ITEM 1. BUSINESS
General. Westfield Financial, Inc. ("Westfield Financial," "Company" "us," "our," or "we") is a Massachusetts-chartered stock holding company organized in November 2001 in connection with the reorganization of Westfield Mutual Holding Company, a Massachusetts chartered mutual holding company which owns 53% of the outstanding common stock of Westfield Financial. Westfield Financial serves as the bank holding company for Westfield Bank, a Massachusetts chartered stock savings bank. Unless the context otherwise requires, all references herein to Westfield Bank or Westfield Financial include Westfield Financial and Westfield Bank on a consolidated basis. Westfield Financial sold 4,972,600 shares of its common stock to eligible depositors of Westfield Bank. Net proceeds of the stock offering were $47.7 million. The reorganization of Westfield Mutual Holding Company and the related stock offering by Westfield Financial were completed on December 27, 2001. The common stock of Westfield Financial commenced trading on The American Stock Exchange under the symbol "WFD" on December 28, 2001.
Westfield Securities Corp., a Massachusetts chartered security corporation, and Westfield Bank are the only operating subsidiaries of Westfield Financial. Westfield Securities Corp. was formed in December 2001 by Westfield Financial for the primary purpose of holding qualified investment securities.
Westfield Bank was formed in 1853 and reorganized into a mutual holding company structure without a stock offering in 1995. Historically, Westfield Bank has been a community-oriented provider of banking products and services to businesses and individuals, including traditional products such as residential and commercial real estate loans, consumer loans and a variety of deposit products. In recent years, however, Westfield Bank has developed and implemented a lending strategy that focuses less on residential real estate lending and more on servicing commercial customers, including increased emphasis on commercial and industrial and consumer lending and deposit relationships, extending its branch network and broadening its product lines and services.
In addition, beginning on September 1, 2001, Westfield Bank began referring its residential real estate loan customers to a third party mortgage company. Under the program, substantially all of Westfield Bank's residential real estate loans are underwritten and originated by a third party mortgage company. In connection with this referral program, Westfield Bank receives fee income for each of the loans originated by the third party mortgage company. Westfield Bank may purchase residential real estate loans from the third party mortgage company depending on market conditions.
Westfield Bank believes that this business strategy is best for its long term success and viability, and complements its existing commitment to high quality customer service. Westfield Bank operates through 10 banking offices in Agawam, East Longmeadow, Holyoke, Southwick, Springfield, West Springfield and Westfield, Massachusetts. It also has three free-standing ATM locations in Agawam, Feeding Hills and Springfield, Massachusetts. Westfield Bank's primary deposit gathering area is concentrated in the communities surrounding these locations and its primary lending area includes all of Hampden County in western Massachusetts. In addition, Westfield Bank provides online banking services through its web site.
Westfield Bank's revenues are derived principally from interest on its loans and interest and dividends on its investment securities. Its primary sources of funds are deposits, scheduled amortization and prepayments of loan principal and mortgage-backed securities, maturities and calls of investment securities, and funds provided by operations.
Market Area. Westfield Bank conducts its operations out of the Bank's main office in Westfield, Massachusetts. It also operates through nine other banking offices located in Westfield and in the communities of Agawam, East Longmeadow, Holyoke, Southwick, Springfield and West Springfield, Massachusetts. Its deposits are gathered from the general public in these towns and surrounding communities, and its lending activities are concentrated primarily in Hampden County, Massachusetts.
The City of Westfield is largely suburban and is located in the Pioneer Valley near the intersection of U.S. Interstates 90 (the Massachusetts Turnpike) and 91. Interstate 90 is the major east-west highway that crosses Massachusetts. Interstate 91 is the major north-south highway that runs directly through the heart of New England. Westfield is located approximately 90 miles west of Boston, Massachusetts, 70 miles southeast of Albany, New York and 30 miles north of Hartford, Connecticut. Westfield's 2001 population was approximately 40,100 and the estimated 2001 population for Hampden County was approximately 456,300.
The economy of Westfield Bank's market area historically has been supported by a variety of industries. Its primary market area has benefited from the presence of large employers centered in insurance, health care, warehouse, manufacturing and education. Among the largest employers currently in its market area are American Saw, Bay State Health Systems, Big Y Foods, Friendly Ice Cream Corporation, Hasbro, Mass Mutual Life Insurance Company, Mestek, Noble Hospital, C&S Wholesale, the University of Massachusetts, Westfield State College and the Sullivan Paper Company. In addition, other employment and economic activity is provided by substantial number of small and medium size businesses in the area.
During the late 1990's, the regional economy in our primary market area, based on economic indicators, such as unemployment rates, vacancy rates and household income trends, strengthened, and residential and commercial real estate values in some areas approached the market values existing before the economic downturn in the late 1980s.
In recent years, however, the regional economy in Westfield Bank's primary market area has showed signs of weakening. Unemployment rates in Westfield Bank's market area have recently increased and Westfield Bank expects that unemployment rates may increase further as the regional and national economy weakens. Westfield Bank's future growth opportunities will be influenced by the growth and stability of the statewide and regional economies, other demographic population trends and the competitive environment. Westfield Bank believes that it has developed lending products and marketing strategies to address the diverse credit-related needs of the residents in its market area.
As of December 2002, the unemployment rate of Westfield Bank's primary market area and Massachusetts was 4.9% and 5.5%, respectively, compared to 3.6% and 3.7%, respectively,
in December 2001. From July 2001 to July 2002, the median household income in Westfield Bank's market area increased by 3.5% to $54,073 compared to $52,245 as of June 2001. Despite the increase, the median household income in Westfield Bank's market area is below state and national averages.
Competition. Westfield Bank faces intense competition both in making loans and attracting deposits. Its primary market area is highly competitive and it faces direct competition from 24 financial institutions, many with a local, state-wide or regional presence and, in some cases, a national presence. Many of these financial institutions are significantly larger than and have greater financial resources than Westfield Bank. Westfield Bank's competition for loans comes principally from commercial banks, savings institutions, mortgage banking firms, credit unions, finance companies, mutual funds, insurance companies and brokerage and investment banking firms. Westfield Bank's most direct competition for deposits has historically come from commercial banks, savings banks, co-operative banks and credit unions. Westfield 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. Historically, Westfield Bank's most direct competition for deposits has come from savings, co-operative and commercial banks. In Westfield Bank's market area, there were approximately ten of the foregoing institutions at December 31, 2002.
Lending Activities
Loan Portfolio Composition. Westfield Bank's loan portfolio primarily consists of residential real estate loans, home equity loans, commercial real estate loans, commercial and industrial loans and consumer loans.
At December 31, 2002, Westfield Bank had total loans of $361.4 million, of which $157.9 million were residential mortgage loans and home equity loans. Of this total, 39.6% were adjustable-rate loans and 60.4% were fixed-rate loans. The remainder of its loans at December 31, 2002 consisted of commercial real estate loans, commercial and industrial loans, and consumer loans. Commercial real estate loans outstanding at December 31, 2002 totaled $100.9 million, or 27.92% of total loans. Commercial and industrial loans outstanding at December 31, 2002 totaled $61.5 million, or 17.01% of total loans. Consumer loans outstanding on December 31, 2002 totaled $41.1 million, or 11.37% of total loans.
Westfield Bank's loans are subject to federal and state law and regulations. The interest rates Westfield Bank charges on loans are affected principally by the demand for loans, the supply of money available for lending purposes and the interest rates offered by its competitors. These factors are, in turn, affected by general and local economic conditions, monetary policies of the federal government, including the Federal Reserve Board, legislative tax policies and governmental budgetary matters. The following table presents the composition of Westfield Bank's loan portfolio in dollar amounts and in percentages of the total portfolio at the dates indicated.
Loan Maturity and Repricing. The following table shows the repricing dates or contractual maturity dates as of December 31, 2002. The table does not reflect prepayments or scheduled principal amortization. Demand loans, loans having no stated maturity, and overdrafts are shown as due in within one year.
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.
The following table presents our loan originations, purchases, sales and principal payments for the periods indicated.
Residential Mortgage Loans and Originations. Westfield Bank originates mortgage loans secured by one-to-four family properties that serve as the primary residence of the owner. Most of its loan originations are generated by referrals from real estate brokers and builders, its marketing efforts and existing and walk-in customers. As of December 31, 2002, loans on one-to-four family residential properties accounted for $146.7 million, or 40.59%, of Westfield Bank's total loan portfolio.
Beginning on September 1, 2001, Westfield Bank began referring its residential real estate borrowers to a third party mortgage company. Residential real estate borrowers submit applications to Westfield Bank, but the loan is closed on the books of the mortgage company. Westfield Bank receives a fee of 65 basis points for each of these loans originated by the third party mortgage company. Under the program, substantially all of Westfield Bank's residential real estate loans are underwritten and originated by the third party mortgage company, whose underwriting standards were similar to those of Westfield Bank. In addition, depending on market conditions, Westfield Bank may purchase residential real estate loans from the third party mortgage company. Westfield Bank believes that this program will diversify its loan portfolio and reduce its interest rate risk.
Westfield Bank also originates residential real estate loans on either a fixed-rate or adjustable-rate basis, as consumer demand dictates. The maximum loan-to-value ratios depend on the type of property and the size of the loan involved. The loan-to-value ratio is the loan amount divided by the appraised value of the property. The loan-to-value ratio is a measure commonly used by financial institutions to determine exposure to risk. The majority of Westfield Bank's real estate loans are originated with a loan-to-value ratio of 80% or less. Loans originated with loan-to- value ratios in excess of 80% require the borrower to obtain mortgage insurance.
Westfield Bank offers adjustable-rate mortgage loans with either a one- year, three-year or five-year term to the initial repricing date. After that initial period, the interest rate for each adjustable-rate mortgage loan generally adjusts annually for the remainder of the term of the loan. Westfield Bank uses a different number of indices to reprice its adjustable-rate mortgage loans.
Westfield Bank's residential adjustable-rate mortgage loans generally are fully amortizing loans with contractual maturities of up to 30 years, payments due monthly. Its adjustable-rate mortgage loans generally provide for specified minimum and maximum interest rates, with a lifetime cap and floor, and a periodic adjustment on the interest rate over the rate in effect on the date of origination. As a consequence of using caps, the interest rates on these loans are not generally as rate sensitive as its cost of funds. The adjustable-rate mortgage loans that Westfield Bank originates generally are not convertible into fixed-rate loans.
Adjustable-rate mortgage loans generally pose different credit risks than fixed-rate loans, primarily because as interest rates rise, the borrower's payments rises, increasing the potential for default. To date, Westfield Bank has not experienced difficulty with the payment history for these loans. At December 31, 2002, its loan portfolio included $62.63 million in adjustable-rate residential mortgage loans or 17.33% of its total loan portfolio, and $95.27 million in fixed-rate residential real estate loans, or 26.36% of its total loan portfolio.
Westfield Bank's home equity lines of credit totaled $11.2 million and comprised 3.11% of its total loan portfolio at December 31, 2002. These loans may be originated in amounts of the existing first mortgage, or up to 100% of the value of the property securing the loan. The term to maturity on Westfield Bank's home equity and home improvement loans may be up to 15 years.
Commercial Real Estate Loans. Westfield Bank originates commercial real estate loans to finance the purchase of real property, which generally consists of apartment buildings, business properties, multi-family investment properties and construction loans to developers of commercial and residential properties. In underwriting commercial real estate loans, consideration is given to the property's historic cash flow, current and projected occupancy, location and physical condition. At December 31, 2002, Westfield Bank's commercial real estate loan portfolio consisted of 426 loans, totaling $100.9 million, or 27.92% of total loans.
Substantially all of the commercial real estate portfolio consists of loans which are collateralized by properties in Westfield Bank's normal lending area. Westfield Bank's commercial real estate loan portfolio is diverse, and does not have any significant loan concentration by type of property or borrower. Westfield Bank generally lends up to a maximum loan- to-value ratio of 80% on commercial properties and requires a minimum debt coverage ratio of 1.20 times. Its largest commercial real estate loan relationship had an outstanding balance of $4.9 million at December 31, 2002 which was secured by apartment buildings located in western Massachusetts.
Westfield Bank also offers construction loans to finance the construction of commercial properties located in its primary market area. Westfield Bank had $6.6 million in commercial construction loans and commitments at December 31, 2002. Of this amount, approximately $5.6 million were loans made to experienced developers with whom Westfield Bank has an established relationship, $4.1 million of which was to a prominent developer to fund a single construction project in Springfield, Massachusetts.
Commercial real estate lending involves additional risks compared with one-to-four family residential lending. Payments on loans secured by commercial real estate properties often depend on the successful management of the properties, on the amount of rent from the properties, or on the level of expenses needed to maintain the properties. Repayment of such loans may therefore be adversely affected by conditions in the real estate market or the general economy. Also, commercial real estate loans typically involve large loan balances to single borrowers or groups of related borrowers. In order to mitigate this risk, Westfield Bank monitors its loan concentration on a quarterly basis and its loan policies generally limit the amount of loans to a single borrower or group of borrowers.
Because of increased risks associated with commercial real estate loans, Westfield Bank's commercial real estate loans generally have higher rates and shorter maturities than residential mortgage loans. Westfield Bank usually offers commercial real estate loans at adjustable rates tied to the prime rate or to yields on U.S. Treasury securities. The terms of such loans generally do not exceed 20 years.
Commercial and Industrial Loans. Westfield Bank offers commercial and industrial loan products and services which are designed to give business owners borrowing opportunities for modernization, inventory, equipment, construction, consolidation, real estate, working capital, vehicle purchases and the financing of existing corporate debt. Westfield Bank offers business installment loans, vehicle and equipment financing, lines of credit, equipment leasing and other commercial loans. At December 31, 2002, Westfield Bank's commercial and industrial loan portfolio consisted of 798 loans, totaling $61.5 million or 17.01% of its total loans. Since 1996, commercial and industrial loans have grown $43.2 million, or 236.1% from $18.3 to $61.5 million. In addition, Westfield Bank has added five commercial loan officers and one business development officer since 1997. Westfield Bank may hire additional commercial loan officers on an as needed basis in connection with its potential branch expansion.
As part of Westfield Bank's strategy of increasing its emphasis on commercial lending, Westfield Bank seeks to attract its business customers' entire banking relationship. All commercial borrowers are required to maintain a commercial deposit at Westfield Bank. Westfield Bank also provides complementary commercial products and services, including an equipment leasing program with a third party vendor, a variety of commercial deposit accounts, cash management services, sweep accounts, a broad ATM network and night deposit services. Commercial loan officers are based in its main and branch offices, and Westfield Bank views its recent and potential branch expansion as a means of facilitating these commercial relationships. Westfield Bank intends to use the proceeds of the stock offering to continue to expand the volume of its commercial business products and services within its current underwriting standards.
Westfield Bank's commercial loan portfolio does not have any significant loan concentration by type of property or borrower. The largest concentration of loans were for industrial and commercial machinery and computer equipment which comprise approximately 3.36% of the total loan portfolio. At December 31, 2002, Westfield Bank's largest commercial and industrial loan relationship was $6.6 million to a company engaged in precision machining and rapid prototype manufacture of metal parts for sale to commercial and governmental customers throughout the United States.
Commercial and industrial loans are limited to terms of seven years but generally have terms of five years or less. Although Westfield Bank does originate fixed-rate commercial loans, substantially all of its commercial loans have variable interest rates tied to the prime rate. Whenever possible, Westfield Bank also collateralizes these commercial and industrial loans with a lien on commercial real estate. Alternatively, Westfield Bank may collateralize these loans with a lien on business assets and equipment. In some cases, both types of liens are required. Westfield Bank also generally requires the personal guarantee of the business owner. Interest rates on commercial loans generally have higher yields than residential or commercial real estate loans.
Commercial and industrial loans are generally considered to involve a higher degree of risk than residential or commercial real estate loans because the collateral may be in the form of intangible assets and/or inventory subject to market obsolescence. Commercial and industrial loans may also involve relatively large loan balances to single borrowers or groups of related borrowers, with the repayment of such loans typically dependent on the successful operation and income stream of the borrower. These risks can be significantly affected by economic conditions. In addition, business lending generally requires substantially greater oversight efforts by Westfield Bank's staff compared to residential or commercial real estate lending. In order to mitigate this risk, Westfield Bank monitors its loan concentration and its loan policies generally limit the amount of loans to a single borrower or group of borrowers. Westfield Bank also utilizes the services of an outside consultant to conduct on-site credit quality reviews of the commercial and industrial loan portfolio.
Consumer Loans. Consumer loans are generally originated at higher interest rates than residential and commercial mortgage loans, but they also generally tend to have a higher credit risk than residential mortgage loans because they are usually unsecured or secured by rapidly depreciable assets. Management, however, believes that offering consumer loan products helps to expand and create stronger ties to Westfield Bank's existing customer base by increasing the number of customer relationships and providing cross-marketing opportunities.
Westfield Bank offers a variety of consumer loans to retail customers in the communities its serves. Examples of its consumer loans include:
* direct and indirect automobile loans;
* secured passbook loans;
* credit lines tied to deposit accounts to provide overdraft protection; and
* unsecured personal loans.
At December 31, 2002, the consumer loan portfolio totaled $41.1 million or 11.37% of total loans. Westfield Bank's consumer lending will allow it to diversify its loan portfolio while continuing to meet the needs of the individuals and businesses that it serves.
Indirect automobile loans currently represent the largest portion of its consumer loan portfolio, totaling $33.8 million, or 9.37% of its total loan portfolio and 82.2% of its consumer loan portfolio, at December 31, 2002.
Westfield Bank offers fixed-rate automobile loans in a direct and indirect basis with terms up to 72 months for new and recent model used cars and up to 60 months for older model used cars. Westfield Bank generally will make such loans up to 100% of the retail value shown in the NADA Used Car Guide. The interest rates offered differ depending on the age of the automobile and current interest rates offered by competitors.
Westfield Bank began offering indirect automobile loans through automobile dealers approximately eight years ago. Currently, Westfield Bank maintains contractual relationships with approximately 40 new and used car dealers located through western Massachusetts and northern Connecticut. Westfield Bank has a contractual arrangement and outsources a portion of the origination function and all of the servicing function to a nationally recognized service provider. The collection and liquidation functions are handled in-house by Westfield Bank personnel. Indirect auto loans are made only after an underwriting review and approval under established guidelines set by Westfield Bank. On loans originated by its automobile dealers, Westfield Bank compensates the originator based upon the higher interest rate paid on the loan, up to a maximum of 4%.
For the years ended December 31, 2002 and 2001, Westfield Bank originated $10.8 million and $17.5 million of automobile loans, respectively, the majority of which were originated indirectly through the automobile dealers. The majority of automobile loans are secured by used automobiles. The indirect automobile loan portfolio grew substantially in 1999 as the result of aggressive pricing and the addition of several new dealers. Management determined to curtail its indirect lending in fiscal years 2000 through 2002 to allow the portfolio to become more seasoned, but may decide to grow the indirect automobile loan portfolio in the future. Westfield Bank has not sold any of its automobile loans since inception. Westfield Bank anticipates that in the future it may sell a portion of its automobile loans in the secondary market for liquidity purposes and to manage the credit risk of the loan portfolio.
Loans collateralized by rapidly depreciable assets such as automobiles or that are unsecured entail greater risks than residential mortgage loans. In such cases, repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance, since there is a greater likelihood of damage, loss or depreciation of the underlying collateral. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. Further, collections on these loans are dependent on the borrower's continuing financial stability and, therefore, are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Repossessed collateral relating to consumer loans at December 31, 2002 approximated $88,000. Finally, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans if a borrower defaults.
Loan Approval Procedures and Authority. As established by the Executive Committee of the Board of Directors, Westfield Bank's lending policies provide that its mortgage underwriting department may review and approve mortgage loans up to $500,000. Westfield Bank's underwriting department also may review and approve home equity loans up to $100,000. Any loan applications, including mortgage loans, that exceed $500,000 or $100,000 for home equity loans require approval of the Executive Committee. For loans requiring board approval, management is responsible for presenting to the board information about the creditworthiness of a borrower and the estimated value of the subject property. Generally, the estimated value of the property must be supported by an independent appraisal report prepared in accordance with Westfield Bank's appraisal policy.
The following generally describes Westfield Bank's current lending procedures. Upon receipt of a completed loan application from a prospective borrower, Westfield Bank must order a credit report and verify other information. If necessary, Westfield Bank obtains additional financial or credit related information. Westfield Bank requires an appraisal for all mortgage loans. Appraisals for mortgage loans are performed by licensed or certified third-party appraisal firms and are reviewed by Westfield Bank's lending department. Appraisals for second mortgages or home equity loans are not required. Rather, a designated employee of Westfield Bank conducts an inspection of the property. Westfield Bank requires title insurance on all mortgage loans and certain other loans. Westfield Bank requires borrowers to obtain hazard insurance. Westfield Bank also requires borrowers to obtain flood insurance, if applicable, prior to closing. In addition, Westfield Bank makes available to borrowers the option to advance funds on a monthly basis together with each payment of principal and interest to a mortgage escrow account from which it makes disbursements for items such as real estate taxes, flood insurance, and private mortgage insurance premiums. Beginning on September 1, 2001, Westfield Bank began referring its residential real estate loans to a third-party mortgage company. Residential real estate borrowers submit applications to Westfield Bank, but the loan is closed on the books of the mortgage company.
Asset Quality. One of Westfield Bank's key operating objectives has been and continues to be the achievement of a high level of asset quality. Westfield Bank maintains a large proportion of loans secured by residential and commercial properties, set sound credit standards for new loan originations and follow careful loan administration procedures. Westfield Bank also utilizes the services of an outside consultant to conduct on-site credit quality reviews of Westfield Bank's commercial and industrial loan portfolio on an annual basis. These practices and relatively favorable economic and real estate market conditions have resulted in historically low delinquency ratios and, in recent years, a low level of nonaccrual loans. These factors have helped strengthen Westfield Bank's financial condition.
Delinquent Loans and Foreclosed Assets. Westfield Bank's policies require that management continuously monitor the status of the loan portfolio and report to the Board of Directors on a monthly basis. These reports include information on delinquent loans and foreclosed real estate, as well as Westfield Bank's actions and plans to cure the delinquent status of the loans and to dispose of the foreclosed property.
The following table presents information regarding non-accrual mortgage, consumer and other loans, and foreclosed real estate as of the dates indicated. All loans where the interest payment is 90 days or more in arrears as of the closing date of each month are placed on non-accrual status. At December 31, 2002, 2001, and 2000, Westfield Bank had $2.4 million, $2.7 million, and $2.3 million, respectively, of non-accrual loans. If all non-accrual loans had been performing in accordance with their terms, Westfield Bank would have earned additional interest income of $324,000, $263,000 and $191,000 for the years ended December 31, 2002, 2001, and 2000, respectively.
Allowance for Loan Losses. The following table presents the activity in Westfield Bank's allowance for loan losses and other ratios at or for the dates indicated.
Westfield Bank maintains an allowance for loan losses to absorb losses inherent in the loan portfolio based on ongoing quarterly assessments of the estimated losses. Westfield Bank's methodology for assessing the appropriateness of the allowance consists of a review of the components, which include a specific allowance for identified problem loans and a formula allowance for current performing loans. Fluctuations in the balances of impaired loans affect the specific reserve while fluctuations in volume and concentrations of loans affects the formula reserve and the allocation of the allowance of the loan losses among loan types.
The specific allowance incorporates the results of measuring impairment for specifically identified non-homogenous problem loans in accordance with Statement of Financial Accounting Standards (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. 114 and No. 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. A loan is not deemed to be impaired if there is a short delay in receipt of payment or if, during a longer period of delay, the Westfield Bank expects to collect all amounts due including interest accrued at the contractual rate during the period of delay. Measurement of impairment can be based on the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's observable market price or the fair value of the collateral, if the loan is collateral dependent. Measurement of impairment does not apply to large groups of smaller balance homogenous loans that are collectively evaluated for impairment such as the Westfield Bank portfolios of home equity loans, real estate mortgages, installment and other 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. As part of this analysis, each quarter Westfield Bank prepares an allowance for loan losses 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 Westfield Bank's assessment of each category's inherent risk. In determining the loss factors to apply to each loan category, Westfield Bank considers historical losses, peer group comparisons, industry data and loss percentages used by banking regulators for similarly graded loans. Loss factors may be adjusted for qualitative factors that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date. Loss factors are described as follows:
* Classified loan loss factors are derived from loss percentages utilized by banking regulators for similarly graded loans. Loss factors of 3% to 5%, 10% to 15% and 50% to 75% are applied to the outstanding balance of loans internally classified special mention, substandard and doubtful, respectively.
* Pass graded loan loss factors are based on actual losses for the previous twelve quarters adjusted for qualitative factors, such as new loan products, credit quality trends (including trends in nonperforming loans expected to result from existing conditions), collateral values, loan volumes and concentrations and specific industry conditions within portfolio segments that exist at the balance sheet date. The loss factors are applied to outstanding loans by loan type.
In addition, management employs an independent third party to perform an annual review of all of Westfield Bank's commercial and industrial loans with principal balances equal to or greater than $600,000 and commercial real estate loans in excess of $1,000,000. Another objective was to review all watch list loans with aggregate balances greater than $100,000 and all 30 day or longer past due commercial loans with balances in excess of $50,000.
Westfield Bank's methodologies include several factors that are intended to reduce the difference between estimated and actual losses. The loss factors that are used to establish the allowance for pass graded loans are designated to be self-correcting by taking into account changes in loan classification, loan concentrations and loan volumes and by permitting adjustments based on management's judgments of qualitative factors as of the evaluation date. Similarly, by basing the pass graded loan loss factors on loss experience over the prior three years, the methodology is designed to take Westfield Bank's recent loss experience into account.
Westfield Bank's allowance methodology has been applied on a consistent basis. Based on this methodology, Westfield Bank believes that it has established and maintained the allowance for loan losses at adequate levels, future adjustments to the allowance for loan losses, however, may be necessary if economic, real estate and other conditions differ substantially from the current operating environment resulting in estimated and actual losses differing substantially. Adjustments to the allowance for loan losses are charged to income through the provision for loan losses.
A summary of the components of the allowance for loan losses is as follows:
In addition, various regulatory agencies, as an integral part of their examination process, periodically review Westfield Bank's loan and foreclosed real estate portfolios and the related allowance for loan losses and valuation allowance for foreclosed real estate. These agencies, including the Federal Deposit Insurance Corporation and the Massachusetts Division of Banks, may require Westfield Bank to adjust the allowance for loan losses or the valuation allowance for foreclosed real estate based on their judgments of information available to them at the time of their examination, thereby adversely affecting Westfield Bank's results of operations.
For the year ended December 31, 2002, Westfield Bank provided $934,000 to the allowance for loan losses based on its evaluation of the items discussed above. Westfield Bank believes that the allowance for loan losses accurately reflects the level of risk in the current loan portfolio as of December 31, 2002.
Allocation of Allowance for Loan Losses. 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.
Investment Activities The Board of Directors reviews and approves Westfield Bank's investment policy on an annual basis. The President and Treasurer, as authorized by the Board, implement this policy based on the established guidelines within the written policy.
Westfield Bank's investment policy is designed primarily to manage the interest rate sensitivity of its assets and liabilities, to generate a favorable return without incurring undue interest rate and credit risk, to complement its lending activities and to provide and maintain liquidity within the range established by policy. In determining Westfield Bank's investment strategies, it considers its interest rate sensitivity, yield, credit risk factors, maturity and amortization schedules, and other characteristics of the securities to be held.
Massachusetts-chartered savings banks have authority to invest in various types of assets, including U.S. Treasury obligations, securities of various federal agencies, mortgage-backed securities, certain certificates of deposit of insured financial institutions, repurchase agreements, overnight and short term loans to other banks, corporate debt instruments, and equity securities.
Securities Portfolio Westfield Bank classifies securities as held to maturity or available for sale at the date of purchase. Westfield Bank does not have any securities classified as trading. Held to maturity securities are reported at cost, adjusted for amortization of premium and accretion of discount. Available for sale securities are reported at fair market value. At December 31, 2002, held to maturity securities totaled $205.3 million, or 55% of the total securities portfolio, and available for sale investments totaled $170.3 million, or 45% of Westfield Bank's total securities portfolio. Westfield Bank classifies U.S. Government securities and U.S. Government Agency securities as available for sale and held to maturity. These securities predominately have maturities of less than five years, although Westfield Bank also invests in adjustable rate securities with maturities of up to 15 years. Westfield Bank's mortgage-backed securities, which are directly or indirectly insured or guaranteed by Freddie Mac, Ginnie Mae or Fannie Mae or are rated AAA, consist of both 30- year securities and seven-year balloon securities. The latter are so named because they mature (i.e. balloon) prior to completing their normal 30-year amortization. The 30-year mortgage backed securities are classified as held to maturity while the seven year balloon securities are classified as available for sale. In addition, Westfield Bank has investments in Federal Home Loan Bank stock and other equity securities.
The following table sets forth the composition of Westfield Bank's securities portfolio at the dates indicated.
Securities Portfolio Maturities. The composition and maturities of the 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.
Sources of Funds
General. Deposits, scheduled amortization and prepayments of loan principal, maturities and calls of investments securities and funds provided by operations are Westfield Bank's primary sources of funds for use in lending, investing and for other general purposes. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources."
Deposits. Westfield Bank offers a variety of deposit accounts having a range of interest rates and terms. Westfield Bank currently offers regular savings deposits (consisting of passbook and statement savings accounts), interest-bearing demand accounts, noninterest-bearing demand accounts, money market accounts and time deposits. Westfield Bank has expanded the types of deposit products that it offers to include jumbo certificates of deposit, tiered money market accounts and customer repurchase agreements to compliment its increased emphasis on attracting commercial banking relationships.
Deposit flows are influenced significantly by general and local economic conditions, changes in prevailing interest rates, pricing of deposits and competition. Westfield Bank's deposits are primarily obtained from areas surrounding our offices. Westfield Bank relies primarily on paying competitive rates, service and long-standing relationships with customers to attract and retain these deposits. Westfield Bank does not use brokers to obtain deposits.
When Westfield Bank determines its deposit rates, it considers local competition, U.S. Treasury securities offerings and the rates charged on other sources of funds. Core deposits (defined as regular accounts, money market accounts, NOW accounts and demand accounts) represented 42.8% of total deposits on December 31, 2002 and 40.3% on December 31, 2001. At December 31, 2002 and December 31, 2001, time deposits with remaining terms to maturity of less than one year amounted to $265.8 million and $282.2 million, respectively. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Net Interest and Dividend Income" for information relating to the average balances and costs of Westfield Bank's deposit accounts for the years ended December 31, 2002, 2001, 2000.
Deposit Distribution Weighted Average. The following table sets forth the distribution of Westfield Bank's deposit accounts, by account type, at the dates indicated.
C.D. Maturities. At December 31, 2002, Westfield Bank had $80.6 million in time certificates of deposits with balances of $100,000 and over maturing as follows:
C.D. Balances by Rates. The following table sets forth, by interest rate ranges, information concerning Westfield Bank's time certificates of deposit at the dates indicated.
Borrowings. In addition to deposits, borrowings from the Federal Home Loan Bank are available as an additional source of funds to finance Westfield Bank's lending and investing activities. Westfield Bank traditionally has not relied upon borrowings from the Federal Home Loan Bank. However, in 2002, Westfield Bank borrowed $15.0 million from the Federal Home Loan Bank to take advantage of the current yield curve.
Westfield Bank offers retail repurchase agreements to commercial customers and higher balance retail customers. These agreements are direct obligations of Westfield Bank to repay at maturity or on demand the purchase price of an undivided interest in a U.S. Government or agency security owned by Westfield Bank. Since these agreements are not deposits, they are not insured by the Federal Deposit Insurance Corporation. At December 31, 2002, such repurchase agreement borrowings totaled $8.7 million.
Personnel
As of December 31, 2002, Westfield Bank had 130 full-time employees and 26 part-time employees. The employees are not represented by a collective bargaining unit, and we consider our relationship with our employees to be excellent.
FEDERAL AND STATE TAXATION
Federal
General. For federal income tax purposes, we report income on the basis of a taxable year ending December 31, using the accrual method of accounting, and we are generally subject to federal income taxation in the same manner as other corporations. Westfield Bank and Westfield Financial constitute an affiliated group of corporations and, therefore, are eligible to report their income on a consolidated basis. Because Westfield Mutual Holding Company owns less than 80% of the common stock of Westfield Financial, it is not a member of such affiliated group and therefore, must report its income on a separate return. Westfield Bank and Westfield Mutual Holding Company are not currently under audit by the IRS.
Distributions. To the extent that Westfield Bank makes "non-dividend distributions" to Westfield Financial, such distributions will be considered to result in distributions from unrecaptured tax bad debt reserve as of December 31, 1987 (our "base year reserve"), to the extent thereof and then from supplemental reserve for losses on loans, and an amount based on the amount distributed will be included in income. Non- dividend distributions include distributions in excess of current and accumulated earnings and profits, distributions in redemption of stock and distributions in partial or complete liquidation. Dividends paid out of current or accumulated earnings and profits will not be included in income.
The amount of additional income created from a non-dividend distribution is equal to the lesser of the base year reserve and supplemental reserve for losses on loans or an amount that, when reduced by the tax attributable to the income, is equal to the amount of the distribution. Thus, in some situations, approximately one and one-half times the non-dividend distribution would be includible in gross income for federal income tax purposes, assuming a 34% federal corporate income tax rate. Westfield Bank does not intend to pay dividends that would result in the recapture of any portion of the bad debt reserves.
Corporate Alternative Minimum Tax. The Internal Revenue Code of 1986, as amended (the "Code"), imposes a tax on alternative minimum taxable income at a rate of 20%. Only 90% of alternative minimum taxable income can be offset by net operating loss carryovers of which we currently have none. Alternative minimum taxable income is also adjusted by determining
the tax treatment of certain items in a manner that negates the deferral of income resulting from the regular tax treatment of those items. We have not been subject to a tax on alternative minimum taxable income during the past five years.
Elimination of Dividends; Dividends Received Deduction. Westfield Financial may exclude from its income 100% of dividends received from Westfield Bank as a member of the same affiliated group of corporations. Because Westfield Mutual Holding Company is not a member of such affiliated group, it does not qualify for such 100% dividends exclusion, but is entitled to deduct 80% of the dividends it receives from Westfield Financial so long as it owns more than 20% of the common stock.
State
Westfield Bank files Massachusetts Financial Institution excise tax returns. Generally, the income of financial institutions in Massachusetts, which is calculated based on federal taxable income, subject to certain adjustments, is subject to Massachusetts tax. Westfield Bank is not currently under audit with respect to its Massachusetts income tax returns and its state tax returns have not been audited for the past five years.
Westfield Financial is also required to file a Massachusetts income tax return and is generally subject to a state income tax rate that is the same tax rate as the tax rate for financial institutions in Massachusetts. However, Westfield Securities Corp. is taxed at a rate that is currently lower than income tax rates for savings institutions in Massachusetts.
Massachusetts legislation was signed on March 5, 2003 amending the corporate tax law affecting the treatment of dividends received form Real Estate Investment Trusts (REITs). Dividends from the REIT subsidiary are no longer eligible for a dividends-received deduction. As a result of the enactment of this legislation, the Company has ceased recording the tax benefits associated with the dividend received deduction effective for the 2003 tax year.
In addition to the effect on 2003, the legislation includes a retroactive effective date that reaches back to 2002 and prior years. Accordingly, the Company recorded an additional liability for prior years taxes, including interest (net of any federal and state tax deductions associated with such taxes and interest), relating to the deduction for dividends received from a REIT of approximately $2.9 million in the first quarter of 2003.
The Company is reviewing the retroactive effect of the legislation with its legal advisors and intends to defend vigorously its position that the deductibility of dividends received from Elm Street was fully compliant with Massachusetts law at the time.
REGULATION
General
Westfield Bank is a Massachusetts-chartered savings bank, and its deposit accounts are insured up to applicable limits by the Bank Insurance Fund of the FDIC and by the Depositors Insurance Fund. Westfield Bank is subject to extensive regulation, examination and supervision by the Commonwealth of Massachusetts Division of Banks as its primary corporate regulator, and by the FDIC as the deposit insurer.
Westfield Financial as the bank holding company controlling Westfield Bank, is subject to the Bank Holding Company Act of 1956, as amended, and the rules and regulations of the Federal Reserve Board under the Bank Holding Company Act. Westfield Financial are also subject to the provisions of 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 Massachusetts Division of Banks under the Massachusetts banking laws applicable to bank holding companies. Westfield Financial 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 Westfield Financial and Westfield Bank and their operations and stockholders.
Massachusetts Banking Regulation
Community Reinvestment Act. Westfield Bank is subject to provisions of the Massachusetts Community Reinvestment Act, which are similar to those imposed by the federal Community Reinvestment Act with the exception of the assigned exam 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 is required to consider a bank's Massachusetts Community Reinvestment Act rating when reviewing the bank's application to engage in certain transactions, including mergers, asset purchases and the establishment of branch offices or automated teller machines, and provides that such assessment may serve as a basis for the denial of any such application. The Massachusetts Community Reinvestment Act requires the Division to assess a bank's compliance with the Massachusetts Community Reinvestment Act and to make such assessment available to the public. Westfield Bank's latest Massachusetts Community Reinvestment Act rating, received by letter, dated October 30 2001, from the Division was a rating of "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% stockholder's equity. 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. Westfield Bank currently complies with applicable loans-to-one- borrower limitations.
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 Westfield Bank. See "- Federal Banking Regulation - Prompt Corrective Action."
Examination and Enforcement. The Division is required to periodically examine savings banks at least once every calendar year or at least once each 1 8-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."
Federal Banking Regulation
Capital Requirements. FDIC regulations require BIF-insured banks, such as Westfield Bank to maintain minimum levels of capital. The FDIC regulations define two classes of capital known as Tier 1 and Tier 2 capital.
The FDIC regulations establish a minimum leverage capital requirement for banks in the strongest financial and managerial condition, with a rating of 1 (the highest examination rating of the FDIC for banks) under the Uniform Financial Institutions Rating System, 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 leverage capital ratio is warranted by the particular circumstances or risk profile of the depository institution.
The 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 the risks the FDIC believes are inherent in the type of asset or item.
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. Westfield Bank was considered "well-capitalized" under FDIC guidelines at December 31, 2002.
Activity Restrictions on State-Chartered Banks. Section 24 of the Federal Deposit Insurance Act, as amended (FDIA), which was added by the Federal Deposit Insurance Corporation Improvement Act of 1991 (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, unless such activities and investments are specifically exempted by Section 24 or consented to by the FDIC.
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
(1) the bank held such types of investments during the 14-month period from September 30, 1990 through November 26, 1991;
(2) the state in which the bank is chartered permitted such investments as of September 30, 1991; and
(3) the bank notifies the FDIC and obtains approval from the FDIC to make or retain such investments. Upon receiving such FDIC approval, an institution's investment in such equity ecurities will be subject to an aggregate limit up to the amount of its Tier 1 capital.
Westfield Bank 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 Westfield Bank' Tier 1 capital or the maximum permissible amount specified by the Banking Act. Section 24 also provides an exception for majority owned subsidiaries of a bank, but Section 24 limits the activities of such subsidiaries to those permissible for a national bank, permissible under Section 24 of the FDIA and the FDIC regulations issued pursuant thereto, or as approved by the FDIC.
Before making a new investment or engaging in a new activity not permissible for a national bank or otherwise permissible under Section 24 of the FDIC regulations thereunder, an insured bank must seek approval from the FDIC to make such investment or engage in such activity. The FDIC will not approve the activity unless the bank meets its minimum capital requirements and the FDIC determines 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 Westfield 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 certain 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 FDICIA, the FDIC established a system for setting deposit insurance premiums based upon the risks a particular institution poses to its deposit insurance fund. 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 most recent quarterly report filed with the applicable bank regulatory agency prior to the assessment period. The three capital categories are (1) well capitalized, (2) adequately capitalized and (3) undercapitalized using capital ratios that are substantially similar to the prompt corrective action capital ratios discussed below. See "- Federal Banking Regulation - Prompt Corrective Action" below. The FDIC also assigns an institution to supervisory subgroup based on a supervisory evaluation provided to the FDIC by the institution's primary federal regulator and information that the FDIC determines to be relevant to the institution's financial condition and the risk posed to the deposit insurance funds (which may include, if applicable, information provided by the institution's state supervisor). 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 Westfield Bank.
Under the Deposit Insurance Funds Act of 1996, the assessment base for the payments on the bonds issued in the late 1980's by the Financing Corporation to recapitalize the now defunct Federal Savings and Loan Insurance Corporation was expanded to include, beginning January 1, 1997, the deposits of BIF-insured institutions, such as Westfield Bank. The rate of assessment for BIF-assessable deposits will be one-fifth of the rate imposed on deposits insured by the Savings Association Insurance Fund (SAIF).
Under the FDIA, the FDIC may terminate the insurance of an institution's deposits upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. The management of Westfield Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance.
Transactions with Affiliates of Westfield Bank. Transactions between an insured bank, such as Westfield Bank, 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:
* 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
* 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 Community Reinvestment Act (CRA), any insured depository institution, including Westfield 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 and to take such record into account in its evaluation of certain applications by such 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. Westfield Bank received a "satisfactory" rating on its last CRA exam in December 1999.
Safety and Soundness Standards. Pursuant to the requirements of FDICIA, as amended by the Riegle Community Development and Regulatory Improvement Act of 1994, each federal banking agency, including the FDIC, has adopted guidelines establishing general standards relating to internal controls, information and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, asset quality, earnings, and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines prohibit 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, the FDIC adopted regulations to require a bank that is given notice by the FDIC that it is not satisfying any of such safety and soundness standards to submit a compliance plan to the FDIC. If, after being so notified, 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 of the types to which a significantly undercapitalized institution is subject under the "prompt corrective action" provisions of 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. 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.
Federal Reserve System
Under Federal Reserve Board regulations, Westfield Bank is required to maintain noninterest-earning reserves against its transaction accounts. The Federal Reserve Board regulations generally require that reserves of 3% must be maintained against aggregate transaction accounts of $42.1 million or less, subject to adjustment by the Federal Reserve Board, and an initial reserve of $1.3 million plus 10%, subject to adjustment by the Federal Reserve Board between 8% and 14%, against that portion of total transaction accounts in excess of $48.1 million. The first $6.0 million of otherwise reservable balances, subject to adjustments by the Federal Reserve Board, are exempted from the reserve requirements. Westfield Bank is in compliance with these requirements. Because required reserves must be maintained in the form of either vault cash, a noninterest-bearing account at a Federal Reserve Bank or a pass-through
account as defined by the Federal Reserve Board, the effect of this reserve requirement is to reduce Westfield Bank's interest-earning assets.
Holding Company Regulation
Federal Regulation. As a bank holding company, Westfield Financial 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 will be required for Westfield Financial 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.
A bank holding company is required to give the Federal Reserve Board prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, will be equal to 10% or more of the company's consolidated net worth. The Federal Reserve Board may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe and unsound practice, or would violate any law, regulation, Federal Reserve Board order or directive, or any condition imposed by, or written agreement with, the Federal Reserve Board. Such notice and approval is not required for a bank holding company that would be treated as "well capitalized" under applicable regulations of the Federal Reserve Board, that has received a composite "1" or "2" rating at its most recent bank holding company inspection by the Federal Reserve Board, and that is not the subject of any unresolved supervisory issues.
In addition, a bank holding company which does not qualify as a financial holding company under the Gramm-Leach-Bliley Financial Services Modernization Act, is generally prohibited from engaging in, or acquiring direct or indirect control of any company engaged in non-banking activities. One of the principal exceptions to this prohibition is for activities found by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be permissible.
Bank holding companies that do qualify as a financial holding company may engage in activities that are financial in nature or incident to activities which are financial in nature. Bank holding companies may qualify to become a financial holding company if it meets certain criteria set forth by the Federal Reserve Board.
Under the Federal Deposit Insurance Act, depository institutions are liable to the FDIC for losses suffered or anticipated by the FDIC in connection with the default of a commonly controlled depository institution or any assistance provided by the FDIC to such an institution in danger of default. This law would potentially be applicable to Westfield Mutual Holding Company or Westfield Financial if it ever acquired as a separate subsidiary a depository institution in addition to Westfield Bank.
Massachusetts Regulation
Under the Massachusetts banking laws, a company owning or controlling two or more banking institutions, including a savings bank, is regulated as a bank holding company. The term "company" is defined by the Massachusetts banking laws similarly to the definition of "company" under the Bank Holding Company Act. Each Massachusetts bank holding company:
* must obtain the approval of the Massachusetts Board of Bank Incorporation before engaging in certain transactions, such as the acquisition of more than 5% of the voting stock of another banking institution;
* must register, and file reports, with the Division; and
* is subject to examination by the Division.
Westfield Mutual Holding Company or Westfield Financial will become a Massachusetts bank holding company if they acquire a second banking institution and hold and operate it separately from Westfield Bank.
Acquisition of Westfield Financial or Westfield Bank
Federal Restrictions. Under the federal Change in Bank Control Act, any person (including a company), or group acting in concert, seeking to acquire 10% or more of the outstanding shares of Westfield Financial's common stock will be 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 Westfield Financial. Under the Change in Bank Control Act, the Federal Reserve Board has 60 days within which to act on such notices, taking into consideration factors, including the financial and managerial resources of the acquirer, the convenience and needs of the communities served by Westfield Financial and Westfield 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," within the meaning of the Bank Holding Company Act, of Westfield Financial. The term "control" is defined generally under the Bank Holding Company Act to mean the ownership or power to vote 25% 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. An existing bank holding company would require FRB approval prior to acquiring more than 5% of any class of voting stock of Westfield Financial.
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. For this purpose, the term "person" is defined broadly to mean a natural person or a corporation, company, partnership, or other forms of organized entities. 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 the bank holding company acquires more than 5% of any class of the voting shares of the bank holding company. 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 of the bank holding company.
Other Federal Regulation
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:
* 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. Westfield Bank is in compliance with the FDIC's anti-money laundering regulations.
* 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 FDIC 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.
* 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.
* 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.
* 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:
* the creation of an independent accounting oversight board;
* auditor independence provisions which restrict non-audit services that accountants may provide to their audit clients;
* additional corporate governance and responsibility measures, including the requirement that the chief executive officer and chief financial officer certify financial statements;
* 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;
* 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.
* requirement that audit committee members must be independent and are absolutely barred from accepting consulting, advisory or other compensatory fees from the issuer;
* 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;
* expanded disclosure requirements for corporate insiders, including accelerated reporting of stock transactions by insiders and a prohibition on insider trading during pension blackout periods;
* a prohibition on personal loans to directors and officers, except certain loans made by insured financial institutions;
* disclosure of a code of ethics and filing a Form 8-K for a change or waiver of such code;
* mandatory disclosure by analysts of potential conflicts of interest; and
* 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.
Federal Securities Law
Our common stock is registered with the Securities and Exchange Commission under Section 12(b) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). We are subject to information, proxy solicitation, insider trading restrictions, and other requirements under the Exchange Act.
ITEM 2.
ITEM 2. PROPERTIES
Properties
Westfield Bank currently conducts its business through its 10 banking offices and two off-site ATMs. As of December 31, 2002, the properties and leasehold improvements owned by us had an aggregate net book value of $12.9 million.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We are not involved in any pending legal proceeding other than routine legal proceedings occurring in the ordinary course of business. None of which, in the opinion of management, will have a material effect on the company's consolidated financial position or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock is listed on The American Stock Exchange under the symbol "WFD." Westfield Mutual Holding Company owns 5,607,400 shares, or 53% of our outstanding common stock. At December 31, 2002, there were 10,154,150 shares of common stock issued and outstanding, and there were approximately 2,566 holders of record.
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 American Stock Exchange.
The stock price information set forth above has been provided by The American Stock Exchange. High, low, and closing prices and daily trading volumes are reported in most major newspapers.
A quarterly cash dividend of $0.05 per share was declared by the Board of Directors on March 26, June 28 and September 24, 2002. The continued payment of dividends also depend upon our debt and equity structure, earnings, financial condition, need for capital in connection with possible future acquisitions and other factors, including economic conditions, regulatory restrictions and tax considerations. We cannot guarantee that we will pay dividends or that, if paid, that we will not reduce or eliminate dividends in the future.
The only funds available for the payment of dividends on the capital stock of Westfield Financial will be cash and cash equivalents held by Westfield Financial, dividends paid by Westfield Bank to Westfield Financial, and borrowings. Westfield Bank will be prohibited from paying cash dividends to Westfield Financial to the extent that any such payment would reduce Westfield Bank's capital below required capital levels or would impair the liquidation account to be established for the benefit of the Westfield Bank's eligible account holders and supplemental eligible account holders at the time of the reorganization and stock offering.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The summary information presented below at or for each of the years presented is derived in part from the consolidated financial statements of Westfield Financial. The following information is only a summary, and you should read it in conjunction with our consolidated financial statements and notes beginning on page.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General
Westfield Financial's consolidated results of operations are comprised of earnings on investments and the net income recorded by its principal operating subsidiary, Westfield Bank. Westfield Bank's consolidated results of operations depend primarily on net interest and dividend income. Net interest and dividend income is the difference between the interest income earned on interest-earning assets and the interest paid on interest-bearing liabilities. Interest-earning assets consist primarily of residential mortgage loans, commercial mortgage loans, commercial loans, consumer loans, mortgage-backed securities and investment securities. Interest-bearing liabilities consist primarily of certificates of deposit, savings and money market and NOW account deposits, and borrowings from the Federal Home Loan Bank of Boston. The consolidated results of operations also depend on provision for loan losses, noninterest income, and noninterest expense. Noninterest expense includes salaries and employee benefits, occupancy expenses and other general and administrative expenses. Noninterest income includes gains (losses) on sales of securities and securities writedowns and service fees and charges.
The consolidated results of operations may also be affected significantly by economic and competitive conditions in the market area and elsewhere, including those conditions that influence market interest rates, government policies and the actions of regulatory authorities. Future changes in applicable laws, regulations or government policies may materially affect the results of operations. Furthermore, because Westfield Bank's lending activity is concentrated in loans secured by residential and commercial real estate located in Hampden County, Massachusetts, downturns in this regional economy could have a negative impact on its earnings.
Critical Accounting Policies
Westfield Financial's accounting policies are disclosed in Note 2 to the Consolidated Financial Statements. The more critical policies given Westfield Financial's current business strategy and asset/liability structure are accounting for non performing loans, the allowance for loan losses and provision for credit loans and the classification of securities as either held to maturity or available for sale. In addition to the information disclosure in the Notes to the Consolidated Financial Statements, Westfield Financial's policy on each of these accounting policies is described in detail in the applicable sections of Management's Discussion and Analysis of Financial Condition and results of Operations. Senior management has discussed the development and selection of these accounting estimates and the related disclosures with the Audit Committee of the Company's Board of Directors.
On a quarterly basis, the Company reviews available for sale investment securities with unrealized depreciation on a judgmental basis to assess whether the decline is fair value is temporary or other than temporary. The Company judges whether the decline in value is from company- specific events, industry developments, general economic conditions or other reasons. Once the estimated reasons for the decline are identified, further judgements are required as to whether those conditions are likely to reverse and, if so, whether that reversal is likely to result in a recovery of the fair value of the investment in the near term. Unrealized losses which are not expected to reverse in the near term are charged to operations.
Securities, including mortgage backed securities, which management has the positive intent and ability to hold until maturity are classified as held to maturity and are carried at amortized cost. Securities, including mortgage-backed securities, which have been identified as assets for which there is not a positive intent to hold to maturity are classified as available for sale and are carried at fair value with unrealized gains and losses, net of income taxes, reported as a separate component of equity. Accordingly, a misclassification would have a direct effect on stockholders' equity. Sales or reclassification as available for sale (except for certain permitted reasons) of held to maturity securities may result in the reclassification of all such securities to available for sale. The company has never sold held to maturity securities or reclassified such securities to available for sale other than in specifically permitted circumstances. Westfield Financial does not acquire securities or mortgage backed securities for purposes of engaging in trading activities.
Westfield Financial's general policy is to discontinue the accrual of interest when principal or interest payments are delinquent 90 days or more, or earlier if the loan is considered impaired. Any unpaid amounts previously accrued on these loans are reversed from income. Subsequent cash receipts are applied to the outstanding principal balance or to interest income if,
in the judgment of management, collection of principal balance is not in question. Loans are returned to accrual status when they become current as to both principal and interest and when subsequent performance reduces the concern as to the collectibility of principal and interest. Loan fees and certain direct loan origination costs are deferred, and the net fee or cost is recognized as an adjustment to interest income over the estimated average lives of the related loans. Compensation to an auto dealer is normally based upon a spread that a dealer adds on the loan base rate set by Westfield Financial. The compensation is paid to an automobile dealer shortly after the loan is originated. Westfield Financial records the amount as a deferred cost that is amortized over the life of the loans in relation to the interest paid by the consumer.
The process of evaluating the loan portfolio, classifying loans and determining the allowance and provision is described in detail on page 16. Westfield Financial's methodology for assessing the appropriations of the allowance consists of two key components, which are a specific allowance for identified problem or impaired loans and a formula allowance for the remainder of the portfolio. Measurement of impairment can be based on present value of expected future cash flows discounted at the loan's effective interest rate, the loan's observable market price or the fair value of the collateral, if the loan is collateral dependent. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant change. The appropriations of the allowance is also reviewed by management based upon its evaluation of then- existing economic and business conditions affecting the key lending areas of Westfield Financial and other conditions, such as new loan products, credit quality trends (including trends in non performing loans expected to result from existing condition), collateral values, loan volumes and concentrations, specific industry conditions within portfolio segments that existed as of the balance sheet date and the impact that such conditions were believed to have had on the collectibility of the loan portfolio. Although management believes it has established and maintained the allowance for loan losses at adequate levels, future adjustments may be necessary if economic, real estate and other conditions differ substantially from the current operating environment.
Management Strategy
Westfield Bank strives to remain a leader in meeting the financial service needs of the local community and to provide quality service to the individuals and businesses in the market areas that it has served since 1853. Historically, Westfield Bank has been a community-oriented provider of traditional banking products and services to business organizations and individuals, including products such as residential and commercial real estate loans, consumer loans and a variety of deposit products.
In recent years, in addition to real estate lending, we have adopted a growth-oriented strategy that has focused on increased emphasis on commercial and consumer lending and deposit relationships, extending our branch network and broadening our product lines and services. We believe that this business strategy is best for our long term success and viability, and complements our existing commitment to high quality customer service. In connection with our overall growth strategy, Westfield Bank seeks to:
* increase lending to support the continued growth of its commercial loan portfolio as a means to increase the yield on and diversify its loan portfolio and build transactional deposit account relationships; * continue to focus on consumer lending as a means of diversifying its loan portfolio; * continue to focus on expanding its retail banking franchise, and increasing the number of households served within its market area; * depending on market conditions, sell substantially all of the fixed-rate residential real estate loans that it originates and invest the proceeds of these sales in commercial and industrial loans, consumer loans, commercial real estate loans and investment securities in order to diversify its loan portfolio and reduce interest rate risk; * maintain its capital strength and asset quality; and * meet the needs of its local community through a community-based and service-orientated approach to banking.
Average Balance Sheet and Analysis of Net Interest and Dividend Income
The following tables set forth information relating to our financial condition and net interest and dividend income for the years ended December 31, 2002, 2001 and 2000 and reflect the average yield on assets and average cost of liabilities for the periods indicated. The yields and costs were derived by dividing income or expense by the average balance of interest- earning assets or interest-bearing liabilities, respectively, for the periods shown. Average balances were 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.
Rate/Volume Analysis. The following table shows how changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected our interest and dividend income and interest expense during the periods indicated. Information is provided in each category with respect to:
(1) interest income changes attributable to changes in volume (changes in volume multiplied by prior rate); (2) interest income changes attributable to changes in rate (changes in rate multiplied by prior volume); and (3) 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.
Comparison of Financial Condition at December 31, 2002 and December 31, 2001
Consolidated assets increased $30.3 million, or 3.9%, to $813.0 million at December 31, 2002 from $782.7 million at December 31, 2001. Securities increased $87.6 million, or 30.4%, to $375.6 million at December 31, 2002 from $288.0 million at December 31, 2001. Federal Funds sold increased $2.9 million to $37.2 million at December 31, 2002 from $34.3 million at December 31, 2001 primarily because of the decrease in net loans. Net loans during this period decreased by $56.3 million, or 13.6%, to $357.2 million at December 31, 2002, from $413.5 million at December 31, 2001. Residential loans decreased $54.9 million from $212.8 million at December 31, 2001 to $157.9 million at December 31, 2002. The decrease is primarily the result of the current residential loan referral program with a third party mortgage company. Under this program which commenced on September 1, 2001, Westfield Bank refers its residential real estate borrowers to a third party mortgage company and substantially all of the Bank's residential real estate loans are underwritten, originated and serviced by a third party mortgage company. The Bank receives a fee of 65 basis points for each of these loans originated. The Bank believes that this program will diversify its loan portfolio and reduce interest risk. In 2001, Westfield Bank securitized $35.7 million in thirty-year fixed rate residential mortgage loans and $24.6 million in fifteen year fixed rate residential mortgage loans with Fannie Mae. This transaction was done to reduce interest rate risk as well as improve liquidity and enhance the subsequent saleability of the resulting securities. Because Westfield Bank retained all beneficial interests in the resulting mortgage backed securities, the securitization did not result in a material change in total assets. Commercial and industrial loans increased $14.5 million, or 30.8 %, for the year ended December 31, 2002.
Asset growth was funded by an increase in deposits of $19.0 million or 3.0% to $656.1 million at December 31, 2002 from $637.1 million at December 31, 2001. Demand deposits, NOW and money market accounts increased $9.6 million and $12.5 million respectively, while regular accounts increased $2.2 million to $44.9 million at December 31, 2002. Time deposits decreased $5.3 million to $375.0 million at December 31, 2002 from $380.3 million at December 31, 2001.
Customer repurchase agreements increased $2.6 million or 42.6% to $8.7 million at December 31, 2002 from $6.1 million at December 31, 2001. A "customer repurchase agreement" is an agreement by Westfield Bank to sell to and repurchase from the customer an interest in specific securities issued by or guaranteed by the United States Government. This transaction settles immediately on a same day basis in immediately available funds. Interest paid is commensurate with other products of equal interest and credit risk. Federal Home Loan Bank borrowings increased $15.0 million from zero at December 31, 2001 to $15.0 million at December 31, 2002 to take advantage of the current yield curve.
Stockholders' equity at December 31, 2002 and December 31, 2001 was $126.7 million and $131.3 million, respectively, representing 15.6% and 16.8% of total assets. The change is comprised of net income of $4.0 million for the year ended December 31, 2002, a decrease in net unrealized gains on securities available for sale of $562,000, net of income taxes, the recording of the purchase of 380,150 shares of stock for the employee stock ownership plan amounting to $5.6 million and shares for the management recognition and retention plan amounting to $2.7
million and the declaration by the Board of Directors of three $0.05 per share cash dividends on March 26, June 28, and September 24, 2002 amounting to $1.6 million.
Comparison of Operating Results for the Year Ended December 31, 2002 and December 31, 2001.
General
Net income was $4.0 million for the year ended December 31, 2002, a decrease of $1.0 million, or 20%, compared with net income of $5.0 million for the year ended December 31, 2001. The decrease was primarily attributable to net losses from sales and writedowns of certain equity securities of $1.8 million for 2002 compared with net gains of $830,000 for the year ended December 31, 2001. Writedowns of certain equity securities in 2002 resulted from impairment that was determined to be other than temporary of $2.1 million. The provision for loan losses decreased $696,000 from $1.6 million in 2001 to $934,000 for 2002. Noninterest expense increased $760,000 while federal and state income taxes decreased $273,000 and net interest and dividend income increased $1.7 million compared with the prior year.
Interest and Dividend Income
Total interest and dividend income decreased $4.5 million or 9.5% to $43.0 million for the year ended December 31, 2002 compared with $47.5 million for the same period in 2001. Interest and dividends on securities increased $1.4 million to $13.6 million from $12.2 million as the company invested principal paydowns on its residential real estate portfolio in investment securities. Interest income on loans decreased $5.8 million due to the decline of loans held in portfolio over the prior period. The average balance of interest earning assets increased $87.1 million, or 12.9%. However, the yield on earning assets decreased from 7.03% in 2001 to 5.63% for 2002 due to the low interest rate environment.
Interest Expense
Interest expense decreased $6.2 million, or 24.8%, to $18.8 million for 2002 compared to $25.0 million for 2001. The average balance of total interest-bearing deposits increased $21.8 million in 2002 to $598.7 million, while the average cost of deposits decreased 119 basis points to 3.09% due to the low interest rate environment. The average balance of customer repurchase agreements increased $1.1 million from $7.2 million in 2001 to $8.3 million in 2002.
Net Interest and Dividend Income
Net interest and dividend income for 2002 was $24.2 million as compared with $22.5 million for 2001. Net interest rate spread decreased to 2.54% for 2002 from 2.75% for the prior year. Net interest margin decreased to 3.18% for 2002 compared with 3.33% for 2001. The decrease in interest rate spread and net interest margin was primarily the result of the yield on earning assets falling more than the cost of interest-bearing liabilities.
Provision for Loan Losses
During 2002, Westfield Bank provided $934,000 million for loans losses, compared to $1.6 million for 2001. The provision for loan losses brings Westfield Bank's allowance for loan losses to a level determined appropriate by management based on the methodology discussed under "Allowance for Loan Losses". The allocation of the provision among loan types and between the specific and formula components of the allowance for loan losses is also determined based on the methodology discussed under "Allowance for Loan Losses". The following factors resulted in an increase in the provision for 2002 as compared to 2001.
* Loan concentrations - Commercial real estate loans and commercial and industrial loans increased $16.0 million or 10.9%. Westfield Bank considers these types of loans to contain more risk than conventional residential mortgages which remained relatively constant as a percentage of the loan portfolio. These increases resulted in an increase in the allowance requirements for commercial real estate and commercial and industrial loans. These increases were partially offset by a decrease in consumer loans from $58.0 million at December 31, 2001 to $41.1 million at December 31, 2002, resulting in a decrease in the allowance requirement for consumer loans.
* Credit quality - Actual loss experience on loans decreased significantly with charge-offs totaling $928,000 million in 2002 as compared to $1.8 million in 2001. Net loans charged off as a percent of average loans outstanding decreased from 0.26% in 2001 to 0.13% in 2002. Non-accrual loans decreased $300,000 from $2.7 million at December 31, 2001 to $2.4 million at December 31, 2002.
As a result of the detailed allowance for loan loss methodology and consideration of the above factors, management determined that an decrease in the provision of $696,000 was appropriate.
The allowance for loan losses at the end of 2002 was 1.20% of total loans compared with 0.94% at the end of 2001. The increase in the coverage ratio reflects the changes in the loan portfolio described above.
Noninterest Income
Noninterest income decreased $2.9 million to ($362,000) in 2002 from $2.5 million for 2001. Included in noninterest income in the year 2002 were writedown of certain equity securities of $2.5 million. Included in noninterest in the year 2001 were life insurance proceeds of $300,000. Fees received from our current residential loan referral program with a third party mortgage company were $196,000 for the year ended December 31, 2002 compared with $17,000 for the same period in 2001.
Noninterest Expense
Noninterest expense for the year ended December 31, 2002 was $16.7 million compared to $15.9 million for the same period in 2001. Employee salary and benefits for the year ended December 31, 2002 was $8.9 million compared to $8.4 million in 2001. For the year ended
December 31, 2002, stock based benefit plans expense amounted to $302,000. Because the Company converted to stock form on December 27, 2001, no stock based benefit plans expense was recognized in 2001.
Income Taxes
Income taxes decreased $273,000, or 10.9%, to $2.2 million in 2002. The effective tax rate was 35.6% in 2002 compared to 33.4% for 2001. The effective tax rate also reflects the utilization of Westfield Securities Corporation, a qualified securities corporation, and Elm Street Real Estate Investments, Inc., a wholly-owned subsidiary of Westfield Bank, as a real estate investment trust.
Massachusetts legislation was signed on March 5, 2003 amending the corporate tax law affecting the treatment of dividends received form Real Estate Investment Trusts (REITs). Dividends from the REIT subsidiary are no longer eligible for a dividends-received deduction. As a result of the enactment of this legislation, the Company has ceased recording the tax benefits associated with the dividend received deduction effective for the 2003 tax year.
In addition to the effect on 2003, the legislation includes a retroactive effective date that reaches back to 2002 and prior years. Accordingly, the Company recorded an additional liability for prior years taxes, including interest (net of any federal and state tax deductions associated with such taxes and interest), relating to the deduction for dividends received from a REIT of approximately $2.9 million in the first quarter of 2003.
The Company is reviewing the retroactive effect of the legislation with its legal advisors and intends to defend vigorously its position that the deductibility of dividends received from Elm Street was fully compliant with Massachusetts law at the time.
Comparison of Financial Condition at December 31, 2001 and December 31, 2000
The consolidated assets increased $ 87.9 million, or 12.7%, to $782.7 million at December 31, 2001 from $694.8 million at December 31, 2000. Securities increased $113.4 million, or 65%, to $288.0 million at December 31, 2001 from $174.6 million at December 31, 2000. Federal Funds sold increased $24.2 million to $ 34.3 million at December 31, 2001 from $10.0 million at December 31, 2000. Westfield Bank securitized $35.7 million in thirty-year fixed rate residential mortgage loans and $24.6 million in fifteen year fixed rate residential mortgage loans with Fannie Mae. This transaction was done to reduce interest rate risk as well as improve liquidity and enhance the subsequent saleability of the resulting securities. Because the Bank retained all beneficial interests in the resulting mortgage-backed securities, the securitization did not result in a material change in total assets. Commercial and industrial loans increased $9.5 million, or 25.3 % for the year ended December 31, 2001.
Asset growth was funded primarily by an increase in deposits of $35.2 million or 5.9% to $637.1 million at December 31, 2001 from $601.9 million at December 31, 2000 and funds raised in the initial public offering of Westfield Financial's common stock completed on
December 27, 2001. Interest-bearing deposits accounted for $25.5 million of the growth in total deposits, while demand deposits accounted for $9.7 million.
Customer repurchase agreements decreased $1.6 million or 21.1% to $6.1 million at December 31, 2001 from $7.7 million at December 31, 2000. A "customer repurchase agreement" is an agreement by Westfield Bank to sell to and repurchase from the customer an interest in specific securities issued by or guaranteed by the United States Government. This transaction settles immediately on a same day basis in immediately available funds. Interest paid is commensurate with other products of equal interest and credit risk.
Total equity increased $53.6 million, or 68.9%, to $131.3 million at December 31, 2001 from $77.8 million at December 31, 2000. The increase was primarily attributable to funds raised in the initial public offering of the Westfield Financial's common stock, net income for the year ended December 31, 2001 and an increase in unrealized gains on investment securities available for sale of $816,000 for the year ended December 31, 2001.
Comparison of Operating Results for the Year Ended December 31, 2001 and December 31, 2000.
General
Net income was $5.0 million for the year ended December 31, 2001 a decrease of $1.1 million, or 17.5%, compared with net income of $6.1 million for the year ended December 31, 2000. The decrease was primarily attributable to a decrease in gains on sales of securities of $705,000 from $1.5 million in 2000 to $830,000 in year 2001, and an increase in provision for loan losses of $541,000. Noninterest expense increased $1.2 million, while federal and state income taxes decreased $673,000 and net interest and dividend income increased $358,000 compared with the prior year. Interest and Dividend Income
Total interest and dividend income increased $825,000 or 1.8% to $47.5 million for the year ended December 31, 2001 compared with $46.7 million for the same period in 2000. Interest and dividends on securities increased $3.0 million to $12.2 million from $9.2 million, while interest income on loans decreased $2.3 million. The average balance of interest earning assets increased $42.8 million, or 6.8%, however the yield on earning assets decreased from 7.43% in 2000 to 7.08% for 2001.
Interest Expense
Interest expense increased $467,000 or 1.9%, to $25.0 million for the 2001 compared with $24.5 million for 2000. The average balance of total interest - bearing deposits increased $36.9 million in 2001 to $576.9 million, while the average cost of deposits decreased 17 basis points to 4.29%. The average balance of customer repurchase agreements decreased $897,000 from $8.1 million in 2000 to $7.2 million in 2001.
Net Interest and Dividend Income
Net interest and dividend income for 2001 was $22.5 million as compared with $22.2 million for 2000. Net interest rate spread decreased to 2.80% for 2001 from 2.95% for the prior year. Net interest margin decreased to 3.36% for 2001 compared with 3.53% for 2000. The decrease in interest rate spread and net interest margin was primarily the result of the increase in the cost of certificates of deposit.
Provision for Loan Losses
During 2001, Westfield Bank provided $1.6 million for loans losses, compared to $1.1 million for 2000. The provision for loan losses brings Westfield Bank's allowance for loan losses to a level determined appropriate by management based on the methodology discussed under "Allowance for Loan Losses". The allocation of the provision among loan types and between the specific and formula components of the allowance for loan losses is also determined based on the methodology discussed under "Allowance for Loan Losses". The following factors resulted in an increase in the provision for 2001 as compared to 2000.
* Loan concentrations - Commercial real estate loans and commercial and industrial loans increased $16.1 million or 12.4%. Westfield Bank considers these types of loans to contain more risk than conventional residential mortgages which remained relatively constant. These increases resulted in an increase in the allowance requirements for commercial real estate and commercial and industrial loans. These increases were partially offset by a decrease in consumer loans from $73.3 million at December 31, 2000 to $58.1 million at December 31, 2001, resulting in a decrease in the allowance requirement for consumer loans.
* Credit quality - Actual loss experience on loans increased significantly with charge-offs totaling $1.8 million in 2001 as compared to $1.1 million in 2000. Net loans charged off as a percent of average loans outstanding increased from 0.17% to 0.26% in 2001. Non-accrual loans increased $376,000 from $2.3 million at December 31, 2000 to $2.7 million at December 31, 2001. The increases in charge-offs and non-accrual loans increases the loss factors applied to outstanding loans and results in an increase in the allowance requirement.
As a result of the detailed allowance for loan loss methodology and consideration of the above factors, management determined that an increase in the provision of $541,000 was appropriate.
The allowance for loan losses at the end of 2001 was 0.94% of total loans compared with 0.73% at the end of 2000. The increase in the coverage ratio reflects the changes in the loan portfolio described above.
Noninterest Income
Noninterest income decreased $338,000 to $2.5 million in 2001 from $2.9 million for 2000. Security gains were $830,000 for 2001, down from $1.5 million in 2000. Included in
noninterest income in the year 2001 were life insurance proceeds of $300,000 collected in November of that year.
Noninterest Expense
Total noninterest expense increased $1.2 million, or 8.3%, to $15.9 million in 2001 compared with $14.7 million for the prior year. Salaries and benefits expense represented $545,000 or 44.9% of the increase. In June 2001, Westfield Bank increased its staffing levels in order to open two new full service branches. These two new branches were also the reason for the $366,000 increase in occupancy expense. In May of 2001, Westfield Bank converted its data processing to a new core system, which accounted for the $400,000 increase in computer operating expense.
Income Taxes
Income taxes decreased $673,000, or 21.1%, to $2.5 million in 2001. The effective tax rate was 33.4% in 2001 compared to 34.4% for 2000. The effective tax rate also reflects the utilization of Westfield Securities Corporation, a qualified securities corporation, and Elm Street Real Estate Investments, Inc., a wholly-owned subsidiary of Westfield Bank, as a real estate investment trust.
Liquidity and Capital Resources
The term "liquidity" refers to our ability to generate adequate amounts of cash to fund loan originations, loan purchases, deposit withdrawals and operating expenses. Our 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 our operations. Westfield Bank also can borrow funds from the Federal Home Loan Bank based on eligible collateral of loans and securities. Outstanding borrowings from the Federal Home Loan Bank at December 31, 2002 and 2001 were $15 million and zero, respectively. At December 31, 2002, Westfield Bank's maximum borrowing capacity from the Federal Home Loan Bank was approximately $99.2 million, net of any outstanding borrowings. In addition, we may enter into reverse repurchase agreements with approved broker-dealers. Reverse repurchase agreements are agreements that allow us to borrow money using our securities as collateral.
The Bank also has outstanding, at any time, a significant number of commitments to extend credit and provide financial guarantees to third parties. These arrangements are subject to strict credit control assessments. Guarantees specify limits to the Bank's obligations. Because many commitments and almost all guarantees expire without being funded in whole or in part, the contract amounts are not estimates of future cash flows. The Bank is also obligated under leases for certain of its branches and equipment. A summary of lease obligations and credit commitments at December 31, 2002 follows:
Maturing investment securities are a relatively predictable source of funds. However, deposit flows, calls of 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.
Our primary investing activities are the origination of commercial real estate, commercial and industrial and consumer loans, and the purchase of mortgage-backed and other investment securities. During the year ended December 31, 2002, Westfield Bank originated loans of approximately $99.6 million, and during the comparable period of 2001, Westfield Bank originated loans of approximately $156.4 million. Under the Bank's residential loan referral program which commenced on September 1, 2001, Westfield Bank refers its residential real estate borrowers to a third party mortgage company and substantially all of the Bank's residential real estate loans are underwritten, originated and serviced by a third party mortgage company. Purchases of securities totaled $270.0 million for the year ended December 31, 2002 and $198.0 million for the year ended December 31, 2001. At December 31, 2002, Westfield Bank had loan commitments to borrowers of approximately $3.0 million, and available home equity and unadvanced lines of credit of approximately $62.4 million.
Deposit flows are affected by the level of interest rates, by the interest rates and products offered by competitors and by other factors. Total deposits increased $18.9 million and $35.2 million during the year ended December 31, of 2002 and 2001, respectively. Time deposit accounts scheduled to mature within one year were $265.8 million at December 31, 2002. Based on Westfield Bank's deposit retention experience and current pricing strategy, it anticipates that a significant portion of these certificates of deposit will remain on deposit. We monitor our liquidity position frequently and anticipate that we will have sufficient funds to meet our current funding commitments.
At December 31, 2002, we exceeded each of the applicable regulatory capital requirements. Our tier 1 leverage capital was $125.0 million, or 15.65% to average assets. Our tier 1 capital to risk weighted assets was $125.0 million or 28.77%. We had total capital to risk weighted assets of $129.4 or 29.78%.
We do not anticipate any other material capital expenditures during calendar year 2002, nor do we 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.
Management of Market Risk
As a financial institution, our primary market risk is interest rate risk since substantially all transactions are denominated in U.S. dollars with no direct foreign exchange or changes in commodity price exposure. Fluctuations in interest rates will affect both our level of income and expense on a large portion of our assets and liabilities. Fluctuations in interest rates will also affect the market value of all interest earning assets.
The primary goal of our interest rate management strategy is to limit fluctuations in net interest income as interest rates vary up or down and control variations in the market value of assets, liabilities and net worth as interest rates vary. We seek to coordinate asset and liability decisions so that, under changing interest rate scenarios, net interest income will remain within an acceptable range.
To achieve the objectives of managing interest rate risk, Westfield Bank's Asset and Liability Management Committee meets monthly to discuss and monitor the market interest rate environment relative to interest rates that are offered on its products. The Asset and Liability Management Committee presents periodic reports to the Board of Directors of Westfield Bank and the Board of Trustees of Westfield Mutual Holding Company at their regular meetings.
Historically, Westfield Bank's lending activities have emphasized residential real estate and commercial real estate loans. However, since 1996, Westfield Bank has increased its emphasis on commercial and consumer lending and deposit relationships. Commercial and industrial loans and consumer loans have grown 237.0% and 25.6%, respectively, since December 31, 1996. Commercial and industrial loans have also grown 63.9% since December 31, 2000. The indirect automobile loan portfolio grew substantially in 1999 as a result of aggressive pricing and the addition of several new automobile dealers. Management determined to temporarily curtail its indirect lending in fiscal year 2000 and 2001 to allow the portfolio to become more seasoned, but may decide to grow the indirect automobile loan portfolio in the future. We believe that Westfield Bank's increased emphasis on commercial and consumer lending will allow it to diversify its loan portfolio while continuing to meet the needs of the businesses and individuals that it serves.
Westfield Bank's primary source of funds has been deposits, consisting primarily of time deposits, money market accounts, savings accounts, demand accounts and NOW accounts, which have shorter terms to maturity than the loan portfolio. Several strategies have been employed to manage the interest rate risk inherent in the asset/liability mix, including but not limited to:
* maintaining the diversity of our existing loan portfolio through the origination of commercial loans, commercial real estate loans and consumer loans which typically have variable rates and shorter terms than residential mortgages; and
* emphasizing investments with expected short-term maturities of five years or less.
In addition, emphasis on commercial and consumer loans has reduced the average maturity of Westfield Bank's loan portfolio. Moreover, the actual amount of time before loans are repaid can be significantly affected by changes in market interest rates. Prepayment rates will also vary due to a number of other factors, including the regional economy in the area where the loans were originated, seasonal factors, demographic variables and the assumability of the loans. However, the major factors affecting prepayment rates are prevailing interest rates, related financing opportunities and competition. We monitor interest rate sensitivity so that we can adjust our asset and liability mix in a timely manner and minimize the negative effects of changing rates.
Each of the Westfield Bank's sources of liquidity is vulnerable to various uncertainties beyond the control of the Westfield Bank. Scheduled loan and security payments are a relatively stable source of funds, while loan and security prepayments and calls, and deposit flows vary widely in reaction to market conditions, primarily prevailing interest rates. Asset sales are influenced by pledging activities, general market interest rates and unforeseen market conditions. The Westfield Banks's financial condition is affected by its ability to borrow at attractive rates, retain deposits at market rates and other market conditions. Management considers the Westfield Banks's sources of liquidity to be adequate to meet expected funding needs and also to be responsive to changing interest rate markets.
Net Interest and Dividend Income Simulation. We use a simulation model to monitor interest rate risk. This model reports the net interest income at risk primarily under six different interest rate change environments. Specifically, an analysis is performed of changes in net interest income assuming changes in interest rates, both up and down 100, 200 and 300 basis points from current rates over the one year time period following the current consolidated financial statement.
The changes in interest income and interest expense due to changes in interest rates reflect the interest sensitivity of our interest earning assets and interest bearing liabilities. For example, in a rising interest rate environment, the interest income from an adjustable rate mortgage will increase depending on its repricing characteristics while the interest income from a fixed rate loan would not increase until it was repaid and loaned out at a higher interest rate.
The tables below set forth as of December 31, 2002 the estimated changes in net interest and dividend income that would result from incremental changes in interest rates over the applicable twelve-month period.
Market rates were assumed to increase and decrease 100 basis points, 200 basis points, and 300 basis points in even increments over the twelve month period. The repricing and/or new rates of assets and liabilities moved in tandem with market rates. However, in certain deposit products, the use of data from a historical analysis indicated that the rates on these products would move only a fraction of the rate change amount.
Westfield Bank developed consolidated balance sheet growth projections for the twelve month period. The same product mix and growth strategy was used for all rate change scenarios. Income from tax exempt assets is calculated on a fully taxable equivalent basis.
Pertinent data from each loan account, deposit account and investment security was used to calculate future cash flows. The data included such items as maturity date, payment amount, next repricing date, repricing frequency, repricing index and spread. Prepayment speed assumptions were based upon the difference between the account rate and the current market rate.
Another circumstance that affects the results is that market rates are relatively low. In the three declining rate scenarios, Westfield Bank forecasted that its rates on some deposit products would not fall as sharply as market rates. For example, because the rate on regular savings accounts is 1.05%, it is not possible for the rate to decrease by 200 basis points or 300 basis points.
Recent Accounting Pronouncements
In April 2002, the Financial Accounting Standards Board ("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 rescinds SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt" and an amendment of that statement, SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements". SFAS No. 145 also rescinds SFAS No. 44, "Accounting for Intangible Assets of Motor Carriers". SFAS No. 145 amends SFAS No. 13, "Accounting for Leases", to eliminate an inconsistency between the
required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. SFAS No. 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The provisions relating to the extinquishment of debt become effective for financial statements issued for fiscal years beginning after May 15, 2002. The provisions of this statement relating to lease modifications are effective for transactions occurring after May 15, 2002.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities". ("SFAS No. 146"). The statement specifies the accounting for certain employee termination benefits, contract termination costs and costs to consolidate facilities or relocate employees and is effective for exit and disposal activities initiated after December 31, 2002.
In October 2002, the FASB issued SFAS No. 147, "Acquisitions of Certain Financial Institutions" which became effective October 1, 2002. SFAS No. 147 removes acquisitions of financial institutions from the scope of SFAS No. 72, "Accounting for Certain Acquisitions of Banking or Thrift Institutions" and FASB Interpretation No. 9, "Applying APB Opinions No. 16 and 17. When a Savings and Loan Association or Similar Association is Acquired in a Business Combination Accounted for by the Purchase Method" and requires that those transactions be accounted for in accordance with SFAS No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets". In addition, SFAS No. 147 amends SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", to include in its scope long-term customer relationship intangible assets of financial institutions.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure and amendment to FASB No. 123", which provides three optional transition methods for entities that decide to voluntarily adopt the fair value recognition principles of SFAS No. 123, "Accounting for Stock Issued to Employees", and modifies the disclosure requirements of that Statement. The Company has not adopted the fair value recognition principles of SFAS No. 123. The Company has included the annual disclosures in the consolidated financial statements required by SFAS No. 148 in this filing and will include the quarterly disclosure requirements in future quarterly filings.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"). The Interpretation requires certain guarantees to be recorded at fair value and also requires a guarantor to make new disclosures, even when the likelihood of making payments under the guarantee is remote. In general, the Interpretation applies to contracts or indemnification agreements that contingently require the guarantor to make payments to the guaranteed party based on changes in an underlying contract that is related to an asset, liability, or an equity security of the guaranteed party. The recognition provisions of FIN 45 are effective on a prospective basis for guarantees issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements of interim and annual periods ending after December 15, 2002.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities", which requires an enterprise to assess if consolidation is appropriate based upon its variable economic interests in variable interest entities ("VIE's"). The initial determination of whether an entity is a VIE shall be made on the date at which an enterprise becomes involved with the entity. An entity is considered to be an VIE if lacks a sufficient amount of voting equity interests (e.g. 10% of total assets) that are subject to the risk of loss or residual return of the entity. An enterprise shall consolidate a VIE if it has a variable interest that will absorb a majority of the VIE's expected losses if they occur, receive a majority of the entity's expected residual returns if they occur or both. A direct or indirect ability to make decisions that significantly affect the results of the activities of a VIE is a strong indication that an enterprise has one or both of the characteristics that would require consolidation of the VIE. Interpretation 46 is effective for new VIE's established subsequent to February 1, 2003 and must be adopted for existing VIE's by July 1, 2003. The Company does not invest in investment structures that require analysis under this Interpretation.
The adoption of the effective provisions of these standards did not have a material effect on the Company's consolidated financial statements. The adoption of the remaining provisions of these standards is not expected to have a material effect on its statements.
Impact of Inflation and Changing Prices
The Consolidated Financial Statements and accompanying Notes of Westfield Financial have been prepared in accordance with Accounting Principles Generally Accepted in the United States of America ("GAAP"). GAAP generally requires the measurement of financial position and operating results in terms of historical dollars without consideration for changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations. Unlike industrial companies, our assets and liabilities are primarily monetary in nature. As a result, changes in market interest rates have a greater impact on performance than do the effects of inflation.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, page 57 - 59, for a discussion of Quantitative and Qualitative Disclosures About Market Risk.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following financial statements are incorporated by reference to the indicated pages of the 2002 Annual Report to Stockholders.
Independent Auditor's Report
Consolidated Balance Sheets as of December 31, 2002 and 2001.
Consolidated Statements of Income 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 -
All schedules are omitted because they are not required or applicable, or the required information is shown in the consolidated financial statements or notes thereto.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The following information included in the Company's Proxy Statement for the 2003 Annual Meeting of Stockholders (the "Proxy Statement") is incorporated herein by reference: "Election of Directors," Nominees for Election as Director," "Continuing Directors", "Executive Officers," and "Section 16(a) Beneficial Ownership Reporting Compliance.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The following information included in the Proxy Statement is incorporated herein by reference: "Management Salary Compensation Committee Report on Executive Compensation," "Compensation Committee Interlocks and Insider Participation," "Performance Graph," "Directors' Compensation," "Executive Compensation," "Employment Agreements," and "Benefits."
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following information included in the Proxy Statement is incorporated herein by reference: "Security Ownership of Certain Beneficial Owners and Management-Principal Shareholders of the Company," and "Security Ownership of Management."
The following table sets forth the aggregate information of our equity compensation plans in effect as December 31, 2002.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The following information included in 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
During the 90-day period prior to the filing date of this report, management, including the Company's President and Chief Executive Officer and Senior Vice President and Chief Financial Officer evaluated the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based upon, and as of the date of that evaluation, the President and Chief Executive Officer and Senior Vice President and Chief Financial Officer concluded that the disclosure controls and procedures were effective, in all material respects, to ensure that information required to be disclosed in the reports the Company files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required.
There have been no significant changes in the Company's internal controls or in other factors which could significantly affect internal controls subsequent to the date the Company carried out its evaluation. There were no significant deficiencies or material weaknesses identified in the evaluation and therefore, no corrective actions were taken.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
Listed below are all financial statements and exhibits filed as part of this report:
a. Financial Statements, Schedules, and Exhibits
(1) The consolidated balance sheets of Westfield Financial, Inc. and subsidiaries as of December 31, 2002 and 2001 and the related consolidated statements of income changes in stockholders equity and cash flows for each of the years in the three-year period ended December 31, 2002, together with the related notes and independent auditors' report of Deloitte & Touche LLP, independent certified public accountants.
(2) Schedules omitted as they are not applicable.
(3) See Exhibit Index.
b. Reports on Form 8-K - none.
Exhibit Description
2.1 Plan of Reorganization and Minority Stock Issuance of Westfield Mutual Holding Company, as amended. * 3.1 Articles of Organization of Westfield Financial, Inc.* 3.2 Bylaws of Westfield Financial, Inc. * 3.3 Amended and Restated Charter of Westfield Mutual Holding Company* 3.4 Amended and Restated Bylaws of Westfield Mutual Holding Company* 4.1 Articles of Organization of Westfield Financial, Inc. (See Exhibit 3.1)* 4.2 Bylaws of Westfield Financial, Inc. (See Exhibit 3.2)* 4.3 Form of Stock Certificate of Westfield Financial, Inc.* 10.1 Form of Employee Stock Ownership Plan of Westfield Financial, Inc.* 10.2 Form of the Benefit Restoration Plan of Westfield Financial, Inc.* 10.3 Form of Employment Agreement between Donald A. Williams and Westfield Financial, Inc.* 10.4 Form of Employment Agreement between Victor J. Carra and Westfield Financial, Inc.* 10.5 Form of Employment Agreement between Michael J. Janosco, Jr. and Westfield Financial, Inc.* 10.6 Form of One Year Change in Control Agreement by and among certain officers and Westfield Financial, Inc. and Westfield Bank* 10.7 Form of Directors' Deferred Compensation Plan* 10.8 The SBERA 401(k) Plan adopted by Westfield Bank** 10.9 Amendments to the Employee Stock Ownership Plan of Westfield Financial, Inc. 21.1 Subsidiaries of the Registrant* 23.1 Consent of Deloitte & Touche LLP 99.1 Certifications pursuant to 18 U.S.C. Section 1350
* Incorporated herein by reference to the Registration Statement No. 333-68550, on Form S-1 of Westfield Financial filed with the SEC on August 28, 2001, as amended.
** Incorporated herein by reference to the Registration Statement No. 333-73132, on Form S-8, filed with the SEC on November 9, 2001, as amended.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 26, 2002.
WESTFIELD FINANCIAL, INC.
By: /s/ Donald A. Williams ------------------------------- Donald A. Williams President and Chief Executive Officer
Pursuant to the requirements of the Securities Act of 1933, as amended, and any rules and regulations promulgated thereunder, this Annual Report on Form 10-K, has been signed by the following persons in the capacities and on the dates indicated.
CERTIFICATIONS
I, Donald A. Williams certify that:
1. I have reviewed this annual report on Form 10-K of Westfield Financial, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report.
4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
(a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
(b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and
(c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function):
(a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and
(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this annual report whether or not there significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 26, 2002 By: /s/ Donald A. Williams ------------------------------- President and Chief Executive Officer
CERTIFICATIONS
I, Michael J. Janosco, Jr., certify that:
1. I have reviewed this annual report on Form 10-K of Westfield Financial, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; and
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report.
4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
(a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
(b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and
(c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function):
(a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and
(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this annual report whether or not there significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 26, 2002 By: /s/ Michael J. Janosco, Jr. ------------------------------- Michael J. Janosco, Jr. Senior Vice President and Chief Financial Officer
WESTFIELD FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (Dollars in Thousands Except per Share Amount)
See notes to consolidated financial statements.
WESTFIELD FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME (Dollars in thousands except per share amounts)
See notes to consolidated financial statements.
WESTFIELD FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Dollars in Thousands)
See notes to consolidated financial statements.
WESTFIELD FINANCIAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS (Dollars in Thousands)
See notes to consolidated financial statements.
WESTFIELD FINANCIAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2002, 2001, AND 2000
1. REORGANIZATION AND STOCK OFFERING
On December 27, 2001, the Board of Directors of Westfield Mutual Holding Company ("Mutual Holding Company") completed a plan of reorganization (the "Plan") whereby the Mutual Holding Company formed a mid-tier stock holding company ("Westfield Financial, Inc." or the "Company") and exchanged 100% of the common stock of Westfield Bank (the "Bank") for a majority interest in Westfield Financial, Inc. Pursuant to the Plan, shares of Westfield Financial, Inc. were offered for subscription by depositors with eligible accounts at the Bank as of specified dates. The Company issued 10,580,000 shares of Common Stock (par value $0.01 per share) at a price of $10.00 per share, of which 47% of these shares, or 4,972,600 shares, were sold to the public, including depositors of the Bank and 53% of these shares, or 5,607,400 shares, were issued to the Mutual Holding Company. Net proceeds from the stock offering totaled $47.7 million. Costs related to the reorganization were charged against the proceeds from the shares sold in the reorganization. Reorganization costs of approximately $2.3 million were incurred.
In connection with the reorganization, a "Liquidation Account" was established in an amount equal to the net worth of the Mutual Holding Company set forth in its latest consolidated statement of financial condition contained in the reorganization prospectus. The function of the Liquidation Account is to establish a priority on liquidation to the assets of the Company to Eligible Account Holders (as defined in the Plan) who continue to maintain deposits in the Bank after the reorganization. In the unlikely event of a complete liquidation of the Company, and only in such event, each Eligible Account Holder would receive from the Liquidation Account a liquidation distribution based on the their proportionate share of the then remaining qualifying deposits.
Current regulations allow the Bank to pay dividends on its stock if its regulatory capital would not thereby be reduced below the amount then required for the aforementioned Liquidation Account. Also, capital distribution regulations limit the Bank's ability to make capital distributions which include dividends, stock redemptions and repurchases and other transactions charged to the capital accounts based on their capital level and supervisory condition. Federal regulations also limit any repurchase of the stock for the Bank or its holding company for three years after reorganization except for repurchases pursuant to an open-market stock repurchase program with certain regulatory criteria and approval of the FDIC.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations and Basis of Presentation - Westfield Financial, Inc. (the "Company") is a Massachusetts security corporation. The Company has a state chartered stock savings bank subsidiary called Westfield Bank (the "Bank"). The Bank's deposits are insured to the limits specified by the Federal Deposit Insurance Corporation ("FDIC") and the Deposit Insurance Fund ("DIF"), a corporation formed by the Massachusetts' legislature. The Bank operates 10 branches in Western Massachusetts. The Bank's primary source of revenue is earned from loans to small and middle-market businesses and to residential property homeowners.
The Bank formed Westfield Elm Associates, Inc., ("Westfield Elm"), a wholly owned subsidiary. In addition, Westfield Elm formed two subsidiaries, Elm Street Real Estate Investments Inc., (the "REIT") and Elm Street Business Trust (the "MBT"). The REIT is 99.9% owned by Westfield Elm with the remaining 0.1% owned by other shareholders. The MBT was 100% wholly owned by Westfield Elm. During 2000, the Company eliminated Westfield Elm and the MBT to streamline the overall bank structure.
Westfield Securities Corp., a Massachusetts chartered security corporation, was formed in 2001 by the Company for the primary purpose of holding qualified investment securities.
Principles of Consolidation - The consolidated financial statements include the accounts of the Company, the Bank, Westfield Securities Corp., and the REIT. All material intercompany balances and transactions have been eliminated in consolidation. Certain amounts in the prior year financial statements have been reclassified to conform to the current year presentation.
Estimates - The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of income and expenses for each. Actual results could differ from those estimates. Estimates that are particularly susceptible to significant change in the near-term relate to the determination of the fair value of financial instruments and the allowance for loan losses.
Cash and Cash Equivalents - The Company defines cash on hand, cash due from banks, federal funds sold and interest bearing deposits having an original maturity of 90 days or less as cash and cash equivalents. Cash and due from banks at December 31, 2002 and 2001 includes partially restricted cash of approximately $220,000, and $3,352,000 respectively, for Federal Reserve Bank of Boston cash reserve requirements.
Securities and Mortgage Backed Securities - Securities, including mortgage backed securities, which management has the positive intent and ability to hold until maturity are classified as held to maturity and are carried at amortized cost. Securities, including mortgage backed securities, which have been identified as assets for which there is not a positive intent to hold to maturity are classified as available for sale and are carried at fair value with unrealized gains and losses, net of income taxes, reported as a separate component of equity. The Company does not acquire securities and mortgage backed securities for purposes of engaging in trading activities.
Realized gains and losses on sales of securities and mortgage backed securities are computed using the specific identification method and are included in noninterest income. Securities and mortgage backed securities which have experienced an other than temporary decline in value are written down to estimated fair value, establishing a new cost basis with the amount of the write-down included in noninterest expense as a realized loss. The amortization of premiums and accretion of discounts is determined by using the level yield method to the earlier of the call or maturity date.
Other than Temporary Impairment of Securities - On a quarterly basis, the Company reviews available for sale investment securities with unrealized depreciation on a judgmental basis to assess whether the decline is fair value is temporary or other than temporary. The Company judges whether the decline in value is from company-specific events, industry developments, general economic conditions or other reasons. Once the estimated reasons for the decline are identified, further judgements are required as to whether those conditions are likely to reverse and, if so, whether that reversal is likely to result in a recovery of the fair value of the investment in the near term. Unrealized losses which are not expected to reverse in the near term are charged to operations.
Loans - Loans are recorded at the principal amount outstanding. Interest on loans is calculated using the effective yield method on daily balances of the principal amount outstanding and is credited to income on the accrual basis to the extent it is deemed collectible. The Company's general policy is to discontinue the accrual of interest when principal or interest payments are delinquent 90 days or more, or earlier if the loan is considered impaired. Any unpaid amounts previously accrued on these loans are reversed from income. Subsequent cash receipts are applied to the outstanding principal balance or to interest income if, in the judgment of management, collection of the principal balance is not in question. Loans are returned to accrual status when they become current as to both principal and interest and when subsequent performance reduces the concern as to the collectibility of principal and interest. Loan fees and certain direct loan origination costs are deferred, and the net fee or cost is recognized as an adjustment to interest income over the estimated average lives of the related loans. Compensation to an auto dealer is normally based upon a spread that a dealer adds on the loan base rate set by the Company. The compensation is paid to an automobile dealer shortly after the loan is originated. The Company records the amount as a deferred cost that is amortized over the life of the loans in relation to the interest paid by the customer.
Allowance for Loan Losses - The allowance for loan losses is established through provisions for loan losses charged to expense. Loans are charged off against the allowance when management believes that the collectibility of the principal is unlikely. Recoveries of amounts previously charged-off are credited to the allowance.
The Bank maintains an allowance for loan losses to absorb losses inherent in the loan portfolio based on ongoing quarterly assessments of the estimated losses. The Bank's methodology for assessing the appropriateness of the allowance consists of two key components, which are a specific allowance for identified problem loans and a formula allowance for the remainder of the portfolio. The specific allowance incorporates the results of measuring impaired loans as provided in 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." These accounting standards prescribe the measurement methods, income recognition and disclosures related to 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. In determining the loss factors to apply to each loan category, Westfield Bank considers historical losses, peer group comparisons, industry data and loss percentages used by banking regulators for similarly graded loans. Loss factors may be adjusted for qualitative factors that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date.
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. A loan is not deemed to be impaired if there is a short delay in receipt of payment or if, during a longer period of delay, the Company expects to collect all amounts due including interest accrued at the contractual rate during the period of delay. Measurement of impairment can be based on present value of expected future cash flows discounted at the loan's effective interest rate, the loan's observable market price or the fair value of the collateral, if the loan is collateral dependent. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant change. If the fair value of the impaired loan is less than the related recorded amount, a specific valuation allowance is established within the allowance for loan losses or a writedown is charged against the allowance for loan losses if the impairment is considered to be permanent. Measurement of impairment does not apply to large groups of smaller balance homogeneous loans that are collectively evaluated for impairment such as the Company's portfolios of home equity loans, real estate mortgages, installment and other loans.
The appropriateness of the allowance is also reviewed by management based upon its evaluation of then-existing economic and business conditions affecting the key lending areas of the Company and other conditions, such as new loan products, credit quality trends (including trends in nonperforming loans expected to result from existing conditions), collateral values, loan volumes and concentrations, specific industry conditions within portfolio segments that existed as of the balance sheet date and the impact that such conditions were believed to have had on the collectibility of the loan portfolio. There may be other factors that warrant the Company's consideration in maintaining the allowance at a level sufficient to cover probable losses. Although management believes it has established and maintained the allowance for loan losses at adequate levels, future adjustments may be necessary if economic, real estate and other conditions differ substantially from the current operating environment.
In addition, various regulatory agencies, as an integral part of their examination process, periodically review the loan and foreclosed real estate portfolios and the related allowance for loan losses and valuation allowance for foreclosed real estate. These agencies, including the FDIC and the Massachusetts Division of Banks, may require adjustment to the allowance for loan losses based on their judgments of information available to them at the time of their examination, thereby adversely affecting results of operations.
Management believes that the allowance for loan losses accurately reflects estimated credit losses for specifically identified loans, as well as probable credit losses inherent in the remainder of the portfolio as of the end of the periods presented.
Transfers and Servicing of Financial Assets - Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Corporation, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Corporation does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Premises and Equipment - Land is carried at cost. Buildings and equipment are stated at cost, less accumulated depreciation, computed on either the straight-line or accelerated methods over the estimated useful lives of the assets, or lease term, if shorter, as follows:
It is general practice to charge the cost of maintenance and repairs to expense when incurred; major expenditures for betterments are capitalized and depreciated.
Other Real Estate Owned - Other real estate owned represents property acquired through foreclosure or deeded to the Company in lieu of foreclosure. Other real estate owned is recorded at the lower of the carrying value of the related loan, or the estimated fair value of the real estate acquired, net of estimated selling costs. Initial write-downs are charged to the allowance for loan losses at the time the loan is transferred to other real estate owned. Subsequent valuations are periodically performed by management and the carrying value is adjusted by a charge to expense to reflect any subsequent declines in the estimated fair value. Operating costs associated with other real estate owned are expensed as incurred.
Retirement Plans and Employee Benefits - The Company provides a defined benefit pension plan for eligible employees through membership in the Savings Banks Employees Retirement Association ("SBERA"). The Company's policy is to fund pension cost as accrued. Employees are also eligible to participate in a 401(k) plan through SBERA. Beginning in 2000, the Company began making matching contributions to this plan at 50% of up to 6% of the employees' eligible compensation.
The Company currently offers postretirement life insurance benefits to retired employees. Such postretirement benefits represent a form of deferred compensation which requires that the cost and obligations of such benefits are recognized in the period in which services are rendered.
Income Taxes - The Company uses the asset and liability method for income tax accounting, whereby, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates applied to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
Earnings per Common Share - Basic earnings per share represents income available to common stockholders divided by the weighted- average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Corporation relate solely to outstanding stock awards, and are determined using the treasury stock method.
Earnings per common share for the year ended December 31, 2002 have been computed based on the following:
The Common Stock of the Company commenced trading on December 28, 2001. As such, earnings per share data for the year ended 2001 and prior is not meaningful.
Stock Options - The Company applies APB Opinion No. 25 and related Interpretations in accounting for stock options. Accordingly, no compensation cost has been recognized. Had compensation cost for the Company's stock options been determined based on the fair value at the grants dates for awards under the plan consistent with the method prescribed by SFAS No. 123, the Company's net income (in thousands) and earnings per share would have been adjusted to the pro forma amounts indicated below:
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:
Derivative Financial Instruments - In 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" as amended by SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities- Deferral of Effective Date of FASB Statement No. 133", which establishes accounting and reporting standards for derivatives, derivative instruments embedded in other contracts and for hedging activities. In 2000, the FASB issued SFAS No. 138, Accounting for Certain Derivative Instruments and Hedging Activities, which establishes accounting and reporting standards for certain derivatives, derivative instruments embedded in other contracts and for certain hedging activities. These statements became effective for the Company on January 1, 2001. The adoption of these statements had no effect on the Company's consolidated financial statements because no derivative financial instruments or embedded derivative financial instruments requiring application of this statement were outstanding at January 1, 2001 or at any time during the years ended December 31, 2002 and 2001.
Comprehensive Income - SFAS No. 130, "Reporting Comprehensive Income", establishes standards for reporting comprehensive income and its components (revenues, expenses, gains and losses). Components of comprehensive income are net earnings and all other non-owner changes in equity. SFAS No. 130 requires that an enterprise (a) classify items of other comprehensive income by their nature in a financial statement and (b) display the accumulated balance of other comprehensive income (loss) separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position. The Company's accumulated other comprehensive income (loss) included in stockholders' equity is comprised exclusively of net unrealized gains (losses) on securities available for sale, net of related tax effects.
New Accounting Standards - In April 2002, the Financial Accounting Standards Board ("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 rescinds SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt" and an amendment of that statement, SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements". SFAS No. 145 also rescinds SFAS No. 44, "Accounting for Intangible Assets of Motor Carriers". SFAS No. 145 amends SFAS No. 13, "Accounting for Leases", to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale- leaseback transactions. SFAS No. 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The provisions relating to the extinquishment of debt become effective for financial statements issued for fiscal years beginning after May 15, 2002. The provisions of this statement relating to lease modifications are effective for transactions occurring after May 15, 2002.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities". ("SFAS No. 146"). The statement specifies the accounting for certain employee termination benefits, contract termination costs and costs to consolidate facilities or relocate employees and is effective for exit and disposal activities initiated after December 31, 2002.
In October 2002, the FASB issued SFAS No. 147, "Acquisitions of Certain Financial Institutions" which became effective October 1, 2002. SFAS No. 147 removes acquisitions of financial institutions from the scope of SFAS No. 72, "Accounting for Certain Acquisitions of Banking or Thrift Institutions" and FASB Interpretation No. 9, "Applying APB Opinions No. 16 and 17. When a Savings and Loan Association or Similar Association is Acquired in a Business Combination Accounted for by the Purchase Method" and requires that those transactions be accounted for in accordance with SFAS No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets". In addition, SFAS No. 147 amends SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", to include in its scope long-term customer relationship intangible assets of financial institutions.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure and amendment to FASB No. 123", which provides three optional transition methods for entities that decide to voluntarily adopt the fair value recognition principles of SFAS No. 123, "Accounting for Stock Issued to Employees", and modifies the disclosure requirements of that Statement. The Company has not adopted the fair value recognition principles of SFAS No. 123. The Company has included the annual disclosures in the consolidated financial statements required by SFAS No. 148 in this filing and will include the quarterly disclosure requirements in future quarterly filings.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"). The Interpretation requires certain guarantees to be recorded at fair value and also requires a guarantor to make new disclosures, even when the likelihood of making payments under the guarantee is remote. In general, the Interpretation applies to contracts or indemnification agreements that contingently require the guarantor to make payments to the guaranteed party based on changes in an underlying contract that is related to an asset, liability, or an equity security of the guaranteed party. The recognition provisions of FIN 45 are effective on a prospective basis for guarantees issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements of interim and annual periods ending after December 15, 2002.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities", which requires an enterprise to assess if consolidation is appropriate based upon its variable economic interests in variable interest entities ("VIE's"). The initial determination of whether an entity is a VIE shall be made on the date at which an enterprise becomes involved with the entity. An entity is considered to be an VIE if lacks a sufficient amount of voting equity interests (e.g. 10% of total assets) that are subject to the risk of loss or residual return of the entity. An enterprise shall consolidate a VIE if it has a variable interest that will absorb a majority of the VIE's expected losses if they occur, receive a majority of the entity's expected residual returns if they occur or both. A direct or indirect ability to make decisions that significantly affect the results of the activities of a VIE is a strong indication that an enterprise has one or both of the characteristics that would require consolidation of the VIE. Interpretation 46 is effective for new VIE's established subsequent to February 1, 2003 and must be adopted for existing VIE's by July 1, 2003. The Company does not invest in investment structures that require analysis under this Interpretation.
The adoption of the effective provisions of these standards did not have a material effect on the Company's consolidated financial statements. The adoption of the remaining provisions of these standards is not expected to have a material effect on its statements.
Reclassifications - Certain reclassifications have been made to prior year accounts to conform to the current year's presentation.
3. SECURITIES
Securities at December 31, 2002 are summarized as follows:
Securities at December 31, 2001 are summarized as follows:
The amortized cost and fair value of debt securities at December 31, 2002, by maturity, are shown below. Actual maturities may differ from contractual maturities because certain issues have the right to call or repay obligations.
Gross gains of $422,991, $952,674, and $1,878,716 and gross losses $897,337, $477,334, and $328,395 were recorded on securities during the years ended December 31, 2002, 2001, and 2000, respectively. During 2002 and 2001, the Company realized losses of $2,105,000 and $315,000, respectively, for other than temporary impairments in value.
Securities with a par value of $15,000,000 and $12,000,000 were pledged as collateral to the Federal Reserve Bank of Boston at December 31, 2002 and 2001, respectively.
Unrealized gains (losses) on securities available for sale, net of tax was $51,000 and $973,000 at December 31, 2002 and 2001, respectively.
4. MORTGAGE BACKED SECURITIES
Mortgage backed securities at December 31, 2002 are summarized as follows:
Mortgage backed securities at December 31, 2001 are summarized as follows:
Collateralized Mortgage Obligations ("CMO's") - CMOs include traunches of AAA investment grade and consist of high quality mortgage obligations.
Gross gains of $849,703, $833,147 and $15,781 and gross losses of $20,544, $162,697 and $31,365 were recorded on mortgage backed securities during the years ended December 31, 2002, 2001 and 2000 respectively.
Unrealized gains (losses) on securities available for sale, net of tax was $1,167,000 and $807,000 at December 31, 2002 and 2001, respectively.
5. LOANS
Loans consisted of the following amounts as of:
The following table summarizes information regarding impaired loans:
There were no restructured loans at December 31, 2002, 2001 and 2000.
Nonaccrual loans at December 31, 2002, December 31, 2001 and 2000 and related interest income are summarized as follows:
Mortgage loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid balances of these loans totaled $70,284,971 and $97,616,627 at December 31, 2002 and 2001, respectively. Service fee income of $75,972, $119,605, and $119,927 was recorded for the years ended December 31, 2002, 2001, and 2000, respectively.
Loan Securitization - On June 1, 2001, the Company securitized residential real estate mortgages with a recorded value of approximately $60 million. The Company retained servicing responsibilities and all beneficial interests in the resulting mortgage backed securities. The Company has not committed to sell any of the retained mortgage backed securities before or during the securitization process. The resulting mortgage backed securities in the amount of $19.7 and $1.5 million are included in the balance sheet caption Mortgage Backed Securities - Available for Sale as of December 31, 2001 and 2002, respectively. No securitizations were done in 2002.
The Company's servicing assets are recorded at fair value at the time the asset is acquired. The fair value is based upon the net present value of future cash flows of the net servicing revenue. Assumptions used in determining fair value include service fee revenue, float revenue, escrow revenue, servicing expense, and estimated life of the underlying loans. The fair value of the asset is recalculated quarterly to determine possible impairment. In 2002 the Company recorded an impairment writedown of $253,000, to reduce the carrying value of the servicing assets as of December 31, 2002 to $212,000. The servicing asset is amortized in proportion to the estimated net servicing revenue of the loans.
6. ALLOWANCE FOR LOAN LOSSES
An analysis of changes in the allowance for loan losses is as follows:
7. PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows:
8. DEPOSITS
Deposit accounts by type and weighted average rates are summarized as follows:
Time deposits of $100,000 or more totaled approximately $80,578,000 and $78,651,000 at December 31, 2002 and 2001, respectively. Interest expense on such deposits totaled $3,126,175, $3,996,419 and $3,481,955 for the years ended December 31, 2002, 2001 and 2000 respectively.
Cash paid for interest was:
At December 31, 2002, the scheduled maturities of time certificates of deposits are as follows:
9 CUSTOMER REPURCHASE AGREEMENTS
The following table summarizes information regarding repurchase agreements:
10. FEDERAL HOME LOAN BANK ADVANCES
The following advances are secured by a blanket lien on the Company's investment portfolios:
11. LINE OF CREDIT
The Company has a line of credit with the Federal Reserve Bank of Boston to be collateralized by marketable securities. Additionally, the Company has an "Ideal Way" line of credit with the Federal Home Loan Bank for $9,541,000 at December 31, 2002 and 2001. No amounts were outstanding under these lines at December 31, 2002 and 2001.
12. STOCK-BASED INCENTIVE PLAN AND EMPLOYEE STOCK OWNERSHIP PLAN
Stock Options
Under the Company's based Incentive Plan, the Company may grant options to its directors, officers and employees for up to 497,260 shares of common stock. Both incentive stock options and non- statutory stock options may be granted under the plan. The exercise price of each option equals the market price of the Company's stock on the date of grant and an option's maximum term is ten years. Options vest at 20% per year.
A summary of the status of the Company's stock options for the year ended December 31, 2002 is presented below:
Information pertaining to options outstanding at December 31, 2002 is as follows:
Stock Awards
Under the Company's Recognition and Retention Plan, the Company may grant stock awards to its directors, officers and employees to purchase up to 198,904 shares of common stock. The Company applies APB Opinion No. 25 and related Interpretations in accounting for stock awards. The stock allocations, based on the market price at the date of grant, is recorded as unearned compensation. Unearned compensation is amortized over the vesting period to be benefited. The Company recorded compensation cost related to the stock awards of approximately $109,000 in 2002. No compensation expense was recorded in 2001 as the plan was approved in 2002.
A summary of the status of the Company's stock awards is presented below:
Employee Stock Ownership Plan
The Company has established an Employee Stock Ownership Plan (the ESOP) for the benefit of each employee that has reached the age of 21 and has completed at least 1,000 hours of service in the previous twelve-month period. Compensation expense is recognized as ESOP shares are committed to be released, ESOP shares are considered outstanding for earnings per share calculations based on the value of shares issued. Other ESOP shares are excluded from earnings per share calculations. Dividends declared on allocated ESOP shares are charged to retained earnings. The value of unearned shares to be allocated to ESOP participants for future services not yet performed is reflected as a reduction of stockholders equity.
13. RETIREMENT PLANS AND EMPLOYEE BENEFITS
Pension Plan - The Company provides basic and supplemental pension benefits for eligible employees through the Savings Banks Employees Retirement Association Pension Plan (the "Plan"). Employees must work a minimum of 1,000 hours per year to be eligible for the Plan. Eligible employees become vested in the Plan after five years of service.
The following table provides information for the Plan at December 31:
Net pension cost includes the following components for the years ended December 31:
The following actuarial assumptions were used for the years ended December 31:
Postretirement Benefits - The Company provides postretirement life insurance benefits to employees based on the employee's salary at time of retirement. The accrual of postretirement benefits other than pension expense is made during the years an employee provides service. The following sets forth the funded status:
Supplemental Retirement Benefits - The Company provides supplemental retirement benefits to certain key officers. At December 31, 2002 and 2001, the Company had accrued $1,702,822 and $1,747,695, respectively, relating to these benefits. Amounts charged to expense were $23,150, $180,000 and $190,000 for the years ended December 31, 2002, 2001 and 2000, respectively.
401(k) - Employees are eligible to participate in a 401(k) plan through SBERA. During 2000, the Company began making a matching contribution of 50% with respect to the first 6% of each participant's annual earnings contributed to the plan. The Company's contribution to the plan were $112,906 and $50,494, for the years ended December 31, 2002 and 2001.
14. REGULATORY CAPITAL
The Company and the Bank are subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's and the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 2002 and 2001, 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 Deposit Insurance Corporation categorized the Bank as "well capitalized" under the regulatory framework for prompt corrective action. To be categorized as "well capitalized" the Bank must maintain minimum total risk-based, Tier I risk based and Tier I leverage ratios as set forth in the following. 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 ratios as of December 31, 2002 and 2001 are also presented in the table.
15. INCOME TAXES
The reasons for the differences between the statutory federal income tax rate and the effective rates are summarized below:
Cash paid for income taxes for the years ended December 31, 2002, 2001 and 2000 was $4.6 million, $200,000 and $3.3 million, respectively.
The tax effects of each type of income and expense item that give rise to deferred taxes are as of:
A summary of the change in the net deferred tax asset is as follows:
Massachusetts legislation was signed on March 5, 2003 amending the corporate tax law affecting the treatment of dividends received from Real Estate Investment Trusts (REITs). Dividends from the REIT subsidiary are no longer eligible for a dividends-received deduction. As a result of the enactment of this legislation, the Company has ceased recording the tax benefits associated with the dividend received deduction effective for the 2003 tax year.
In addition to the effect on 2003, the legislation includes a retroactive effective date that reaches back to 2002 and prior years. Accordingly, the Company recorded an additional liability for prior years taxes, including interest (net of any federal and state tax deductions associated with such taxes and interest), relating to the deduction for dividends received from a REIT of approximately $2.9 million in the first quarter of 2003.
The company is reviewing the retroactive effect of the legislation with its legal advisors and intends to defend vigorously its position that the deductibility of dividends received from Elm Street was fully compliant with Massachusetts law at the time.
The federal income tax reserve for loan losses at the Bank's base year is $5.8 million. If any portion of the reserve is used for purposes other than to absorb loan losses, approximately 150% of the amount actually used, limited to the amount of the reserve, would be subject to taxation in the fiscal year in which used. As the Bank intends to use the reserve solely to absorb loan losses, a deferred tax liability of approximately $2.4 million has not been provided.
16. TRANSACTIONS WITH DIRECTORS AND TRUSTEES
The Company has had, and expects to have in the future, loans with its directors, trustees, and executive officers. Such loans, in the opinion of management do not include more than the normal risk of collectibility or other unfavorable features. Following is a summary of activity for such loans:
17. COMMITMENTS AND CONTINGENCIES
In the normal course of business, various commitments and contingent liabilities are outstanding, such as standby letters of credit and commitments to extend credit with off-balance-sheet risk that are not reflected in the consolidated financial statements. Financial instruments with off-balance-sheet risk involve elements of credit, interest rate, liquidity and market risk.
Management does not anticipate any significant losses as a result of these transactions. The following summarizes these financial instruments and other commitments and contingent liabilities at their contract amounts:
The Company uses the same credit policies in making commitments and conditional obligations as it does for on balance sheet instruments.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some commitments expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management's credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties.
Standby letters of credit are written conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. In the ordinary course of business, the Company is party to various legal proceedings, none of which, in the opinion of management, will have a material effect on the Company's consolidated financial position or results of operations.
The Company leases facilities and certain equipment under cancelable and noncancelable leases expiring in various years through the year 2007. Certain of the leases provide for renewal periods for up to fifteen years at the discretion of the Company. Rent expense under operating leases was $179,089, $171,246, and $165,620, for the years ended December 31, 2002, 2001, and 2000, respectively.
Aggregate future minimum rental payments under the terms of the operating leases at December 31, 2002, are as follows:
18. CONCENTRATIONS OF CREDIT RISK
Most of the Company's loans consist of residential and commercial real estate loans located in Western Massachusetts. As of December 31, 2002 and 2001, the Company's residential and commercial related real estate loans represented 72% and 75% of total loans, respectively. The Company's policy for collateral requires that the amount of the loan may not exceed 95% and 80% of the appraised value of the property for residential and commercial real estate, respectively; at the date the loan is granted. For residential loans, in cases where the loan exceeds the percentage, private mortgage insurance is typically obtained for that portion of the loan in excess of 80% of the appraised value of the property.
19. FAIR VALUE OF FINANCIAL INSTRUMENTS
Methods and assumptions for valuing the Company's financial instruments are set forth below for financial instruments that have fair values different than their carrying values. Estimated fair values are calculated based on the value without regard to any premium or discount that may result from concentrations of ownership of a financial instrument, possible tax ramifications or estimated transaction costs.
Cash and Cash Equivalents and Accrued Interest Receivable and Accrued Interest Payable - The carrying amounts of these items are considered to be a reasonable estimate of fair value due to their short-term nature.
Securities and Mortgage Backed Securities - The estimated fair values for securities and mortgage backed securities, except certain state and municipal securities, are based on quoted market prices or dealer quotations. The estimated fair value of certain state and municipal securities, not readily available through market sources other than dealer quotations, are based on quoted market prices of similar instruments, adjusted for differences between the quoted instruments and the instruments being valued.
Federal Home Loan Bank and Other Stock - These investments are carried at cost which approximates fair value.
Loans - Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type, net of the applicable portion of the allowance for loan losses, such as commercial and industrial, commercial real estate, residential mortgage, and consumer. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories.
The fair value of performing loans, except residential mortgage loans, is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The estimate of maturity is based on the Company's historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions. For performing residential mortgage loans, fair value is estimated by discounting contractual cash flows adjusted for prepayment estimates using discount rates based on secondary market sources adjusted to reflect differences in servicing and credit costs.
Estimated fair value for impaired loans is based on recent external appraisals if the loan is collateral dependent. Assumptions regarding credit risk cash flows and discount rates are judgmentally determined using available market information and specific borrower information.
Management has made estimates of fair value discount rates that it believes to be reasonable.
Deposits - The estimated fair value of deposits with no stated maturity, such as noninterest-bearing demands deposits, savings and NOW accounts, and money market and checking accounts, is equal to the amount payable on demand. The estimated fair value of certificates of deposit is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.
Customer Repurchase Agreements - The fair value of these agreements is estimated based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered.
Borrowings - The estimated fair value of borrowings is based upon the discounted value of contractual cash flows. The discount rate is estimated using Federal Home Loan Bank advance rates currently offered for borrowings with similar maturities.
Commitments to Extend Credit - The stated value of commitments to extend credit approximates fair value as the current interest rates for similar commitments do not differ significantly. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. Such differences are not considered significant.
The estimated fair values of the Company's financial instruments at December 31 are as follows:
Limitations - 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 Company's entire holdings of a particular financial instrument. Where quoted market prices are not available, 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. Changes in assumptions could significantly affect the estimates.
20. SEGMENT INFORMATION
The Company has one reportable segment, "Community Banking." All of the Company's activities are interrelated, and each activity is dependent and assessed based on how each of the activities of the Company supports the others. For example, commercial lending is dependent upon the ability of the Bank to fund itself with retail deposits and other borrowings and to manage interest rate and credit risk. This situation is also similar for consumer and residential mortgage lending. Accordingly, all significant operating decisions are based upon analysis of the Company as one operating segment or unit.
The Company operates only in the U.S. domestic market, primarily in Western Massachusetts. For the years ended December 31, 2002, 2001 and 2000, there is no customer that accounted for more than 10% of the Company's revenue.
21. CONDENSED PARENT COMPANY FINANCIAL STATEMENTS
The balance sheets of the Company are as follows:
The statement of cash flows of the Company are as follows:
22. OTHER NONINTEREST EXPENSE
Indirect auto lending processing charges, as a component of other noninterest expense, exceeds 1% of the aggregate of total interest income and noninterest income in 2001 and 2000. It is not shown separately on the consolidated statements of income. Indirect auto lending processing charges of approximately $719,000 and $746,000 were recorded for the years ended December 31, 2001 and 2000, respectively. There is no item that as a component of noninterest expense, exceeds 1% of the aggregate of total interest income and noninterest income in 2002.
23. SUMMARY OF QUARTERLY FINANCIAL INFORMATION (UNAUDITED)