace maturing debt and to supplement the funding of the growth in the loan portfolio. The increase in the expense on long-term borrowings is the result of average balances of long-term FHLB borrowings increasing $5,093,000 while the weighted average interest rate on the long-term debt remained constant. Short-term borrowing interest increased $392,000 as a result of the before mentioned FOMC rate increases and an increase of the average balances outstanding during the year of $460,000.

 

2004 vs 2003

 

Reported net interest income increased $1,985,000 or 10.2% from fiscal 2003 to 2004. Total interest income increased $1,461,000 and is attributed to the increase of $41,067,000 in the average balance of the loan portfolio offset partially by the decrease in the average balance of the investment securities of $2,490,000 and a decrease in the return of loans of 62 basis points.

 

On a tax equivalent basis, net interest income increased 7.3% or $1,497,000, to $21,983,000 in a period when both average interest earning assets and average interest-bearing liabilities increased. The increase of taxable security income of $1,216,000 is due to the purchases of U.S. Government securities over the past year, with the average of these securities increasing $17,221,000, while the decrease in the average of tax-exempt State & Political securities decreased tax equivalent interest income $1,366,000. The investment portfolio has been repositioned from longer term assets to shorter

 

14

 

term assets to take advantage of the cash flow opportunities for reinvestment in anticipation of rising rates. The net growth in the volume of the loan portfolio has generated additional interest income that has offset the 29 basis point decline in the overall earning asset weighted average interest rate.

 

Within the loan portfolio, a 62 basis point decrease of the tax equivalent return on loans was offset by an increase of $41,067,000 in the average balance of loans when comparing the year 2004 to the year 2003. Variable rate loans within the portfolio and other new loan originations at lower effective rates aided in the reduction of income compared to a year ago because of the historically low rates.

 

For the year ended December 31, 2004, reported interest expense decreased $497,000 or 5.4% over the same period of 2003. Lower rates for all deposit accounts contributed the most substantial decrease in interest expense. The weighted average rate on deposits declined 38 basis points for 2004 as compared to 2003. Interest expense on time deposits decreased $538,000 due to both the 39 basis point decline in the weighted average rate and the decrease in the average balance of $1,020,000.

 

During 2004, the Company borrowed an additional $5,000,000 in long term advances through the FHLB to minimize future borrowing costs and to enhance liability positioning. These additional borrowings were utilized by management to fund the substantial loan growth of 2004. The $273,000 increase in expense on long-term borrowings is the result of average balances of long term FHLB borrowings increasing $8,442,000 partially offset by the 17 basis point decline in the resulting weighted average interest rate for the year ending December 31, 2004 compared to the same period in 2003. Interest paid on short-term borrowings increased $111,000 as a result of an increase of the average balances outstanding during the year of $6,866,000. The opportunity to borrow from the Federal Home Loan Bank at historically low interest rates was utilized to assist the funding of the loan portfolio growth and is attributed to the increase of interest expense paid on borrowings.

 

15

 

AVERAGE BALANCES AND INTEREST RATES

 

The following tables set forth certain information relating to the Company’s average balance sheet and reflects the average yield on assets and average cost of liabilities for the periods indicated and the average yields earned and rates paid. Such yields and costs are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods presented.

 

(In Thousands)		2005
		Average Balance			Interest			Average Rate
ASSETS:
Tax-exempt loans		$	5,370		$	307		5.72	%
All other loans		325,177			21,924			6.74	%
Total Loans		330,547			22,231			6.73	%
Taxable securities		115,041			5,554			4.83	%
Tax-exempt securitites		72,892			4,882			6.70	%
Total securities		187,933			10,436			5.55	%
Total interest-earning assets		518,480			32,667			6.30	%
Other assets		34,181
Total assets		$	552,661
LIABILITIES:
Savings		$	64,795		500			0.77	%
Super Now deposits		50,756			438			0.86	%
Money market deposits		29,317			412			1.41	%
Time deposits		146,391			4,424			3.02	%
Total Deposits		291,259			5,774			1.98	%
Short-term borrowings		32,114			931			2.90	%
Long-term borrowings		80,820			3,676			4.55	%
Total borrowings		112,934			4,607			4.08	%
Total interest-bearing liabilities		404,193			10,381			2.57	%
Demand deposits		69,457
Other liabilities		4,057
Shareholders’ equity		74,954
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY		$	552,661
Interest rate spread								3.73	%
Net interest income/margin					$	22,286		4.30	%

 

*    Fees on loans are included with interest on loans. Loan fees are included in interest income as follows:  2005 $149,000, 2004 $171,000, 2003 $184,000

*    Information on this table has been calculated using average daily balances to obtain average balances for the year.

*    Nonaccrual loans have been included with loans for the purpose of analyzing net interest earnings.

*    Income and rates on a fully taxable equivalent basis include an adjustment for the difference between annual income from tax-exempt obligations and the taxable equivalent of such income utilizing a 34% tax rate.

 

16

 

		2004								2003
		Average Balance			Interest			Average Rate		Average Balance			Interest			Average Rate
ASSETS:
Tax-exempt loans		$	1,359		$	82		6.03	%	$	1,008		$	68		6.75	%
All other loans		301,248			20,207			6.71	%	260,532			19,070			7.32	%
Total Loans		302,607			20,289			6.70	%	261,540			19,138			7.32	%
Taxable securities		170,876			7,876			4.61	%	153,655			6,661			4.34	%
Tax-exempt securitites		34,665			2,586			7.46	%	54,376			3,952			7.27	%
Total securities		205,541			10,462			5.09	%	208,031			10,613			5.10	%
Total interest-earning assets		508,148			30,751			6.05	%	469,571			29,751			6.34	%
Other assets		29,498								28,809
Total assets		$	537,646							$	498,380
LIABILITIES:
Savings		$	69,796		578			0.83	%	$	64,583		755			1.17	%
Super Now deposits		54,690			391			0.71	%	43,983			328			0.75	%
Money market deposits		35,164			392			1.11	%	38,602			621			1.61	%
Time deposits		130,340			3,414			2.62	%	131,361			3,952			3.01	%
Total Deposits		289,990			4,775			1.65	%	278,529			5,656			2.03	%
Short-term borrowings		31,857			539			1.69	%	25,446			428			1.68	%
Long-term borrowings		75,727			3,454			4.56	%	67,285			3,181			4.73	%
Total borrowings		107,584			3,993			3.71	%	92,731			3,609			3.89	%
Total interest-bearing liabilities		397,574			8,768			2.21	%	371,260			9,265			2.50	%
Demand deposits		64,434								56,672
Other liabilities		4,091								3,121
Shareholders’ equity		71,547								67,327
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY		$	537,646							$	498,380
Interest rate spread								3.85	%							3.84	%
Net interest income/margin					$	21,983		4.33	%				$	20,486		4.36	%

 

Reconcilement of Taxable Equivalent Net Interest Income

 

		2005			2004			2003
Total interest income		$	30,903		$	29,845		$	28,384
Total interest expense		10,381			8,768			9,265
Net interest income		20,522			21,077			19,119
Tax equivalent adjustment		1,764			906			1,367
Net interest income (fully taxable equivalent)		$	22,286		$	21,983		$	20,486

 

Rate/Volume Analysis

 

The table below sets forth certain information regarding changes in our interest income and interest expense for the periods indicated. For interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (changes in average volume multiplied by old rate); (ii) changes in rates (changes in rate multiplied by

 

17

 

old average volume). Increases and decreases due to both interest rate and volume, which cannot be separated, have been allocated proportionally to the change due to volume and the change due to interest rate. Income and interest rates are on a taxable equivalent basis.

 

		Year Ended December 31,
		2005 vs 2004									2004 vs 2003
		Increase (Decrease)									Increase (Decrease)
		Due to									Due to
(In Thousands)		Volume			Rate			Net			Volume			Rate			Net
Interest income:
Taxable investment securities		$	(2,681	)	$	359		$	(2,322	)	$	855		$	360		$	1,215
Tax-exempt investment securities		2,585			(289		)	2,296			(1,467		)	101			(1,366		)
Loans		1,614			103			1,717			2,818			(1,681		)	1,137
Loans, tax-exempt		229			(4		)	225			22			(8		)	14
Total interest-earning assets		1,747			169			1,916			2,228			(1,228		)	1,000
Interest expenses:
Savings deposits		17			(95		)	(78		)	57			(234		)	(177		)
Super Now deposits		(29		)	76			47			77			(14		)	63
Money market deposits		(72		)	92			20			(62		)	(167		)	(229		)
Time deposits		161			849			1,010			(31		)	(507		)	(538		)
Short-term borrowings		8			384			392			116			(5		)	111
Long-term borrowings		231			(9		)	222			388			(115		)	273
Total interest-bearing liabilities		316			1,297			1,613			545			(1,042		)	(497		)
Change in net interest income		$	1,431		$	(1,128	)	$	303		$	1,683		$	(186	)	$	1,497

 

PROVISION FOR LOAN LOSSES

 

2005 vs 2004

 

The provision for loan losses is based upon management’s quarterly review of the loan portfolio. The purpose of the review is to assess loan quality, identify impaired loans, analyze delinquencies, ascertain loan growth, evaluate potential charge-offs and recoveries, and assess general economic conditions in the markets served. An external independent loan review is also performed annually for the Bank. Management remains committed to an aggressive program of problem loan identification and resolution.

 

The allowance is calculated by applying loss factors to outstanding loans by type, excluding loans for which a specific allowance has been determined. Loss factors are based on management’s consideration of the nature of the portfolio segments, changes in mix and volume of the loan portfolio, and historical loan loss experience. In addition, management considers industry standards and trends with respect to nonperforming loans and its knowledge and experience with specific lending segments.

 

Although management believes that it uses the best information available to make such determinations and that the allowance for loan losses is adequate at December 31, 2005, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making the initial determinations. A downturn in the local economy, employment, and delays in receiving financial information from borrowers could result in increased levels of nonperforming assets and charge-offs, increased loan loss provisions and reductions in income. Additionally, as an integral part of the examination process, bank regulatory agencies periodically review the Bank’s loan loss allowance. The banking regulators could require the recognition of additions to the loan loss allowance based on their judgment of information available to them at the time of their examination.

 

The allowance for loan losses increased from $3,338,000 at December 31, 2004 to $3,679,000 at December 31, 2005. At December 31, 2005, allowance for loan losses was 1.09% of total loans compared to 1.03% of

 

18

 

total loans at December 31, 2004. Management’s conclusion is that the allowance for loan losses is adequate to provide for probable losses inherent in its loan portfolio as of the balance sheet date.

 

The provision for loan losses totaled $720,000 for the year ended December 31, 2005. The provision for the same period in 2004 was $465,000. Management concluded that the increase of the provision was appropriate when considering the loan growth experienced during 2005 and economic changes during the year. Utilizing both internal and external resources, as noted, senior management has concluded that the allowance for loan losses remains at a level adequate to provide for probable losses inherent in the loan portfolio.

 

2004 vs 2003

 

The allowance for loan losses increased 8.8% or $269,000 from fiscal 2003 after net charge-offs of $196,000 contributed to a year-end allowance for loan losses of $3,338,000 or 1.03% of total loans. Based upon this analysis, as well as the others noted above, senior management has concluded that the allowance for loan losses remains at a level adequate to provide for probable losses inherent in the loan portfolio.

 

Following is a table showing the changes in the allowance for loan losses for the years ended December 31:

 

		YEAR ENDED DECEMBER 31,
(In Thousands)		2005			2004			2003			2002			2001
Balance at beginning of period		$	3,338		$	3,069		$	2,953		$	2,927		$	2,879
Charge-offs:
Real estate		132			121			63			262			154
Commercial and industrial		206			50			37			80			122
Installment loans to individuals		108			112			116			60			82
Total charge-offs		446			283			216			402			358
Recoveries:
Real estate		45			50			42			25			9
Commercial and industrial		8			4			16			21			8
Installment loans to individuals		14			33			19			17			17
Total recoveries		67			87			77			63			34
Net charge-offs		379			196			139			339			324
Additions charged to operations		720			465			255			365			372
Balance at end of period		$	3,679		$	3,338		$	3,069		$	2,953		$	2,927
Ratio of net charge-offs during the period to average loans outstanding during the period		0.11		%	0.06		%	0.05		%	0.13		%	0.13		%

 

NON-INTEREST INCOME

 

2005 vs 2004

 

Total non-interest income increased $513,000 from fiscal 2004 to 2005. Excluding security gains and the gain on sale of loans, non-interest income increased $604,000. Service charges increased $245,000 due to the implementation of a new overdraft protection program that was started in May 2005. Earnings on bank-owned life insurance increased $274,000 due in large part to the receipt of a $196,000 to a death benefit claim. Commissions earned on the sale of insurance products increased $45,000 as The M Group continues to expand its market area by adding sales representatives to meet commitments made with other financial institutions to provide these same services to their customers. Gain on sale of loans decreased as the volume of loans sold decreased as compared to 2004. The increase in other income was primarily due to increases in card revenues from both ATM and debit cards offset by decreases in other areas of other income. Transaction

 

19