ITEM 1. BUSINESS
General
Port Financial Corp. ("Port" or the "Company") is a Massachusetts-chartered stock holding company, which owns all of the capital stock of Cambridgeport Bank ("Cambridgeport" or the "Bank"). In April 2000, as part of its conversion, the Company converted from a Massachusetts-chartered mutual holding company, Cambridgeport Mutual Holding Company, to a Massachusetts-chartered stock holding company and changed its name to Port Financial Corp.
The Company's principal business is its investment in Cambridgeport, which is a Massachusetts-chartered stock savings bank, chartered in 1853 and headquartered in Cambridge, Massachusetts. The Bank was named for the neighborhood of Cambridge in which it was established. The Cambridgeport district of Cambridge is located along the Charles River between the campuses of Harvard and MIT.
Cambridgeport is a community-oriented bank providing retail and business customers with value-driven products and services to meet customer needs. The Bank offers a wide variety of deposit products, residential mortgage loans, commercial real estate loans, commercial loans and consumer loans to its customers in the cities and towns around Cambridge, Massachusetts. The Bank has a network of eleven full service banking offices and one Telebanking Center. The branch offices are strategically located in cities and towns with a strong base for real estate lending and deposit growth and where community bank competition has been reduced by the consolidating banking industry. As of December 31, 2002 approximately 58% of the Company's total assets were invested in loans. These loans are funded primarily by deposits with some reliance on Federal Home Loan Bank ("FHLB") borrowings. Total deposits amounted to $1.16 billion at December 31, 2002 while FHLB borrowings totaled $175.6 million.
As of December 31, 2002, $297.2 million of the loan portfolio consisted of commercial real estate and commercial construction loans and $76.8 million consisted of home equity lines of credit. Commercial real estate and commercial construction loans grew by $19.9 while home equity lines of credit decreased $13.3 million compared with December 31, 2001. Non-performing assets were .02% of total assets while the Tier 1 leverage capital ratio was 7.6% on that date.
Regulation
Because the Bank is a Massachusetts-chartered savings bank, its deposit accounts are insured up to applicable limits by the Bank Insurance Fund (the "BIF") of the FDIC and by the Depositors Insurance Fund. The Bank is subject to extensive regulation, examination and supervision by both the Commonwealth of Massachusetts Division of Banks (the "Division") as its primary corporate regulator, and by the FDIC as its deposit insurer.
The Company, as a bank holding company controlling the Bank, is subject to the Bank Holding Company Act of 1956, as amended (the "BHCA"), and the rules and regulations of the Federal Reserve Board under the BHCA and to the provisions. The Company is also subject to the Massachusetts General Laws applicable to savings banks and other depository institutions and their holding companies (the "Massachusetts banking laws") and the regulations of the Division under the Massachusetts banking laws. The Company is also subject to the rules and regulations of the Securities and Exchange Commission.
Any change in such laws and regulations, whether by the Division, the FDIC, the Federal Reserve Board, or the Securities and Exchange Commission or through legislation, could have a material adverse impact on the Company and the Bank and their operations and stockholders.
Massachusetts Banking Regulation
Massachusetts Community Reinvestment Act
. Cambridgeport Bank is subject to provisions of the Massachusetts banking laws that, like the provisions of the federal Community Reinvestment Act, impose continuing and affirmative obligations upon a banking institution organized in Massachusetts to serve the credit needs of its local communities. The obligations of the Massachusetts Community Reinvestment Act ("MCRA") are similar to those imposed by the federal Community Reinvestment Act with the exception of the assigned exam
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ratings. Massachusetts banking law provides for an additional exam rating of "high satisfactory" in addition to the federal Community Reinvestment Act ratings of "outstanding," "satisfactory," "needs to improve" and "substantial noncompliance." The Division has adopted regulations to implement the MCRA that are based on the federal Community Reinvestment Act, including periodic assessment of a bank's compliance with the MCRA. See "Federal Banking Regulation - Community Reinvestment Act." The MCRA also requires the Division to make its assessments available to the public.
When reviewing a bank's application to engage in certain transactions, including mergers, asset purchases, new branch offices or new automated teller machines, the Division is required to consider a bank's MCRA rating. Such assessment may serve as a basis for the denial of any such application. Cambridgeport's latest MCRA rating, received by letter from the Division dated July 8, 1999 was "satisfactory."
Loans-to-One-Borrower Limitations. With specified exceptions, the total obligations of a single borrower to a Massachusetts-chartered savings bank may not exceed 20% of the savings bank's retained earnings account. A savings bank may lend additional amounts up to 100% of the bank's retained earnings account if secured by collateral meeting the requirements of the Massachusetts banking laws. Cambridgeport currently complies with applicable loans-to-one-borrower limitations.
Loans to a Bank's Insiders. The Massachusetts banking laws prohibit any officer, director or trustee from borrowing, otherwise becoming indebted, or becoming liable for a loan or other extension of credit by such bank to any other person, except under limited circumstances. Any such loans require approval of the majority of the members of the bank's executive committee, excluding any member involved in the loan or extension of credit. No such loan or extension of credit may be granted with an interest rate or other terms that are preferential in comparison to loans granted to persons not affiliated with the savings bank.
Dividends. Under the Massachusetts banking laws, a stock savings bank may, subject to several limitations, declare and pay a dividend on its capital stock out of the bank's net profits. A dividend may not be declared, credited or paid by a stock savings bank so long as there is any impairment of capital stock. No dividend may be declared on the bank's common stock for any period other than for which dividends are declared upon preferred stock, except as authorized by the Commissioner. The approval of the Commissioner is also required for a stock savings bank to declare a dividend, if the total of all dividends declared by the savings bank in any calendar year shall exceed the total of its net profits for that year combined with its retained net profits of the preceding two years, less any required transfer to surplus or a fund for the retirement of any preferred stock. In addition, federal law may also limit the amount of dividends that may be paid by Cambridgeport. See "Federal Banking Regulation - Prompt Corrective Action" below.
Examination and Enforcement. The Division is required to examine savings banks at least once every calendar year or at least once each 18-month period if the savings bank qualifies as well capitalized under the prompt corrective action provisions of the Federal Deposit Insurance Act. See "Federal Banking Regulation - Prompt Corrective Action" below.
Federal Banking Regulation
Capital Requirements.
FDIC regulations require BIF-insured banks, such as the Bank, to maintain minimum levels of capital. The FDIC regulations define two tiers, or classes, of capital.--Tier 1 Capital and Tier 2 Capital. The FDIC regulations establish minimum leverage capital requirements for banks. For banks with a rating of 1 (the highest examination rating of the FDIC for banks) under the Uniform Financial Institutions Rating System, the FDIC may require a minimum leverage capital ratio of not less than a ratio of 3.0% of Tier 1 capital to total assets. For all other banks, the minimum leverage capital requirement is 4.0%, unless a higher ratio is warranted by the particular circumstances or risk profile of the depository institution.
FDIC regulations also require that savings banks meet a risk-based capital standard. The risk-based capital standard requires the maintenance of a ratio of total capital (which is defined as the sum of Tier 1 capital and Tier 2 capital) to risk-weighted assets of at least 8% and a ratio of Tier 1 capital to risk-weighted assets of at least 4%. In determining the amount of risk-weighted assets, all assets, plus certain off balance sheet items, are multiplied by a risk-weight of 0% to 100%, based on risks the FDIC believes are inherent in the type of asset or item.
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The federal banking agencies, including the FDIC, have also adopted regulations to require an assessment of an institution's exposure to declines in the economic value of a bank's capital due to changes in interest rates when assessing the bank's capital adequacy. Under such a risk assessment, examiners will evaluate a bank's capital for interest rate risk on a case-by-case basis, with consideration of both quantitative and qualitative factors.
Institutions with significant interest rate risk may be required to hold additional capital. The agencies also issued a joint policy statement providing guidance on interest rate risk management, including a discussion of the critical factors affecting the agencies' evaluation of interest rate risk in connection with capital adequacy.
At December 31, 2002, the Bank was considered "well-capitalized" under FDIC guidelines.
Activity Restrictions on State-Chartered Banks. Section 24 of the Federal Deposit Insurance Act (the "FDIA"), which was amended by the Federal Deposit Insurance Corporation Improvement Act of 1991 (the "FDICIA"), generally limits the activities and investments of state-chartered FDIC insured banks and their subsidiaries to those permissible for federally-chartered national banks and their subsidiaries. Section 24 provides an exception for investments by a bank in common and preferred stocks listed on a national securities exchange or the shares of registered investment companies if: (a) the bank held such types of investments during the period from September 30, 1990 through November 26, 1991; (b) the state in which the bank is chartered permitted such investments as of September 30, 1991; and (c) the bank obtains approval from the FDIC to make or retain such investments. Upon receiving such FDIC approval, an institution's investment in such equity securities will be subject to an aggregate limit up to the amount of its Tier 1 capital. The Bank has received approval from the FDIC to retain and acquire such equity investments subject to a maximum permissible investment equal to the lesser of: 100% of the Bank's Tier 1 capital; or the maximum permissible amount specified by the Massachusetts banking laws. Section 24 also limits the activities of majority-owned subsidiaries of a bank.
Before initiating any new investment or activity that is not permissible for a national bank or otherwise permissible under Section 24 of the FDIC regulations, an insured bank must seek approval from the FDIC. As conditions for FDIC approval, banks must meet the FDIC's minimum capital requirements and the FDIC must determine that the activity does not present a significant risk to the FDIC insurance funds.
Enforcement. The FDIC has extensive enforcement authority over insured savings banks, including Cambridgeport Bank. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease and desist orders and to remove directors and officers. In general, these enforcement actions may be initiated in response to violations of laws and regulations and to unsafe or unsound practices.
The FDIC is required, with some exceptions, to appoint a receiver or conservator for an insured state bank if that bank is "critically undercapitalized." For this purpose, "critically undercapitalized" means having a ratio of tangible capital to total assets of less than 2%. The FDIC may also appoint a conservator or receiver for a state bank on the basis of the institution's financial condition or upon the occurrence of certain events.
Deposit Insurance. Pursuant to the FDICIA, the FDIC established a system for setting deposit insurance premiums based upon the risks a particular bank or savings association posed to its deposit insurance funds. Under the risk-based deposit insurance assessment system, the FDIC assigns an institution to one of three capital categories based on the institution's financial information, as of the reporting period ending six months before the assessment period. The three capital categories are (1) well capitalized, (2) adequately capitalized and (3) undercapitalized. The FDIC also assigns an institution to one of three supervisory subcategories within each capital group. An institution's assessment rate depends on the capital category and supervisory category to which it is assigned. Any increase in insurance assessments could have an adverse effect on the earnings of insured institutions, including Cambridgeport Bank.
The Deposit Insurance Funds Act of 1996 establishes the assessment base for payments on bonds issued in the late 1980's by the Financing Corporation to recapitalize the now defunct Federal Savings and Loan Insurance Corporation. Beginning January 1, 1997, the assessment base is defined as deposits of institutions such as Cambridgeport Bank that are insured by the Bank Insurance Fund. The rate of assessment for Bank Insurance Fund-assessable deposits is one-fifth of the rate applied to deposits that are insured by the Savings Association Insurance Fund.
Under the FDIA, the FDIC may terminate the insurance of an institution's deposits if the FDIC finds that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue
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operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. The management of Cambridgeport Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance.
Transactions with Affiliates of Cambridgeport Bank. Transactions between an insured bank, such as Cambridgeport, and any of its affiliates is governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a bank is any company or entity that controls, is controlled by or is under common control with the bank. Currently, a subsidiary of a bank that is not also a depository institution is not treated as an affiliate of the bank for purposes of Sections 23A and 23B, but the Federal Reserve Board has proposed a comprehensive regulation implementing Sections 23A and 23B, which would establish certain exceptions to this policy.
Section 23A:
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limits the extent to which the bank or its subsidiaries may engage in "covered transactions" with any one affiliate to an amount equal to 10% of such bank's capital stock and retained earnings, and limit on all such transactions with all affiliates to an amount equal to 20% of such capital stock and retained earnings; and
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requires that all such transactions be on terms that are consistent with safe and sound banking practices.
The term "covered transaction" includes the making of loans, purchase of assets, issuance of guarantees and other similar types of transactions. Further, most loans by a bank to any of its affiliates must be secured by collateral in amounts ranging from 100 to 130 percent of the loan amounts. In addition, any covered transaction by a bank with an affiliate and any purchase of assets or services by a bank from an affiliate must be on terms that are substantially the same, or at least as favorable to the bank, as those that would be provided to a non-affiliate.
Effective April 1, 2003, the Federal Reserve Board, or FRB, is rescinding its interpretations of Sections 23A and 23B of the FRA and is replacing these interpretations with Regulation W. In addition, Regulation W makes various changes to existing law regarding Sections 23A and 23B, including expanding the definition of what constitutes an affiliate subject to Sections 23A and 23B and exempting certain subsidiaries of state-chartered banks from the restrictions of Sections 23A and 23B.
Under Regulation W, all transactions entered into on or before December 12, 2002, which either became subject to Sections 23A and 23B solely because of Regulation W, and all transactions covered by Sections 23A and 23B, the treatment of which will change solely because of Regulation W, will become subject to Regulation W on July 1, 2003. All other covered affiliate transactions become subject to Regulation W on April 1, 2003. The Federal Reserve Board expects each depository institution that is subject to Sections 23A and 23B to implement policies and procedures to ensure compliance with Regulation W. We do not expect that the changes made by Regulation W will have a material adverse effect on our business.
Community Reinvestment Act. Under the federal Community Reinvestment Act ("CRA"), any insured depository institution, including Cambridgeport Bank, has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution's discretion to develop the types of products and services that it believes are best suited to its particular community. The CRA requires the FDIC, in connection with its examination of a savings bank, to assess the depository institution's record of meeting the credit needs of its community. The CRA also requires the FDIC to take such record into account when it evaluates applications by the institution, including applications for additional branches and acquisitions.
The CRA requires the FDIC to provide a written evaluation of an institution's CRA performance utilizing a four-tiered descriptive rating system and requires public disclosure of an institution's CRA rating. Cambridgeport Bank received a "satisfactory" rating in its CRA examination conducted by the FDIC on October 16, 2002.
Safety and Soundness Standards. Pursuant to the requirements of the FDICIA, as amended by the Riegle Community Development and Regulatory Improvement Act of 1994, each federal banking agency, including the FDIC, has adopted established general standards relating to internal controls, information and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, asset quality, earnings, and
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compensation, fees and benefits. The FDIC requires an institution to maintain systems and practices to identify and manage the risks and exposures in accordance with the standards. The standards categorize excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director, or principal stockholder.
In addition, FDIC regulations require a bank that it is not satisfying such safety and soundness standards to submit a compliance plan to the FDIC. If, after being notified by the FDIC of such non-compliance, a bank fails to submit an acceptable compliance plan or fails in any material respect to implement an accepted compliance plan, the FDIC may issue an order directing corrective and other actions. These actions may include those specified for a significantly undercapitalized institution under the "prompt corrective action" provisions of the FDICIA. If a bank fails to comply with such an order, the FDIC may seek to enforce such an order in judicial proceedings and to impose civil monetary penalties.
Prompt Corrective Action. The FDICIA also established a system of prompt corrective action to resolve the problems of undercapitalized institutions. The FDIC, as well as the other federal banking regulators, adopted regulations governing the supervisory actions that may be taken against undercapitalized institutions. The regulations establish five categories, consisting of "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized."
The severity of the action authorized or required to be taken under the prompt corrective action regulations increases as a bank's capital decreases within the three undercapitalized categories. All banks are prohibited from paying dividends or other capital distributions or paying management fees to any controlling person if, following such distribution, the bank would be undercapitalized.
Loans to a Bank's Insiders. A bank's loans to its executive officers, directors, any owner of 10% or more of its stock (each, an "insider") and any entities affiliated with an insider are subject to the conditions and limitations imposed by Section 22(h) of the Federal Reserve Act and the Federal Reserve Board's Regulation O. Under these restrictions, the aggregate amount of the loans to any insider and any entities affiliated with such insider may not exceed the loans-to-one-borrower limit applicable to national banks, which is comparable to the loans-to-one-borrower limit applicable to Cambridgeport Bank's loans. (See "Massachusetts Banking Regulation - Loans-to-One Borrower Limitations.") All loans by a bank to all insiders and their affiliates in the aggregate may not exceed the bank's unimpaired capital and unimpaired retained earnings. Generally, such loans must be made on substantially the same terms as, and follow credit underwriting procedures that are not less stringent than, those that are prevailing at the time for comparable transactions with other persons. An exception is made for extensions of credit made pursuant to a benefit or compensation plan of a bank that is widely available to employees of the bank and that does not give any preference to insiders of the bank over other employees of the bank.
Section 402 of the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley, prohibits the extension of personal loans to directors and executive officers of issuers (as defined in Sarbanes-Oxley). The prohibition, however, does not apply to mortgages advanced by an insured depository institution, such as the Bank, that are subject to the insider lending restrictions of Section 22(h) of the FRA.
Holding Company Regulation
Port Financial Corp. is regulated as a bank holding company. Bank holding companies are subject to examination, regulation and periodic reporting under the Bank Holding Company Act, as administered by the Federal Reserve Board. The Federal Reserve Board has adopted minimum capital adequacy requirements for bank holding companies, measured on a consolidated basis, that are substantially similar to those of the FDIC for Cambridgeport Bank. As of December 31, 2002, Port Financial Corp.'s total capital and Tier 1 capital ratios exceeded these minimum capital requirements.
The activities of bank holding companies are generally limited to the business of banking, managing or controlling banks, and other activities that the Federal Reserve Board determines to be so closely related to banking or managing or controlling banks as to be properly incident thereto. In addition, a bank holding company whose controlled depository institutions are all "well capitalized" and "well managed," as defined in FRB Regulation Y, and have all received satisfactory CRA ratings, can declare itself to be a "financial holding company". A financial holding company may engage in a broader spectrum of activities than those generally permitted to bank holding companies. These activities include insurance underwriting and brokerage (including annuities), and underwriting and dealing securities without a revenue limit and without limits on the amounts of equity securities it may hold in
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conducting its underwriting and dealing activities. If a financial holding company does not continue to meet the requirements for financial holding company status, depending on the requirements it fails to meet, it may not be permitted to undertake new activities or acquisitions that are financial in nature and it may lose the ability to conduct activities that are not generally permissible for bank holding companies. The Company has not elected to be regulated as a financial holding company, but may elect to do so in the future.
Regulations of the Federal Reserve Board provide that a bank holding company must serve as a source of strength to any of its subsidiary banks and must not conduct its activities in an unsafe or unsound manner. Under the prompt corrective action provisions of the FDICIA, a bank holding company parent of an undercapitalized subsidiary bank would be directed to guarantee, within limitations, the capital restoration plan that is required of such an undercapitalized bank. See "Federal Banking Regulation - Prompt Corrective Action" above. If an undercapitalized bank fails to file an acceptable capital restoration plan or fails to implement an accepted plan, the Federal Reserve Board may prohibit the holding company of the undercapitalized bank from paying any dividend or making any other form of capital distribution.
As a bank holding company, Port Financial Corp. is required to obtain the prior approval of the Federal Reserve Board to acquire all, or substantially all, of the assets of any bank or bank holding company. Prior Federal Reserve Board approval is required for Port to acquire direct or indirect ownership or control of any voting securities of any bank or bank holding company if, after giving effect to such acquisition, it would, directly or indirectly, own or control more than 5% of any class of voting shares of such bank or bank holding company.
Subject to certain limitations and restrictions, a bank holding company, with the prior approval of the Federal Reserve Board, may acquire an out-of-state bank. Banks in states that do not prohibit out-of-state mergers may merge with other banks only after receiving the approval of the appropriate federal bank regulatory agency. A national or state bank may establish a de novo branch out of state if such branching is expressly permitted by the other state.
Securities and Exchange Commission Availability of Filings on Company Web Site. Under the Securities Exchange Act of 1934 Sections 13 and 15(d), periodic and current reports must be filed with the Securities and Exchange Commission ("SEC"). The Company electronically files the following reports with the SEC: Form 10-K (Annual Report), 10-Q (Quarterly Report), DEF 14A (Proxy Statement), and Form S-3 and 8-A (Registration Statements. The Company may also file additional forms. The SEC maintains an internet site, www.sec.gov, in which all forms filed electronically may be accessed. Additionally, all forms filed with the SEC and additional shareholder information is available free of charge on the Company's website: www.PortFinancial.Net
Change in Control Regulations
Federal Restrictions
. Under the federal Change in Bank Control Act, any person (including a company or a group acting in concert) seeking to acquire 10% or more of the outstanding shares of Port's common stock is required to submit prior notice to the Federal Reserve Board, unless the Federal Reserve Board has found that the acquisition of such shares will not result in a change in control of Port. Under the Bank Holding Company Act, the Federal Reserve Board has 60 days within which to act on such a notice, taking into consideration such factors as the financial and managerial resources of the acquirer, the convenience and needs of the communities served by Port and Cambridgeport Bank, and the anti-trust effects of the acquisition. Under the Bank Holding Company Act, any company would be required to obtain prior approval from the Federal Reserve Board before it may obtain "control" of Port. The term "control" is defined generally under the Bank Holding Company Act to mean the ownership or power to vote 25% or more of any class of voting securities of an institution, or the ability to control in any manner the election of a majority of the institution's directors. Massachusetts Restrictions. Under the Massachusetts banking laws, the prior approval of the Division is required before any person may acquire a Massachusetts bank holding company, such as Port Financial Corp. For this purpose, the term "person" is defined broadly to mean a natural person or a corporation, company, partnership, or any other form of organized entity. The term "acquire" is defined differently for an existing bank holding company and for other companies or persons. A bank holding company will be treated as "acquiring" a Massachusetts bank holding company if it acquires more than 5% of any class of the voting shares. Any other person will be treated as "acquiring" a Massachusetts bank holding company if it acquires ownership or control of more than 25% of any class of the voting shares.
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Federal Securities Law
The common stock of Port Financial Corp. is registered with the SEC under Section 12(g) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Accordingly, the Company is subject to the information, proxy solicitation, insider trading restrictions and other requirements of the Exchange Act.
USA PATRIOT Act
In response to the events of September 11th, President George W. Bush signed into law the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, or the USA PATRIOT Act, on October 26, 2001. The USA PATRIOT Act gives the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. By way of amendments to the Bank Secrecy Act, Title III of the USA PATRIOT Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions, including banks, thrifts, brokers, dealers, credit unions, money transfer agents and parties registered under the Commodity Exchange Act.
Among other requirements, Title III of the USA PATRIOT Act imposes the following requirements with respect to financial institutions:
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Pursuant to Section 352, all financial institutions must establish anti-money laundering programs that include, at minimum: (i) internal policies, procedures, and controls, (ii) specific designation of an anti-money laundering compliance officer, (iii) ongoing employee training programs, and (iv) an independent audit function to test the anti-money laundering program. Interim final rules implementing Section 352 were issued by the Treasury Department on April 29, 2002. Such rules state that a financial institution is in compliance with Section 352 if it implements and maintains an anti-money laundering program that complies with the anti-money laundering regulations of its federal functional regulator. Port Financial is in compliance with the OTS's anti-money laundering regulations.
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Pursuant to Section 326, on July 23, 2002 the Secretary of the Department of Treasury, in conjunction with other bank regulators, issued a Proposed Rule that provides for minimum standards with respect to customer identification and verification. On July 23, 2002, the OTS and the other federal bank regulators jointly issued proposed rules to implement Section 326. The proposed rules require financial institutions to establish a program specifying procedures for obtaining identifying information from customers seeking to open new accounts. This identifying information would be essentially the same information currently obtained by most financial institutions for individual customers generally. A financial institution's program would also have to contain procedures to verify the identity of customers within a reasonable period of time, generally through the use of the same forms of identity verification currently in use, such as through driver's licenses, passports, credit reports and other similar means.
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Section 312 requires financial institutions that establish, maintain, administer, or manage private banking accounts or correspondent accounts in the United States for non-United States persons or their representatives (including foreign individuals visiting the United States) to establish appropriate, specific, and, where necessary, enhanced due diligence policies, procedures, and controls designed to detect and report money laundering. Interim rules under Section 312 were issued by the Treasury Department on July 23, 2002. The interim rules state that a due diligence program is reasonable if it comports with existing best practices standards for banks that maintain correspondent accounts for foreign banks and evidences good faith efforts to incorporate due diligence procedures for accounts posing increased risk of money laundering. In addition, an enhanced due diligence program is reasonable if it comports with best practices standards and focuses enhanced due diligence measures on those correspondent accounts posing a particularly high risk of money laundering based on the bank's overall assessment of the risk posed by the foreign correspondent bank. Finally, a private banking due diligence program must be reasonably designed to detect and report money laundering and the existence of proceeds of foreign corruption. Such a program is reasonable if it focuses on those private banking accounts the present a high risk of money laundering.
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Effective December 25, 2001, financial institutions are prohibited from establishing, maintaining, administering or managing correspondent accounts for foreign shell banks (foreign banks that do not have a physical presence in any country), and will be subject to certain recordkeeping obligations with respect to correspondent accounts of foreign banks.
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Bank regulators are directed to consider a holding company's effectiveness in combating money laundering when ruling on Federal Reserve Act and Bank Merger Act applications.
Although we anticipate that we will incur additional expense in complying with the provisions of the USA PATRIOT Act and the resulting regulations, management does not expect that such compliance will have a material impact on our results of operations or financial condition.
The Sarbanes-Oxley Act
On July 30, 2002, President George W. Bush signed into law the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act implements a broad range of corporate governance and accounting measures for public companies designed to promote honesty and transparency in corporate America and better protect investors from the type of corporate wrongdoing that occurred in Enron, WorldCom and similar companies. The Sarbanes-Oxley Act's principal legislation includes:
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the creation of an independent accounting oversight board;
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auditor independence provisions which restrict non-audit services that accountants may provide to their audit clients;
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additional corporate governance and responsibility measures, including the requirement that the chief executive officer and chief financial officer certify financial statements;
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the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer's securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement;
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an increase the oversight of, and enhancement of certain requirements relating to audit committees of public companies and how they interact with the company's independent auditors.
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requirement that audit committee members must be independent and are absolutely barred from accepting consulting, advisory or other compensatory fees from the issuer;
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requirement that companies disclose whether at least one member of the committee is a "financial expert" (as such term will be defined by the Securities and Exchange Commission) and if not, why not;
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expanded disclosure requirements for corporate insiders, including accelerated reporting of stock transactions by insiders and a prohibition on insider trading during pension blackout periods;
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a prohibition on personal loans to directors and officers, except certain loans made by insured financial institutions;
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disclosure of a code of ethics and filing a Form 8-K for a change or waiver of such code;
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mandatory disclosure by analysts of potential conflicts of interest; and
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a range of enhanced penalties for fraud and other violations.
Although we anticipate that we will incur additional expense in complying with the provisions of the Sarbanes-Oxley Act and the resulting regulations, management does not expect that such compliance will have a material impact on our results of operations or financial condition.
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Competition
The Company faces intense competition both in making loans and attracting deposits. Eastern Massachusetts has a high concentration of financial institutions, many of which are branches of large money center and regional banks that have emerged from the consolidation of the banking industry in Massachusetts and surrounding states. Some of these competitors have greater resources and therefore may offer services that Port and the Bank do not provide.
Competition for loans comes from commercial banks, savings institutions, mortgage banking firms, credit unions, finance companies, mutual funds, insurance companies and brokerage and investment banking firms. The most direct competition for deposits has historically come from commercial banks, savings banks, savings and loan associations and credit unions. The Bank faces additional competition for deposits from short-term money market funds and other corporate
and government securities funds, and from brokerage firms and insurance companies. Personnel
As of December 31, 2002, the Company had 163 full-time employees and 36 part-time employees. The employees are not represented by a collective bargaining unit.
ITEM 2.
ITEM 2. PROPERTIES
Port conducts business from its administrative center at 1380 Soldiers Field Road, Brighton, Massachusetts, and from its ten full-service banking offices. Port and certain administrative and operations departments of the Bank, including the Telebanking Center, occupy approximately 42,000 square feet of the 74,000 square-foot administrative center, which is owned by a subsidiary of the Bank. Tenants under long-term leases occupy the remainder of the building.
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The Bank's headquarters and its main branch are located at 689 Massachusetts Avenue in Cambridge, in a three-story building owned by the Bank. The building contains approximately 40,000 square feet. An unaffiliated company occupies the upper two floors under a long-term lease. As of December 31, 2002, the Company's properties and leasehold improvements had an aggregate net book value of $20.6 million.
Location
Ownership
Year Opened
Lease or License Expiration (1)
Corporate Headquarters
Owned
-
1380 Soldiers Field Road
Brighton, MA 02135
Bank Headquarters/Main Office:
689 Massachusetts Avenue
Owned
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Cambridge, MA 02139
Branch Offices:
1751 Massachusetts Avenue
Leased
Lexington, MA 02420
522 Main Street
Leased
Winchester, MA 01890
Harvard Square Office
Leased
1290 Massachusetts Avenue
Cambridge, MA 02139
177 Linden Street
Leased
Wellesley, MA 02482
1243 Centre Street
Leased
Newton, MA 02459
133 Chapel Street
Leased
Needham, MA 02492
860 Massachusetts Avenue
Leased
Arlington, MA 02476
315 Harvard Street
Leased
Brookline, MA 02446
Supermarket Offices:
150 W. Central Street
Leased
Natick, MA 01760
338 Washington Street
Licensed
Westwood, MA 02090
Other general office space:
2150 Washington Street
Leased
Newton, MA 02462 (2)
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(1)
Lease expiration dates assume all options to extend lease terms are exercised.
(2)
This office is currently subleased to an unaffiliated company through the lease term, which expires on September 30, 2003. The Company does not intend to extend this lease after the expiration period.
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ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Neither the Company nor the Bank is involved in any pending legal proceeding other than routine legal proceedings occurring in the ordinary course of business. The Company believes that these routine legal proceedings, in the aggregate, are immaterial to its financial condition and results of operation.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to security holders, through the solicitation of proxies or otherwise, during the quarter ended December 31, 2002.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Port's common stock is traded under the symbol "PORT" on the Nasdaq National Market. At December 31, 2002, its common stock closed at $44.60 per share. At March 12, 2003, there were 5,287,401 shares of Port Financial Corp.'s common stock outstanding, which were held of record by approximately 1,889 stockholders, not including persons or entities who hold the stock in nominee or "street" name through various brokerage firms.
Management and the Board of Directors frequently review the Company's cash dividend payout policy. The Board of Directors considers paying dividends, dependent on the results of operations and financial condition of Port, tax considerations, industry standards, economic conditions, regulatory restrictions and other factors. Port's ability to pay dividends also may depend on the dividends it receives from its subsidiary, Cambridgeport Bank. Dividend payments from the Bank are subject to regulations including the Bank's continued compliance with all regulatory capital requirements and its overall financial health.
On January 28, 2003, the Board of Directors of Port Financial Corp. declared a quarterly cash dividend of $.20 per share of common stock, which was paid on February 21, 2002 to shareholders of record on February 7, 2002.
The table below shows the high and low sales price during the periods indicated as well as dividends declared per share. The information set forth in the table below was provided by the Nasdaq Stock Market. Such information reflects interdealer prices without retail mark-up or mark-down, and may not represent actual transactions.
<PAGE> 14
ITEM 6.
ITEM 6. SELECTED FINANCIAL AND OTHER DATA
The summary information presented below at or for each of the years presented is derived in part from the consolidated financial statements of Port Financial Corp. The following information is only a summary and should be read in conjunction with the consolidated financial statements and notes beginning on page.
___________________
(1)
Loans include loans held for sale and are shown net of deferred loan fees and allowance for loan loss.
(2)
Includes mortgagor's escrow payments.
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___________________
(3)
Net interest margin represents net interest income as a percentage of average interest-earning assets.
(4)
The efficiency ratio represents the ratio of non-interest expenses divided by the sum of net interest income and non-interest income excluding gains or losses on sales of investments and provision for loan losses.
<PAGE> 16
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
For the Years Ended 2002, 2001, and 2000
The following discussion and analysis of financial condition and results of operations of the Company and its subsidiaries should be read in conjunction with the consolidated financial statements and accompanying notes and selected statistical information incorporated by reference.
Critical Accounting Policies
The Company's significant accounting policies are described in Note 1 to the consolidated financial statements included in Item 14 of this Form 10-K. The Company considers the following accounting policies to be most critical in their potential effect on its financial position or results of operations:
Allowance for Loan Losses
The allowance for loan losses is established through a charge to the provision for loan losses, which are made in order to reserve for estimated future loan losses. The allowance for loan losses represents a significant estimate. Therefore, the Company regularly reviews the adequacy of the allowance by assessing such factors as: changes in the mix and size of the loan portfolio; trends in portfolio credit quality including payment delinquencies and loan charge-offs; and other economic conditions or events that may affect a borrower's ability to repay. The Company's methodology with respect to the assessment of the adequacy of the allowance for loan losses is more fully discussed on pages 24-25 of Management's Discussion and Analysis.
Income Taxes
The Company must estimate income tax expense for each period for which a statement of operations is presented. This involves estimating the Company's actual current tax exposure as well as assessing temporary differences resulting from differing treatment of items, such as timing of the deduction of expenses for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in the Company's consolidated balance sheets. The Company must also assess the likelihood that any deferred tax assets will be recovered from future taxable income and establish a valuation allowance for those assets determined to not likely be recoverable. Management judgement is required in determining the amount and timing of recognition of the resulting deferred tax assets and liabilities, including projections of future taxable income. As of December 31, 2002, there were no valuation allowances set aside against any deferred tax assets.
Interest Income Recognition
Interest on loans is included in income as earned based upon interest rates applied to unpaid principal. Interest is not accrued on loans 90 days or more past due unless the loans are adequately secured and in the process of collection. Interest is not accrued on other loans when management believes collection is doubtful. All loans considered impaired are nonaccruing. Interest on nonaccruing loans is recognized as payments are actually received and when the ultimate collectibility of interest is no longer considered doubtful. When a loan is placed on nonaccrual status, all unpaid interest previously accrued is reversed against current-period interest income.
General
Port's operating results reflect earnings on its investments and the net income of its principal operating subsidiary, Cambridgeport. Cambridgeport's results of operations depend primarily on net interest income. Net interest income is the difference between the income earned on interest-earning assets and the interest paid on interest-bearing liabilities. Interest-earning assets consist of residential mortgage loans including home equity loans, commercial mortgage loans, consumer loans, mortgage-backed securities, other investment securities and interest-bearing cash balances. Interest-bearing liabilities include certificates of deposit, savings, money market and NOW account deposits, and borrowings from the Federal Home Loan Bank of Boston. The Company's operating results also depend on the provision for loan losses, non-interest income, and non-interest expense. Non-interest expense includes salaries and employee benefits, occupancy expenses and other general and administrative expenses. Non-interest income includes service fees and charges.
<PAGE> 17
Port's results of operations may be affected significantly by economic and competitive conditions in its market area and elsewhere, including government policies, actions of regulatory authorities, and other events that may have an influence on interest rates. Future changes in applicable laws, regulations or government policies may materially impact the Company and the Bank. Furthermore, much of the Bank's loan portfolio is concentrated in loans secured by real estate located in the Boston metropolitan area.
The Company's total assets increased $331.1 million, or 29.1%, to $1.47 billion at December 31, 2002, from $1.14 billion at December 31, 2001. This asset growth included a $73.8 million increase in net loans and loans held for sale, nearly all of which were secured by residential or commercial real estate. Asset growth also included an increase of $273.5 million in investment securities, including mortgage-backed securities.
Asset growth was funded by deposits, which rose by $272.0 million, or 30.6%, to $1.16 billion at December 31, 2002, and by an increase in Federal Home Loan Bank borrowings of $60.3 million, or 52.3%. During 2002, the Bank focused its marketing efforts on acquiring new core deposit and loan relationships. The Bank's Money Manager Checking Account marketing campaign began in April, offering a premium-rate checking account to high balance checking account customers. The promotion offered a rate of 4%, guaranteed through September 30, 2002. This promotion was the primary reason for the deposit growth during 2002.
Total stockholders' equity at December 31, 2002 was $121.1 million, a reduction of $2.3 million from $123.4 million at December 31, 2001. The Company repurchased a total of 593,365 shares during 2002 at a total cost of $21.6 million, which reduced stockholders' equity. The effect of these repurchases on stockholders' equity was partially offset by increases of $10.7 million in retained earnings and $5.0 million in accumulated other comprehensive income.
FINANCIAL CONDITION
Investment Portfolio
Port's investment policy provides that its investment portfolio be used to limit the Company's exposure to interest rate changes, to generate a favorable return without incurring undue credit risk and to maintain adequate levels of liquidity. Therefore, short and intermediate term government, government agency, and investment grade (rated "A" or better) corporate fixed income securities comprise $538.8 million of the portfolio as of December 31, 2002. Other marketable equity securities of $10.5 million include shares of Cambridge Bancorp, whose principal subsidiary is Cambridge Trust Company. Additional equity holdings include investment in the Federal Home Loan Bank of Boston and the Savings Bank Life Insurance Company.
The Company believes that the credit quality of the portfolio is high, with 96% of the fixed income portfolio invested in securities issued or guaranteed by U.S. Government Agencies as of December 31, 2002. These include securities that are backed by residential mortgages, which are predominately adjustable-rate mortgages. The mortgage-backed securities portfolio also includes securities backed by 5-year and 7-year balloon mortgages. The entire principal balance of a balloon mortgage is due prior to the completion of the normal 30-year amortization schedule. The remaining 4% of the fixed income portfolio consists of corporate bonds with maturities of less than five years. The amortized cost of the securities that mature or reprice within five years is $81.1 million or 15.1% of the total fixed income securities portfolio.
<PAGE> 18
The following table sets forth the composition of the investment securities portfolio at the dates indicated.
<PAGE> 19
The following table sets forth the amortized cost and fair value of mortgage-backed and mortgage-related securities, which are classified as available for sale or held to maturity as of the dates indicated.
<PAGE> 20
The composition and maturities of the investment securities portfolio (debt securities) and the mortgage-backed securities portfolio at December 31, 2002 are summarized in the following table. Maturities are based on the final contractual payment dates, and do not reflect the impact of prepayments or redemptions that may occur.
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Loan Portfolio
The Bank provides one- to-four-family residential first mortgage loans, home equity loans and credit lines, commercial real estate loans, construction loans, consumer loans and commercial business loans. The Bank's loan policy establishes underwriting standards to address the risks of these types of loans, including maximum loan-to-value ratios for various collateral categories. The policy also contains lending authority guidelines by loan type. All commercial real estate must be approved by the Credit Committee, which consists of the Chief Executive Officer, the Executive Vice President, the Chief Financial Officer and two outside members of the Board of Directors. Minutes of the weekly Credit Committee meetings list all approved loans. At its monthly meetings, the Bank's Board of Directors reviews the Credit Committee minutes as well as summaries of all Credit Committee loan approvals. The Bank's lending strategy emphasizes real estate financing, and the importance of staffing key officer, management and director positions with individuals who have many years of commercial and residential lending experience in Eastern Massachusetts, and who are well-known in the marketplace.
As part of its strategy to limit exposure to interest rate fluctuations, the Bank generally sells most 30-year fixed rate residential loans it originates, and retains most adjustable rate loans and its Express Mortgage loans. Express Mortgages are 10-year and 15-year fully amortizing fixed rate first mortgage loans. At December 31, 2002, the gross loan portfolio totaled $860.1 million, up $74.5 million, or 9.5%, from the 2001 year-end balance of $785.6 million. At the end of 2002, 73.0% of total loans were scheduled to mature or reprice within five years.
Loans collateralized by real estate represented $856.2 million, or 99.6% of total gross loans at the end of 2002, compared to $780.6 million, or 99.4%, at the end of 2001. Residential first mortgage loans of $482.3 million comprised 56.1% of the December 31, 2002 loan portfolio, up from 52.6% at the end of 2001. Of the total residential mortgage portfolio, $102.5 million represented Express Mortgages at December 31, 2002 compared to a balance of $57.8 million at December 31, 2001. Declining residential mortgage rates during 2002 produced strong demand from homeowners interested in refinancing into fixed rate mortgages, including both Express and 30-year mortgages.
Commercial real estate and commercial construction loan balances of $297.2 million were up $19.9 million, or 7.2%, over the year-end 2001 balance of $277.3 million. The percentage of the gross loan portfolio represented by commercial real estate and construction loans declined from 35.3% at the end of 2001 to 34.6% at the end of 2002. Within the December 31, 2002 commercial real estate portfolio balance, loans secured by multi-unit residential buildings represent the largest segment, $98.8 million, or 33.8% of the total portfolio, compared to $84.2 million, or 31.7% of the total portfolio balance at December 31, 2001. The next two largest segments, by collateral type, are loans secured by mixed office/retail properties and office buildings, representing 18.1% and 15.5% of the portfolio respectively. Loans secured by hospitality properties declined during 2002, from $16.8 million or 6.3% of the portfolio balance at the end of 2001, to $15.1 million or 5.1% of the portfolio at December 31, 2002. In addition to the pledged collateral, all hospitality loans are fully guaranteed by the property owners, and all are performing.
Outstanding balances under home equity lines of credit were $76.8 million at December 31, 2002, representing a 14.8% decrease from $90.1 million at December 31, 2001. Home equity lines of credit balances represented 8.9% of total gross loans as of December 31, 2002 compared to 11.5% at year-end 2001. Many home equity customers took advantage of low interest rates during 2002 to combine their home equity outstandings with refinanced first mortgages.
Loan portfolio balances at the end of 2001 were up $88.0 million, or 12.8%, from the end of 2000. All of the growth was in loans collateralized by real estate.
<PAGE> 22
The following table presents the composition of the loan portfolio in dollar amounts and in percentages of the total portfolio at the dates indicated.
_________________________
(1) Includes loans held for sale.
<PAGE> 23
The following table shows the repricing dates or contractual maturity dates of the Bank's loans as of December 31, 2002. The table does not reflect prepayments or scheduled principal amortization.
The following table presents, as of December 31, 2002, the dollar amount of all loans contractually due or scheduled to reprice after December 31, 2003 and whether such loans have fixed interest rates or adjustable interest rates.
<PAGE> 24
Loan Portfolio Quality
One of the Company's operating objectives is to maintain a high level of asset quality. The Company believes that it sets sound credit standards for new loans and follows careful loan administration procedures. These practices and relatively favorable economic and real estate market conditions have resulted in low delinquency ratios and, in recent years, a low level of non-performing assets. The Company's policies require frequent monitoring of the status of the loan portfolio and monthly reporting to the Board of Directors and the Credit Committee. These management reports include information on delinquent loans and foreclosed real estate, as well as management's plans to cure any delinquent loans and to dispose of the foreclosed property.
The Company generally stops accruing income when interest or principal payments are 90 days in arrears. It may stop accruing income on certain loans earlier than 90 days, when the collection of contractual interest or principal payments appears to be doubtful. When a loan is designated non-accrual, the Company reverses all unpaid interest that had previously been credited to income. If the Company receives a payment on a non-accrual loan, it may recognize a portion of that payment as interest income if the ultimate collectibility of principal is no longer in doubt. However, such loans would remain on non-accrual status. For a loan to return to accrual status the borrower must have made all past due interest and principal payments, and the full collection of principal and interest must no longer be in doubt.
At December 31, 2002 and 2001, the Company classified approximately $361,000 and $133,000 respectively as non-accrual loans. The non-accrual loan balance at the end of 2002 included one residential mortgage totaling $283,000, with the remaining balance comprised of consumer loans; all non-accrual loans as of December 31, 2001 were consumer loans.
Under the Company's loan policy, any non-accrual commercial real estate and commercial loans would be considered impaired. Impaired loans are individually assessed to determine whether the carrying value exceeds the fair value of the collateral or the present value of the cash flow generated from the underlying collateral. Smaller balance homogeneous loans that have been designated as non-accrual, such as residential mortgage loans, are evaluated collectively for impairment.
<PAGE> 25
The following table presents information regarding non-accrual real estate loans, accruing loans delinquent 90 days or more, and foreclosed real estate as of the dates indicated. If all non-performing loans had been performing in accordance with their original terms and had been outstanding from the earlier of the beginning of the period or origination, the Company would have recorded interest income on these loans of approximately $25,000 for 2002, $14,000 for 2001, and $7,000 for 2000.
Allowance for Loan Losses
The Company maintains an allowance for loan losses through a provision that is charged to income. Management determines the adequacy of the allowance through regular monitoring of the loan portfolio, and quarterly assessments of the loss potential in the portfolio. Although it involves significant uncertainties, this review process takes into account historical loan loss experience, known and inherent risks in the loan portfolio, changes in categories with higher loss potential such as commercial real estate loans and jumbo residential mortgage loans and the estimated values of the underlying collateral. Management also considers the effects on the portfolio and its underlying collateral from economic and market trends. Management's methodology for assessing the adequacy of the allowance includes a review of the components, which include a formula allowance for performing loans and a specific allowance for any identified problem loans. Changes in the volume and concentrations of performing loans affects the formula allowance and the allocation of the allowance among types of loans. Changes in the balance of impaired loans affect the specific allowance.
The specific allowance incorporates the results of measuring impairment for specifically identified problem loans in accordance with SFAS No. 114, "Accounting By Creditors for Impairment of a Loan," and SFAS No. 118, "Accounting by Creditors for Impairment of a Loan--Income Recognition and Disclosures." In accordance with SFAS No.'s 114 and 118, the specific allowance reduces the carrying amount of the impaired loans to their estimated fair value. A loan is recognized as impaired when it is probable that principal and/or interest are not collectible in accordance with the loan's contractual terms. Measurement of impairment is based on the present value of anticipated future cash flows, fair value of collateral, or the loan's observable market price. Measurement of impairment does not apply to large groups of smaller balance homogeneous loans such as consumer installment and student loans. As of December 31, 2002, the Company had no impaired loans. At December 31, 2002 the
<PAGE> 26
Company identified potential problems loans of $13.9 million not included in non-performing loans. Payments on these loans are all current as of December 31, 2002.
The formula allowance is calculated by applying loss factors to outstanding loans by type, excluding loans for which a specific allowance has been determined, loans held for sale and loans that are secured by pledged deposits. Each quarter, the Bank prepares an allowance for loan loss worksheet which categorizes the loan portfolio by risk characteristics such as loan type and loan grade. Changes in the mix of loans and the internal loan grades affect the amount of the formula allowance. Loss factors are assigned to each category based on the Bank's assessment of each category's inherent risk. In determining the loss factors to apply to each loan category, the Bank considers historical losses, peer group comparisons, industry data and loss percentages used by banking regulators for similarly graded loans. Because the determination of future loss potential is inherently uncertain, a portion of the formula allowance is not allocated to any loan category. This non-specific reserve is maintained because the analysis of the economy, the business environment, and other external factors is inherently a subjective and imprecise process, and therefore the impact of such external factors on the portfolio can be precisely measured.
For the fiscal year ended December 31, 2002, the Company increased the allowance for loan losses through a $650,000 provision for loan losses, based on an evaluation process described above. The provision, plus net recoveries totaling $36,000 of previously charged off loans, increased the allowance for loan losses to $10.0 million, from $9.3 million at the end of 2001. At December 31, 2002, the allowance represented 1.18% of total loans, net of loans held for sale and loans secured by cash deposits. This compares to 1.19% at the end of 2001. The $650,000 provision represented a decrease of $575,000 from the 2001 provision of $1.2 million. Management cited several factors in its decision to reduce the provision. First, the total loan growth, not including loans held for sale, of $62.4 million in 2002, was down from growth of $89.3 million the previous year. Second, growth in commercial real estate and construction loans was $19.9 million during 2002 compared to $24.5 million during 2001. Third, the portion of the portfolio representing home equity lines of credit declined by $13.3 million during 2002; during 2001, the home equity lines of credit portfolio grew by $7.2 million. The allowance for loan losses as of December 31, 2002 as a percentage of total loans was 1.18%, essentially unchanged from 1.19% at December 31, 2001.
The unallocated portion of the allowance was $1.2 million at December 31, 2002, $2.1 million at December 31, 2001 and $1.4 million at December 31, 2000. This represented 11.8% of the total allowance as of December 31, 2002, 22.0% as of December 31, 2001, and 17.9% as of December 31, 2000.
Although the Company believes that the allowance for loan losses is adequate, future additions may be necessary if economic conditions, real estate values and other factors differ substantially from the current operating environment.
<PAGE> 27
The following table presents the activity in the allowance for loan losses and other ratios at or for the dates indicated.
(1) Does not include loans held for sale or passbook loans.
<PAGE> 28
The following tables set forth the allowance for loan losses allocated by loan category, the total loan balances by category, and the percent of loans in each category to total loans indicated
_________________________
(1) Includes home equity lines of credit, excludes loans held for sale.
(2) Excludes passbook loans.
<PAGE> 29
Deposits
Deposit flows are influenced by a number of factors including general economic conditions, economic conditions in communities served by the Company's branches, the perceived strength of the stock market, prevailing interest rates and competition from other financial institutions. Most of the Company's deposits come from areas surrounding its branch offices. To attract and retain deposits, the Company utilizes a strategy that incorporates competitive pricing with high quality service. It determines deposit rates by evaluating competitors' pricing, the cost of obtaining funds from other sources, rates on U.S. Treasury securities and other related financial instruments.
Total deposits rose by $272.0 million, or 30.6%, to $1.2 billion at December 31, 2002, from $888.5 million at the end of 2001. During 2002, the Company focused its branch strategy and marketing efforts on acquiring new consumer and small business core deposit relationships. The Money Manager Checking marketing campaign, which was introduced in March, offered a premium rate guaranteed through September 30, 2002. In September the Company introduced the Money Manager Savings account, a money market account available to checking account customers. As the Company reduced the rate on the Money Manager Checking account during the fourth quarter of 2002, many customers moved funds from Money Manager Checking into Money Manager Savings. The promotion was the primary reason for the deposit growth during 2002, which was also a period when customers were moving funds out of the stock market. This included 41.1% growth in NOW account balances, which rose from $112.5 million at December 31, 2001 to $158.7 million at the end of 2002, and 53.3% growth in money market account balances, from $334.7 million at the end of 2001 to $512.9 million at the end of 2002. Another reason for the deposit growth was the addition of a new branch office. In April, 2002 the Company opened a new banking office in Brookline, Massachusetts. At December 31, 2002, the Brookline branch had total deposit balances of $59.8 million.
Demand deposit balances increased $3.8 million, to $62.1 million at December 31, 2002 from $58.2 million at the end of the previous year. Certificates of Deposit rose $34.7 million, to $361.8 million at the end of 2002 from $327.1 million at December 31, 2001. Savings account balances increased by $9.0 million, to $65.0 million at December 31, 2002 from $56.0 million at December 31, 2001. Balances in savings accounts have remained relatively stable over the past five years, despite market rate fluctuations and higher rate account promotions by Cambridgeport and its competitors.
Year-end 2001 total deposits of $888.5 million represented an increase of $78.7 million over the December 31, 2000 total of $809.8 million. The growth included $51.7 million in demand and NOW account balances, most of which was in the Money Manager Checking account, and $18.5 million in time deposits.
<PAGE> 30
The following table sets forth the distribution of deposit accounts, by account type, at the dates indicated.
___________________
(1) Includes mortgagor's escrow payments.
<PAGE> 31
The following table summarizes deposit activity for the periods indicated.
___________________
(1) Includes mortgage escrow payments.
At December 31, 2002, the Bank had $97.9 million in certificates of deposit with balances of over $100,000 and maturing as follows:
The following table sets forth, by interest rate ranges, information concerning certificates of deposit at December 31, 2002:
<PAGE> 32
Borrowings
Deposits are the Company's primary source of funds; however, the Company may also use borrowings and other non-deposit sources of funds in order to acquire specific assets, fund asset growth that exceeds the level of deposits, and manage interest rate risk. Through the Bank, the Company may obtain funds from the Federal Home Loan Bank of Boston. The Bank increased borrowings from the Federal Home Loan Bank by $60.3 million to $175.5 million at December 31, 2002 from $115.2 million at December 31, 2001. These borrowings were sought to take advantage of low interest rates to increase intermediate-term and long-term funding. Included in the 2002 and 2001 figures were $13.1 million and $13.4 million, respectively, representing the remaining outstanding balance of a $14.5 million, 20-year advance used to finance the construction of the Company's administrative center.
The following table sets forth information concerning balances and interest rates on borrowings from the Federal Home Loan Bank at the dates and for the periods indicated.
Stockholders' Equity
The Company's equity decreased by $2.3 million from $123.4 million at December 31, 2001 to $121.1 million at December 31, 2002. This change resulted primarily from share repurchases during the year, partially offset by increases in retained earnings and accumulated other comprehensive income. During 2002, the Company repurchased 593,365 shares at a total cost of $21.6 million.
During 2001 the Company repurchased 1,653,712 shares at a total cost of $35.4 million. This was the primary reason for the $28.6 million decrease in total equity at December 31, 2001 compared to December 31, 2000.
The capital to assets ratios at the end of 2002, 2001 and 2000 were 8.2%, 10.84% and 15.13%, respectively. In every case, the ratios exceeded regulatory requirements.
<PAGE> 33
RESULTS OF OPERATIONS
General
Port's net income in 2002 was $13.6 million, up $3.2 million from the previous year's net income of $10.4 million, which included non-recurring after-tax gains of $1.7 million ($3.2 million pre-tax). The gains in resulted from the termination of the Company's defined benefit pension plan, the sale of shares in the New York Cash Exchange (NYCE) ATM network, and the sale of deposits at its Quincy branch.
The primary reason for the growth in net income during 2002 was higher net interest income, which rose 29.2% to $45.1 million from $34.9 million in 2001. The main contributors to this improvement were higher average balances of earning assets and a 102 basis point reduction in the cost of interest-bearing liabilities. Non-interest income totaled $5.4 million in 2002, compared to $7.3 million in 2001. The non-recurring gains mentioned above were included in 2001's non-interest income.
The Company reduced its provision for loan losses in 2002 to $650,000 compared to $1.2 million in 2001, as non-performing asset and payment delinquencies continued to be minimal. Operating expenses grew by $3.5 million, or 14.3%, in 2002 compared with 2001.
Net Interest Income
Net interest income increased $10.2 million in 2002 compared to 2001, primarily because of growth in the average balance of earning assets and lower average cost of deposits and borrowings, partially offset by lower yields on assets. The net interest margin--the ratio of net interest income to average earning assets--declined 3 basis points in 2002 compared to the previous year. However, the effect of the lower margin was more than offset by growth in the balance sheet.
Net interest income in 2001 rose $5.2 million compared with 2000. Average earning assets increased by $145.3 million in 2001 to $980.7 million, from $835.4 million the year before. At the same time, interest-bearing liabilities increased $136.7 million, to $832.1 million in 2001. Therefore, the difference between earning assets and interest-bearing liabilities was $8.6 million higher in 2001 than in 2000. Non-interest bearing deposits and additional capital funded these additional assets--their average balances were up $5.1 million and $6.7 million respectively in 2001.
Interest Income
Interest and dividend income in 2002 totaled $81.4 million, an increase of 16.8%, compared to 2001. The average balance of earning assets grew $297.4 million, or 30.3%, to $1.28 billion compared to an average earning asset balance of $980.7 million in 2001. Earning asset growth offset the effect of a 73 basis point decline in their average yield, as rates on new loans and investments in 2002 were lower than in the previous year. See the "Average Balance Sheet" and "Rate/Volume Analysis" tables below.
Interest earned on loans totaled $58.7 million in 2002, up $5.5 million from 2002, as average balance of loans, which was $133.4 million, or 18.7%, higher in 2002. This growth more than offset declining loan yields, which were 52 basis points lower in the 2002 period. Loan portfolio growth during 2002 reflected customer demand for residential and commercial real estate loans in the low interest rate environment that prevailed during the year.
Interest earned on short term investments, certificates of deposits and investment securities totaled $22.7 million in 2002, an increase of $6.2 million over 2001. The average balance of investment securities was $177.8 million higher in 2002, offsetting the effect of a 100 basis point decline in yield on that portfolio.
Total interest and dividend income rose $7.2 million in 2001 to $69.6 million, compared to $62.4 million in 2000. The growth in average earning assets mentioned above was the reason for the increase, which was partially offset by a decline of 37 basis points in yield on those assets, from 7.43% in 2000 to 7.06% in 2001. As market interest rates declined during 2001, cash flow from amortization and payoffs of higher yielding loans and securities was redeployed into lower yielding assets.
<PAGE> 34
Interest Expense
Total interest expense increased by $1.5 million in 2002, to $36.2 million, compared to $34.7 million in 2001. Interest paid on deposits declined by $1.8 million, while interest paid on borrowings rose $3.3 million. The average cost of deposits was 113 basis points lower in 2002 than in the previous year, as Federal Reserve rate reductions during 2001 and 2002 enabled the Company to reduce deposit rates, which more than offset the effect of growth in the average balance of deposits. The average balance of interest bearing deposits rose $233.4 million, to $999.0 million in 2002, compared to an average balance of $765.6 million in 2001. The previously mentioned marketing promotion of the Money Manager Checking and Savings account was a major reason for the growth in NOW account and money market account balances, which averaged $94.6 and $79.3 million respectively higher in 2002 than in 2001. Time deposit balances were also higher in 2002, averaging $359.5 million in 2002 compared to $308.9 million in 2001. In the declining rate environment, some customers opted for the guaranteed yields offered by the Company's time deposit products.
The average balance of borrowings rose $79.9 million in 2002, as the Company took advantage of low rates to increase its longer term borrowings from the Federal Home Loan Bank of Boston. The average cost of borrowed funds declined by 70 basis points, from 5.35% in 2001 to 4.65% in 2002 reflecting the lower interest rate environment.
Total interest expense increased by $2.0 million in 2001 compared to 2000. Interest paid on borrowings rose $1.6 million, while interest paid on deposits increased $400,000. Average balances of deposits and borrowings grew 19.7% in 2001 compared with 2000, reflecting the success of the Bank's Real Banking and Premier Banking marketing campaigns, which offered high rate money market accounts for customers who maintained core checking accounts with the Bank. Average money market balances grew 37.3% in 2001, to $315.1 million, compared to $229.5 million in 2000. Average balances of NOW accounts grew 62.9%, to $88.3 million, compared to $54.2 million the previous year. Average balances of Federal Home Loan Bank borrowings also rose during 2001 as the Bank took advantage of low interest rates to increase intermediate and long-term funding, and thus reduce its exposure to rising interest rates. Federal Home Loan Bank borrowings averaged $66.5 million in 2001 compared to $38.1 million in 2000. Lower deposit rates, particularly the reduced cost of money market accounts, largely offset the impact of higher average balances of interest-bearing deposits and borrowings. Two factors explain the lower average cost of money market deposits in 2001, which declined 143 basis points compared with the previous year. First, the promotional rate period on the Real Savings money market account expired on March 31, 2001. The Bank introduced the Real Savings account in June, 2000, to coincide with large bank merger activity in the region. The promotional rate of 6.25% was guaranteed through March 31, 2001. The second cause of lower money market deposit costs were the actions during 2001 taken by the Federal Reserve to lower interest rates. The unprecedented reductions in the Federal Reserve's overnight borrowing rate created an environment in which the Company could reduce rates on all money market accounts to levels significantly below the rates paid in 2000.
The average cost of borrowings rose by 27 basis points from 5.08% in 2000 to 5.35% in 2001. During 2000, the Company capitalized a portion of the interest paid on the $14.5 million borrowing used to fund construction of the Company's administrative center. The capitalized interest totaled $478,000; had it been included in interest expense, the cost of borrowings during 2000 would have been 6.13%.
<PAGE> 35
The following tables set forth information relating to Port's financial condition and net interest income at and for the fiscal years ended December 31, 2002, 2001 and 2000, and reflect the average yield on assets and average cost of liabilities for the periods indicated. Yields and costs are derived by dividing interest income by the average balance of interest-earning assets and interest expense by the average balance of interest-bearing liabilities for the periods shown. Average balances are derived from actual daily balances over the periods indicated. Interest income includes fees earned from making changes in loan rates or terms, and fees earned when commercial real estate loans were prepaid or refinanced.
___________________
(1)
Short-term investments include federal funds sold.
(2)
Investment securities that are considered available for sale are carried at market value, while securities that are held to maturity are carried at cost. Also includes both Federal Home Loan Bank and Savings Bank Life Insurance stock carried at cost.
(3)
Loans are net of deferred loan origination costs (fees).
(4)
Net interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average cost of interest-bearing liabilities.
(5)
Net interest margin represents net interest income as a percentage of average interest-earning assets.
The following table shows how changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected the Company's interest income and interest expense during the periods indicated. Information is provided in each category with respect to:
*
Interest income changes attributable to changes in volume (changes in volume multiplied by prior rate);
*
Interest income changes attributable to changes in rate (changes in rate multiplied by prior volume); and
*
The net change.
The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate.
<PAGE> 37
Provision for Loan Losses
For the fiscal year ended December 31, 2002, the Company increased the allowance for loan losses through a $650,000 provision for loan losses based on an evaluation of the items discussed above in the section entitled "Allowance for Loan Losses". The $650,000 provision represented a decrease of $575,000 from the 2001 provision of $1.2 million. Management cited several factors in its decision to reduce the provision. First, the total gross loan growth of $74.5 million in 2002 was down from the loan growth of $89.3 million the previous year. Second, growth in commercial real estate and construction loans was $19.9 million during 2002 compared to $24.5 million during 2001. Third, the portion of the portfolio representing home equity lines of credit declined by $13.3 million in 2002. In 2001, the home equity lines of credit portfolio grew by $7.2 million. The allowance for loan losses as of December 31, 2002 as a percentage of total loans was 1.18%, essentially unchanged from 1.19% at December 31, 2001.
The Company's $1.2 million provision for loan losses in 2001 represented an increase of $309,000 from the 2000 provision expense of $916,000. Management cited several factors in its decision to increase the provision. First, the general economy deteriorated in 2001, as growth slowed from the previous year. Management believed that the impact of the economic slowdown might be felt across all segments of the loan portfolio. Second, the market for commercial real estate deteriorated as vacancy rates rose, rental rates declined, and major companies scaled back expansion plans. Third, the Company downgraded certain commercial real estate loans based on the deteriorating financial condition of tenant occupants. Fourth, the impact of the September 11 attacks on the travel and hospitality industries prompted downgrades within the hospitality sector of the commercial real estate portfolio.
The unallocated portion of the allowance was $1.2 million at December 31, 2002, $2.1 million at December 31, 2001 and $1.4 million at December 31, 2000. This represented 11.8% of the total allowance as of December 31, 2002, 22.0% as of December 31, 2001, and 17.9% as of December 31, 2000.
Future provisions for loan losses will continue to be based upon the Company's assessment of the overall loan portfolio and its underlying collateral, the mix of loans within the portfolio, delinquency trends, economic conditions, current and prospective trends in real estate values, and other relevant factors.
Non-interest Income
Non-interest income includes service fees and charges for bank services, fees from sales of investment products, gains or losses from loan sales, and other income resulting from miscellaneous transactions. Non-interest income totaled $5.4 million in 2002 compared to $7.3 million in 2001, which included $3.2 million pre-tax in non-recurring gains mentioned above. Gains from sales of fixed rate residential mortgages, and revenue from servicing mortgages, totaled $1.7 million in 2002, compared to $1.1 million in 2001. Declining mortgage rates generated higher volumes of 30-year fixed rate mortgages in 2002, which the Company normally sells. Customer service fees increased by $209,000 in 2002, reflecting the growth in the number of demand deposit and NOW accounts as well as activity in those accounts. Fees from sales of insurance and investment products totaled $914,000 in 2002, an increase of $98,000 from 2001. The Company initiated sales of annuities and other investment products in April 2001.
Non-interest income, excluding non-recurring items, totaled $4.2 million in 2001 compared to $2.7 million in 2000. The 2000 results included a non-recurring loss of $603,000 from the sale of investment securities and a non-recurring gain of $448,000 from the curtailment of the Bank's defined benefit pension plan. The main reasons for the growth in non-interest income in 2001 were increased customer service fees, fees earned from sales of investment products, gains from the sale of fixed rate residential mortgages, and increases in the cash surrender value of life insurance policies. Customer services fees rose $213,000 in 2001 compared with the previous year primarily because of the higher number of transaction accounts, which generate activity-related fees. Fees from investment product sales were $816,000 in 2001 compared to $205,000 in 2000. The Company expanded its wealth management product line during 2001, generating increased fees from sales of annuities and other investment products. Loan sale gains in 2001 were $370,000 higher than in 2000, as declining mortgage rates during 2001 produced more demand for fixed rate mortgages. The cash surrender value of bank-owned life insurance policies increased by $194,000 in 2001 compared to an increase of $10,000 in 2000. During 2000, the Company changed the investments of the insurance policy-related assets from equities to fixed income securities in order to reduce earnings volatility related to stock market performance.
Non-interest Expense
Total non-interest expense increased $3.5 million, or 14.3%, to $28.3 million in 2002 compared to $24.8 million in 2001. Compensation and benefits expense increased $2.5 million, or 17.3%, to $17.1 million in 2002 from
<PAGE> 38
$14.6 million in 2001. The higher expense in 2002 reflects annual wage adjustments as well as higher costs of short and long-term incentive plans, health and life insurance plans, retirement plans and stock benefit plans. Occupancy costs of $3.8 million in 2002 represented an increase of $511,000 over the previous year, primarily because of added cost from the expanded and renovated Harvard Square branch and the new branch in Brookline. Marketing expense increased $210,000 in 2002, reflecting the cost of the Money Manager Checking marketing campaign mentioned above.
Total non-interest expense rose $2.5 million in 2001 compared to the 2000 total of $22.3 million. Compensation and benefits expense increased $2.2 million or 17.2% to $14.6 million from $12.4 million in 2000. This increase included $688,000, which was the effect of a full year of expense from the RRP. The RRP expenses commenced following shareholder approval in October 2000. Expenses related to other stock-based benefit plans rose $168,000 in 2001 compared to the previous year, largely because of the increase in the market price of the Company's common stock during 2001. The remaining $1.2 million compensation expense increase was the result of annual wage adjustments and higher commissions paid to mortgage originators and other sales representatives. Transaction account volume and the costs of internet banking services were the main factors leading to an increase of $428,000 in data processing expense, which totaled $2.0 million in 2001 compared to $1.6 million in 2000. Occupancy expense decreased $232,000 in 2001 compared with 2000, as the Company received a full year of rental income from its administrative center tenants in 2001. Rental income is accounted for as an offset to occupancy expense.
Income Taxes
The 2002 tax provision of $8.0 million represented an effective tax rate of 36.9% in 2002 compared to $5.8 million, or 35.9%, in 2001. Increased earnings in the Bank during 2002 resulted in higher state tax liability than in the previous year.
In March 2003, the Company announced that it would accrue a liability in the first quarter of 2003 of approximately $840,000, representing an estimate of the additional state tax liability, including interest (net of any federal and state tax deductions associated with such taxes and interest), relating to the deduction for dividends received from its real estate investment trust subsidiary ("REIT") for the 2001 and 2002 fiscal years. The accrued liability is the result of new legislation signed by the Governor of Massachusetts that amended Massachusetts law to expressly disallow the deduction for dividends received from a REIT. This amendment applies retroactively to tax years ending on or after December 31, 1999. As a result of the enactment of this legislation, the Company also ceased recording the tax benefits associated with the dividend received deduction effective for the 2003 tax year and accrued the liability described above.
The Company believes that this legislation will be challenged, especially the retroactive provisions, on constitutional and other grounds. The Company intends to support such a challenge and defend vigorously its position that the deductibility of dividends received by the Bank from its REIT was fully compliant with Massachusetts law at the time.
Income tax expense was $3.1 million in 2000, representing an effective tax rate of 34.8%. The higher effective tax rate in 2001 was primarily the result of the Company moving into a higher federal tax bracket.
Liquidity and Capital Resources
The term "liquidity" refers to the Company's ability to generate adequate amounts of cash to fund loan originations, loan purchases, deposit withdrawals and operating expenses. Primary sources of liquidity are deposits, scheduled amortization and prepayments of loan principal and mortgage-backed securities, maturities and calls of investment securities and funds provided by operations. Loan repayment and maturing investment securities are a relatively predictable source of funds. However, deposit flows, calls of investment securities and prepayments of loans and mortgage-backed securities are strongly influenced by interest rates, general and local economic conditions and competition in the marketplace. These factors reduce the predictability of the timing of these sources of funds.
The Bank also can borrow funds from the Federal Home Loan Bank based on eligible collateral of loans and securities. Its maximum borrowing capacity from the Federal Home Loan Bank is approximately $152.5 million, net of borrowings that are already outstanding. In addition, the Bank may enter into reverse repurchase agreements with approved broker-dealers. Reverse repurchase agreements are agreements that allow the Bank to borrow using investment securities as collateral.
<PAGE> 39
Total deposits increased $272.0 million and $78.7 million during the 2002 and 2001, respectively. Time deposit accounts scheduled to mature within one year were $160.9 million at December 31, 2002. Based on the Company's experience and current pricing strategy, it anticipates that a significant portion of these certificates of deposit will remain on deposit. At December 31, 2002, outstanding borrowings from Federal Home Loan Bank were $175.6 million, $60.3 million above the level at December 31, 2001. During 2002, the Bank took advantage of low intermediate and long-term rates, and increased its extended-term borrowings from the Federal Home Loan Bank.
The Company's primary investing activities are the origination of one- to four-family real estate, and commercial real estate loans, and the purchase of investment securities. During 2002, it originated loans of approximately $526.9 million, and during the previous year it originated loans of approximately $379.6 million. Purchases of investment securities totaled $427.0 million during 2002 and $176.7 million during 2001. At December 31, 2002, Cambridgeport had loan commitments to borrowers of approximately $56.0 million, and available home equity and unadvanced lines of credit of approximately $191.3 million.
The Company monitors its liquidity position daily and expects to have sufficient funds to meet its current funding commitments.
At December 31, 2002, Port exceeded each of the applicable regulatory capital requirements. Tier 1 leverage capital was $109.9 million, or 15.4% of risk-weighed assets, and 7.6% of average assets. It had a risk-based total capital of $121.1 million and a risk-based capital ratio of 17.0%.
The Company does not anticipate any material capital expenditures during calendar year 2003. It does not have any balloon or other payments due on any long-term obligations or any off-balance-sheet items other than the commitments and unused lines of credit noted above and an interest swap agreement.
Contractual Obligations and Commitments
The following table summarizes the Company's contractual cash obligations and other commitments.
<PAGE> 40
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates/prices such as interest rates, foreign currency exchange rates, commodity prices, and equity prices. Port is exposed to interest rate risk, which occurs from interest rate volatility. Fluctuations in interest rates may impact both its income and expense on a large portion of assets and liabilities, as well as the market value of all interest-earning assets.
The ongoing monitoring and management of interest rate risk is an important component of the Company's asset/liability management process. This process is governed by policies established by the Board of Directors. The Board reviews these policies annually, and reviews the Company's interest rate risk position quarterly. The Board of Directors delegates responsibility for carrying out the asset/liability management policies to the Asset/Liability Management Committee ("ALCO"), comprised of the Chief Executive Officer, the President, the Chief Financial Officer and various other members of management. ALCO develops strategies based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. The primary goal of the interest rate management strategy is to limit fluctuations in net interest income as interest rates rise or fall. ALCO seeks to coordinate asset and liability decisions so that, under changing interest rate scenarios, the Company's net interest income will remain within an acceptable range.
The Company's lending activities have emphasized one-to-four family and commercial mortgage loans. Its largest source of funds has been deposits, consisting of certificates of deposit, which generally have shorter terms to maturity than the loan portfolio, savings and money market accounts, and transaction accounts. The Company has also funded loan growth with Federal Home Loan Bank advances. It has employed several strategies to manage the interest rate risk inherent in the asset/liability mix, including but not limited to:
*
Selling most 30 year fixed-rate mortgages to the secondary market;
*
Maintaining the diversity of the existing loan portfolio through the origination of commercial and consumer real estate loans, which typically have variable rates and shorter amortization schedules than residential mortgages;
*
Emphasizing investments with short- and intermediate-term maturities of less than ten years, with most maturities or rate resets currently under 5 years; and
*
Entering into interest rate swap agreements, as appropriate, to hedge the Company's interest rate risk.
Loan repayment activity can be significantly impacted by changes in market interest rates. Prepayment rates vary due to a number of other factors, including regional economic conditions, demographic variables, borrowers' refinancing opportunities, and competition. The Company monitors interest rate sensitivity in order to make timely adjustments to its asset and liability mix and minimize the negative effects of changing rates. The Company uses a simulation model to monitor interest rate risk. The model calculates the net interest income at risk under different interest rate environments. It performs an analysis of changes in net interest income over a two-year period, assuming market interest rates rise or fall 200 basis points in the first twelve months following the current financial statement. The Company also uses the model to simulate other scenarios, altering the modeling assumptions on interest rate changes to include a swing of 400 basis points, and extending the analysis to include a five-year period. The Company's policy objective is to maintain net interest income over a one-year period within 10% of the current level, given a 200 basis point change in market interest rates in either direction.
<PAGE> 41
The table below sets forth the estimated changes in net interest income that would result from a 200 basis point change in interest rates over the applicable twelve-month period.
In addition to net interest income simulation, the Company uses gap analysis to monitor interest rate risk. Gap analysis entails measuring the extent to which such assets and liabilities are "interest rate sensitive". An asset or liability is deemed to be interest rate sensitive within a specific time period if it is scheduled to mature or reprice within that time period. The interest rate sensitivity gap for a given time period is defined as the difference between the amount of interest-earning assets and the amount of interest-bearing liabilities maturing or repricing within that time period.
A gap is considered positive when the amount of interest-earning assets exceeds the amount of interest-bearing liabilities maturing or repricing within a specific time period. A gap is considered negative when the amount of interest-bearing liabilities exceeds the amount of interest-earning assets maturing or repricing within the same period. When interest rates rise, a financial institution with a negative gap position would be expected, absent the effects of other factors, to experience a greater increase in the costs of its liabilities relative to the yields of its assets. Thus, net interest income would likely decrease. An institution with a positive gap position would be expected, absent the effect of other factors, to experience the opposite result. Conversely, during a period of declining interest rates, a negative gap would tend to result in an increase in net interest income. A positive gap would tend to reduce net interest income.
At December 31, 2002, based on the assumptions outlined below, the Company's interest-bearing liabilities maturing or repricing within one year exceeded interest-earning assets maturing or repricing within the same period by $75.9 million. This represented a negative cumulative one-year interest rate sensitivity gap of 5.4% of total assets (within the Company's policy limit of 20%) and a ratio of cumulative interest-earning assets maturing or repricing within one year to cumulative interest-bearing liabilities maturing or repricing within one year of 89.3%. The negative gap position could more adversely impact net interest income in a rising rate environment than a positive gap position.
The following table presents information as of December 31, 2002. It shows the amounts of interest-earning assets and interest-bearing liabilities that reprice or mature in each of the future time periods shown. Except as stated below, the repricing/maturity schedule corresponds with the earlier of the repricing date or the contractual maturity date. The information is also based on the following assumptions:
*
Various mortgage-related products will prepay principal balances depending on the interest rate environment, mortgage product type, outstanding principal balances, average life to maturity and other factors. The residential mortgage portfolio is segregated based on these factors and prepayment speeds are calculated using analytical historical data from the Office of Thrift Supervision.
*
10% of commercial mortgages and home equity loans are assumed to prepay annually.
*
Federal agency securities with call features that are likely to exercised were reported at the next call date. Other agency securities were reported at the contractual maturity date.
*
Higher earning savings accounts and money market accounts are reported in the three-month category. This classification is based on regulatory guidance, as modified by historical analysis of deposit levels during periods of changing market rates.
<PAGE> 42
Deposit assumptions, prepayment rates and anticipated call dates can have a significant impact on the estimated interest sensitivity gap. While the Company believes that its assumptions are reasonable, they may not be indicative of actual future deposit activity, mortgage and mortgage-backed securities prepayments, and the actual timing of federal agency calls.
___________________
(1)
Interest-earning assets are included in the period in which the balances are expected to be redeployed and/or repriced as a result of anticipated prepayments, scheduled rate adjustments and contractual maturities.
(2)
Includes interest bearing overnight bank balances and money market mutual funds.
(3)
Debt securities are presented at amortized cost.
(4)
For the purposes of the gap analysis, the allowance for loan losses has been excluded.
(5)
NOW accounts also include Appreciation, Premier and Money Manager checking and are included in the over five year column.
(6)
Treasury Index, Premier Index, Money Manager Savings and Real Savings accounts are included in 3 months or less.
<PAGE> 43
During 2001, the Company entered into an interest-rate-swap agreement, designated as a "cash flow' hedge, with a notional value of $20.0 million. An interest rate swap is an agreement whereby one party agrees to receive a variable rate of interest on a notional value in exchange for paying a fixed rate of interest on the same notional amount for a predetermined period of time from a second party. The purpose of this swap is to hedge the variability of interest expense payments on Treasury Index deposit accounts attributable to changes in interest rates. Under the terms of the swap agreement, the Company receives payments based on weekly average rate on three month U.S. Treasury bills in exchange for payments based on a fixed rate. The swap has a maturity of 2 years and is not callable. As of December 31, 2002, the Company was receiving a variable rate of 1.207% and paying a fixed rate of 4.10% on this swap. As a result of this interest rate swap, the Company realized interest expense of $492,000 for the year ended December 31, 2002. As of December 31, 2002, the fair value of the swap of $296,000 was recorded as a liability and the change in fair value (net of tax) of $71,000 recorded against accumulated other comprehensive income in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements of Port Financial Corp. and Subsidiaries as of December 31, 2002 and 2001 are included in pages throughof this report.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Effective May 10, 2002, the Audit Committee terminated the engagement of Arthur Andersen LLP ("Andersen") as independent public accountant of Port Financial. Effective as of and on May 28, 2002, based on the recommendation of the Audit Committee, the Board of Directors voted to engage KPMG LLP to serve as the independent auditors for Port Financial for the fiscal year ending December 31, 2002. The decision to change accountants was recommended and approved by the Audit Committee of the Board of Directors of Port Financial.
During the fiscal years ended December 31, 2002 and 2001 and subsequent interim periods, the financial statements of Port Financial did not contain an adverse opinion or a disclaimer of opinion and was not qualified or modified as to uncertainty, audit scope, or accounting principles. Further, there were no disagreements with Andersen on any matter of accounting principles or practices, financial statement disclosure, or auditing scope of procedure, which disagreements, if not resolved to Andersen's satisfaction, would have caused Andersen to make reference in connection with their report to the subject matter of the disagreement.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The following information included on pages 7 - 15 and 24 of Port Financial Corp.'s Proxy Statement for the 2002 Annual Meeting of Stockholders (the "Proxy Statement") is incorporated herein by reference: "Election of Directors," "Information as to Nominees and Continuing Directors," "Nominees for Election as Director," "Executive Officers," and " Section 16(a) Beneficial Ownership Reporting Compliance." ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The following information included on pages 16 through 23 of the Proxy Statement is incorporated herein by reference: "Compensation of Directors and Executive Officers--Directors' Compensation," "Executive Compensation," "Employment Agreements," and "Benefits."
<PAGE> 44
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following information included on pages 3 through 6 of the Proxy Statement is incorporated herein by reference: "Security Ownership of Certain Beneficial Owners and Management--Principal Stockholders of Port Financial Corp." and "Security Ownership of Management." The following table sets forth the aggregate information of our equity compensation plans in effect as of December 31, 2002.
Plan category
Number of securities to
be issued upon exercise
of outstanding options,
warrants and rights
Weighted-average
exercise price of
outstanding options,
warrants and rights
Number of securities
remaining available for
future issuance under
equity compensation
plans (excluding
securities reflected in
column (a)
(a)
(b)
(c)
Equity compensation
plans approved by
security holders
687,022
$18.81
3,700
Equity compensation
plans not approved by
security holders
-
-
-
Total
687,022
$18.81
3,700
___________________
(1)
The number of securities remaining for future issuance under equity compensation plans and also includes 3,700 shares available for issuance under the 2000 Recognition and Retention Plan.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The following information included on page 24 of the Proxy Statement is incorporated herein by reference: "Compensation of Directors and Executive Officers--Transactions with Certain Related Persons." ITEM 14.
ITEM 14. CONTROLS AND PROCEDURES
Within the 90 days prior to the date of this report, the Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer along with the Company's Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to the Securities Exchange Act of 1934 ("Exchange Act") Rule 13a-14. Based upon that evaluation, the Company's Chief Executive Officer along with the Company's Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's periodic Securities and Exchange Commission ("SEC") filings. There have been no significant changes in the Company's internal controls or in other factors which could significantly affect these controls subsequent to the date the Company carried out its evaluation.
Disclosure controls and procedures are Company controls and other procedures that are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms.
Disclosure controls and procedures include, without limitations, controls and procedures designed to ensure that information required to be disclosed by the Company in the reports that it files under the Exchange Act is accumulated and communicated to the Company's management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
<PAGE> 45
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
___________________
*
Incorporated herein by reference to Registration Statement No. 333-91549 on Form S-1 of Port Financial Corp. filed with the Securities and Exchange Commission on November 23, 1999, as amended.
**
Incorporated herein by reference to Exhibit 10.1 filed on November 14, 2000 on Form 10-Q for the quarter ended September 30, 2000.
***
Incorporated herein by reference to the Exhibit 21.1 filed on March 29, 2001 on the Form 10-K for the fiscal year ended December 31, 2000.
(b)
The Company has not filed any reports on Form 8-K for the quarter ended December 31, 2002.
<PAGE> 46
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant certifies that it has duly caused this report to be signed on its behalf by the undersigned, hereunto duly authorized, in the City of Boston, Commonwealth of Massachusetts, on March 24, 2003.
Port Financial Corp.
/s/ James B. Keegan
By: James B. Keegan
Chairman and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed by the following persons in the capacities and on the dates indicated.
Name
Title
Date
/s/ James B. Keegan
Director, Chairman of the Board
March 24 , 2003
James B. Keegan
and Chief Executive Officer
(Principal Executive Officer)
/s/ Charles Jeffrey
Senior Vice President, Treasurer
March 24, 2003
Charles Jeffrey
and Chief Financial Officer
(Principal Financial and Accounting
Officer)
/s/ Maliz E. Beams
Director
March 21, 2003
Maliz E. Beams
/s/ Paul R. Corcoran, Jr.
Director
March 21, 2003
Paul R. Corcoran, Jr.
/s/ Daniel C. Crane
Director
March 21, 2003
Daniel C. Crane
/s/ Samuel C. Fleming
Director
March 21, 2003
Samuel C. Fleming
/s/ Thomas J. Galligan III
Director
March 24, 2003
Thomas J. Galligan III
/s/ Robert D. Happ
Director
March 22, 2003
Robert D. Happ
/s/ Jane L. Lundquist
Director and President
March 24, 2003
Jane L. Lundquist
/s/ Frances K. Moseley
Director
March 24, 2003
Frances K. Moseley
/s/ Thomas H. Niles
Director
March 21, 2003
Thomas H. Niles
/s/ Rudolph R. Russo
Director
March 21, 2003
Rudolph R. Russo
/s/ Sandra J. Sucher
Director
March 21, 2003
Sandra J. Sucher
<PAGE> 47
PORT FINANCIAL CORP.
Consolidated Financial Statements
as of December 31, 2002, 2001 and 2000
Together with Independent Auditors' Reports
<PAGE>
Page
Independent Auditors' Reports
Consolidated Balance Sheets as of December 31, 2002
and 2001
Consolidated Statements of Operations for the Years
Ended December 31, 2002, 2001 and 2000
Consolidated Statements of Changes in Stockholders'
Equity for the Years Ended December 31, 2002, 2001 and 2000
Consolidated Statements of Cash Flows for the Years
Ended December 31, 2002, 2001 and 2000
Notes to Consolidated Financial Statements
-F-38
All schedules are omitted because they are not required or applicable, or the required information is shown in the financial statements or notes thereto.
<PAGE>
Independent Auditors' Report
The Board of Directors
Port Financial Corp.:
We have audited the accompanying consolidated balance sheets of Port Financial Corp. and subsidiaries (the Company) as of December 31, 2002 and the related consolidated statements of operations, changes in stockholders' equity and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. The 2001 and 2000 consolidated financial statements of the Company were audited by other auditors who have ceased operations. That auditors' report, dated February 22, 2002, was unqualified.
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Port Financial Corp. and its subsidiaries as of December 31, 2002 and the results of their operations and their cash flows for the year ended then ended, in conformity with accounting principles generally accepted in the United States of America.
/s/ KPMG LLP
Boston, Massachusetts
January 17, 2003, except as to Note 7,
which is as of March 7, 2003
<PAGE>
Independent Auditors' Report
To the Shareholders and Board of Directors of
Port Financial Corp.
We have audited the accompanying consolidated balance sheets of Port Financial Corp. and subsidiaries (collectively, the Company) as of December 31, 2001 and 2000 and the related consolidated statements of operations, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 2001. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Port Financial Corp. and its subsidiaries as of December 31, 2001 and 2000 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States.
/s/ Arthur Andersen LLP
Arthur Andersen LLP
Boston, Massachusetts
February 22, 2002
This report of Independent Certified Public Accountants is a copy of a previously issued Arthur Andersen LLP ("Andersen") report and has not been reissued by Andersen. This inclusion of this previously issued Andersen report is made pursuant to Section 2.02(e) of regulation S-X. Note that this previously issued Andersen report includes references to certain fiscal years which are not required to be presented in the accompanying consolidated financial statements as of and for the years ended December 31, 2002.
<PAGE>
PORT FINANCIAL CORP.
Consolidated Balance Sheets
(in thousands, except share data)
The accompanying notes are an integral part of these consolidated financial statements.
<PAGE>
PORT FINANCIAL CORP.
Consolidated Statements of Operations
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
<PAGE>
PORT FINANCIAL CORP.
Consolidated Statements of Changes in Stockholder's Equity
for the Years Ended December 30, 2002, 2001 and 2000
(in thousands, except share data)
Accumulated
Unearned
Other
Common
Additional
Treasury
Compensation
Retained
Comprehensive
Comprehensive
Stock
Paid-In Capital
Stock
ESOP/RRP
Earnings
Income
Total
Income
Balance, December 31, 1999
-
-
-
-
77,221
1,909
79,130
$ 3,042
Net income
-
-
-
-
5,901
-
5,901
$ 5,901
Issuance of stock less stock offering costs (of $2.6 million)
71,746
-
-
-
-
71,820
-
Change in unrealized gains on securities available-for-sale,
net of taxes of $1,273
-
-
-
-
-
2,227
2,227
2,227
Less reclassification of securities gains included in net income,
net of taxes of $213
-
-
-
-
-
ESOP unearned compensation:
-
-
-
-
-
-
-
-
Acquisition of shares
-
-
-
(7,514)
-
-
(7,514)
-
Amortization of unearned compensation
-
-
-
-
-
RRP unearned compensation:
-
-
-
-
-
-
-
-
Grant of RRP stock awards
-
4,488
-
(4,488)
-
-
-
-
Amortization of unearned compensation
-
-
-
-
-
-
Cash dividend - $0.05 per share
-
-
-
-
(372
)
-
(372
)
-
Balance, December 31, 2000
76,284
-
(11,581)
82,750
4,526
152,053
$ 8,518
Net income
-
-
-
-
10,366
-
10,366
$ 10,366
Change in unrealized gains on securities available-for-sale,
net of taxes of $1,154
-
-
-
-
-
1,970
1,970
1,970
Change in fair market value of swap agreements,
net of taxes ($169)
-
-
-
-
-
(243)
(243)
(243)
Purchase of RRP stock
-
(5,453)
-
-
-
-
(5,453)
-
Purchase of treasury stock
-
-
(35,390)
-
-
-
(35,390)
-
Exercise of stock options
-
(65)
-
-
-
-
Net forfeiture of RRP awards
-
(82)
-
-
-
-
-
Amortization of unearned compensation
-
-
1,134
-
-
1,297
-
Cash dividend - $0.24 per share
(1,464)
(1,464)
RRP and Stock Option Tax benefits
-
-
-
-
-
-
Balance, December 31, 2001
$ 74
$ 70,879
$ (35,095)
$ (10,365)
$ 91,652
$ 6,253
$123,398
$ 12,093
<PAGE>
PORT FINANCIAL CORP.
Consolidated Statements of Changes in Stockholder's Equity (Continued)
for the Years Ended December 30, 2002, 2001 and 2000
(in thousands, except share data)
Accumulated
Unearned
Other
Common
Additional
Treasury
Compensation
Retained
Comprehensive
Comprehensive
Stock
Paid-In Capital
Stock
ESOP/RRP
Earnings
Income
Total
Income
Balance, December 31, 2001
$ 74
$ 70,879
$ (35,095)
$ (10,365)
$ 91,652
$ 6,253
$123,398
$ 12,093
Net income
-
-
-
-
13,579
-
13,579
$ 13,579
Change in unrealized gains on securities available-for-sale, net of taxes of $3,399
-
-
-
-
-
4,924
4,924
4,924
Less reclassification of securities gains included in net income, net of taxes of $30
-
-
-
-
-
(42)
(42)
(42)
Change in fair market value of swap agreements, net of taxes $45
-
-
-
-
-
Purchase of treasury stock
-
-
(21,554)
-
-
-
(21,554)
-
Exercise of stock options
-
(355)
-
-
-
-
ESOP supplemental
-
-
-
-
-
-
Grant of RRP stock awards
-
-
(497)
-
-
-
Amortization of unearned compensation
-
-
1,549
-
-
2,014
-
Cash dividend - $0.58 per share
-
-
-
-
(2,875)
-
(2,875)
-
RRP and Stock Option Tax benefits
-
-
-
-
-
-
Balance, December 31, 2002
$ 74
$ 72,135
$ (55,365
)
$ (9,313
)
$102,356
$ 11,206
$121,093
$ 18,532
The accompanying notes are an integral part of these consolidated financial statements.
<PAGE>
PORT FINANCIAL CORP.
Consolidated Statements of Cash Flows
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
(1) Summary of Significant Accounting Policies
Basis of Presentation
Port Financial Corp. (Port or the Company) is a Massachusetts-chartered stock holding company, which owns all of the capital stock of Cambridgeport Bank (the Bank). As part of its conversion, the Company converted from a Massachusetts-chartered mutual holding company, Cambridgeport Mutual Holding Company, to a Massachusetts-chartered stockholding company and changed its name to Port Financial Corp. Port sold 7,442,818 shares of its common stock to its eligible depositors, management, employees and to the Company's Employee Stock Ownership Plan (ESOP). Net proceeds of the stock offering were $71.8 million. The conversion and stock offering were completed on April 11, 2000.
The accompanying consolidated financial statements include the accounts of the Company and its two wholly owned subsidiaries, Cambridgeport Bank (the "Bank") and Brighton Investment Corporation. The Bank has four wholly owned subsidiaries, Temple Investment Corporation, River Investment Corporation, Cambridgeport Insurance Services, Inc. and Prospect Real Estate Investment Corp. Temple Investment Corporation and River Investment Corporation both engage in securities investment activities. Cambridgeport Insurance Services, Inc. was established in April 2000 and intends to provide insurance. Prospect Real Estate Investment Corp. was established in April 2001, and holds certain mortgage loans originated by the Bank as well as mortgage-backed securities. In addition, the Bank is the sole member of Temple Realty, LLC, which owns the Company's administration center. Brighton Investment Corporation also engages in securities investment activities. All significant intercompany balances and transactions have been eliminated in the accompanying consolidated financial statements.
Certain reclassifications have been made to the 2001 and 2000 consolidated financial statements to conform to the 2002 presentation. Such reclassifications have no effect on previously reported consolidated net income.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the Unites States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the date of the financial statements and the reported amounts of income and expenses during the reporting periods. Actual results could differ from those estimates. Material estimates that are particulary susceptible to significant changes in the near term relate to the determination of the allowance for loan losses.
Statements of Cash Flows
For purposes of the consolidated statements of cash flows, cash and cash equivalents include cash and due from banks, federal funds sold and overnight deposits with maturities of one day,and investments in the highly liquid Bank Investment Fund.
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
Investment Securities
Debt securities that the Bank has the positive intent and ability to hold to maturity are classified as held-to-maturity and are reported at cost, adjusted for amortization of premiums and accretion of discounts, using the effective-yield method. Debt and equity securities that are bought and held principally for the purpose of selling in the near term are classified as trading and reported at fair value, with unrealized gains and losses included in earnings. The Bank has no securities classified as trading. Debt and equity securities not classified as either held-to-maturity or trading are classified as available-for-sale and reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of other comprehensive income in the consolidated statement of stockholders' equity, net of the related taxes. The Bank classifies its securities based on the Bank's intention at the time of purchase.
Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. The Company evaluates individual securities that have fair values below cost for six months or longer to determine if the decline in fair value is other than temporary. When securities are sold, the adjusted cost of the specific security sold is used to compute gains or losses on the sale.
Loans Held for Sale
Loans held for sale are carried at the lower of the recorded loan balance or market value based on prevailing market conditions and commitments from institutional investors to purchase such loans. There were no adjustments required for unrealized losses at December 31, 2002 and 2001.
Loans, Deferred Fees and the Allowance for Loan Losses
Loans are stated at the amount of unpaid principal, reduced by amounts due to borrowers on unadvanced loans, net deferred loan fees and the allowance for loan losses.
Deferred loan origination fees and certain deferred loan origination costs are amortized over the contractual life of the related loan using the interest method or taken into income at the time the loans are sold. At December 31, 2002 and 2001, the Bank had net deferred loan expenses of approximately $465,000 and net deferred loan fees of approximately $3,000, respectively.
The allowance for loan losses is maintained at a level considered adequate to provide for loan losses. The allowance is increased by provisions charged to operations and realized losses, net of recoveries, are charged directly to the allowance. The allowance for loan losses is evaluated on a regular basis by management. It is based upon management's systematic periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective, as it requires estimates that are susceptible
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
to significant revision as more information becomes available. Changes in estimates are provided currently in earnings.
Loans are considered impaired when, based upon current information and events, it is probable that the Bank will not be able to collect principal payments, interest and fees according to the contractual terms of the loan agreement. Management considers the payment status, net worth and earnings potential of a borrower, as well as the value and related cash flow derived from the collateral as factors to evaluate whether a loan will be paid in accordance with its contractual terms. The amount judged to be impaired is the difference between the present value of the expected future cash flows discounted at the loan's original contractual effective interest rate and the net carrying amount of the loan. If foreclosure on a collateralized loan is probable, impairment is measured based on the fair value of the collateral, less costs to sell, compared to the carrying value. If appropriate, a valuation reserve is established to recognize the difference between the carrying value and the fair value. Impaired loans are charged off when management believes that the collectibility of the loan's principal is doubtful. The Bank considers nonaccrual loans, except for smaller-balance homogenous consumer installment and student loans, to be impaired. All impaired loans are classified as nonaccrual.
Banking Premises and Equipment
Land is stated at cost. Banking premises, leasehold improvements and furniture, fixtures and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are primarily computed by use of the straight-line method over the estimated useful lives of the respective assets or the terms of the respective leases, if shorter. The cost of maintenance and repairs is charged to expense as incurred; major expenditures for betterments are capitalized and depreciated.
Impairment of Long-Lives Assets
The Company reviews long-lived assets, including premises and equipment, for impairment whenever events or changes in business circumstances indicate that the remaining useful life may warrant revision or that the carrying amount of the long-lived asset may not be fully recoverable. If impairment is determined to exist, any related impairment loss is recognized though a charge to earnings. Impairment losses on assets to be disposed of, if any, are based on the estimated proceeds to be received, less costs of disposal.
Income Taxes
The Company records income taxes under the asset and liability method. Under this method, deferred tax assets and liabilities are established for the temporary differences between the accounting basis and the tax basis of the Company's assets and liabilities. Deferred taxes are measured using the enacted tax rates that are expected to be in effect when the amounts related to such temporary differences are realized or settled. The Company must also assess the likelihood that any deferred tax assets will be recovered from future taxable income and to the extent that recovery is not likely, a valuation allowance must be established. Significant management judgement is required in determining income tax expense, and deferred
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
tax assets and liabilities. As of December 31, 2002, there were no valuation allowances set aside against any deferred tax assets.
Stock Based Compensation
In October 1995, the FASB issued SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123 establishes a fair-value-based method of accounting for stock-based compensation plans. The Company has determined that it will account for stock-based compensation for employees under APB Opinion No. 25, Accounting for Stock Issued to Employees, and elect the disclosure-only alternative under SFAS No. 123.
The Company has computed the pro forma disclosures required under SFAS No. 123 for options granted in 2002 and 2001 using the Black-Scholes option pricing model prescribed by SFAS No. 123 using the following assumptions:
Risk-free interest rate
3.39%
4.42%
Expected dividend yield
1.4%
1.3%
Expected lives
4 years
4.5years
Expected volatility
62.43%
29.13%
Weighted average fair value of options granted
$18.84
$5.78
Had compensation cost for the Company's stock option plan been determined consistent with SFAS No. 123, the pro forma net income would have been as follows:
Net income-
As reported
$ 13,579
$ 10,366
Deduct:
Total stock-based employee compensation
expense determined under fair value based
method for all awards, net of tax
(414
)
(328
)
Pro forma
$ 13,165
$ 10,038
Basic EPS-
As reported
$ 2.85
$ 1.74
Pro forma
$ 2.77
$ 1.68
Diluted EPS-
As reported
$ 2.72
$ 1.71
Pro forma
$ 2.64
$ 1.66
Earnings per Share
Earnings per share is not presented for the year ended December 31, 2000 because the earnings per share calculation for the period prior to April 11, 2000 (the date of
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
conversion to a stock company) is not meaningful. Prior to April 11, 2000, the Company was a mutual holding company and no stock was outstanding.
Basic earnings per share is computed by dividing net income by the weighted average number of shares of common stock outstanding during the period presented. Diluted earnings per share is computed in a manner similar to that of basic earnings per share except that the weighed average number of common shares outstanding is increased to include the number of additional common shares that would have been outstanding if contracts to issue common stock for stock options and stock awards were exercised during the period using the treasury stock method. Options to purchase 32,122 shares of common stock as of December 31, 2002 were excluded from the calculation of diluted EPS because the options exercise price was greater than the average market price of the common shares for the year ended December 31, 2002 and their inclusion would have been anti-dilutive. ESOP shares committed to be released are considered outstanding while unallocated common shares held by the ESOP are not included in the weighted average number of common shares outstanding for either basic or diluted earnings per share calculations. The Bank has previously awarded RRP shares in the years 2000 and 2001 that vest at a rate of 20% per year and RRP shares awarded in 2002 vest at a rate of 25% per year. For purposes of calculating EPS, these vested shares are included in both basic and diluted shares.
Derivative Instruments and Hedging Activities
Effective January 1, 2001, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities. This statement establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item, and requires that a company must formally document, designate and assess the effectiveness of transactions that receive hedge accounting at inception of the hedge and on an ongoing basis. If a derivative qualifies as a hedge, depending on the nature of the hedge, changes in the fair value of the derivatives are either offset against the change in the fair value of assets, liabilities, or firm commitments through earnings or are recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value is to be immediately recognized in earnings. Also, when a hedged item or derivative is terminated, sold or matures, any remaining value would be recognized in earnings either immediately or over the remaining life of the contract.
During 2001, the Bank entered into an interest rate swap agreement, designated as a cash flow hedge, with a notional value of $20.0 million. The Bank measures the effectiveness of this hedge by modeling the impact on the exposures under various interest rate scenarios. The purpose of this swap is to hedge the variability of interest expense payments on Treasury Index deposit accounts attributable to changes in interest rates. Under the terms of the swap agreement, the Bank receives payments based on weekly average rate on three month U.S. Treasury bills in exchange for payments based on a fixed rate. The swap has a maturity of 2 years and is not callable. As of December 31, 2002, the Bank was receiving a variable rate of
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
1.207% and paying a fixed rate of 4.10% on this swap. The fair value of the swap of $296,000 and $412,000 was recorded as a liability as of December 31, 2002 and 2001, respectively and the change in market value recorded against accumulated other comprehensive income net of tax of $71,000 for the year ended December 31, 2002.
Interest Income Recognition
It is the policy of the Bank to discontinue the accrual of interest on loans when, in the judgment of management, the ultimate collectibility of principal or interest becomes doubtful. It is the general policy of the Bank to discontinue the accrual of interest on loans delinquent in excess of 90 days. When a loan is placed on nonaccrual status, all interest previously accrued during the year is reversed against current-period interest income. Interest received on nonaccrual loans is either applied against principal or reported as income on the cash basis based on management's judgment as to the collectibility of principal.
Recent Accounting Developments
In October 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets but does not apply to goodwill or intangible assets that are not being amortized and certain other long-lived assets. This Statement supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, and the accounting and reporting provisions of Accounting Principles Board (APB) Opinion No. 30, Reporting Effects on Disposal of a Segment of a Business and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for the disposal of a segment of a business (as previously defined in that Opinion). This statement also amends Accounting Research Bulletin No. 51, Consolidated Financial Statements, to eliminate the exception to consolidation for a subsidiary for which control is likely to be temporary. SFAS No. 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001. The adoption of this statement did not have a material impact on the Company's consolidated financial position or results of operations.
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections". SFAS No. 145, among other things, addresses financial accounting and reporting of gains and losses from extinquishment of debt. SFAS No. 145 requires gains and losses resulting from the extinguishment of debt to be classified as extraordinary items only if they meet the criteria in APB Opinion No. 30. This statement recinds SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt, "SFAS No.64, "Extinguishment of Debt Made to Satisfy Sinking-Fund Requirements," and amends SFAS No. 13, "Accounting for Leases." SFAS No. 145 is effective for fiscal years beginning after May 15, 2002, with early applications encouraged. The Company does not expect that the adoption of this statement will have a material impact on its consolidated financial position or results of operations.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." SFAS No. 146 addresses financial accounting and
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
reporting for costs associated with exit or disposal activities. The statement supersedes Emerging Issues Task Force (EITF) Issue No. 94-3 "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)." SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. The Company does not expect that the adoption of this statement will have a material impact on its consolidated financial position or results of operations.
(2) Investment Securities
The amortized cost and fair value of securities classified as available-for-sale at December 31, 2002 and 2001 are as follows (in thousands):
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
A schedule of the maturity distribution of debt securities available-for-sale at December 31, 2002 is as follows (dollars in thousands):
Amortized
Percent of
Cost
Total
Fair Value
One year or less
$ 22,616
4.6%
$ 22,878
Over 1 year to 5 years
53,500
11.0
54,097
Over 5 years to 10 years
175,978
36.0
179,850
Over 10 years
236,261
48.4
242,178
Total
$ 488,355
100.0
%
$ 499,003
The amortized cost and fair value of securities classified as held-to-maturity at December 31, 2002 and 2001 are as follows (in thousands):
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
A schedule of the maturity distribution of debt securities held-to-maturity at December 31, 2002 is as follows (dollars in thousands):
Amortized
Percent of
Cost
Total
Fair Value
One year or less
$ 5,000
12.6%
$ 5,005
Over 1 year to 5 years
-
0.0
-
Over 5 years to 10 years
24,815
62.3
25,502
Over 10 years
9,992
25.1
10,103
Total
$ 39,807
100.0
%
$ 40,610
Actual maturities of mortgage-backed securities may differ from contractual maturities presented because borrowers have the right to prepay obligations without incurring prepayment penalties.
Proceeds from the sales of investment securities and related gross gains and gross losses for the years ended December 31, 2002, 2001 and 2000 were as follows (in thousands):
(3) Loans
The Bank's lending activities are conducted principally in Massachusetts. The Bank grants single-family and multifamily residential loans, commercial real estate loans, commercial loans and a variety of consumer loans. In addition, the Bank grants loans for the construction of residential homes, multifamily properties and commercial real estate properties. Most loans granted by the Bank are collateralized by real estate. The ability and willingness of the single-family residential and consumer borrowers to honor their repayment commitments is generally dependent on the level of overall economic activity within the borrowers' geographic areas and real estate values. The ability and willingness of the commercial real estate, commercial and construction loan borrowers to honor their repayment commitments is generally dependent on the health of the real estate economic sector in the borrowers' geographic areas and the general economy.
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
The Bank's loan portfolio consisted of the following (in thousands):
The Company maintains an allowance for loan losses through a provision that is charged to income. Management determines the adequacy of the allowance through regular monitoring of the loan portfolio, and quarterly assessments of the loss potential in the portfolio. Although it involves significant uncertainties, this review process takes into account historical loan loss experience, known and inherent risks in the loan portfolio, changes in categories with higher loss potential such as commercial real estate loans and jumbo residential mortgage loans and the estimated values of the underlying collateral. Management also considers the effects on the portfolio and its underlying collateral from economic and market trends. Management's methodology for assessing the adequacy of the allowance includes a review of the components, which include a formula allowance for performing loans and a specific allowance for any identified problem loans. Changes in the volume and concentrations of performing loans affects the formula allowance and the allocation of the allowance among types of loans. Changes in the balance of impaired loans affect the specific reserve.
The specific allowance incorporates the results of measuring impairment for specifically identified problem loans in accordance with SFAS No. 114, "Accounting By Creditors for Impairment of a Loan," and SFAS No. 118, "Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures." In accordance with SFAS No.'s 114 and 118, the specific allowance reduces the carrying amount of the impaired loans to their estimated fair value. A loan is recognized as impaired when it is probable that principal and/or interest are not collectible in accordance with the loan's contractual terms. Measurement of impairment is based on the present value of anticipated future cash flows, fair value of collateral, or the loan's observable market price. Measurement of impairment does not apply to large groups of smaller balance homogeneous loans such as consumer
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
installment and student loans. As of December 31, 2002 and 2001, the Company had no impaired loans.
The formula allowance is calculated by applying loss factors to outstanding loans by type, excluding loans for which a specific allowance has been determined, loans held for sale and loans that are secured by pledged deposits. Each quarter, the Bank prepares an allowance for loan loss worksheet which categorizes the loan portfolio by risk characteristics such as loan type and loan grade. Changes in the mix of loans and the internal loan grades affect the amount of the formula allowance. Loss factors are assigned to each category based on the Bank's assessment of each category's inherent risk. In determining the loss factors to apply to each loan category, the Bank considers historical losses, peer group comparisons, industry data and loss percentages used by banking regulators for similarly graded loans. Because the determination of future loss potential is inherently uncertain, a portion of the formula allowance is not allocated to any loan category. This non-specific reserve is maintained because the analysis of the economy, the business environment, and other external factors is inherently a subjective and imprecise process, and therefore the impact of such external factors on the portfolio can be precisely measured.
Nonaccrual loans consisted of the following (in thousands):
If these loans had been paying in accordance with their original contractual terms, approximately $25,000 and $14,000 of additional interest income would have been recorded in 2002 and 2001, respectively. There are no commitments to extend additional credit on these loans.
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
An analysis of the allowance for loan losses is as follows (in thousands):
Balance, beginning of year
$ 9,321
$ 8,059
$ 7,081
Provision for loan losses
1,225
Charge-offs-
Real estate
-
(18)
-
Commercial
-
(2)
-
Consumer
(42
)
(28
)
(38
)
(42
)
(48
)
(38
)
Recoveries-
Consumer
Net (charge-offs)
recoveries
Balance, end of year
$ 10,007
$ 9,321
$ 8,059
In the ordinary course of business, the Bank has granted loans to directors and principal officers at substantially the same terms and conditions as those prevailing at the time of origination for comparable transactions with other borrowers. In the opinion of management, these loans do not involve more than normal risk of collectibility. The aggregate amount of these loans was approximately $650,000 and $400,000 at December 31, 2002 and 2001, respectively. During 2002, there was one loan secured by residential real estate granted for $250,000. None of these loans were on nonaccrual status during 2002 and 2001.
Loans serviced for other investors amounted to approximately $96.7 million and $143.6 million at December 31, 2002 and 2001, respectively. There are no formal recourse provisions related to these loans.
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
(4) Banking Premises and Equipment
A summary of the cost and accumulated depreciation and amortization of banking premises and equipment and their estimated useful lives is as follows (in thousands):
Depreciation and amortization expense of banking premises and equipment for the years ended December 31, 2002, 2001 and 2000 amounted to approximately $1,865,000, $1,863,000 and $1,479,000, respectively, and is included in occupancy and equipment expenses in the accompanying consolidated statements of operations.
(5) Deposits
A summary of deposit balances, by type, is as follows (in thousands):
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
A schedule of the maturity distribution of term certificates with weighted average interest rates is as follows (dollars in thousands):
(6) Federal Home Loan Bank Advances
Federal Home Loan Bank (FHLB) advances are collateralized by a blanket-type pledge agreement on the Bank's FHLB stock, certain qualified investment securities, deposits at the FHLB and first mortgages on residential property. As a member of the FHLB, the Bank is required to invest in stock of the FHLB at an amount equal to 1% of its outstanding first mortgage residential loans, 0.3% of total assets or 5% of its outstanding advances from the FHLB, whichever is higher. As and when such stock is redeemed, the Bank will receive from the FHLB an amount equal to the par value of the stock. The Bank also has access to a preapproved daily line of credit of $11,003,000. Under this line of credit, funds advanced as of December 31, 2002 and December 31, 2001 were $0 and $1,618,000 respectively.
A schedule of the maturity distribution of FHLB advances with weighted average interest rates is as follows (dollars in thousands):
The Bank may be subject to a substantial penalty upon prepayment of FHLB advances.
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
(7) Income Taxes
The components of the provision for income taxes for the years ended December 31 are as follows (in thousands):
Current-Expense
Federal
$ 7,406
$ 5,370
$ 3,204
State
1,011
Total current
8,417
6,119
3,595
Deferred Benefit-
Federal
(369)
(255)
(384)
State
(97
)
(61
)
(64
)
Total deferred
(466
)
(316
)
(448
)
Total
$ 7,951
$ 5,803
$ 3,147
The difference between the income tax rate computed by applying the statutory federal income tax rate to income before income taxes and the actual effective income tax rate is summarized as follows:
Statutory rate
35.0 %
35.0 %
34.0 %
Increase (decrease) resulting from-
State taxes, net of federal benefit
2.8
2.8
2.4
Dividends-received deduction
(0.4)
(0.4)
(0.7)
Tax credits
(0.1)
(1.2)
(0.4)
Other, net
(0.4
)
(0.3
)
(0.5
)
36.9
%
35.9
%
34.8
%
The primary items giving rise to the temporary differences included in the Bank's net deferred tax asset between year ends are the allowance for possible loan losses, certain unfunded employee benefit accruals, unrealized gains and losses on available-for-sale securities, deferred loan origination fees and depreciation. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized.
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
At December 31, the Bank's net deferred tax asset consisted of the following components (in thousands):
Deferred Tax Assets-
Allowance for loan losses
$ 4,185
$ 3,899
Supplemental pension
1,486
Depreciation
Net unrealized loss on swap agreement
Other
1,008
6,822
6,292
Deferred Tax Liabilities-
Net unrealized gain on securities
available-for-sale
6,976
3,607
Limited partnership
2,551
2,446
Other
9,552
6,074
Net deferred tax asset (liability)
$ (2,730
)
$ 218
At December 31, 2002, the Bank's retained earnings include approximately $4,420,000 of bad debt reserves, representing the base year amount, for which income taxes have not been provided. Since the Bank does not intend to use the suspended bad debt reserve for purposes other than to absorb the losses for which it was established, deferred taxes in the amount of $1,850,000 have not been recorded with respect to such reserve.
In March 2003, the Company announced that it would accrue a liability in the first quarter of 2003 of approximately $840,000, representing an estimate of the additional state tax liability, including interest (net of any federal and state tax deductions associated with such taxes and interest), relating to the deduction for dividends received from its real estate investment trust subsidiary ("REIT") for the 2001 and 2002 fiscal years. The accrued liability is the result of new legislation signed by the Governor of Massachusetts that amended Massachusetts law to expressly disallow the deduction for dividends received from a REIT. This amendment applies retroactively to tax years ending on or after December 31, 1999. As a result of the enactment of this legislation, the Company also ceased recording the tax benefits associated with the dividend received deduction effective for the 2003 tax year and accrued the liability described above.
The Company believes that this legislation will be challenged, especially the retroactive provisions, on constitutional and other grounds. The Company intends to support such a challenge and defend vigorously its position that the deductibility of dividends received by the Bank from its REIT was fully compliant with Massachusetts law at the time.
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
(8) Commitments and Contingencies
In the normal course of business, there are outstanding commitments and contingencies that are not reflected in the consolidated financial statements. On April 1, 2002, the Bank entered into a Master Commitment to deliver or sell $5,000,000 in residential mortgage loans to a federal agency on or before March 31, 2003. At December 31,2002 this commitment was primarily fulfilled. The Bank entered into this commitment for continued relationship purposes even though the Bank intends to sell most of its loans servicing released. If the commitment was not fulfilled, a penalty will not have been assessed against the Bank.
The Bank operates branch offices and certain other operations under leases that are classified as operating leases. The leases contain renewal options that guarantee the Bank the right to extend the leases for additional periods and also provide that the Bank shall pay, as additional rent, a proportionate share of any increase in real estate taxes. At December 31, 2002, future minimum lease payments are as follows:
Year ending December 31,
$ 1,117,000
1,074,000
891,000
822,000
685,000
Thereafter
2,454,000
Total minimum lease payments
$ 7,043,000
The operating leases contain renewal options for periods ranging from one to 15 years, the cost of which is not included above. Rental expense amounted to approximately $1,254,000, $963,000 and $1,051,000 for the years ended December 31, 2002, 2001 and 2000, respectively, and is included in occupancy and equipment expenses in the accompanying consolidated statements of operations.
Aggregate reserves (in the form of deposits with the Federal Reserve Bank and vault cash) of $3,215,000 and $4,051,000 were maintained to satisfy regulatory requirements at December 31, 2002 and 2001, respectively.
In the ordinary course of business, the Bank is involved in litigation. Based on its review of current litigation and discussion with legal counsel, management does not expect that the resolution of such matters will have a material adverse effect upon the Bank's consolidated financial condition or results of operations.
(9) Regulatory Matters
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities and certain off-balance-sheet
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
items, as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined) and Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 2002, that the Company and the Bank met all capital adequacy requirements to which they are subject.
As of December 31, 2002, the most recent notification from the Federal Reserve Bank of Boston relating to the Company classified the Company's capital as satisfactory, and the most recent notification from the FDIC relating to the Bank categorized the Bank as well-capitalized under the regulatory framework for prompt corrective action. To be categorized as well-capitalized, an insured depository institution must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank's category.
The Company's and the Bank's actual capital amounts and ratios as of December 31, 2002 and 2001 are also presented in the table.
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
(10) Employee Benefits
Pension Plan
Through October 31, 2000, the Bank provided pension benefits for eligible employees through the Savings Banks Employees' Retirement Association's (SBERA) Pension Plan (the Plan). Each employee reaching the age of 21 and having completed one year of service became a participant. All participants were fully vested after three years of service.
In September 2000, the Board of Directors voted to freeze benefits under the SBERA Plan effective October 31, 2000 and to terminate the SBERA plan on or about March 1, 2001. In connection with this decision, the SBERA Plan was also amended to improve the benefit formula for current employees and permit payment of lump sums.
As a result of the decision to terminate the SBERA Plan, the Bank recognized, in non-interest income, a curtailment gain of $448,000 in 2000, representing the difference between the estimated benefit obligation and the accumulated benefit obligation at the effective date of termination.
In December 2001, all obligations of the Cambridgeport Bank SBERA Plan were settled with excess assets of $1,206,000 to be returned to the bank. A pretax gain of $2,212,000 was recognized with this settlement.
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
According to the Plan's actuary, and in accordance with SFAS No. 132, Employers' Disclosures About Pensions and Other Postretirement Benefits, the following summary sets forth the Plan's funded status and amounts included in the Bank's consolidated balance sheet as of December 31, 2001.
(in thousands)
Benefit obligation at beginning of year
$ 4,256
Settlements
(4,907)
Plan amendments
Benefit obligation at end of year
$ -
Fair value of assets at beginning of year
$ 5,880
Actual return on plan assets
Settlements
(4,907)
Reversion to employer
(1,206
)
Fair value of assets at end of year
$ -
Actuarial assumptions used in determining plan obligations and net pension expense are as follows:
Discount rate used to calculate projected
benefit obligation
N/A
7.75%
Expected long-term rate of return on plan
assets
N/A
8.0%
Annual salary increase
N/A
4.5%
Service cost benefit earned during the
period
$ -
$ 413
Interest cost on projected benefit
obligation
-
Expected return on plan assets
-
(421)
Amortization of transition asset
-
(22)
Amortization of net gain
-
(93
)
Net pension cost
$ -
$ 197
Effective May 4, 1999, the Bank adopted a 1999 Nonqualified Pension Plan (the 1999 Nonqualified Plan) for certain executive officers. The accrued liability associated with this 1999 Nonqualified Plan for the periods ended December 31, 2002 and 2001 was approximately $2,606,000 and $1,997,000, respectively. The net expense associated with the 1999 Nonqualified Plan for the years ended December 31, 2002, 2001 and 2000 was approximately $609,000, $164,000 and $136,000,
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
respectively, and is included in compensation and employee benefits in the accompanying consolidated statements of operations.
The Nonqualified Plan is being funded through a life insurance program, with policy benefits accruing to the Bank. The cash surrender value of the policies was approximately $4,437,000 and $4,246,000 at December 31, 2002 and 2001, respectively, and is included in other assets in the accompanying consolidated balance sheets.
The Bank offers a SBERA 401(k) Plan (the 401(k) Plan) for employees. Each employee reaching the age of 21 and work between 20 to 40 hours per week are eligible to participate in the first payroll of the month following their being hired. Participants are 100% vested in their accounts. Participating employees are able to contribute up to 15% of their salary, and the Bank matches 100% of a participant's deferral contribution up to the first 5% of the deferral amount subject to the maximum allowable under federal regulations. The Bank's matching contribution expense was approximately $375,000, $318,000 and $175,000 for the years ended December 31, 2002, 2001 and 2000, respectively, and is included in compensation and employee benefits in the accompanying consolidated statements of operations.
Employee Stock Ownership Plan
In connection with the Company's conversion from mutual to stock form and initial public offering, the Company established an Employee Stock Ownership Plan (ESOP) that acquired 8% or 595,425 shares at an average price of $12.62 per share. The purchase of the shares by the ESOP was funded by a loan of $7,514,000 from the Company. The loan is to be repaid over 30 years in equal yearly installments of $645,754. Interest on the loan is fixed at 8.00%. The loan is secured by the unallocated shares of the ESOP. The Company intends to allocate shares annually over the term of the loan.
ESOP expense is recorded when shares are committed to be released for allocation to the employees account and is based on the average market value of the Company's common stock at the time, which may differ from the average purchase price of those shares. Such changes in market value impact the Bank's results of operations but have no impact on stockholders' equity.
At December 31, 2002 and 2001, the ESOP held unallocated shares with an aggregate cost of $6,775,000 and $7,026,000 and a market value of $23,011,000 and $14,488,000, respectively. For the years ended December 31, 2002 and 2001, $714,000 and $424,000 was charged to compensation and employee benefit expense, respectively, based on a commitment to release 19,848 shares to employees in both years.
The ESOP Restoration Plan
In 2000, the Company also implemented a plan to provide payments to certain executives who are prevented from receiving the full benefits contemplated by the ESOP's benefit formula. The payments consist of payments in lieu of shares that cannot be allocated to participants under the ESOP due to the limitations imposed on tax-qualified plans and, in the case of participants who retire before the repayment in
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
full of the ESOP's loan, payments in lieu of the shares that would have been allocated if employment had continued through the full term of the loan. The Company recognized expense of $282,000 and $160,000 for the years ended December 31, 2002 and 2001, respectively.
Stock Option Plan
In October 2000, the Company approved a stock option plan (the Plan) which was approved by the shareholders for officers, key employees and directors. The Plan is authorized to grant options to purchase up to 744,282 shares. As of December 31, 2002 and 2001, 740,582 and 731,000 options had been granted with a weighted average exercise price of $18.60 and $17.48, respectively, representing the fair market values on the dates the options were granted. Stock options vest at a rate of 20% per year and no option has a term that is longer than 10 years.
At December 31, 2002, 3,700 shares remain available for future grants. A summary of plan activity is as follows:
Number of
Exercise Price
Weighted
Shares
Range
Average
Outstanding, December 31, 2001
716,500
$ 15.88-28.06
17.51
Options granted
36,722
28.18-44.80
40.92
Options exercised
(39,060)
15.88-19.13
16.01
Options canceled
(27,140
)
15.88-39.88
18.48
Outstanding, December 31, 2002
687,022
$ 15.88-44.80
$ 18.81
Exercisable, December 31, 2002
238,966
$ 15.88-28.06
$ 17.45
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
Number of
Exercise Price
Weighted
Shares
Range
Average
Granted during 2000
662,250
15.88-16.81
15.88
Outstanding, December 31, 2000
662,250
15.88-16.81
15.88
Options granted
149,410
17.06-28.06
23.78
Options exercised
(14,500)
15.88-15.88
15.88
Options canceled
(80,660
)
15.88-18.13
16.04
Outstanding, December 31, 2001
716,500
$ 15.88-28.06
$ 17.51
Exercisable, December 31, 2001
103,018
$ 15.88-16.81
$ 15.88
Recognition and Retention Plan
The Company adopted the Recognition and Retention Plan (RRP), which was approved by shareholders' in October 2000. The RRP is authorized to purchase up to 297,713 shares of restricted stock. These shares were purchased during the first quarter of 2001. The RRP awarded 17,400 shares and 1,000 shares as of December 31, 2002 and December 31, 2001, respectively. During the year 2002, 1,244 shares were forfeited compared to 7,000 shares forfeited during the year 2001. As of December 31, 2002, the trustee holds 4,822 shares that have not been awarded. RRP that were awarded in 2002 will vest at a rate of 25% per year compared to a 20% vesting rate for 2001 RRP awards. For the years ending December 31, 2002 and 2001, the Company recognized compensation expense of $1,298,000 and $883,000, respectively. Compensation expense is based on the market price on the grant date and amortized over the corresponding vesting period.
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
(11) Financial Instruments with Off-Balance-Sheet Risk and Concentration of
Credit Risk
The Bank is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers and to reduce interest rate risk. These financial instruments primarily include commitments to extend credit.
These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the accompanying consolidated balance sheets.
The contract amounts of those instruments reflect the extent of involvement the Bank has in particular classes of financial instruments. The Bank's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments as it does for on-balance-sheet financial instruments.
Off-balance-sheet financial instruments whose contract amounts present credit risk include the following (in thousands):
Commitments to originate loans and unadvanced lines of credit are agreements to lend to a customer provided there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the borrower. The collateral supporting these commitments varies and may include real property, accounts receivable or inventory. The Bank originates primarily residential and commercial real estate loans and, to a lesser extent, installment loans to customers primarily located in eastern Massachusetts.
In 2001, as a component of its asset/liability, management activities intended to control interest rate exposure, the Bank has entered into a off-balance-sheet hedging transaction. An interest rate swap agreement, representing a transaction, which
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
involves the receiving of a variable rate and paying a fixed rate without the exchange of the underlying principal amounts. The weighted average rate of variable interest payments received was 1.63% and 2.74% during 2002 and 2001, respectively and the weighted average rate of fixed interest payments made was 4.10%. As a result of this interest rate swap, the Bank realized additional interest expense of $492,000 and $152,000 for the years ended December 31, 2002 and 2001, respectively. There was no impact on income as a result of any hedge ineffectiveness associated with this interest rate swap.
Entering into the interest rate swap agreement involves both the credit risk of dealing with counterparties and their ability to meet the terms of the contracts and interest rate risk. While notional principal amounts are generally used to express the volume of these transactions, the amounts potentially subject to credit risk are small due to the structure of the agreements. The Bank is a direct party to this agreement that provides for the net settlement between the Bank and the counterparty, on a quarterly and semiannual basis. Should the counterparty fail to honor the agreement, the Bank's credit exposure is limited to the net settlement amount. The Bank has a net payable on this interest rate swap of $35,000 as of December 31, 2002.
(12) Fair Values of Financial Instruments
The reported fair values of financial instruments are based on a variety of valuation techniques. In some cases, fair values represent quoted market prices for identical or comparable instruments. In other cases, fair values have been estimated based on assumptions concerning the amount and timing of estimated future cash flows, assumed discount rates reflecting varying degrees of risk and future expected-loss assumptions.
Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Bank's entire holdings of a particular financial instrument. Because a market may not readily exist for a significant portion of the Bank's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors.
These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect these estimates.
Fair value estimates are based on existing on- and off-balance-sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. In addition, the tax implications of unrealized gains and losses can also have a significant effect on the fair value of the financial instruments that could have been realized as of December 31, 2002 and 2001 or that will be realized in the future.
The following methods and assumptions were used by the Bank in estimating fair values of the Bank's financial instruments.
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
Cash and Cash Equivalents
The balance sheet carrying amounts for cash and cash equivalents approximate fair value due to the short maturities of those instruments.
Certificates of Deposit and Investment Securities
Fair value for investment securities and certificates of deposit are based on published market prices, if available. If published market prices are not available, fair values are based on quotations received from securities dealers for comparable securities.
Loans Held for Sale
For loans held for sale, fair value is based on prevailing market conditions and commitments from institutional investors to purchase such loans.
Loans
The fair values of loans are estimated for loan portfolios of similar characteristics. Loans are segregated by type, by fixed- and adjustable-rate interest terms and by performing and nonperforming status.
For variable-rate loans tied to the Bank's prime rate, which reprice frequently and entail no significant change in credit risk, fair values are based on the carrying values. The estimated fair values of all other loans are estimated based on discounted cash flow analyses using interest rates currently offered for loans with similar terms to borrowers of similar credit quality. The carrying amount of accrued interest approximates its fair value.
FHLB and Savings Bank Life Insurance Stock
The carrying amount reported in the accompanying consolidated balance sheets approximates fair value. If redeemed, the Company will receive an amount equal to the par value of the stock.
Deposit Liabilities
The fair value of deposits does not include the value of the Bank's long-term relationships with its depositors nor do they reflect the value associated with possessing this relatively inexpensive source of funds, which may be available for a considerable length of time. The fair value of noncertificate deposits is equal to the amount payable on demand at the reporting date. The fair values of certificates of deposit are estimated by discounting the contractual future cash flows at rates currently offered for certificates of deposit with similar remaining maturities. No consideration has been given to determine the deposit premium associated with a core deposit intangible.
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
Borrowings
The fair value of the Bank's borrowings are estimated using discounted cash flow analyses based on the Bank's current incremental borrowing rates for similar types of borrowing arrangements
Interest Rate Swap Agreements
The fair value of the off-balance-sheet interest rate swap agreements is the net of the present values of the pay fixed/receive floating payments, discounted at current swap rates for the appropriate remaining term of existing swaps.
Other Off-balance-Sheet Instruments
The fair values of commitments are estimated using the fees charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. The Bank's commitments for unused lines of credit are at floating rates, which approximate current market rates. The fair value of the commitments to extend credit and for unused lines of credit at December 31, 2002 and 2001 were deemed immaterial to the SFAS No. 107 disclosure and have been excluded.
Certain assets are excluded from disclosure requirements, including banking premises and equipment, the intangible value of the Bank's portfolio of loans serviced for others and the intangible value inherent in the Bank's deposit relationships among others. Accordingly, the aggregate fair value amounts presented below do not represent the underlying value of the Bank.
The estimated fair values of the Bank's financial instruments at December 31, 2002 and 2001 are as follows:
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
(13) Condensed Parent Company Financial Statements
The balance sheets of the Company are as follows (in thousands):
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
The statements of operations of the Company are as follows (in thousands):
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
The statements of cash flows of the Company are as follows (in thousands):
<PAGE>
PORT FINANCIAL CORP.
Notes to Consolidated Financial Statements
December 31, 2002, 2001 and 2000
(14) Selected Quarterly Consolidated Financial Information (unaudited)
The following table presents quarterly unaudited financial information of the Company for 2002 and 2001:
<PAGE>