Item 1. Business. - ----------------
Connecticut Bancshares, Inc. (the "Company"), a Delaware corporation, was organized in October 1999 for the purpose of becoming the holding company for Savings Bank of Manchester ("SBM"), (collectively, "the Bank"), upon the conversion of the Bank's former parent holding company, Connecticut Bankshares, M.H.C. ("M.H.C."), from a mutual to stock form of organization (the "Conversion"). The Conversion was completed on March 1, 2000. In connection with the Conversion, the Company sold 10,400,000 shares of its common stock, par value $0.01 per share ("Common Stock") at a purchase price of $10 per share, to depositors of the Bank in a subscription offering. In addition, the Company issued an additional 832,000 shares, representing 8% of the shares sold in the subscription offering, to SBM Charitable Foundation, Inc., a charitable foundation established by the Bank. The Company used 50% of the net proceeds from the conversion to buy all of the common stock of SBM and retained the remaining 50% which were primarily invested in fixed income securities. Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank. The Company, SBM and its wholly-owned subsidiaries are referred to herein as the Bank.
SBM was founded in 1905 as a Connecticut-chartered mutual savings bank. In 1996, SBM converted to stock form as part of M.H.C.'s mutual holding company formation. SBM is regulated by the Connecticut Department of Banking and the Federal Deposit Insurance Corporation. SBM's deposits are insured to the maximum allowable amount by the Bank Insurance Fund of the Federal Deposit Insurance Corporation. SBM has been a member of the Federal Home Loan Bank System since 1977.
The Bank is a traditional savings association that accepts retail deposits from the general public in the areas surrounding its 23 full-service banking offices and uses those funds, together with funds generated from operations and borrowings, to originate residential mortgage loans, commercial loans and consumer loans, primarily home equity loans and lines of credit. The Bank primarily holds the loans that it originates for investment. However, the Bank also sells loans, primarily fixed-rate mortgage loans, in the secondary market, while generally retaining the servicing rights. The Bank also invests in mortgage-backed securities, debt and equity securities and other permissible investments. The Bank's revenues are derived principally from the generation of interest and fees on loans originated and, to a lesser extent, interest and dividends on investment and mortgage-backed securities. The Bank's primary sources of funds are deposits, principal and interest payments on loans and investments and mortgage-backed securities and advances from the Federal Home Loan Bank of Boston.
Pending Acquisition
On February 7, 2001, the Company and First Federal Savings and Loan Association of East Hartford ("First Federal") entered in a definitive agreement (the "Agreement") under which the Company will acquire all of the outstanding common stock of First Federal for cash equal to approximately $110 million. Immediately after the completion of the acquisition, First Federal will be merged into SBM, a wholly-owned subsidiary of the Company. The Board of Directors of the Company expects the transaction to close in the third quarter of 2001. The transaction is subject to approval by the First Federal shareholders and federal and state regulatory agencies.
Under certain circumstances, if the Agreement is terminated by the Company for the reasons set forth in the Agreement before the consummation of the merger, First Federal may be required to pay the Company cash of $4.50 million plus out-of-pocket expenses.
Market Area
The Bank is headquartered in Manchester, Connecticut in Hartford County. The Bank's primary deposit gathering and lending areas are concentrated in the communities surrounding its 23 banking offices located in Hartford, Tolland and Windham Counties.
Hartford County is located in central Connecticut approximately two hours from both Boston and New York City and contains the City of Hartford. The region serves as the governmental and as a financial center of Connecticut. Hartford County has a diversified mix of industry groups, including insurance and financial services, manufacturing, service, government and retail. The major employers in the area include several prominent international and national insurance and manufacturing companies, such as Aetna, Inc., The Hartford Financial Services Group, Inc., United Technologies Corp., Stanley Works, as well as many regional banks and the Connecticut State Government.
Competition
The Bank faces intense competition in attracting deposits and loans in its primary market area. Historically, the Bank's most direct competition for deposits came from commercial and savings banks operating in its primary market area and, to a lesser extent, from other financial institutions, such as brokerage firms, credit unions and insurance companies. Although these entities continue to provide a source of competition for deposits, the Bank faces increasingly significant competition for deposits from the mutual fund industry as customers seek alternative sources of investment for their funds. The Bank also must compete for investors' funds which may be used to purchase short-term money market securities and other corporate and government securities. While the Bank faces competition for loans from the significant number of traditional financial institutions, primarily savings banks and commercial banks in its market area, its most significant competition comes from other financial service providers, such as the mortgage companies and mortgage brokers operating in its primary market area. Additionally, the Bank expects competition to increase as a result of recent regulatory actions and legislative changes, most notably the recent enactment of the Financial Services Modernization Act of 1999. These changes have eased and likely will continue to ease restrictions on interstate banking and entry into the financial services market by non-depository and non- traditional financial services providers, including insurance companies, securities brokerage and underwriting firms, and specialty financial services companies such as internet-based providers.
Lending Activities
General. The types of loans that the Bank may originate are limited by federal and state laws and regulations. Interest rates charged by the Bank on loans are affected principally by the Bank's current asset/liability strategy, the demand for such loans, the supply of money available for lending purposes and the rates offered by competitors. These factors are, in turn, affected by general and economic conditions, monetary policies of the federal government, including the Federal Reserve Board, legislative tax policies and governmental budgetary matters.
Loan Portfolio Analysis. The following table sets forth the composition of the Bank's loan portfolio in dollar amounts and as a percentage of the portfolio at the dates indicated.
(1) Includes residential and commercial real estate loans.
One- to Four-Family Real Estate Loans. The Bank's primary lending activity is to originate loans secured by one- to four-family residences located in its primary market area. At December 31, 2000, $586.54 million, or 58.22%, of the Bank's total loans consisted of one- to four-family mortgage loans. Of the one- to four-family loans outstanding at that date, 50.75% were fixed-rate mortgage loans and 49.25% were adjustable-rate loans.
The Bank originates fixed-rate fully amortizing loans with maturities ranging between ten and 30 years. Management establishes the loan interest rates based on market conditions. The Bank offers mortgage loans that conform to Fannie Mae and Freddie Mac guidelines, as well as jumbo loans, which are presently loans in amounts over $275,000. Fixed-rate conforming loans are generally originated for portfolio. However, the Bank may sell such loans from time to time. Management periodically determines whether or not to sell loans based on changes in prevailing market interest rates. Loans that are sold are generally sold to Freddie Mac, with the servicing rights retained.
Currently, the Bank also offers adjustable-rate mortgage loans, with an interest rate based on the one year Constant Maturity Treasury index, which is adjusted annually at the outset of the loan or which is adjusted annually after a three or five year initial fixed period and with terms of up to 30 years. Interest rate adjustments on such loans are limited to no more than 2% during any adjustment period and 6% over the life of the loan. Adjustable-rate loans may possess a conversion option, whereby the borrower may opt to convert the loan to a fixed interest rate after a predetermined period of time, generally within the first 60 months of the loan term. Included in the Bank's adjustable- rate mortgage loan portfolio are adjustable-rate loans which are originated at an interest rate below the fully indexed rate. During 2000, the Bank originated $16.43 million of these discounted adjustable-rate mortgage loans, or 1.63% of the total loan portfolio, with an average yield of 5.89%. The time period in which such loans will reprice to their fully indexed rate may be longer than the Bank's other fully indexed adjustable-rate loans. However, the Bank's experience, which cannot be guaranteed in future periods, is that these discounted adjustable-rate loans tend to be more stable and less susceptible to prepayment activity in a falling interest rate environment and less subject to default in a rising interest environment.
Adjustable-rate mortgage loans help reduce the Bank's exposure to changes in interest rates. There are, however, unquantifiable credit risks resulting from the potential of increased costs due to changed rates to be paid by borrowers. It is possible that during periods of rising interest rates the risk of default on adjustable-rate mortgage loans may increase as a result of repricing and the increased payments required to be paid by borrowers. In addition, although adjustable-rate mortgage loans allow the Bank to adjust the sensitivity of its asset base to changes in interest rates, the extent of this interest sensitivity is limited by the annual and lifetime interest rate adjustment limits. Because of these considerations, the Bank has no assurance that yields on adjustable-rate mortgage loans will be sufficient to offset increases in the Bank's cost of funds during periods of rising interest rates. The Bank believes these risks, which have not had a material adverse effect on the Bank to date, are generally less than the risks associated with holding fixed-rate loans in its portfolio in a rising interest rate environment.
The Bank underwrites fixed- and variable-rate one- to four-family residential mortgage loans with loan-to-value ratios of up to 97% and 95%, respectively, provided that a borrower obtains private mortgage insurance on loans that exceed 80% of the appraised value or sales price, whichever is less, of the secured property. The Bank also requires fire, casualty, title, hazard insurance and, if appropriate, flood insurance be maintained on all properties securing real estate loans made by the Bank. An independent licensed appraiser generally appraises all properties.
In an effort to provide financing for moderate income and first-time home buyers, the Bank offers FHA and CHFA (Connecticut Housing Finance Authority) loans and has its own First-Time Home Buyer loan program. These programs offer residential mortgage loans to qualified individuals. These loans are offered with adjustable- and fixed-rates of interest and terms of up to 30 years. Such loans may be secured by one- to four-family residential property, in the case of FHA and CHFA loans, and must be secured by a single family owner-occupied unit in the case of First-Time Home Buyer loans. All of these loans are originated using modified underwriting guidelines. FHA loans are closed in the name of SBM and immediately sold on the secondary market to Countrywide Mortgage Company with the loan servicing released. CHFA loans are immediately assigned after closing to the Connecticut Housing Finance Authority with servicing rights retained by the Bank. Countrywide Mortgage and CHFA establish their respective rates and terms upon which such loans are offered. First-Time Home Buyer loans are offered with a
discounted interest rate (approximately 50 basis points) and usually with no application or loan origination fees. All such loans are originated in amounts of up to 97% of the lower of the property's appraised value or the sale price. Private mortgage insurance is required on all such loans.
The Bank also offers to its full-time employees who satisfy certain criteria and the general underwriting standards of the Bank fixed and adjustable-rate mortgage loans with reduced interest rates, which are currently 50 to 100 basis points below the rates offered to the Bank's other customers. The Employee Mortgage Rate is limited to the purchase, construction or refinancing of an employee's owner-occupied primary residence. The Employee Mortgage Rate normally ceases upon termination of employment or if the property no longer is the employee's primary residence. Upon termination of the Employee Mortgage Rate, the interest rate reverts to the contract rate in effect at the time that the loan was extended. All other terms and conditions contained in the original mortgage and note continue to remain in effect. As of December 31, 2000, the Bank had $6.82 million of Employee Mortgage Rate loans, or 0.68% of total loans.
Construction Loans. The Bank originates construction loans to individuals for the construction and acquisition of personal residences. At December 31, 2000, residential construction loans amounted to $5.84 million, or 0.58% of the Bank's total loans. At December 31, 2000, the unadvanced portion of construction loans totalled $5.62 million.
The Bank's residential construction loans generally provide for the payment of interest only during the construction phase, which is usually twelve months. At the end of the construction phase, the loan converts to a permanent mortgage loan. Loans can be made with a maximum loan-to-value ratio of 90%, provided that the borrower obtains private mortgage insurance on the loan if the loan balance exceeds 80% of the appraised value or sales price, whichever is less, of the secured property. At December 31, 2000, the largest outstanding residential construction loan commitment was for $750,000, $3,200 of which was outstanding. This loan was performing according to its terms at December 31, 2000. Construction loans to individuals are generally made on the same terms as the Bank's one- to four-family mortgage loans.
Before making a commitment to fund a residential construction loan, the Bank requires an appraisal of the property by an independent licensed appraiser. The Bank also reviews and inspects each property before disbursing any funds during the term of the construction loan. Loan proceeds are disbursed after each inspection based on the percentage of completion method.
The Bank also originates residential development loans primarily to finance the construction of single-family homes and subdivisions. At December 31, 2000, residential development loans totalled $20.24 million, or 2.01% of the Bank's total loans. These loans are generally offered to experienced builders with whom the Bank has an established relationship. Residential development loans are typically offered with terms of up to 24 months. The maximum loan-to-value limit applicable to these loans is 80% for contract sales and 70% for speculative properties. Construction loan proceeds are disbursed periodically in increments as construction progresses and as inspection by an approved appraiser of the Bank warrants. At December 31, 2000, the Bank's largest residential development loan was a nonperforming loan for $3.68 million secured by a retirement facility located in Central New England. That facility is part of a larger development, that also had a loan which matured on June 30, 1999 in the amount of $563,000 secured by eight residential units. Interest payments were kept current on the latter loan, and the latter loan was repaid in 2000. Proceeds from the sale of units were used to reduce the amount outstanding on the overall lending relationship by $2.05 million in 2000.
The Bank also makes construction loans for commercial development projects. The projects include multi-family, apartment, industrial, retail and office buildings. These loans generally have an interest-only phase during construction and then convert to permanent financing. Disbursement of funds are at the sole discretion of the Bank and are based on the progress of construction. The maximum loan-to-value limit applicable to these loans is 75%. At December 31, 2000, commercial construction loans totalled $7.34 million, or 0.73%, of total loans.
The Bank also originates land loans to local contractors and developers for the purpose of improving the property, or for the purpose of holding or developing the land for sale. Such loans are secured by a lien on the property, are limited to 70% of the lower of the acquisition price or the appraised value of the land and have a term
of up to two years with a floating interest rate based on the Bank's internal base rate. The Bank's land loans are generally secured by property in its primary market area. The Bank requires title insurance and, if applicable, a hazardous waste survey reporting that the land is free of hazardous or toxic waste.
Construction and development financing is generally considered to involve a higher degree of credit risk than long-term financing on improved, owner- occupied real estate. Risk of loss on a construction loan depends largely upon the accuracy of the initial estimate of the property's value at completion of construction compared to the estimated cost (including interest) of construction and other assumptions. If the estimate of construction cost proves to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed in order to protect the value of the property. Additionally, if the estimate of value proves to be inaccurate, the Bank may be confronted with a project, when completed, having a value which is insufficient to assure full repayment.
Commercial and Multi-Family Real Estate Loans. The Bank originates multi- family and commercial real estate loans that are generally secured by five or more unit apartment buildings and properties used for business purposes such as small office buildings, industrial facilities or retail facilities primarily located in the Bank's primary market area. At December 31, 2000, the Bank had $161.58 million in commercial and multi-family real estate loans which amounted to 16.04% of total loans. The Bank's multi-family and commercial real estate underwriting policies provide that such real estate loans may be made in amounts of up to 75% of the appraised value of the property provided such loan complies with the Bank's current loans-to-one-borrower limit, which at December 31, 2000 was $36.63 million. The Bank's multi-family and commercial real estate loans may be made with terms of up to 25 years and are offered with interest rates that adjust periodically and are generally indexed to the one, three or five year Constant Maturity Treasury index. In reaching its decision on whether to make a multi-family or commercial real estate loan, the Bank considers the net operating income of the property, the borrower's expertise, credit history and profitability and the value of the underlying property. In addition, with respect to commercial real estate rental properties, the Bank will also consider the term of the lease and the quality of the tenants. The Bank has generally required that the properties securing these real estate loans have debt service coverage ratios (the ratio of earnings before debt service to debt service) of at least 1.20x. Environmental surveys are generally required for commercial real estate loans. Generally, multi-family and commercial real estate loans made to corporations, partnerships and other business entities require personal guarantees by the principals. The largest multi-family or commercial real estate relationship in the Bank's portfolio was performing with $10.65 million committed of which $7.49 million was outstanding at December 31, 2000. The relationship was secured mainly by office and industrial buildings located in Glastonbury, Berlin, Bloomfield and Avon, Connecticut.
Loans secured by multi-family and commercial real estate properties generally involve larger principal amounts and a greater degree of risk than one- to four-family residential mortgage loans. Because payments on loans secured by multi-family and commercial real estate properties often depend on the successful operation or management of the properties, repayment of such loans may be affected by adverse conditions in the real estate market or the economy. The Bank tries to minimize these risks through its underwriting standards.
Commercial Loans. At December 31, 2000, the Bank had $146.36 million in commercial loans which amounted to 14.53% of total loans. In addition, at such date, the Bank had $63.19 million of unadvanced commercial lines of credit. The Bank makes commercial business loans primarily in its market area to a variety of professionals, sole proprietorships and small businesses. The Bank offers a variety of commercial lending products, including term loans for fixed assets and working capital, revolving lines of credit, letters of credit, and Small Business Administration guaranteed loans. The maximum amount of a commercial business loan is limited by the Bank's loans-to-one-borrower limit which at December 31, 2000, was $36.63 million. Term loans are generally offered with initial fixed rates of interest for one to five years and with terms of up to ten years. Business lines of credit have adjustable rates of interest and are payable on demand, subject to annual review and renewal. Business loans with variable rates of interest adjust on a daily basis and are indexed to the Bank's internal base rate.
When making commercial business loans, the Bank considers the financial statements of the borrower, the Bank's lending history with the borrower, the debt service capabilities of the borrower, the projected cash flows of the business and the value of the collateral. Commercial business loans are generally secured by a variety of collateral, primarily accounts receivable, inventory and equipment, and are supported by personal guarantees. Depending on the collateral used to secure the loans, commercial loan relationships are made in amounts of up to
90% of the value of the collateral securing the loan. The Bank generally does not make unsecured commercial loans.
Unlike residential mortgage loans, which generally are made on the basis of the borrower's ability to make repayment from his or her employment or other income, and which are secured by real property whose value tends to be more easily ascertainable, commercial loans are of higher risk and typically are made on the basis of the borrower's ability to make repayment from the cash flow of the borrower's business. As a result, the availability of funds for the repayment of commercial loans may depend substantially on the success of the business itself. Further, any collateral securing such loans may depreciate over time, may be difficult to appraise and may fluctuate in value. At December 31, 2000, the Bank's largest commercial loan relationship had $6.68 million committed with $5.43 million outstanding and was secured by commercial real estate located in Windham, Connecticut and operating as a mobile home park. This loan was performing according to its original terms at December 31, 2000.
Consumer Loans. The Bank offers a variety of consumer loans, including second mortgage loans and home equity lines of credit, both of which are secured by owner-occupied one- to four-family residences. At December 31, 2000, second mortgage loans and equity lines of credit totalled $55.45 million, or 5.50% of the Bank's total loans and 69.70% of consumer loans. Additionally, at December 31, 2000, the unadvanced amounts of home equity lines of credit totalled $26.90 million. The underwriting standards employed by the Bank for second mortgage loans and equity lines of credit include a determination of the applicant's credit history, an assessment of the applicant's ability to meet existing obligations and payments on the proposed loan and the value of the collateral securing the loan. Home equity lines of credit have adjustable rates of interest which are indexed to the prime rate as reported in The Wall Street Journal. Interest rate adjustments on home equity lines of credit are limited to no more than a maximum of 17%. Generally, the maximum loan-to-value ratio on home equity lines of credit is 90%. A home equity line of credit may be drawn down by the borrower for a period of 10 years from the date of the loan agreement. During this period, the borrower has the option of paying, on a monthly basis, either principal and interest or only the interest. The borrower has to pay back the amount outstanding under the line of credit at the end of a 20 year period. The Bank offers fixed- and adjustable-rate second mortgage loans with terms up to 20 years. The loan-to-value ratios of both fixed-rate and adjustable-rate home equity loans are generally limited to 90%.
The Bank offers fixed-rate automobile loans for new or used vehicles with terms of up to 72 months and loan-to-value ratios of the lesser of the purchase price or the retail value shown in the NADA Used Car Guide. At December 31, 2000, automobile loans totalled $10.38 million, or 1.03% of the Bank's total loans and 13.05% of consumer loans.
Other consumer loans at December 31, 2000 amounted to $13.73 million, or 1.36% of the Bank's total loans and 17.26% of consumer loans. These loans include unsecured personal loans, collateral loans, credit card loans and education loans. Unsecured personal loans generally have a fixed-rate, a maximum borrowing limitation of $25,000 and a maximum term of five years. Collateral loans are generally secured by a passbook account, a certificate of deposit or marketable securities.
Consumer loans entail greater risk than residential mortgage loans, particularly in the case of loans that are unsecured or secured by rapidly depreciating assets such as automobiles. In these cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections depend on the borrower's continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy.
Loans to One Borrower. The maximum amount that the Bank may lend to one borrower is limited by statute. At December 31, 2000, the Bank's statutory limit on loans to one borrower was $36.63 million. At that date, the Bank's largest amount of loans to one borrower, including the borrower's related interests, was $10.65 million committed, of which $7.49 million was outstanding and consisted of ten loans secured by various residential and commercial properties. These loans were performing according to their original terms at December 31, 2000.
Maturity of Loan Portfolio. The following table shows the remaining contractual maturity of the Bank's total loans at December 31, 2000, excluding the effect of future principal prepayments.
(1) Includes residential and commercial real estate loans.
The following table sets forth, at December 31, 2000, the dollar amount of loans contractually due after December 31, 2001, and whether such loans have fixed interest rates or adjustable interest rates.
(1) Includes residential and commercial real estate loans.
Scheduled contractual principal repayments of loans do not reflect the actual life of the loans. The average life of a loan is substantially less than its contractual term because of prepayments. In addition, due-on-sale clauses on loans generally give the Bank the right to declare loans immediately due and payable if, among other things, the borrower sells the real property with the mortgage and the loan is not repaid. The average life of a mortgage loan tends to increase, however, when current mortgage loan market rates are substantially higher than rates on existing mortgage loans and, conversely, tends to decrease when rates on existing mortgage loans are substantially higher than current mortgage loan market rates.
Loan Approval Procedures and Authority. The Bank's lending activities follow written, non-discriminatory, underwriting standards and loan origination procedures established by the Bank's Board of Directors and management. The Bank's policies and loan approval limits are established by management and are approved by the Board of Directors. The Board of Directors has designated certain individuals of the Bank and certain branch managers to consider and approve loans within their designated authority.
All one- to four-family mortgage loans secured by the borrower's primary residence in amounts of up to $500,000 and all residential construction and second mortgage loans and home equity lines of credit in amounts of up to $250,000 may be approved by any two designated individuals. All residential construction and second mortgage loans and home equity lines of credit in excess of $250,000 and up to $500,000 require the approval of the Bank's loan committee. All residential loans in excess of $500,000 and up to $1.00 million require the approval of the Bank's loan committee. All residential loans in excess of $1.00 million require the approval of the Executive Committee of the Board of Directors.
All commercial loans, including commercial real estate loans, multi-family loans, commercial construction and development loans and commercial business loans in amounts of up to $500,000 may be approved by any two of the designated individuals with the appropriate authority. All commercial loans in excess of $500,000 and up to $1.00 million require the approval of the Bank's loan committee; and all commercial loans where an individual loan is in excess of $1.00 million or the aggregate indebtedness exceeds $3.00 million require the approval of the Executive Committee of the Board of Directors.
With regard to consumer loans, automobile loans in amounts of up to $50,000 and unsecured personal loans in amounts of up to $25,000 may be approved by either one or two of the designated individuals depending on the credit score; automobile loans in excess of $50,000 and unsecured personal loans in excess of $25,000 must be approved by the Bank's loan committee. Collateral loans of up to $25,000 may be approved by any branch manager.
Loan Originations, Purchases and Sales. The Bank's lending activities are conducted by its salaried and commissioned loan personnel and through non-bank third-party correspondents. Currently, the Bank uses 17 loan originators who solicit and originate mortgage loans on behalf of the Bank. These loan originators accounted for approximately three quarters of the adjustable-rate and fixed-rate mortgage loans originated by the Bank in 2000. Loan originators are compensated by a commission that is based on product, mortgage type, and new or existing customer relationship. The commission currently ranges from 30 to 60 basis points of the loan amount. All loans originated by the loan originators are underwritten in conformity with the Bank's loan underwriting policies and procedures. At December 31, 2000, the Bank serviced $210.15 million of residential mortgage loans for others.
From time to time, the Bank will purchase loans primarily secured by one- to four-family residential properties located outside of the Bank's primary market area, usually in Fairfield County, Connecticut or in Massachusetts. Purchased loans are underwritten according to the Bank's own underwriting criteria and procedures and are generally purchased without the accompanying servicing rights. Amounts outstanding related to loan purchases totalled $88.22 million at December 31, 2000.
Substantially all of the Bank's adjustable-rate mortgage loans are originated for inclusion in the Bank's loan portfolio. Historically, the Bank originated fixed-rate mortgage loans for sale in the secondary market. However, since 1998 and due to the low demand for adjustable-rate mortgage loans, the Bank has begun to retain for its portfolio a significant portion of fixed-rate mortgage loans. Sales are generally to Freddie Mac, with servicing rights retained. Loan sale decisions are made by the Bank's management and are generally based on prevailing market interest rates and the Bank's asset- liability position.
The following table presents total loans originated, sold, purchased and repaid during the periods indicated.
(1) Includes residential and commercial real estate loans.
Loan Commitments. The Bank issues loan commitments to prospective borrowers on the condition that certain events occur. Commitments are made in writing on specified terms and conditions and are generally honored for up to 60 days from approval. At December 31, 2000, the Bank had loan commitments and unadvanced loans and lines of credit totalling $176.67 million.
Loan Fees. In addition to interest earned on loans, the Bank receives income from fees derived from loan originations, loan modifications, late payments and for miscellaneous services related to its loans. Income from these activities varies from period to period depending upon the volume and type of loans made and competitive conditions. On loans originated by third-party originators, the Bank may pay a premium to compensate an originator for loans where the borrower is paying a higher rate on the loan.
The Bank charges loan origination fees which are calculated as a percentage of the amount borrowed. As required by applicable accounting principles, loan origination fees, discount points and certain loan origination costs are deferred and recognized over the contractual remaining lives of the related loans on a level yield basis. At December 31, 2000, the Bank had approximately $1.20 million of net deferred loan fees. The Bank amortized approximately $301,000 of net deferred loan fees during the year ended December 31, 2000.
Nonperforming Assets, Delinquencies and Impaired Loans. All loan payments are due on the first day of each month. When a borrower fails to make a required loan payment, the Bank attempts to cure the deficiency by contacting the borrower and seeking the payment. A late notice is mailed on the 16/th/ day of the month. In most cases, deficiencies are cured promptly. If a delinquency continues beyond the 30/th/ day of the month, the account is referred to an in- house collector. The Bank generally prefers to work with borrowers to resolve problems, but the Bank will institute foreclosure or other proceedings, as necessary, to minimize any potential loss.
On a monthly basis, management informs the Board of Directors of the amount of loans delinquent for more than 30 days, all loans in foreclosure, and all foreclosed and repossessed property that the Bank owns. The Bank ceases accruing interest on mortgage loans when principal or interest payments are delinquent 90 days or more unless management determines that the loan principal and interest is fully secured and in the process of collection. Once the accrual of interest on a loan is discontinued, all interest previously accrued is reversed against current period interest income once management determines that interest is uncollectible.
On January 1, 1995, the Bank adopted SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," as amended by SFAS No. 118 "Accounting by Creditors for Impairment of a Loan--an amendment to SFAS No. 114." At December 31, 2000 and 1999, the Bank had a $6.77 million and $11.49 million, respectively, recorded investment in impaired loans all of which had no specific allowances.
At December 31, 2000, the Bank's largest residential development loan was a nonperforming loan for $3.68 million secured by a retirement facility located in Central New England. That facility is part of a larger development, that also had a loan which matured on June 30, 1999 in the amount of $563,000 secured by eight residential units. Interest payments were kept current on the latter loan, and the latter loan was repaid in 2000. Proceeds from the sale of units were used to reduce the amount outstanding on the overall lending relationship by $2.05 million in 2000.
The following table sets forth information regarding nonperforming loans, troubled debt restructurings and other real estate owned at the dates indicated.
Interest income that would have been recorded for the years ended December 31, 2000, 1999 and 1998 had nonaccruing loans been current according to their original terms amounted to approximately $568,000, $635,000 and $136,000, respectively. No interest related to these loans was included in interest income in either year.
The following tables set forth the delinquencies in the Bank's loan portfolio as of the dates indicated.
Real Estate Owned. Real estate acquired by the Bank as a result of foreclosure or by deed in lieu of foreclosure is classified as real estate owned until sold. When property is acquired, it is recorded at fair market value at the date of foreclosure, establishing a new cost basis. Holding costs and declines in fair value after acquisition are expensed. At December 31, 2000, the Bank had $125,000 of real estate owned consisting of a one- to four-family residence.
Asset Classification. Banking regulators have adopted various regulations and practices regarding problem assets of savings institutions. Under such regulations, federal and state examiners have authority to identify problem assets during examinations and, if appropriate, require their classification.
There are three classifications for problem assets: substandard, doubtful and loss. Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified as loss is considered uncollectible and of such little value that its continued status as an asset of the institution is not warranted. If an asset or portion thereof is classified as loss, the insured institution establishes specific allowances for loan losses for the full amount of the portion of the asset classified as loss. All or a portion of general loan loss allowances established to cover probable losses related to assets classified substandard or doubtful can be included in determining an institution's regulatory capital, while specific valuation allowances for loan losses generally do
not qualify as regulatory capital. Assets that do not currently expose the insured institution to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses are designated "special mention." The Bank performs an internal analysis of its loan portfolio and assets to classify such loans and assets similar to the manner in which such loans and assets are classified by the federal banking regulators. In addition, the Bank regularly analyzes the losses inherent in its loan portfolio and its nonperforming loans in determining the appropriate level of the allowance for loan losses.
Allowance for Loan Losses. In originating loans, the Bank recognizes that losses will be experienced on loans and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower over the term of the loan, general economic conditions and, in the case of a secured loan, the quality of the security for the loan. The Bank maintains an allowance for loan losses to absorb losses inherent in the loan portfolio. The allowance for loan losses represents management's estimate of probable losses based on information available as of the date of the financial statements. The allowance for loan losses is based on management's evaluation of the collectibility of the loan portfolio, including past loan loss experience, known and inherent risks in the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, and economic conditions.
The loan portfolio and other credit exposures are regularly reviewed by management to evaluate the adequacy of the allowance for loan losses. The methodology for assessing the appropriateness of the allowance includes comparison to actual losses, peer group comparisons, industry data and economic conditions. In addition, the regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses and may require the Bank to make additional provisions for estimated losses based upon judgments different from those of management.
In assessing the allowance for loan losses, loss factors are applied to various pools of outstanding loans and certain unused commitments. The Bank segregates the loan portfolio according to risk characteristics (i.e., mortgage loans, home equity, consumer). Loss factors are derived using the Bank's historical loss experience and may be adjusted for significant factors that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date.
In addition, management assesses the allowance using factors that cannot be associated with specific credit or loan categories. These factors include management's subjective evaluation of local and national economic and business conditions, portfolio concentration and changes in the character and size of the loan portfolio. The allowance methodology reflects management's objective that the overall allowance appropriately reflects a margin for the imprecision necessarily inherent in estimates of expected credit losses.
At December 31, 2000, the Bank had an allowance for loan losses of $11.69 million which represented 1.16% of total loans and 172.68% of nonperforming loans. Although management believes that it uses the best information available to establish the allowance for loan losses, future adjustments to the allowance for loan losses may be necessary and results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making the determinations. Furthermore, while the Bank believes it has established its existing allowance for loan losses consistent with generally accepted accounting principles, there can be no assurance that regulators, in reviewing the Bank's loan portfolio, will not request the Bank to increase its allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above. Any material increase in the allowance for loan losses may adversely affect the Bank's financial condition and results of operations.
The following table presents an analysis of the Bank's allowance for loan losses at and for the periods indicated.
The following table presents the approximate allocation of the allowance for loan losses by loan categories at the dates indicated and the percentage of such amounts to the total allowance and to total loans. Management believes that the allowance can be allocated by category only on an approximate basis. The allocation of the allowance to each category is not indicative of future losses and does not restrict the use of any of the allowance to absorb losses in any category.
Investment Activities
General. Under Connecticut law, the Bank has authority to purchase a wide range of investment securities. As a result of recent changes in federal banking laws, however, financial institutions such as SBM may not engage as principals in any activities that are not permissible for a national bank, unless the Federal Deposit Insurance Corporation has determined that the investments would pose no significant risk to the Bank Insurance Fund and that SBM is in compliance with applicable capital standards. In 1993, the Regional Director of the Federal Deposit Insurance Corporation approved a request by SBM to invest in certain listed stocks and/or registered stocks subject to certain conditions.
The Bank's Board of Directors has the overall responsibility for the Bank's investment portfolio, including approval of the Bank's investment policy, appointment of the Bank's investment adviser and approval of the Bank's investment transactions. All investment transactions are reviewed by the Board on a monthly basis. The Bank's President and/or Chief Financial Officer, or their designees, are authorized to make investment decisions consistent with the Bank's investment policy and the recommendations of the Bank's investment adviser and the Board's Investment Committee. The Investment Committee meets quarterly with the President and Chief Financial Officer in order to review and determine investment strategies.
The Bank's investment policy is designed to complement the Bank's lending activities, provide an alternative source of income through interest, dividends and capital gains, diversify the Bank's assets and improve liquidity while minimizing the Bank's tax liability. Investment decisions are made in accordance with the Bank's investment policy and are based upon the quality of a particular investment, its inherent risks, the composition of the balance sheet, market expectations, the Bank's liquidity, income and collateral needs and how the investment fits within the Bank's interest rate risk strategy. Although the Bank utilizes the investment advisory services of a Boston-based investment firm, management is ultimately and completely responsible for all investment decisions.
The Bank's investment policy divides investments into two categories, fixed income and equity portfolios. The primary objective of the fixed income portfolio is to maintain an adequate source of liquidity sufficient to meet regulatory and operating requirements, and to safeguard against deposit outflows, reduced loan amortization and increased loan demand. The fixed income portfolio primarily includes debt issues, including mortgage-backed and asset-backed securities. Substantially all of the Bank's mortgage-backed securities are issued or guaranteed by agencies of the U.S. Government. Accordingly, they carry lower credit risk than mortgage-backed securities of a private issuer. Asset-backed securities are typically collateralized by the cash flow from a pool of auto loans, credit card receivables, consumer loans and other similar obligations.
The Bank's investment policy permits the Bank to be a party to financial instruments with off-balance sheet risk in the normal course of business in order to manage interest rate risk. The Bank's derivative position is reviewed by the Investment Committee on a quarterly basis. The investment policy authorizes the Bank to be involved in and purchase various types of derivative transactions and products including interest rate swap, cap and floor agreements. At December 31, 1999, the Bank was a party to one interest rate cap agreement with a notional principal amount of $25 million. Under the terms of the cap agreement, the Bank paid a premium totalling $123,000. The cap was sold during first quarter of 2000 resulting in a net gain of $72,000. At December 31, 2000, the Bank was not party to any interest rate swap, cap, or other derivative agreement.
The marketable equity securities portfolio has the objective of producing capital appreciation through long-term investment. Safety of principal and prudent risk taking are of paramount importance. The total market value of the marketable equity securities portfolio, excluding Federal Home Loan Bank stock, is limited by the investment policy to 50% of the SBM's Tier 1 capital. At December 31, 2000, the market value of the marketable equity securities portfolio was $49.14 million or 28.43% of the SBM's Tier 1 capital. At December 31, 2000, the net unrealized gains associated with the marketable equity securities portfolio were $13.92 million. In future periods and subject to market conditions and other factors, the Bank intends to increase its marketable equity securities portfolio through periodic purchases of high quality equity investments. Emphasis will be placed on companies with established records of growth and financial strength.
SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" requires that investments be categorized as "held to maturity," "trading securities" or "available for sale," based on management's intent as to the ultimate disposition of each security. SFAS No. 115 allows debt securities to be classified as "held to maturity" and reported in financial statements at amortized cost only if the reporting entity has the positive intent and ability to hold those securities to maturity. Securities that might be sold in response to changes in market interest rates, changes in the security's prepayment risk, increases in loan demand, or other similar factors cannot be classified as "held to maturity." Debt and equity securities held for current resale are classified as "trading securities." These securities are reported at fair value, and unrealized gains and losses on the securities would be included in earnings. The Bank does not currently use or maintain a trading account or have any investments classified as held to maturity. Debt and equity securities not classified as either "held to maturity" or "trading securities" are classified as "available for sale." These securities are reported at fair value, and unrealized gains and losses on the securities are excluded from earnings and reported, net of deferred taxes, as a separate component of capital. As permitted by SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," the Bank adopted the provisions of SFAS No. 133 on January 1, 2000, earlier than required, and reclassified all held to maturity investments to available for sale.
All of the Bank's debt securities and mortgage-backed and asset-backed securities carry market risk insofar as increases in market rates of interest may cause a decrease in their market value. They also carry prepayment risk insofar as they may be called or repaid before maturity in times of low market interest rates, so that the Bank may have to invest the funds at a lower interest rate. The marketable equity securities portfolio also carries equity price risk in that, if equity prices decline due to unfavorable market conditions or other factors, SBM's capital would decrease.
The following table presents the amortized cost and fair value of the Bank's securities, by type of security, at the dates indicated.
At December 31, 2000, the Bank did not own any investment or mortgage-backed securities of a single issuer, other than U.S. Government and agency securities, which had an aggregate book value in excess of 10% of SBM's capital at that date.
The following presents the activity in the investment securities and mortgage-backed securities portfolios for the periods indicated.
(1) Available for sale securities are presented at market value and held to maturity securities are presented at amortized cost.
The following table presents certain information regarding the carrying 194,042 value, weighted average yields and maturities or periods to repricing of the Bank's debt securities at December 31, 2000.
Deposit Activities and Other Sources of Funds
General. Deposits are the major external source of funds for the Bank's lending and other investment activities. In addition, the Bank also generates funds internally from loan principal repayments and prepayments and maturing investment securities. Scheduled loan repayments are a relatively stable source of funds, while deposit inflows and outflows and loan prepayments are influenced significantly by general interest rates and money market conditions. SBM may use borrowings from the Federal Home Loan Bank of Boston to compensate for reductions in the availability of funds from other sources.
Deposit Accounts. Substantially all of the Bank's depositors reside in Connecticut. The Bank offers a wide variety of deposit accounts with a range of interest rates and terms. The Bank's deposit accounts consist of interest- bearing checking, noninterest-bearing checking, regular savings, money market savings and certificates of deposit. The maturities of the Bank's certificate of deposit accounts range from seven days to five years. In addition, the Bank offers retirement accounts, including IRAs and Keogh accounts and simplified employee pension plan accounts. The Bank also offers commercial business products to small businesses operating within its primary market area. Deposit account terms vary with the principal differences being the minimum balance deposit, early withdrawal penalties, limits on the number of transactions and the interest rate. The Bank reviews its deposit mix and pricing on a weekly basis.
The Bank believes it offers competitive interest rates on its deposit products. The Bank determines the rates paid based on a number of factors, including rates paid by competitors, the Bank's need for funds and cost of funds, borrowing costs and movements of market interest rates. While certificate accounts in excess of $100,000 are accepted by the Bank, and may receive preferential rates, the Bank does not actively seek such deposits as they are more difficult to retain than core deposits. The Bank does not utilize brokers to obtain deposits and at December 31, 2000, had no brokered deposits.
In the unlikely event SBM is liquidated, eligible depositors as of a specific record date will be entitled to full payment of their deposit accounts before any payment is made to the Company as the sole stockholder of the SBM.
The following table presents the deposit activity of the Bank for the periods indicated.
At December 31, 2000, the Bank had $57.76 million in certificate of deposit accounts in amounts of $100,000 or more maturing as follows:
The following table presents information concerning average balances and weighted average interest rates for the periods indicated.
Certificates of Deposit by Rates and Maturities. The following table presents by various rate categories, the amount of certificate accounts outstanding at the dates indicated and the periods to maturity of the certificate accounts outstanding at December 31, 2000.
Borrowings. SBM may use advances from the Federal Home Loan Bank of Boston to supplement its supply of lendable funds and to meet deposit withdrawal requirements. The Federal Home Loan Bank of Boston functions as a central reserve bank providing credit for savings banks and certain other member financial institutions. As a member of the Federal Home Loan Bank of Boston, SBM is required to own capital stock in the Federal Home Loan Bank of Boston and is authorized to apply for advances on the security of the capital stock and certain of its mortgage loans and other assets, principally securities that are obligations of, or guaranteed by, the U.S. Government or its agencies, provided certain creditworthiness standards have been met. Advances are made under several different credit programs. Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based on the financial condition of the member institution and the adequacy of collateral pledged to secure the credit. At December 31, 2000, SBM had the ability to borrow a total of approximately $447.29 million from the Federal Home Loan Bank of Boston. Of the total maximum borrowing capacity SBM had $100.00 million outstanding at December 31, 2000.
Federal banking laws and regulations prohibit a bank from paying interest on commercial checking accounts. However, SBM offers to its commercial customers a transactional repurchase agreement, a form of non-deposit borrowing by SBM, that is designed as a mechanism to offer business customers the functional equivalent of a commercial checking account that pays interest. This account, overseen by an outside agent, is not a FDIC-insured deposit account, but is backed by a security interest in U.S. Government and agency securities at a ratio of approximately 1.10 to 1.00. At December 31, 2000, SBM had such accounts with balances aggregating $105.73 million, which are included in short-term borrowed funds, backed by a security interest of $133.43 million or a ratio of 1.26 to 1.00.
The following table presents certain information regarding SBM's Federal Home Loan Bank advances and short-term borrowed funds at the dates or for the periods indicated.
Subsidiary Activities
The following are descriptions of SBM's wholly owned subsidiaries, which are indirectly owned by the Company.
SBM, Ltd. SBM, Ltd. was organized in February 1983 for the purpose of acquiring and holding real estate acquired by the Bank. In 1990, the purpose changed to acquire, hold and dispose of real estate acquired through foreclosure. At December 31, 2000, SBM, Ltd. held no properties and had no assets.
923 Main, Inc. 923 Main was incorporated in December 1994 for the purpose of maintaining an ownership interest in a third party registered broker-dealer, Infinex Financial Group. Infinex maintains an office at the Bank and offers to customers a complete range of nondeposit investment products, including mutual funds, debt, equity and government securities, retirement accounts, insurance products and fixed and variable annuities. The Bank receives a portion of the commissions generated by Infinex from sales to customers. For the years ended December 31, 2000 and 1999, the Bank received fees of $1.38 million and $1.16 million, respectively, through its relationship with Infinex.
Savings Bank of Manchester Mortgage Company, Inc. SBM Mortgage was established in January 1999 to service and hold loans secured by real property. SBM Mortgage was established and is managed to qualify as a passive investment company for Connecticut income tax purposes. Income earned by a qualifying passive investment company is exempt from Connecticut income tax. Accordingly, no state income taxes were provided in 1999 or 2000.
Savings Bank of Manchester Foundation, Inc.
In 1998, SBM established a private charitable foundation, Savings Bank of Manchester Foundation, Inc. This foundation, which is not a subsidiary of the Company or SBM, provides grants to individuals and not-for-profit organizations within the communities that the Bank serves. In 1998, SBM contributed marketable equity securities with a cost basis and fair market value of $700,000 and $3.00 million, respectively, at the date of contribution and transfer. At December 31, 2000, the foundation had assets of approximately $3.19 million. The foundation's four member Board of Trustees consists of current directors, officers and employees of the Bank. The Bank intends to maintain the foundation, but does not expect to make any further contributions to the foundation in the future.
SBM Charitable Foundation, Inc.
During 2000, the Bank established a second private charitable foundation, SBM Charitable Foundation, Inc. This foundation, which is not a subsidiary of the Company or SBM, provides grants to individuals and not-for-profit organizations within the communities that the Bank serves. In 2000, in connection with the Company's conversion to stock form, the Company contributed 832,000 shares of company stock with a cost basis and fair market value of $8.32 million, at the date of contribution and transfer. At December 31, 2000, the foundation had assets of approximately $15.18 million, consisting primarily of the company stock. The foundation's thirteen member Board of Directors consists of current directors, officers and employees of the Bank. The Bank intends to maintain the foundation, but does not expect to make any further contributions to the foundation in the future.
REGULATION AND SUPERVISION
General
As a savings bank chartered by the State of Connecticut, SBM is extensively regulated under state law by the Connecticut Banking Commissioner ("Commissioner") with respect to many aspects of its banking activities. In addition, as a bank whose deposits are insured by the Federal Deposit Insurance Corporation ("FDIC") through the Bank Insurance Fund ("BIF"), SBM must pay deposit insurance assessments and is examined and supervised by the FDIC. These laws and regulations have been established primarily for the protection of depositors, customers and borrowers of SBM, not its stockholders.
The Bank is also required to file reports with, and otherwise comply with the rules and regulations of, the Office of Thrift Supervision ("OTS"), the Commissioner, and the Securities and Exchange Commission ("SEC") under the federal securities laws. The following discussion of the laws and regulations material to the operations of the Company and SBM is a summary and is qualified in its entirety by reference to such laws and regulations.
SBM and the Company, as a savings and loan holding company, are extensively regulated and supervised. Regulations, which affect the Bank on a daily basis, may be changed at any time, and the interpretation of the relevant law and regulations may also change because of new interpretations by the authorities who interpret those laws and regulations. Any change in the regulatory structure or the applicable statutes or regulations, whether by the Commissioner, the State of Connecticut, the OTS, the FDIC or the U.S. Congress, could have a material impact on the Company and SBM.
Connecticut Banking Laws and Supervision
The Commissioner regulates SBM's internal organization as well as its deposit, lending and investment activities. The approval of the Commissioner is required for, among other things, the establishment of branch offices and business combination transactions. The Commissioner conducts periodic examinations of SBM. The FDIC also regulates many of the areas regulated by the Commissioner and federal law may limit some of the authority provided to SBM by Connecticut law.
Lending Activities. Connecticut banking laws grant banks broad lending authority. With certain limited exceptions, however, total secured and unsecured loans made to any one obligor under this statutory authority may not exceed 10% and 15%, respectively, of the bank's equity capital and reserves for loan and lease losses.
A savings bank may pay cash dividends out of its net profits. For purposes of this restriction, "net profits " means the remainder of all earnings from current operations. Further, the total amount of all dividends declared by a savings bank in any calendar year may not exceed the sum of the bank's net profits for the year in question combined with its retained net profits from the preceding two calendar years. Additionally, earnings appropriated to reserves for loan losses and deducted for federal income tax purposes are not available for cash dividends without the payment of taxes at then current income tax rates on the amount used. Federal law also prevents an institution from paying dividends or making other capital distributions if doing so would cause it to become "undercapitalized." The FDIC may limit a savings bank's ability to pay dividends. No dividends may be paid to the Bank's stockholders if such dividends would reduce stockholders' equity below the amount of the liquidation account required by the Connecticut conversion regulations.
Branching Activities. Any Connecticut-chartered bank meeting certain statutory requirements may, with the Commissioner's approval, establish and operate branches in any town or towns within the state and establish mobile branches.
Investment Activities. Connecticut law requires the board of directors of each Connecticut bank to adopt annually an investment policy to govern the types of investments the bank makes, and to periodically review the bank's adherence to its investment policy. The investment policy must establish standards for the making of prudent investments and procedures for divesting investments no longer deemed consistent with the bank's investment policy. In recent years, Connecticut law has expanded bank investment activities.
Connecticut banks may invest in debt securities and debt mutual funds without regard to any other liability to the Connecticut bank of the maker or issuer of the debt securities and debt mutual funds, if the debt securities and debt mutual funds are rated in the three highest rating categories or otherwise deemed to be a prudent investment, and so long as the total amount of debt securities and debt mutual funds of any one issuer will not exceed 25% of the bank's total equity capital and reserves for loan and lease losses and the total amount of all its investments in debt securities and debt mutual funds will not exceed 25% of its assets. In addition, a Connecticut bank may invest in certain government and agency obligations according to the same standards as debt securities and debt mutual funds except without any percentage limitation.
Similarly, Connecticut banks may invest in equity securities and equity mutual funds without regard to any other liability to the Connecticut bank of the issuer of equity securities and equity mutual funds, so long as the total amount of equity securities and equity mutual funds of any one issuer will not exceed 25% of the bank's total equity capital and reserves for loan and lease losses and the total amount of the bank's investment in all equity securities and equity mutual funds will not exceed 25% of its assets.
Powers. In recent years, Connecticut law has expanded bank powers. Connecticut law permits Connecticut banks to sell insurance and fixed and variable rate annuities if licensed to do so by the Connecticut Insurance Commissioner. Connecticut law authorizes a new form of Connecticut bank known as an uninsured bank. An uninsured bank has the same powers as banks except that it does not accept retail deposits and is not required to insure deposits with the FDIC. With the prior approval of the Commissioner, Connecticut banks are also authorized to engage in a broad range of activities related to the business of banking, or that are financial in nature or that are permitted under the Bank Holding Company Act ("BHCA") or the Home Owners' Loan Act ("HOLA"), both
federal statutes, or the regulations promulgated as a result of these statutes. Connecticut banks are also authorized to engage in any activity permitted for a national bank or a federal savings association upon filing notice with the Commissioner unless the Commissioner disapproves the activity.
Recent Legislation. Connecticut legislation enacted in 2000 has expanded the authority of the Commissioner. The Commissioner now has the authority to waive provisions of Connecticut's regulations governing mutual to stock conversions that are inconsistent with the regulations of the OTS.
Assessments. Connecticut banks may be required to pay annual assessments to the Connecticut Department of Banking to fund the department's operations. The general assessments are paid pro rata based upon a bank's asset size. No assessments were paid by SBM for the year ended December 31, 2000.
Enforcement. Under Connecticut law, the Commissioner has extensive enforcement authority over Connecticut banks and, under certain circumstances, affiliated parties, insiders, and agents. The Commissioner's enforcement authority includes: cease and desist orders, fines, receivership, conservatorship, removal of officers and directors, emergency closures, dissolution, and liquidation.
Federal Regulations
Capital Requirements. Under FDIC regulations, federally insured state-chartered banks that are not members of the Federal Reserve System ("state non-member banks"), such as SBM, are required to comply with minimum leverage capital requirements. For an institution determined by the FDIC to not be anticipating or experiencing significant growth and to be in general a strong banking organization, rated composite 1 under the Uniform Financial Institutions Ranking System (the rating system) established by the Federal Financial Institutions Examination Council, the minimum capital leverage requirement is a ratio of Tier 1 capital to total assets of 3%. For all other institutions, the minimum leverage capital ratio is not less than 4%. Tier 1 capital is the sum of common stockholders' equity, noncumulative perpetual preferred stock (including any related surplus) and minority investments in certain subsidiaries, less intangible assets (except for certain servicing rights and credit card relationships).
The FDIC regulations require state non-member banks to maintain certain levels of regulatory capital in relation to regulatory risk-weighted assets. The ratio of regulatory capital to regulatory risk-weighted assets is referred to as the bank's "risk-based capital ratio." Risk-based capital ratios are determined by allocating assets and specified off-balance sheet items to four risk-weighted categories ranging from 0% to 100%, with higher levels of capital being required for the categories perceived as representing greater risk. For example, under the FDIC's risk-weighting system, cash and securities backed by the full faith and credit of the U.S. government are given a 0% risk weight, loans secured by one- to four-family residential properties generally have a 50% risk weight and commercial loans have a risk weighting of 100%.
State non-member banks must maintain a minimum ratio of total capital to risk-weighted assets of at least 8%, of which at least one-half must be Tier 1 capital. Total capital consists of Tier 1 capital plus Tier 2 or supplementary capital items, which include allowances for loan losses in an amount of up to 1.25% of risk-weighted assets, cumulative preferred stock and certain other capital instruments, and a portion of the net unrealized gain on equity securities. The includable amount of Tier 2 capital cannot exceed the amount of the institution's Tier 1 capital.
The Federal Deposit Insurance Corporation Improvement Act (the "FDICIA") required each federal banking agency to revise its risk-based capital standards for insured institutions to ensure that those standards take adequate account of interest-rate risk, concentration of credit risk, and the risk of nontraditional activities, as well as to reflect the actual performance and expected risk of loss on multi-family residential loans. The FDIC, along with the other federal banking agencies, has adopted a regulation providing that the agencies will take into account the exposure of a bank's capital and economic value to changes in interest rate risk in assessing a bank's capital adequacy.
As a savings and loan holding company regulated by the OTS, the Company is not, under current law,
subject to any separate regulatory capital requirements.
Standards for Safety and Soundness. As required by statute, the federal banking agencies adopted final regulations and Interagency Guidelines Establishing Standards for Safety and Soundness to implement safety and soundness standards. The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. The guidelines address internal controls and information systems, internal audit system, credit underwriting, loan documentation, interest rate risk exposure, asset growth, asset quality, earnings and compensation, and fees and benefits. If the appropriate federal banking agency determines that an institution fails to meet any standard prescribed by the guidelines, the agency may require the institution to submit to the agency an acceptable plan to achieve compliance with the standard.
Investment Activities
Since the enactment of the FDICIA, all state-chartered FDIC insured banks, including savings banks, have generally been limited to activities as principal and equity investments of the type and in the amount authorized for national banks, notwithstanding state law. The FDICIA and the FDIC permit exceptions to these limitations. For example, state chartered banks, such as SBM, may, with FDIC approval, continue to exercise state authority to invest in common or preferred stocks listed on a national securities exchange or the Nasdaq National Market and in the shares of an investment company registered under the Investment Company Act of 1940, as amended. In addition, the FDIC is authorized to permit such institutions to engage in state authorized activities or investments that do not meet this standard (other than non-subsidiary equity investments) for institutions that meet all applicable capital requirements if it is determined that such activities or investments do not pose a significant risk to the BIF. The FDIC has adopted revisions to its regulations governing the procedures for institutions seeking approval to engage in such activities or investments. All non-subsidiary equity investments, unless otherwise authorized or approved by the FDIC, must have been divested by December 19, 1996, under a FDIC-approved divestiture plan, unless such investments were grandfathered by the FDIC. SBM received grandfathered authority from the FDIC in March 1993 to invest in listed stocks and/or registered shares. However, the maximum permissible investment is 100% of Tier 1 capital, as specified by the FDIC's regulations, or the maximum amount permitted by Connecticut law, whichever is less. Such grandfathered authority may be terminated upon the FDIC's determination that such investments pose a safety and soundness risk to SBM or if SBM converts its charter or undergoes a change in control. As of December 31, 2000, SBM had $49.58 million of securities which were held under such grandfathering authority. The Gramm-Leach-Bliley Act of 1999 (the "GLB Act") specifies that a nonmember bank may control a subsidiary that engages in activities as principal that would only be permitted for a national bank to conduct in a "financial subsidiary" if the bank meets specified conditions and deducts its investment in the subsidiary for regulatory capital purposes.
Interstate Branching
Beginning June 1, 1997, the Interstate Branching Act (the "IBA") permitted the responsible federal banking agencies to approve merger transactions between banks located in different states, regardless of whether the merger would be prohibited under the law of the two states. The IBA also permitted a state to "opt in" to the provisions of the IBA before June 1, 1997, and permitted a state to "opt out" of the provisions of the IBA by adopting appropriate legislation before that date. In 1995, Connecticut affirmatively "opted-in" to the provisions of the IBA. Accordingly, beginning June 1, 1997, the IBA permitted a bank, such as SBM, to acquire branches in a state other than Connecticut unless the other state had opted out of the IBA. The IBA also authorizes de novo branching into another state if the host state enacts a law expressly permitting out of state banks to establish such branches within its borders.
Prompt Corrective Regulatory Action
Federal law requires, among other things, that federal bank regulatory authorities take "prompt corrective action" with respect to banks that do not meet minimum capital requirements. For these purposes, the law establishes five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized.
The FDIC has adopted regulations to implement the prompt corrective action legislation. An institution is deemed to be "well capitalized" if it has a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 6% or greater and a leverage ratio of 5% or greater. An institution is "adequately capitalized" if it has a total risk-based capital ratio of 8% or greater, a Tier 1 risk-based capital ratio of 4% or greater, and generally a leverage ratio of 4% or greater. An institution is "undercapitalized" if it has a total risk-based capital ratio of less than 8%, a Tier 1 risk-based capital ratio of less than 4%, or generally a leverage ratio of less than 4%. An institution is deemed to be "significantly undercapitalized" if it has a total risk-based capital ratio of less than 6%, a Tier 1 risk-based capital ratio of less than 3%, or a leverage ratio of less than 3%. An institution is considered to be "critically undercapitalized" if it has a ratio of tangible equity (as defined in the regulations) to total assets that is equal to or less than 2%. As of December 31, 2000, SBM was a "well capitalized" institution.
"Undercapitalized" banks must adhere to growth, capital distribution (including dividend) and other limitations and are required to submit a capital restoration plan. A bank's compliance with such plan is required to be guaranteed by any company that controls the undercapitalized institution in an amount equal to the lesser of 5% of the institution's total assets when deemed undercapitalized or the amount necessary to achieve the status of adequately capitalized. If an "undercapitalized" bank fails to submit an acceptable plan, it is treated as if it is "significantly undercapitalized." "Significantly undercapitalized" banks must comply with one or more of a number of additional restrictions, including but not limited to an order by the FDIC to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cease receipt of deposits from correspondent banks or dismiss directors or officers, and restrictions on interest rates paid on deposits, compensation of executive officers and capital distributions by the parent holding company. "Critically undercapitalized" institutions are subject to additional measures including, subject to a narrow exception, the appointment of a receiver or conservator within 270 days after it obtains such status.
Transactions with Affiliates
Under current federal law, transactions between depository institutions and their affiliates are governed by Sections 23A and 23B of the Federal Reserve Act (the "FRA"). In a holding company context, at a minimum, the parent holding company of a savings bank and any companies which are controlled by such parent holding company are affiliates of the savings bank. Generally, Section 23A limits the extent to which the savings bank or its subsidiaries may engage in "covered transactions" with any one affiliate to 10% of such savings bank's capital stock and surplus, and contains an aggregate limit on all such transactions with all affiliates to 20% of capital stock and surplus. The term "covered transaction" includes, among other things, the making of loans or other extensions of credit to an affiliate and the purchase of assets from an affiliate. Section 23A also establishes specific collateral requirements for loans or extensions of credit to, or guarantees, acceptances on letters of credit issued on behalf of an affiliate. Section 23B requires that covered transactions and a broad list of other specified transactions be on terms substantially the same, or no less favorable, to the savings bank or its subsidiary as similar transactions with nonaffiliates.
Further, Section 22(h) of the FRA restricts an institution with respect to loans to directors, executive officers, and principal stockholders ("insiders"). Under Section 22(h), loans to insiders and their related interests may not exceed, together with all other outstanding loans to such persons and affiliated entities, the institution's total capital and surplus. Loans to insiders above specified amounts must receive the prior approval of the board of directors. Further, under Section 22(h), loans to directors, executive officers and principal shareholders must be made on terms substantially the same as offered in comparable transactions to other persons, except that such insiders may receive preferential loans made under a benefit or compensation program that is widely available to the bank's employees and does not give preference to the insider over the employees. Section 22(g) of the FRA places additional limitations on loans to executive officers.
Enforcement
The FDIC has extensive enforcement authority over insured savings banks, including SBM. 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 unsafe or unsound practices.
The FDIC has authority under Federal law to appoint a conservator or receiver for an insured bank under limited circumstances. The FDIC is required, with certain exceptions, to appoint a receiver or conservator for an insured state non-member bank if that bank was "critically undercapitalized" on average during the calendar quarter beginning 270 days after the date on which the institution became "critically undercapitalized." The FDIC may also appoint itself as conservator or receiver for an insured state non-member institution under specific circumstances on the basis of the institution's financial condition or upon the occurrence of other events, including: (1) insolvency; (2) substantial dissipation of assets or earnings through violations of law or unsafe or unsound practices; (3) existence of an unsafe or unsound condition to transact business; and (4) insufficient capital, or the incurring of losses that will deplete substantially all of the institution's capital with no reasonable prospect of replenishment without federal assistance.
Insurance of Deposit Accounts
The FDIC has adopted a risk-based insurance assessment system. The FDIC assigns an institution to one of three capital categories based on the institution's financial condition consisting of (1) well capitalized, (2) adequately capitalized or (3) undercapitalized, and one of three supervisory subcategories within each capital group. The supervisory subgroup to which an institution is assigned is based on a supervisory evaluation provided to the FDIC by the institution's primary federal regulator and information which the FDIC determines to be relevant to the institution's financial condition and the risk posed to the deposit insurance funds. An institution's assessment rate depends on the capital category and supervisory category to which it is assigned. Assessment rates for insurance fund deposits currently range from 0 basis points for the strongest institution to 27 basis points for the weakest. BIF members are also required to assist in the repayment of bonds issued by the Financing Corporation in the late 1980's to recapitalize the Federal Savings and Loan Insurance Corporation. For the year ended December 31, 2000, the total FDIC assessment was $187,000. The FDIC is authorized to raise the assessment rates. The FDIC has exercised this authority several times in the past and may raise insurance premiums in the future. If such action is taken by the FDIC, it could have an adverse effect on the earnings of SBM.
The FDIC may terminate insurance of deposits if it finds that the institution is in an unsafe or unsound condition to continue operations, has engaged in unsafe or unsound practices, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. The management of SBM does not know of any practice, condition or violation that might lead to termination of deposit insurance.
Federal Reserve System
The FRB regulations require depository institutions to maintain non-interest-earning reserves against their transaction accounts (primarily NOW and regular checking accounts). The FRB regulations generally require that reserves be maintained against aggregate transaction accounts as follows: for that portion of transaction accounts aggregating $42.8 million or less (which may be adjusted by the FRB) the reserve requirement is 3%; and for accounts greater than $42.8 million, the reserve requirement is $1.28 million plus 10% (which may be adjusted by the FRB between 8% and 14%) against that portion of total transaction accounts in excess of $42.8 million. The first $5.5 million of otherwise reservable balances (which may be adjusted by the FRB) are exempted from the reserve requirements. SBM is in compliance with these requirements.
Federal Home Loan Bank System
SBM is a member of the Federal Home Loan Bank System, which consists of 12 regional Federal Home Loan Banks. The FHLB provides a central credit facility primarily for member institutions. SBM, as a member of the FHLB of Boston, is required to acquire and hold shares of capital stock in the FHLB of Boston in an amount at least equal to 1% of the aggregate principal amount of its unpaid residential mortgage loans and similar obligations at the beginning of each year, or 1/20 of its advances (borrowings) from the FHLB of Boston, whichever is greater. SBM was in compliance with this requirement with an investment in FHLB of Boston stock at December 31, 2000 of $6.65 million. At December 31, 2000, SBM had $100.00 million in FHLB of Boston advances.
The Federal Home Loan Banks are required to provide funds for certain purposes including contributing funds for affordable housing programs. These requirements could reduce the amount of dividends that the Federal Home Loan Banks pay to their members and result in the Federal Home Loan Banks imposing a higher rate of interest on advances to their members. For the years ended December 31, 2000 and 1999, cash dividends from the FHLB of Boston to SBM amounted to approximately $460,000 and $383,000, respectively. Further, there can be no assurance that the impact of recent or future legislation on the Federal Home Loan Banks will not also cause a decrease in the value of the FHLB stock held by SBM.
Holding Company Regulation
Federal law allows a state savings bank that qualifies as a "Qualified Thrift Lender," discussed below, to elect to be treated as a savings association for purposes of the savings and loan holding company provisions of the HOLA. Such election allows its holding company to be regulated as a savings and loan holding company by the OTS rather than as a bank holding company by the FRB. SBM has made such election and the Company is a nondiversified savings and loan holding company within the meaning of the HOLA. The Company is registered with the OTS and has adhered to the OTS' regulations and reporting requirements. In addition, the OTS may examine and supervise the Company and the OTS has enforcement authority over the Company and its non-savings institution subsidiaries. Among other things, this authority permits the OTS to restrict or prohibit activities that are determined to be a serious risk to the subsidiary savings institution. Additionally, SBM is required to notify the OTS at least 30 days before declaring any dividend to the Company. By regulation, the OTS may restrict or prohibit the Company from paying dividends.
The Company is a unitary savings and loan holding company under federal law because SBM is its only insured subsidiary immediately after the Conversion. Formerly, a unitary savings and loan holding company was not restricted as to the types of business activities in which it could engage, provided that its subsidiary savings association continued to be a qualified thrift lender. The GLB Act, however, restricts unitary savings and loan holding companies not existing or applied for before May 4, 1999 to activities permissible for a financial holding company as defined under the legislation, including insurance and securities activities, and those permitted for a multiple savings and loan holding company as described below. The Company is subject to these activities restrictions. Upon any non-supervisory acquisition by the Company of another savings association as a separate subsidiary, the Company would become a multiple savings and loan holding company. The HOLA limits the activities of a multiple savings and loan holding company and its non-insured institution subsidiaries primarily to activities permissible for bank holding companies under Section 4(c)(8) of the BHCA, provided the prior approval of the OTS is obtained, and to other activities authorized by OTS regulation. Multiple savings and loan holding companies are generally prohibited from acquiring or retaining more than 5% of a non-subsidiary company engaged in activities other than those permitted by the HOLA.
The HOLA prohibits a savings and loan holding company from, directly or indirectly, acquiring more than 5% of the voting stock of another savings association or savings and loan holding company or from acquiring such an institution or company by merger, consolidation or purchase of its assets, without prior written approval of the OTS. In evaluating applications by holding companies to acquire savings associations, the OTS considers the financial and managerial resources and future prospects of the Company and the institution involved, the effect of the acquisition on the risk to the insurance funds, the convenience and needs of the community and competitive factors.
The OTS is prohibited from approving any acquisition that would result in a multiple savings and loan holding company controlling savings institutions in more than one state, except: (1) interstate supervisory acquisitions by savings and loan holding companies; and (2) the acquisition of a savings institution in another state if the laws of the state of the target savings institution specifically permit such acquisitions.
To be regulated as a savings and loan holding company by the OTS (rather than as a bank holding company by the FRB), SBM must qualify as a Qualified Thrift Lender ("QTL"). To qualify as a QTL, the Bank must maintain compliance with the test for a "domestic building and loan association," as defined in the Internal Revenue Code, or with a QTL Test. Under the QTL Test, a savings institution is required to maintain at least 65% of its "portfolio assets" (total assets less: (1) specified liquid assets up to 20% of total assets; (2) intangibles,
including goodwill; and (3) the value of property used to conduct business) in certain "qualified thrift investments" (primarily residential mortgages and related investments, including certain mortgage-backed and related securities) in at least 9 months out of each 12 month period. As of December 31, 2000 SBM maintained in excess of 75% of its portfolio assets in qualified thrift investments. SBM also met the QTL test in each of the last 12 months and, therefore, met the QTL Test.
Connecticut Holding Company Regulations. Under Connecticut banking law, no person may acquire beneficial ownership of more than 10% of any class of voting securities of a Connecticut-chartered bank, or any bank holding company of such a bank, without prior notification of, and lack of disapproval by, the Commissioner. Similar restrictions apply to any person who holds in excess of 10% of any such class and desires to increase its holdings to 25% or more of such class. The Commissioner will evaluate the effect of the acquisition on the financial condition of the bank or bank holding company. The Commissioner will also disapprove the acquisition if the bank or holding company to be acquired has been in existence for less than five years, unless the Commissioner waives this requirement, or if the acquisition would result in the acquirer controlling 30% or more of the total amount of deposits in insured depository institutions in Connecticut.
Federal Securities Laws
Upon the completion of the Conversion in March, 2000, the Company's common stock became registered with the SEC under the Exchange Act. The Company now observes the reporting, proxy solicitation, insider trading restrictions and other requirements under the Securities Exchange Act of 1934.
The registration under the Securities Act of 1933 of shares of the common stock issued in the Conversion did not cover the resale of such shares. Shares of the common stock purchased by persons who are not affiliates of the Company may be resold without registration. The resale restrictions of Rule 144 under the Securities Act govern shares purchased by an affiliate of the Company. If the Company meets the current public information requirements of Rule 144 under the Securities Act, each affiliate of the Company who complies with the other conditions of Rule 144 (including those that require the affiliate's sale to be aggregated with those of other persons) would be able to sell in the public market, without registration, a number of shares not to exceed, in any three-month period, the greater of (1) 1% of the outstanding shares of the Company or (2) the average weekly volume of trading in such shares during the preceding four calendar weeks. Provision may be made in the future by the Company to permit affiliates to have their shares registered for sale under the Securities Act under specific circumstances.
FEDERAL AND STATE TAXATION OF INCOME
Federal Income Taxation
General. The Company and SBM report their income on a calendar year basis using the accrual method of accounting. The federal income tax laws apply to the Company and SBM in the same manner as to other corporations with some exceptions, including particularly SBM's reserve for bad debts discussed below. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to SBM or the Company. The Bank's federal income tax returns have been either audited or closed under the statute of limitations through tax year 1996. For its 2000 tax year, the Bank's maximum federal income tax rate was 35%.
Bad Debt Reserves. For fiscal years beginning before December 31, 1995, thrift institutions which qualified under certain definitional tests and other conditions of the Internal Revenue Code of 1986, as amended, were permitted to use certain favorable provisions to calculate their deductions from taxable income for annual additions to their bad debt reserve. A reserve could be established for bad debts on qualifying real property loans, generally secured by interests in real property improved or to be improved, under the percentage of taxable income method or the experience method. The reserve for nonqualifying loans was computed using the experience method.
Federal legislation enacted in 1996 repealed the reserve method of accounting for bad debts and the percentage of taxable income method for tax years beginning after 1995 and require savings institutions to recapture or take into income certain portions of their accumulated bad debt reserves. Approximately $12.56 million of SBM's accumulated bad debt reserves would not be recaptured into taxable income unless SBM makes a "non-dividend distribution" to the Company as described below.
Distributions. If SBM makes "non-dividend distributions" to the Company, they will be considered to have been made from SBM's unrecaptured tax bad debt reserves, including the balance of its reserves as of December 31, 1987, to the extent of the "non-dividend distributions," and then from SBM's supplemental reserve for losses on loans, to the extent of those reserves, and an amount based on the amount distributed, but not more than the amount of those reserves, will be included in SBM's taxable income. Non-dividend distributions include distributions in excess of SBM's current and accumulated earnings and profits, as calculated for federal income tax purposes, distributions in redemption of stock, and distributions in partial or complete liquidation. Dividends paid out of SBM's current or accumulated earnings and profits will not be so included in SBM's taxable income.
The amount of additional taxable income triggered by a non-dividend is an amount that, when reduced by the tax attributable to the income, is equal to the amount of the distribution. Therefore, if SBM makes a non-dividend distribution to the Company, approximately one and one-half times the amount of the distribution not in excess of the amount of the reserves would be includable in income for federal income tax purposes, assuming a 35% federal corporate income tax rate. SBM does not intend to pay dividends that would result in a recapture of any portion of its bad debt reserves.
Connecticut Taxation
The Bank is subject to the Connecticut corporation business tax. The Bank is eligible to file a combined Connecticut corporation business tax return and will pay the regular corporation business tax (income tax).
The Connecticut corporation business tax is based on the federal taxable income before net operating loss and special deductions of the Bank and makes certain modifications to federal taxable income to arrive at Connecticut taxable income. Connecticut taxable income is multiplied by the state tax rate (7.5% for 2000 and thereafter) to arrive at Connecticut income tax.
In May 1998, the State of Connecticut enacted legislation permitting the formation of passive investment company subsidiaries by financial institutions. This legislation exempts qualifying passive investment companies from the Connecticut corporation business tax and excludes dividends paid from a passive investment company
from the taxable income of the parent financial institution. SBM's formation of a passive investment company in January 1999 eliminated the state income tax expense of the Bank for 1999 and 2000. The Bank expects the passive investment company will eliminate substantially all state income taxes of the Bank going forward.
Item 2.
Item 2. Properties. - ------------------
Properties
The Bank currently conducts its business through its main office located in Manchester, Connecticut, and 22 other full-service banking offices. The Bank believes that its facilities are adequate to meet its present and immediately foreseeable needs.
Route 66
(1) The Bank owns the building and leases the land and only owns the building as long as the lease is in effect. (2) The Bank maintains a license to possess the property. Generally, the holder of a license has less property rights than the possessor of a leasehold interest. The license has no expiration date. (3) The Bank owns seventeen commercial condominiums, which were all acquired at various times between 1990 and 2000. (4) The Bank possesses this property on a month-to-month basis.
Item 3.
Item 3. Legal Proceedings. - -------------------------
Periodically, there have been various claims and lawsuits involving the Bank, such as claims to enforce liens, condemnation proceedings on properties in which the Bank holds security interests, claims involving the making and servicing of real property loans and other issues incident to the Bank's business. The Bank is not a party to any pending legal proceedings that it believes would have a material adverse effect on the financial condition or operations of the Bank.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders. - ------------------------------------------------------------
None.
PART II
Item 5.
Item 5. Market for the Registrant's Common Equity and Related Stockholder - ------------------------------------------------------------------------- Matters. - -------
The Company's Common Stock has been traded on the Nasdaq National Market under the symbol "SBMC". The stock began trading on March 2, 2000. The following table indicates the high and the low last sale prices of the Common Stock for the past year as reported by the Nasdaq National Market.
Quarter Ended High Low ------------------------------------ -------- --------
March 31, 2000 (since March 1, 2000) $ 10.81 $ 9.81 June 30, 2000 14.69 10.75 September 30, 2000 18.94 15.00 December 31, 2000 18.94 16.50
As of March 9, 2001, the most recent practicable date, the closing price of the Company's Common Stock as reported by Nasdaq, was $21.00 per share and the Company had approximately 5,350 holders of record.
The Company has not paid any dividends to date. The Board of Directors of the Company has the authority to declare dividends on the Common Stock, subject to statutory and regulatory requirements. In the future, the Board of Directors intends to consider a policy of paying cash or stock dividends on the Common Stock. However, no decision has been made with respect to the payment of dividends. Declarations of dividends by the Board of Directors, if any, will depend upon a number of factors, including investment opportunities available to the Company or SBM, capital requirements, regulatory limitations, the Company's and SBM's financial condition and results of operations, tax considerations and general economic conditions. No assurances can be given, however, that any dividends will be paid or, if commenced, will continue to be paid.
The Company is subject to the requirements of Delaware law, which generally limits dividends to an amount equal to the excess of the net assets of the Company (the amount by which total assets exceed total liabilities) over its statutory capital or, if there is no excess, to its net profits for the current and/or immediately preceding fiscal year.
Item 6.
Item 6. Selected Consolidated Financial Data. - --------------------------------------------
The Bank has derived the following selected consolidated financial and other data of the Bank in part from the Bank's consolidated financial statements and notes appearing elsewhere in this Form 10-K.
(1) Nonperforming assets consist of nonperforming loans, troubled debt restructurings and other real estate owned. (2) Asset Quality and Regulatory Capital Ratios are end of period ratios. Except for end of period ratios, all ratios are based on average monthly balances during the indicated periods and are annualized for interim periods. (3) Average interest rate spread represents the difference between the average yield on interest-earning assets and the average rate paid on interest-bearing liabilities. (4) Net interest margin represents net interest income as a percentage of average interest-earning assets. (5) Nonperforming loans consist of nonperforming loans and loans 90 days or more past due and accruing interest.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results - -------------------------------------------------------------------------------- of Operations. - -------------
The following discussion should be read in conjunction with the "Selected Consolidated Financial Data" and the Consolidated Financial Statements and related Notes appearing elsewhere in this Form 10-K.
General
The Company has only one subsidiary, SBM. The Bank's results of operations depend primarily on net interest income, which is the difference between the interest income earned on its interest-earning assets, such as loans and securities, and the interest expense on its interest-bearing liabilities, such as deposits and borrowings. The Bank also generates noninterest income primarily from fees charged on customers' accounts and fees earned on activities such as investment services provided through a third party registered broker-dealer. Gains on the sales of securities is another source of noninterest income. The Bank's noninterest expenses primarily consist of employee compensation and benefits, occupancy expense, advertising and other operating expenses. The Bank's results of operations are also affected by general economic and competitive conditions, notably changes in market interest rates, government policies and regulations. SBM exceeded all of its regulatory capital requirements at December 31, 2000.
Pending Acquisition
On February 7, 2001, the Bank and First Federal entered in an Agreement under which the Bank will acquire all of the outstanding common stock of First Federal for cash equal to approximately $110.00 million. Immediately after the completion of the acquisition, First Federal will be merged into SBM. The Board of Directors of the Company expects the transaction to close in the third quarter of 2001. The transaction is subject to approval by First Federal shareholders and federal and state regulatory agencies.
Under certain circumstances, if the Agreement is terminated by the Bank for the reasons set forth in the Agreement before the consummation of the merger, First Federal may be required to pay the Bank cash of $4.50 million plus out-of-pocket expenses.
Operating Strategy
The Bank is an independent, community-oriented savings bank, delivering quality customer service and offering a wide range of deposit, loan and investment products to its customers. In recent years, the Bank's strategy has been to enhance profitability by emphasizing the origination of commercial real estate and business loans, increasing sources of noninterest income and by improving operating efficiencies while managing its capital position and limiting its credit and interest rate risk exposure. To accomplish these objectives, the Bank has sought to:
. Operate as a full service community bank.
. Provide superior customer service and innovative products by expanding delivery systems through the opening of new branch offices, offering a bank-issued credit card and debit card services, establishing Internet banking and a call center that provides interest rate information for deposit and loan products and other customer services.
. Increase fee income by providing merchant credit card processing services.
. Originate high quality commercial real estate and commercial business loans which increase the yields earned on its overall loan portfolio, without incurring unacceptable credit risk.
. Control credit risk by focusing on the origination of single- family, owner-occupied residential mortgage loans and consumer loans, consisting primarily of home equity loans and lines of credit.
. Monitor and control interest rate risk primarily by selling longer- term fixed-rate loans as market interest rate conditions dictate, by investing in shorter-term mortgage-backed securities and by selectively using off-balance sheet hedging transactions.
. Invest funds in excess of loan demand primarily in mortgage-backed securities, investment grade debt and equity mutual funds.
. Invest in technological enhancements to increase productivity and efficiency.
Comparison of Financial Condition at December 31, 2000 and 1999
Total assets increased $175.51 million, or 14.27%, to $1.40 billion at December 31, 2000 as compared to $1.23 billion at December 31, 1999. The increase was due primarily to a $80.17 million increase in securities, a $58.50 million increase in the loan portfolio, and a $38.12 million increase in cash and cash equivalents of which $37.89 million of the increase was in short-term investments. The growth in assets was funded primarily by the net proceeds from the Company's public offering in March 2000, and increases in deposits of $26.78 million, Federal Home Loan Bank advances of $16.00 million, and short-term borrowed funds of $10.68 million. The increase in securities and short-term investments reflect management's strategy of investing the net proceeds from the public offering as well as implementing its funds management and asset liability policies. Gross loans increased due to strong loan demand in most sectors of the loan portfolio. The Bank continues to offer an increased array of loan products to an expanded market area using aggressive marketing efforts.
Deposits totalled $933.37 million at December 31, 2000, an increase of $26.78 million, or 2.95%, compared to $906.59 million at December 31, 1999. The deposit growth reflects an increase of $18.80 million, or 16.68%, in NOW accounts, a $17.98 million, or 35.04%, increase in demand deposits and a $10.51 million, or 2.33%, decrease in certificates of deposit. The substantial increases in NOW accounts and demand deposits reflect aggressive marketing of both retail and commercial deposit accounts as well as the Bank's commitment to controlling interest costs by not necessarily increasing rates on certificates of deposits. In addition, the Bank continues to market a short-term commercial transactional repurchase agreement (repo) account to commercial businesses. These repo accounts increased $11.11 million, or 11.74%, from $94.62 million as of December 31, 1999
to $105.73 million as of December 31, 2000.
Nonperforming assets totaled $6.90 million at December 31, 2000 compared to $12.09 million at December 31, 1999, representing an decrease of $5.19 million, or 42.93%. The decrease is primarily due to the full repayment of a nonperforming commercial real estate loan for $4.29 million during April 2000. Nonperforming loans and troubled debt restructurings as a percentage of total gross loans decreased to 0.67% at December 31, 2000 from 1.21% at December 31, 1999. Nonperforming assets and troubled debt restructurings as a percentage of total assets decreased to 0.49% at December 31, 2000 from 0.98% at December 31, 1999. Other real estate owned declined $479,000, or 79.30%, from $604,000 as of December 31, 1999 to $125,000 as of December 31, 2000 due to property sales.
Total capital increased $109.32 million, or 88.72%, to $232.54 million at December 31, 2000 compared to $123.22 million at December 31, 1999. The increase was primarily due to the proceeds after expenses from the public offering of $90.51 million, common stock issued to SBM Charitable Foundation, Inc. of $8.32 million, net income of $7.38 million and an increase of $2.25 million in accumulated other comprehensive income related to unrealized gains on available for sale securities at December 31, 2000.
Comparison of Operating Results for the Years Ended December 31, 2000 and 1999
Net Income. Net income decreased by $1.37 million, or 15.66%, to $7.38 million for 2000 from $8.75 million for 1999. Net income for the year 2000 was reduced by an expense of $8.32 million ($5.41 million after tax) relating to the Bank's establishment of SBM Charitable Foundation, Inc. in March 2000 in connection with the Bank's conversion from the mutual holding company form of organization to the stock holding company form or organization. Due to the timing of the conversion, earnings per share for the twelve months ended December 31, 2000 and prior periods are not presented. Earnings per diluted share were $0.59 for the ten months ended December 31, 2000.
Operating earnings, which exclude securities gains and the previously discussed expense of $8.32 million net of related tax effect, were significantly higher than the prior year's levels. Operating earnings, net of tax, for the year ended December 31, 2000 were $12.50 million, a $4.64 million, or 59.03%, increase compared to $7.86 million for the year ended December 31, 1999. Net interest income after provision for loan losses increased $9.69 million, or 24.01%, to $50.05 million for 2000 compared to $40.36 million for 1999. Service charges and fees and other noninterest income increased $2.11 million, or 28.21%, from $7.48 million for 1999 to $9.59 million for 2000. Noninterest expense, excluding the foundation expense of $8.32 million in 2000, increased $4.37 million, or 11.94%, to $40.96 million for 2000 from $36.59 million for 1999.
Net Interest Income. Net interest income increased $9.79 million, or 23.61%, to $51.25 million for 2000 from $41.46 million for 1999. The increase was primarily a result of higher interest income from an increase in the level of interest earning assets, primarily funded by the net proceeds from the public offering. Loan and investment yields also increased in 2000 as compared to 1999. These increases were partially offset by higher levels of FHLB advances and short-term borrowed funds, and an increased cost of funds. Interest and dividend income increased $16.26 million, or 20.63%, to $95.09 million for 2000 from $78.83 million for 1999. The average yield on interest earning assets increased 17 basis points to 7.26% in 2000 from 7.09% in 1999, primarily due to an increase in general market interest rates. Interest income on loans increased $9.73 million, or 14.65%, to $76.16 million for 2000 compared to $66.43 million for 1999. The increase was primarily due to a $111.93 million increase in the average balance of loans outstanding, as well as a 12 basis point increase in the average yield on loans primarily due to a higher interest rate environment. Interest and dividend income from investment securities and other interest-bearing assets increased $6.52 million, or 52.54%, to $18.93 million for 2000 compared to $12.41 million for 1999. The increase in interest and dividend income from investment securities and other interest-bearing assets was due to an increase in the average balance of $86.39 million, or 37.22%, to $318.52 million for the year ended December 31, 2000, as more funds were available for investment due to the net proceeds received from the public offering. Investment and other interest-bearing asset yields increased 59 basis points in 2000 as compared to 1999 due to an increase in general market interest rates.
Interest expense increased $6.47 million, or 17.31%, to $43.84 million for 2000 from $37.37 million for
1999. The increase reflects an increase in expense on advances from Federal Home Loan Bank of $3.17 million, deposits of $2.37 million and short-term borrowed funds of $923,000. Interest expense on advances from Federal Home Loan Bank increased primarily due to increased average volumes of $46.93 million as well as higher costs of 30 basis points. Interest expense on deposits and escrow increased primarily due to higher costs of certificates of deposit of 41 basis points and savings and money market accounts of 28 basis points. Interest expense on short-term borrowed funds, primarily represented by commercial transactional repurchase agreements, increased primarily due to increased average volumes of $21.39 million as well as higher costs of 25 basis points. The average cost of funds for the Bank increased 30 basis points from 3.81% in 1999 to 4.11% in 2000, mainly due to higher general market interest rates.
Provision for Loan Losses. The provision for loan losses was $1.20 million for 2000 compared to $1.10 million for 1999. The allowance for loan losses was 1.16% of total loans and 172.68% of nonperforming loans at December 31, 2000 compared to 1.12% and 92.44%, respectively, at December 31, 1999. The increase in the allowance for loan losses as a percentage of nonperforming loans is primarily due to the full repayment of a nonperforming commercial real estate loan for $4.29 million during April 2000.
The Bank's management assesses the adequacy of the allowance for loan losses based on known and inherent risks in the loan portfolio and upon management's continuing analysis of the quality of the loan portfolio. While management believes that, based on information currently available, the Bank's allowance for loan losses is sufficient to cover probable losses inherent in its loan portfolio at this time, no assurances can be given that the Bank's level of allowance for loan losses will be sufficient to cover loan losses incurred by the Bank or that future adjustments to the allowance for loan losses will not be necessary if economic and other conditions differ substantially from the economic and other conditions used by management to determine the current level of the allowance for loan losses. Management may increase its level of allowance for loan losses as a percentage of total loans and nonperforming loans if the level of commercial, multi-family, construction or consumer lending as a percentage of total loan portfolio increases. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses. Such agencies may require the Bank to provide additions to the allowance based on judgments different from those of management.
Noninterest Income. Noninterest income increased $863,000, or 9.17%, to $10.27 million for 2000 as compared to $9.41 million for 1999. Fee income from service charges and account fees was $7.65 million in 2000 compared to $5.87 million for 1999. The increase in fee income and service charges is primarily due to the introduction of debit cards and increases in merchant services and individual account fees. Other fee income increased from $1.62 million in 1999 to $1.94 million in 2000 and reflects increases in fees earned from brokerage services. Gains on sales of securities and mortgage loans declined $927,000 and $314,000 respectively, as management chose to retain higher yielding securities and loans rather than sell them and obtain one-time gains.
Noninterest Expense. Noninterest expense increased $12.69 million, or 34.68%, to $49.28 million for 2000 from $36.59 million for 1999. The increase is primarily due to a contribution of securities to SBM Charitable Foundation, Inc. of $8.32 million in 2000. Other increases in noninterest expense include $1.69 million, or 39.30%, for pension and other employee benefits, $1.09 million, or 7.17%, for salaries, and $1.02 million, or 26.91%, for fees and services. Pension and other employee benefits increased due to new qualified and non-qualified benefit plans formed in connection with the public offering. Salaries increased due to annual wage increases and additional staffing necessary for a public entity. Fees and services increased due to director, legal and other fees of the new public holding company, other legal fees and debit card service fees.
Provision for Income Taxes. The provision for income taxes decreased $767,000, or 17.31%, to $3.66 million for 2000 from $4.43 million for 1999. The effective tax rates were 33.14% for 2000 and 33.58% for 1999. The decrease in tax expense is due to a decrease in taxable income.
Comparison of Operating Results for the Years Ended December 31, 1999 and 1998
Net Income. Net income decreased by $564,000, or 6.05%, to $8.75 million for 1999 from $9.32 million for 1998. The decrease was primarily attributable to reduced gains on the sale of mortgages and securities. Net interest income after provision for loan losses increased $1.90 million, or 4.94%, to $40.36 million for 1999 compared to $38.46 million for 1998. Service charges and fees and other noninterest income increased slightly from $7.12 million to $7.48 million for 1999. Noninterest expense decreased $506,000 or 1.36%, to $36.59 million for 1999 from $37.09 million for 1998. Noninterest expense for 1998 included a $3.00 million expense relating to the establishment of Savings Bank of Manchester Foundation, Inc. in June 1998. Excluding the effect of this charge, noninterest expense would have increased in 1999 by $2.49 million, or 7.30%, primarily due to an increase in salaries expense in 1999.
Net Interest Income. Net interest income increased by $1.80 million, or 4.54%, to $41.46 million for 1999 from $39.66 million for 1998. This increase was primarily a result of higher interest income from an increase in the level of average interest-earning assets and a decrease in the average rate paid on interest-bearing liabilities due to a lower interest rate environment, particularly during the early part of 1999. Interest and dividend income increased $1.97 million, or 2.56%, to $78.83 million for 1999 from $76.86 million for 1998. The average yield on interest-earning assets declined 45 basis points to 7.09% in 1999 from 7.54% in 1998 primarily due to a decline in market interest rates. Interest income on loans increased $1.92 million, or 2.98%, to $66.43 million for 1999, compared to $64.51 million for the prior year. This increase was due to a $76.18 million increase in the average balance of loans outstanding, partially offset by a 47 basis point decrease in the average yield on loans primarily due to a lower interest rate environment. Interest and dividend income from investment securities increased $62,000, or 0.50%, from $12.35 million for 1998 to $12.41 million for 1999. The increase in interest and dividend income from investment securities was primarily due to an increase in yield in mortgage-backed securities of 9 basis points.
Interest expense increased $174,000, or 0.47%, to $37.37 million for 1999 from $37.20 million for 1998. The increase is due to an increase in expense for FHLB advances of $1.27 million, and short-term borrowed funds of $432,000, partially offset by a decrease in expense for deposits and escrow of $1.53 million. FHLB advances increased due to higher average advances of $22.23 million, partially offset by lower interest cost of 22 basis points. Short-term borrowed funds, represented primarily by commercial transactional repurchase agreements increased due to $12.61 million higher average agreements and higher interest cost of 6 basis points. Interest expense on deposits and escrow decreased due to a lower cost of funds of 29 basis points. Bankwide cost of funds decreased 21 basis points from 4.02% in 1998 to 3.81% in 1999.
Provision for Loan Losses. The provision for loan losses was $1.10 million for 1999 compared to $1.20 million for 1998. For 1999, management decreased the provision by 50% for the first half of the year, reflecting improved delinquency trends during 1998 and early 1999. The addition of two large commercial real estate relationships to nonaccrual status by September 1999 required an additional provision during the last two quarters of 1999. The allowance for loan losses was 1.12% of total loans and 92.44% of nonperforming loans at December 31, 1999 compared to 1.30% and 694.55% respectively, at December 31, 1998. The changes reflect the addition of two large commercial real estate relationships to nonperforming loan status during 1999.
Noninterest Income. Noninterest income totalled $9.41 million and $12.16 million for 1999 and 1998, respectively. The decline was due to the combined effect of decreased securities gains and reduced gains from the sale of mortgages to the secondary market. The decline in securities gains is due to the gains realized in 1998 relating to the formation of Savings Bank of Manchester Foundation, Inc. and the contribution of appreciated securities to the foundation. The decreased gains from the sale of mortgages to the secondary market reflect management's decision to retain fixed rate mortgages in order to grow the loan portfolio. During 1999, the Bank sold $19.20 million of loans in the secondary market, realizing gains of $551,000, compared with sales of $94.33 million in 1998, which generated gains of $2.42 million. Fee income from service charges and account fees was
$5.87 million in 1999 compared with $5.45 million in 1998. Other fee income declined slightly from $1.68 million in 1998 to $1.62 million in 1999 and reflects fees earned from brokerage services and rental income properties in other real estate owned. Other real estate owned declined from $1.76 million at the end of 1998 to $604,000 at the end of 1999.
Noninterest Expense. Noninterest expense decreased $506,000, or 1.36%, to $36.59 million for 1999 from $37.09 million for 1998. The decrease is attributable to the expense in 1998 relating to the charitable contribution of $3.00 million of appreciated securities to Savings Bank of Manchester Foundation, Inc. Excluding this charitable contribution, 1998 noninterest expense would have been $34.09 million and the increase in 1999 would have been $2.49 million, or 7.30%. Increases in noninterest expense include $1.10 million, or 7.81%, for salaries, $575,000, or 17.86%, for fees and services, and $338,000, or 8.54%, for pension and other employee benefits. These increases reflect an increase in commercial lending staff, continued development of the Merchant Services Center program, the Year 2000 project, and increased benefit costs. Marketing expenses increased $120,000, or 7.23%, due to a new television advertising program.
Provision for Income Taxes. The provision for income taxes increased $218,000 to $4.43 million for 1999, compared to $4.21 million for 1998. During 1998, the Bank created Savings Bank of Manchester Foundation, Inc. and donated appreciated securities to the foundation, resulting in a lower 1998 effective tax rate. During 1999, the Bank formed the Savings Bank of Manchester Mortgage Company, Inc. which eliminated the Bank's Connecticut state income tax liability for 1999. The effective tax rates were 33.58% and 31.11% for 1999 and 1998, respectively.
Average Blances, Interest and Average Yields/Cost
The following table presents certain information for the periods indicated regarding average balances of assets and liabilities, as well as the total dollar amounts of interest income from average interest-earning assets and interest expense on average interest-bearing liabilities and the resulting average yields and costs. The yields and costs for the periods indicated are derived by dividing income or expense by the average balances of assets or liabilities, respectively, for the periods presented. Average balances were derived from average daily balances. The yields and rates include fees which are considered adjustments to yields.
(1) Balances are net of undisbursed proceeds of construction loans in process and include nonperforming loans. (2) Includes mortgage-backed securities available for sale at market value and held to maturity at amortized cost. (3) Includes investment securities available for sale at market and held to maturity at cost. (4) Interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average cost of interest- bearing liabilities. (5) Net interest margin represents net interest income as a percentage of average interest-earning assets.
Rate/Volume Analysis
The following table presents the effects of changing rates and volumes on the interest income and interest expense of the Bank. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior volume). For purposes of this table, changes attributable to changes in both rate and volume, which cannot be segregated, are shown in the rate/volume column.
Liquidity and Capital Resources
Liquidity is the ability to meet current and future financial obligations of a short-term nature. The Bank further defines liquidity as the ability to respond to the needs of depositors and borrowers as well as maintaining the flexibility to take advantage of investment opportunities. Primary sources of funds consist of deposit inflows, loan repayments, maturities, paydowns, and sales of investment and mortgage-backed securities and borrowings from the Federal Home Loan Bank of Boston. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit outflows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition.
The Bank's primary investing activities are (1) originating residential one-to four-family mortgage loans and, to a lesser extent, commercial business and real estate loans, multi-family loans, single-family construction loans, home equity loans and lines of credit and consumer loans and (2) investing in mortgage-backed securities, asset-backed securities, U.S. Government and agency obligations, corporate equity securities and debt obligations. These activities are funded primarily by proceeds from the public offering, principal and interest payments on loans, maturities of securities, deposit growth and Federal Home Loan Bank of Boston advances. The Company received net proceeds (after expenses) from the issuance of stock in connection with the conversion of $90.51 million. The Company used 50% of the net proceeds from the conversion to buy all of the common stock of SBM and retained the remaining 50%, which amount was primarily invested in fixed income securities. During the years ended December 31, 2000 and 1999, the Bank purchased and originated loans totaling $307.37 million and $388.78 million, respectively. During the years ended December 31, 2000 and 1999, the Bank purchased mortgage-backed securities, asset-backed securities, U.S. Government and agency obligations, corporate equity securities and debt obligations of $209.95 million and $64.03 million, respectively. The Bank experienced a net increase in total deposits of $26.78 million and $51.47 million for the years ended December 31, 2000 and 1999, respectively, primarily as a result of retail and commercial programs designed to attract deposits. Deposit flows are affected by the overall level of interest rates, the interest rates and products offered by the Bank and its local competitors and other factors. Principal payments on loans, maturities of securities, and net Federal Home Loan Bank advances were $228.25 million, $31.77 million, and $16.00 million, respectively, for the year ended December 31, 2000. Principal payments on loans, maturities of securities, and net Federal Home Loan Bank advances were $236.87 million, $25.31 million, and $39.00 million, respectively, for the year ended December 31, 1999. The Bank closely monitors its liquidity position on a daily basis. If the Bank should require funds beyond its ability to generate them internally, additional sources of funds are available through Federal Home Loan Bank advances and through repurchase agreement borrowing facilities.
Outstanding commitments for all loans and unadvanced construction loans and lines of credit totalled $176.67 million at December 31, 2000. Management of the Bank anticipates that it will have sufficient funds available to meet its current loan commitments. Certificates of deposit that are scheduled to mature in one year or less from December 31, 2000 totalled $331.85 million. The Bank relies primarily on competitive rates, customer service, and long-standing relationships with customers to retain deposits. Occasionally, the Bank will also offer special competitive promotions to its customers to increase retention and promote deposit growth. Based upon the Bank's historical experience with deposit retention, management believes that, although it is not possible to predict future terms and conditions upon renewal, a significant portion of such deposits will remain with the Bank.
SBM must satisfy various regulatory capital requirements administered by the federal banking agencies including a risk-based capital measure. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk-weighted assets by assigning balance sheet assets and off-balance sheet items to broad risk categories. At December 31, 2000, SBM exceeded all of its regulatory capital requirements with leverage capital of $172.85 million, or 12.82% of average assets, which is above the required level of $53.93 million, or 4.00%, and risk-based capital of $184.54 million, or 19.63% of risk weighted assets, which is above the required level of $75.22 million, or 8.00%. SBM is considered "well capitalized" under regulatory guidelines.
On February 7, 2001, the Bank and First Federal entered into a definitive agreement under which the Bank would acquire all of the outstanding common stock of First Federal for cash equal to approximately $110 million. Immediately after the completion of the acquisition, First Federal will be merged into SBM. The Board of
Directors of the Company expects the transaction to close in the third quarter of 2001. The transaction is subject to approval by First Federal shareholders and federal and state regulatory agencies. Management expects the effect of the transaction on the liquidity and capital of the Bank to be significant. Management will continue to plan for and monitor the liquidity and capital of the Bank as the transaction closing date draws nearer. Management is considering several options to fund the acquisition.
Impact of Inflation and Changing Prices
The consolidated financial statements and related data presented in this Form 10-K have been prepared in conformity with accounting principles generally accepted in the United States, which require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of money over time due to inflation. Unlike many industrial companies, substantially all of the assets and liabilities of the Bank are monetary in nature. As a result, interest rates have a more significant impact on the Bank's performance than the general level of inflation. Over short periods of time, interest rates may not necessarily move in the same direction or in the same magnitude as inflation.
Impact of New Accounting Standards
In September 2000, the Financial Accounting Standards Board ("FASB") issued SFAS No. 140 "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities - a Replacement of FASB Statement No. 125". SFAS No. 140 replaces SFAS No. 125. Certain requirements related to SFAS No. 140 are effective beginning March 31, 2001. The Bank does not expect that these additional requirements will have an effect on the Bank's consolidated financial position or results of operations.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. The statement requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the statement of operations and requires that an entity formally document, designate and assess the effectiveness of transactions that receive hedge accounting. The Bank early adopted SFAS No. 133, as amended by SFAS No. 137, "Accounting for Derivatives and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133" and SFAS No. 138, "Accounting for Certain Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133 - An Amendment of FASB Statement No. 133" on January 1, 2000. In connection with the adoption, the Bank reclassified all held to maturity investments to available for sale as allowed by SFAS No. 133. As of December 31, 2000, the Bank did not have any derivative instruments.
On December 3, 1999, the SEC released Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition in Financial Statements." The guidelines set forth in SAB No. 101 stipulate that revenue should not be recognized until it is realized or realizable and earned. The Bank adopted SAB No. 101 on January 1, 2000 without effect on the Bank's consolidated financial condition or results of operations since the Bank's previous revenue recognition policies complied with SAB No. 101.
Effective January 1, 1999, the Bank adopted SFAS No. 134 "Accounting for Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise, an amendment of SFAS No. 65." This statement requires that after the securitization of mortgage loans held for sale, an entity engaged in mortgage banking activities shall classify the resulting mortgage-backed securities or other retained interests based on its ability and intent to sell or hold those investments. The adoption did not have any effect on the Bank's consolidated financial condition or results of operations.
Item 7A.
Item 7A. Quantitative and Qualitative disclosure About Market Risk - ------------------------------------------------------------------
Qualitative Aspects of Market Risk
The Bank's most significant form of market risk is interest rate risk. The principal objectives of the Bank's interest rate risk management are to evaluate the interest rate risk inherent in certain balance sheet account, determine the level of risk appropriate given its business strategy, operating environment, capital and liquidity requirements and performance objectives, and manage the risk consistent with its established policies. The Bank has an Asset/Liability Committee, responsible for reviewing its asset/liability policies and interest rate risk position, which meets quarterly and reports trends and interest rate risk position to the Executive Committee of the board of Directors and the Board of Directors. The extent of the movement of interest rates is an uncertainty that could have a negative impact on the earnings of the Bank. In recent years, the Bank has managed interest rate risk by:
(1) emphasizing the origination of adjustable-rate loans and selling longer term fixed-rate loans as market interest rate conditions dictate;
(2) originating variable rate commercial real estate loans and prime rate commercial business loans;
(3) emphasizing shorter-term consumer loans including home equity lines of credit indexed to the prime rate, as reported in The Wall Street Journal;
(4) maintaining a high quality securities portfolio that provides adequate liquidity and flexibility to take advantage of opportunities that may arise from fluctuations in market interest rates, the overall maturity and duration of which is monitored in relation to the repricing of its loan portfolio;
(5) promoting lower cost liability accounts such as demand deposits and business repurchase accounts; and
(6) using Federal Home Loan Bank advances to better structure maturities of its interest rate sensitive liabilities.
SBM's market risk also includes equity price risk. SBM's marketable equity securities portfolio had gross unrealized gains of $15.20 million and gross unrealized losses of $1.28 million at December 31, 2000 which are included, net of taxes, in accumulated other comprehensive income, a separate component of the SBM's capital. If equity security prices decline due to unfavorable market conditions or other factors, SBM's capital would decrease.
The Bank's investment policy authorizes it to be a party to financial instruments with off-balance sheet risk in the normal course of business to reduce its exposure to fluctuations in interest rates. These financial instruments include interest rate cap agreements. Interest rate cap agreements generally involve the payment of a premium in return for cash receipts if interest rates rise above or fall below a specified interest rate level. Payments are based on a notional principal amount. Caps generally are not readily available for time periods longer than five years. The Bank's objective in using interest rate caps is to reduce risk associated with adverse rate volatility while enabling the Bank to benefit from favorable interest rate movements. All counter-parties to cap arrangements must be preapproved by the Bank's Executive Committee and reported to its Investment Committee. At December 31, 2000, the Bank had no derivative instruments.
Quantitative Aspects of Market Risk
The matching of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are "interest rate sensitive" and by monitoring a bank's interest rate sensitivity "gap." An asset or liability is said to be interest rate sensitive within a specific time period if it will mature or reprice within that time period. The interest rate sensitivity gap is defined as the difference between the amount of interest-earning assets maturing or repricing within a specific time period and the amount of interest-bearing liabilities maturing or repricing within that same time period. At December 31, 2000, the Bank's one-year gap position, the difference between the amount of interest-earning assets maturing or repricing within one year and interest- bearing liabilities maturing or repricing
within one year, was 3.67%. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. A gap is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets. Accordingly, during a period of rising interest rates, an institution with a positive gap position would be in a better position to invest in higher yielding assets which, consequently, may result in the yield on its assets increasing at a pace more closely matching the increase in the cost of its interest-bearing liabilities than if it had a negative gap. During a period of falling interest rates, an institution with a positive gap would tend to have its assets repricing at a faster rate than one with a negative gap which, consequently, may tend to restrain the growth of, or reduce, its net interest income.
The following table sets forth the amount of interest-earning assets and interest-bearing liabilities outstanding at December 31, 2000, which are anticipated by the Bank, based upon certain assumptions, to reprice or mature in each of the future time periods shown. Except as stated below, the amount of assets and liabilities shown which reprice or mature during a particular period were determined in accordance with the earlier of term to repricing or the contractual maturity of the asset or liability. The table sets forth an approximation of the projected repricing of assets and liabilities at December 31, 2000, on the basis of contractual maturities, anticipated prepayments, and scheduled rate adjustments within a series of time intervals. For residential adjustable-rate, and fixed-rate loans, prepayment rates were assumed to range from 8% to 24% annually. Mortgage-backed securities were assumed to prepay at a rate of 11% annually. Investment securities, which include callable federal agency obligations, are presented based on stated maturities. Money market accounts were assumed to reprice at 40%, 30%, 20%, 10% and 0%, respectively, for each of the following periods: one year, one to two years, two to three years, three to five years, and over five years. Savings accounts were assumed to reprice at 10%, 10%, 10%, 20% and 50%, respectively, for each of the following periods: one year, one to two years, two to three years, three to five years, and over five years. NOW accounts were assumed to reprice at 15%, 15%, 15%, 30%, and 25%, respectively, for each of the following periods: one year, one to two years, two to three years, three to five years, and over five years. Short term borrowed funds were assumed to reprice at 40%, 30%, 20%, 10%, and 0%, respectively, for each of the following periods: one year, one to two years, two to three years, three to five years, and over five years. Prepayment rates can have a significant impact on the Bank's estimated gap. While the Bank believes such assumptions to be reasonable, there can be no assurance that assumed prepayment rates and repricing rates will approximate actual future loan repayment and deposit withdrawal activity.
(1) Includes available for sale at market value. (2) Includes federal funds sold. (3) Includes Federal Home Loan Bank stock.
As of December 31, 2000, the Bank's estimated exposure as a percentage of estimated net interest income for the next twelve and twenty-four month periods is as follows:
Based on the scenario above, net income would be adversely affected (within the Bank's internal guidelines) in both the twelve and twenty-four month periods in a declining rate environment and positively affected (within the Bank's internal guidelines) in both the twelve and twenty-four month periods in a rising rate environment. For each percentage point change in net interest income, the effect on net income would be $361,000, assuming a 35% tax rate.
Item 8.
Item 8. Financial Statements and Supplementary Data. - ----------------------------------------------------
For a listing of consolidated financial statements which are included in this document see page.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and - ------------------------------------------------------------------------ Financial Disclosure. - --------------------
None.
PART III
Item 10.
Item 10. Directors of the Registrant. - ------------------------------------
Information regarding directors and Section 16(a) Compliance is incorporated herein by reference from the Sections entitled "Proposal 1-Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance" of the Company's definitive proxy statement which will be filed no later than 120 days after December 31, 2000.
Item 11.
Item 11. Executive Compensation - -------------------------------
Incorporated herein by reference from the Sections entitled "Proposal 1 - Election of Directors - Directors' Compensation" and "Executive Compensation" of the Company's definitive proxy statement which will be filed no later than 120 days after December 31, 2000.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management - -----------------------------------------------------------------------
Incorporated herein by reference from the Section entitled "Stock Ownership" of the Company's definitive proxy statement which will be filed no later than 120 days after December 31, 2000.
Item 13.
Item 13. Certain Relationships and Related Transactions - -------------------------------------------------------
Incorporated herein by reference from the section entitled "Transactions with Management" of the Company's definitive proxy statement which will be filed no later than 120 days after December 31, 2000.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. - --------------------------------------------------------------------------
(a)(1) Financial Statements
For a listing of consolidated financial statements which are included in this document see Page.
(2) Financial Statement Schedules
Financial Statement Schedules have been omitted because they are not applicable or the required information is shown in the Consolidated Financial Statements or notes thereto.
(b) Reports on Form 8-K filed during the last quarter of 2000
None.
(c) Exhibits Required by Securities and Exchange Commission Regulation S-K
Exhibit Number ------
2.1 Amended Provisional Plan of Conversion for Connecticut Bancshares, M.H.C. and The Savings Bank of Manchester (including the Amended and Restated Stock Articles of Incorporation and Bylaws of the Savings Bank of Manchester). (1) 3.1 Certificate of Incorporation of Connecticut Bancshares, Inc. (1) 3.2 Amended and Restated Bylaws of Connecticut Bancshares, Inc. (2) 10.1 Connecticut Bancshares, Inc. 2000 Stock-Based Incentive Plan (3) 10.2 Employment Agreement between The Savings Bank of Manchester and Richard P. Meduski (4) 10.3 Employment Agreement between The Savings Bank of Manchester and Charles L. Pike (4) 10.4 Employment Agreement between The Savings Bank of Manchester and Douglas K. Anderson (4) 10.5 Employment Agreement between The Savings Bank of Manchester and Roger A. Somerville (4) 10.6 Employment Agreement between Connecticut Bancshares, Inc. and Richard P. Meduski (4) 10.7 Employment Agreement between Connecticut Bancshares, Inc. and Charles L. Pike (4) 10.8 Employment Agreement between Connecticut Bancshares, Inc. and Douglas K. Anderson (4) 10.9 Employment Agreement between Connecticut Bancshares, Inc. and Roger A. Somerville (4) 21.0 Subsidiaries Information Incorporated Herein By Reference to Part 1 - Subsidiaries 23.0 Consent of Independent Auditors (filed herewith)
----------------------------- (1) Incorporated by reference into this document from the Exhibits filed with the Registration Statement on Form S-1, and any amendments thereto, Registration No. 333-90865. (2) Incorporated by reference into this document from the Quarterly Report on Form 10-Q filed on August 14, 2000. (3) Incorporated by reference into this document from the Registrant's Proxy Statement dated August 18, 2000 and filed August 18, 2000. (4) Incorporated by reference into this document from the 1999 Annual Report on Form 10-K filed on March 30, 2000.
CONFORMED
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.
Connecticut Bancshares, Inc.
By: /s/ Richard P. Meduski March 30, 2001 --------------------------- Richard P. Meduski President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
CONNECTICUT BANCSHARES, INC. AND SUBSIDIARY
Index
Page
Report of Independent Public Accountants
Consolidated Statements of Condition As of December 31, 2000 and 1999
Consolidated Statements of Operations For the Years Ended December 31, 2000, 1999 and 1998
Consolidated Statements of Changes in Stockholders' Equity For the Years Ended December 31, 2000, 1999 and 1998
Consolidated Statements of Cash Flows For the Years Ended December 31, 2000, 1999 and 1998
Notes to Consolidated Financial Statements
Report of Independent Public Accountants
To the Board of Directors of Connecticut Bancshares, Inc.:
We have audited the accompanying consolidated statements of condition of Connecticut Bancshares, Inc. (a Connecticut stock holding company) and its subsidiary, The Savings Bank of Manchester (collectively, the Bank), as of December 31, 2000 and 1999, and the related consolidated statements of operations, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 2000. These consolidated financial statements are the responsibility of the Bank's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Connecticut Bancshares, Inc. and subsidiary as of December 31, 2000 and 1999, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2000 in conformity with accounting principles generally accepted in the United States.
/s/ Arthur Andersen
Hartford, Connecticut January 19, 2001 (except with respect to the matter discussed in Note 16, as to which the date is February 7, 2001)
CONNECTICUT BANCSHARES, INC. AND SUBSIDIARY
Consolidated Statements of Condition As of December 31, 2000 and 1999 (In thousands, except share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
CONNECTICUT BANCSHARES, INC. AND SUBSIDIARY
Consolidated Statements of Operations For the Years Ended December 31, 2000, 1999 and 1998 (In thousands, except share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
CONNECTICUT BANCSHARES, INC. AND SUBSIDIARY
Consolidated Statements of Changes in Stockholders' Equity For the Years Ended December 31, 2000, 1999 and 1998 (In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
CONNECTICUT BANCSHARES, INC. AND SUBSIDIARY
Consolidated Statements of Cash Flows For the Years Ended December 31, 2000, 1999 and 1998 (In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
CONNECTICUT BANCSHARES, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements December 31, 2000, 1999 and 1998
(1) ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Organization
The accompanying consolidated financial statements include the accounts of Connecticut Bancshares, Inc. ("Connecticut Bancshares or the Company"), successor to Connecticut Bancshares, M.H.C. ("MHC"), and its wholly-owned subsidiary, The Savings Bank of Manchester ("SBM"), and its wholly-owned subsidiaries, SBM, Ltd., 923 Main, Inc. and Savings Bank of Manchester Mortgage Company, Inc. ("SBM Mortgage"). Collectively, all of the aforementioned entities are referred to herein as the Bank. SBM Mortgage, a passive investment company for Connecticut income tax purposes, was established in January 1999 to service and hold loans secured by real property. SBM Mortgage is included in the consolidated financial statements as of December 31, 1999 and 2000 and for the years then ended. As discussed in Note 2, MHC adopted a Plan of Conversion pursuant to which, in March 2000, MHC merged into SBM, with SBM being the surviving corporation, and SBM continuing as a state-chartered stock savings bank and a wholly-owned subsidiary of the Company. All material intercompany balances and transactions have been eliminated in consolidation.
In 1998, the Bank contributed securities with a fair market value of approximately $3 million to the newly formed Savings Bank of Manchester Foundation, Inc. (the "Foundation"), a not-for-profit organization. The Foundation was formed to provide charitable contributions for the surrounding community. In connection with the contribution, the Bank realized a gain of approximately $2.3 million on the transfer of securities.
Business
The Company does not transact any material business other than through the Bank. The Company used 50% of the net proceeds from the conversion to buy all of the common stock of SBM and retained the remaining 50% (see Note 2), which primarily were invested in fixed income securities. The Bank, with its main office located in Manchester, Connecticut, operates through twenty-three branches located primarily in eastern Connecticut. The Bank's primary source of income is interest received on loans to customers, which include small and middle market businesses and individuals residing within the Bank's service area.
Use of estimates in the preparation of financial statements
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of income and expenses during the reporting periods. Operating results in the future could vary from the amounts derived from management's estimates and assumptions. A material estimate that is particularly susceptible to changes in the near term relates to the determination of the allowance for loan losses (see Note 5).
Cash flows
For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks.
Earnings per share
Basic earnings per share is computed based upon the weighted average shares outstanding during the period presented. Diluted earnings per share is computed based upon the weighted average shares outstanding during the period presented, including the impact of outstanding options, determined under the treasury stock method. Earnings per share data is not presented in these consolidated financial statements prior to March 1, 2000 since shares of common stock were not issued until March 1, 2000; therefore, per share information for prior periods is not meaningful.
The following table sets forth the calculation of basic and diluted earnings per share for the period from March 1, 2000 to December 31, 2000 (dollars in thousands):
Investment and mortgage-backed securities
Investments are classified into one of three categories and accounted for as follows:
Any security that experiences a decline in value that management believes is other than temporary is reduced to its net realizable value by a charge to noninterest income. Realized gains and losses from the sale of investments are recorded on the trade date by specific identification of the security sold.
Loans held for sale
Loans held for sale are valued at the lower of acquisition cost (less principal payments received) or estimated market value. Market is determined by reference to outstanding commitments from investors calculated on an individual loan basis. Net unrealized losses are recognized in a valuation allowance established by charges to noninterest income.
Loans
Loans are stated at their principal amounts outstanding net of unearned income. Interest on loans is recorded as income based on rates applied to principal amounts outstanding. Some installment and commercial loans are made on a discounted basis, and the unearned discount is recorded in income by use of a method that approximates the effective interest method. Interest on loans is credited to income as earned based on contractual rates applied to principal amounts outstanding. The accrual of interest is discontinued when payments are 90 days or more delinquent, and when a reasonable doubt exists as to the collectibility of the principal or interest. When interest accruals are discontinued, previously recognized accrued interest income is charged against earnings. When a loan becomes 90 days or more past due, interest income is recognized on the cash basis, only if in management's judgment all principal is expected to be collected.
Loan origination fees and certain direct loan origination costs are capitalized, and the net fee or cost is recognized in interest income using the effective interest method over the contractual life of the loans. When loans are prepaid, sold or participated out, the unamortized portion of deferred fees and related origination costs are recognized as income at that time. As of December 31, 2000 and 1999, net deferred loan fees were approximately $1,203,000 and $1,301,000, respectively.
The allowance for loan losses is established through a provision charged to expense. Loans are charged against the allowance for loan losses when management believes the collectibility of principal is unlikely. The allowance represents an amount, which, in management's judgment, will be adequate to absorb losses on existing loans that may become uncollectible. Management's judgment in determining the adequacy of the allowance is based on the evaluation of individual performing and impaired loans, risk characteristics of the loan portfolios, assessment of current economic and real estate market conditions, estimates of the current value of underlying collateral, past and current loan loss experience and other relevant factors.
The Bank has identified certain loans as impaired based upon management's belief it is probable that the borrower will be unable to pay all principal and interest amounts in accordance with the loan agreement's contractual terms. The Bank is required to account for the time value of money when determining the adequacy of the Bank's allowance for loan losses for certain impaired loans.
Certain impaired loans are required to be measured based on the present value of expected future cash flows discounted at the loan's original effective interest rate. As a practical expedient, impairment also may be measured based on the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. When the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through a valuation allowance. Interest payments received on impaired loans are recorded as interest income unless collection of the remaining recorded investment is doubtful, at which time payments received are recorded as reductions of principal.
Premises and equipment
Depreciation of premises and equipment and amortization of leasehold improvements are computed using the straight-line basis over the estimated useful lives of the assets (5-39 years) or in the case of leasehold improvements, the lease term if shorter.
Intangible assets
In 1997, the Bank acquired certain assets of a branch in West Hartford, Connecticut. The premium of $250,000, for lease rights acquired, is being amortized over the remaining term of the lease (10 years) using the straight-line method.
In 1995, the Bank acquired certain fixed assets and assumed certain deposit liabilities of two branches in Storrs and Enfield, Connecticut. In consideration of the assumption of certain deposit liabilities, the Bank received cash and other assets. The resultant premium of approximately $4,062,000 is being amortized over 10 years using the straight-line method.
Other real estate owned
Other real estate owned, comprised of real estate acquired through foreclosure or acceptance of a deed in lieu of foreclosure, is carried at the lower of cost or fair market value, net of estimated costs to sell. Property is transferred to other real estate owned at the lower of cost or fair market value, with any excess over cost charged to the allowance for loan losses. Any further decline in value based on subsequent changes to estimated fair market value or any loss upon ultimate disposition of the property is charged to other real estate owned expenses.
Mortgage servicing rights
The Bank applies the provisions of Statement of Financial Accounting Standards ("SFAS") No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," (as amended by SFAS No. 127, "Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125 (an amendment of FASB Statement No. 125)"), which requires that the cost of mortgage servicing rights be amortized in proportion to, and over the period of, estimated net servicing revenues. Impairment of mortgage servicing rights is assessed based on the fair value of those rights. Fair values are estimated using discounted cash flows based on a current market interest rate. The amount of impairment recognized is the amount by which the capitalized mortgage servicing rights for a stratum exceed their fair value.
Under that approach, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished. The adoption of this statement had no effect on the Bank's consolidated financial condition or results of operations.
When participating interests in loans sold have an average contractual interest rate, adjusted for normal servicing fees, that differs from the agreed yield to the purchaser, gains or losses are recognized equal to the present value of such differential over the estimated remaining life of such loans. The resulting "deferred servicing revenue" is amortized over the estimated life using a method approximating the effective interest method.
Quoted market prices are not available for the servicing receivables. Thus, the servicing receivables and the amortization thereon periodically are evaluated in relation to estimated future servicing revenues, taking into consideration changes in interest rates, current prepayment rates and expected future cash flows. The Bank evaluates the carrying value of the servicing receivables by estimating the future servicing income of the servicing receivables based on management's best estimate of remaining loan lives and discounted at the original discount rate.
Short-term borrowed funds
Short-term borrowings are comprised of uninsured accounts which are secured by investment securities.
Income taxes
Items of income and expense recognized in different time periods for financial reporting purposes and for purposes of computing income taxes currently payable (temporary differences) give rise to deferred income taxes which are reflected in the financial statements. A deferred tax liability or asset is recognized for the estimated future tax effects, based upon enacted law, attributed to temporary differences. If applicable, the deferred tax asset is reduced by the amount of any tax benefits that, based on available evidence, are not likely to be realized.
Stock-based compensation
The Bank accounts for stock-based compensation for employees under Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees", and elected the disclosure-only alternative under SFAS No. 123, "Accounting for Stock-Based Compensation."
Related party transactions
Directors and officers of the Bank and their associates have been customers of, and have had transactions with the Bank, and management expects that such persons will continue to have such transactions in the future. All deposit accounts, loans, services and commitments comprising such transactions were made in the ordinary course of business, on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other customers who are not directors or officers and, in the opinion of management, the transactions did not involve more than normal risks of collectibility, favored treatment or terms, or present other unfavorable features (see Note 5 for further details regarding related party transactions).
Comprehensive income
SFAS No. 130, "Reporting Comprehensive Income" establishes standards for separately reporting comprehensive income and its components. Components of comprehensive income represent changes in equity resulting from transactions and other events and circumstances from non-owner sources. Comprehensive income for the years ended December 31, 2000, 1999 and 1998 is as follows (in thousands):
Segment information
SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information", requires public companies to report certain financial information about significant revenue-producing segments of the business for which such information is available and utilized by the chief operating decision-maker. Specific information to be reported for individual operating segments includes a measure of profit and loss, certain revenue and expense items and total assets. As a community-oriented financial institution, substantially all of the Bank's operations involve the delivery of loan and deposit products to customers. Management makes operating decisions and assesses performance based on an ongoing review of these community-banking operations, which constitutes the Bank's only operating segment for financial reporting purposes under SFAS No. 131.
Recent accounting pronouncements
In September 2000, the Financial Accounting Standards Board ("FASB") issued SFAS No. 140 "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities - a Replacement of FASB Statement No. 125." SFAS No. 140 replaces SFAS No. 125. Certain disclosure provisions required by SFAS No. 140 were effective immediately and are included herein. Additional requirements related to SFAS No. 140 are effective beginning March 31, 2001. The Bank does not expect that these additional requirements will have an effect on the Bank's consolidated financial position or results of operations.
In June 1998, FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No. 133"). This statement establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. The statement requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the statement of income and requires that an entity formally document, designate and assess the effectiveness of transactions that receive hedge accounting.
The Bank early adopted SFAS No. 133, as amended by SFAS No. 137, "Accounting for Derivatives and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133 and SFAS No. 138, "Accounting for Certain Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133 - An Amendment of FASB Statement No. 133", on January 1, 2000. In connection with the adoption, the Bank reclassified all held to maturity investments to available for sale as allowed by SFAS No. 133. In March 2000, the Bank realized approximately $72,000 on the sale of an interest rate cap, which amount is included in other noninterest income in the accompanying consolidated statement of operations for the year ended December 31, 2000. As of December 31, 2000, the Bank did not have any other derivative instruments.
On December 3, 1999, the Securities and Exchange Commission released Staff Accounting Bulletin (SAB) No. 101, "Revenue Recognition in Financial Statements." The guidelines set forth in SAB No. 101 stipulate that revenue should not be recognized until it is realized or realizable and earned. The Bank adopted SAB No. 101 on January 1, 2000 without effect on the Bank's consolidated financial condition or results of operations since the Bank's previous revenue recognition policies complied with SAB No. 101.
Effective January 1, 1999 the Bank adopted SFAS No. 134, "Accounting for Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise, an amendment of SFAS No. 65." This statement requires that after the securitization of mortgage loans held for sale, an entity engaged in mortgage banking activities shall classify the resulting mortgage-backed securities or other retained interests based on its ability and intent to sell or hold those investments. The adoption did not have any effect on the Bank's consolidated financial condition or results of operations.
Reclassifications
Certain prior year amounts have been reclassified to conform to the current year presentation.
(2) CONVERSION TO STOCK FORM OF OWNERSHIP
On August 30, 1999, the Boards of Directors of MHC and SBM adopted a Plan of Conversion and, on October 6, 1999 and October 26, 1999, unanimously amended the Plan of Conversion (as amended, the Plan), pursuant to which, on March 1, 2000, MHC converted from the mutual holding company form to the stock holding company form. All of the outstanding common stock of SBM was sold to the Company which issued and sold its stock pursuant to the Plan. The net proceeds of the offering were $90.5 million, after expenses of approximately $4.3 million. All of the stock of the Company sold in the conversion was offered to eligible account holders, employee benefit plans of the Bank and certain other eligible subscribers in subscription and direct community offerings pursuant to subscription rights in order of priority as set forth in the Plan. Additionally, the Bank established an Employee Stock Ownership Plan ("ESOP") for the benefit of eligible employees, which became effective upon the conversion (See Note 9).
The Plan provided for the establishment of an additional charitable foundation, SBM Charitable Foundation, Inc. (the "New Foundation") in connection with the conversion. The New Foundation was funded with a contribution of 832,000 common shares, or an amount equal to 8% of the common stock sold in the conversion. This contribution resulted in the recognition of an expense of $8.3 million in March 2000, related to the fair value of the shares contributed, which is reflected as such in the accompanying consolidated statement of operations for the year ended December 31, 2000. The New Foundation is dedicated to charitable purposes within the Bank's local community, including community development activities.
Effective upon the conversion, the Company entered into employment and change in control agreements with certain executives and certain eligible employees of the Company and the Bank. The agreements include, among other things, provisions for minimum annual compensation and certain lump-sum severance payments in the event of a "change in control."
The Bank's deposit accounts continue to be insured by the FDIC and were not affected by the conversion. In accordance with the Plan, upon the completion of the conversion, the Bank established a special "liquidation account" for the benefit of eligible account holders and in an amount equal to the equity capital of the Bank less any subordinated debt approved as bona fide capital of the Bank, as of the date of its latest statement of condition contained in the final prospectus used in connection with the conversion. The date was September 30, 1999 and the amount established was $117.6 million. The liquidation account which totaled $61.4 million at December 31, 2000 is reduced annually by an amount proportionate to the decrease in eligible deposit accounts. Eligible account holders continuing to maintain deposit accounts at the Bank are entitled, on a complete liquidation of the Bank after the conversion, to an interest in the liquidation account prior to any payment to the stockholders of the Bank. The Bank's retained earnings are substantially restricted with respect to payment of dividends to stockholders due to the liquidation account. The liquidation account will terminate on the tenth anniversary of the consummation date of the conversion.
The primary source of funds for the Company to pay dividends is in the form of dividends received from SBM. Neither the Company nor SBM may declare or pay dividends on, or repurchase any of its shares of common stock, if the effect thereof would cause stockholders' equity to be reduced below either the balance required for the liquidation account or applicable regulatory capital maintenance requirements, or if such declaration, payment or repurchase would otherwise violate regulatory requirements.
(3) REGULATORY MATTERS
SBM is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Bank's consolidated financial statements. The regulations require SBM to meet specific capital adequacy guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. SBM's capital amounts and classification are also subject to qualitative judgments by the banking regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require SBM to maintain minimum capital ratios (set forth in the table below) of Tier I leverage capital (as defined in the regulations) to total average assets (as defined), and minimum ratios of Tier I and total capital (as defined) to risk weighted assets (as defined). To be considered adequately capitalized (as defined) under the regulatory framework from Prompt Corrective Action, SBM must maintain minimum Tier I leverage, Tier I risk-based and total risk-based ratios as set forth in the table.
The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") categorizes banks based on capital levels and triggers certain mandatory and discretionary supervisory responses for institutions that fall below certain capital levels. A bank generally is categorized as "well capitalized" if it maintains a leverage capital ratio of at least 5%, a Tier I risk-based capital ratio of at least 6% and a total risk-based capital ratio of at least 10%, and it is not subject to a written agreement, order or capital directive.
As of December 31, 2000 and 1999, management believes that SBM met all capital adequacy requirements to which it is subject. As of the most recent notification from the Federal Deposit Insurance Corporation, SBM was categorized as well capitalized under the regulatory framework for Prompt Corrective Action, and the highest capital category, as defined in the FDICIA regulations. Management believes that there are no events or conditions which have occurred subsequent to the notification that would change its category.
Actual capital amounts and ratios for SBM were (dollars in thousands):
(4) INVESTMENT SECURITIES
As of December 31, 2000 and 1999, the amortized cost and market value of investment securities were (in thousands):
As of December 31, 2000, the amortized cost and market values of debt securities, by contractual maturity, are shown below (in thousands). Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
For the years ended December 31, 2000 and 1999, proceeds from the sales of available for sale securities were approximately $92,240,000 and $19,081,000, respectively. Gross gains of approximately $2,733,000 and $1,922,000, respectively, and gross losses of approximately $2,288,000 and $550,000, respectively, were realized on those sales for the years ended December 31, 2000 and 1999.
As of December 31, 2000 and 1999, investment securities with a book value of approximately $130,297,000 and $103,627,000 were pledged as security for short-term borrowed funds, U.S. Treasury tax and loan payments and municipal deposits held by the Bank, respectively.
(5) LOANS
As of December 31, 2000 and 1999, the Bank's residential mortgage loan portfolio was entirely secured by one- to four-family homes, located primarily in central and eastern Connecticut. The commercial mortgage loan portfolio was secured primarily by multi-family, commercial and manufacturing properties located in Connecticut and surrounding states. A variety of different assets, including business assets, rental income properties, and manufacturing and commercial properties, secured a majority of the commercial loans. The composition of the Bank's loan portfolio as of December 31, 2000 and 1999 is as follows (in thousands):
The Bank services certain loans that it has sold without recourse to third parties. The aggregate amount of loans serviced for others approximated $210,149,000, $210,158,000 and $218,660,000 as of December 31, 2000, 1999 and 1998, respectively. Income from servicing loans for others was approximately $544,000, $576,000 and $503,000 for the years ended December 31, 2000, 1999 and 1998, respectively. Mortgage servicing rights of approximately $2,555,000, $2,550,000 and $2,480,000 were capitalized as of December 31, 2000, 1999 and 1998, respectively. Amortization of mortgage servicing rights was approximately $387,000, $425,000 and $276,000 for the years ended December 31, 2000, 1999 and 1998, respectively.
As of December 31, 2000 and 1999, loans to related parties totaled approximately $6,300,000 and $15,800,000, respectively. For the year ended December 31, 2000, new loans of approximately $1,156,000 were granted to these parties and payments of approximately $185,000 were received. Related parties include directors and officers of the Bank, their respective affiliates in which they have a controlling interest and their immediate family members. For the years ended December 31, 2000 and 1999, all loans to related parties were performing.
Allowance for loan losses
The allowance for loan losses is maintained at a level determined by management to be the best estimate of losses incurred in the loan portfolio. The allowance is increased or decreased by provisions or credits charged to operations, which represent an estimate of losses that occurred during the period and a correction of estimates of losses recorded in prior periods. Confirmed losses, net of recoveries, are charged directly to the allowance and the loans are written down.
The determination of the adequacy of loan losses by management is based on an assessment of risk elements in the portfolio, identified factors affecting specific loans and available information about the current economic environment in which the Bank and its borrowers operates. Management reviews overall portfolio quality through an analysis of current levels and trends in chargeoffs, delinquency and nonaccruing loan data and the credit risk profile of each component of the portfolio.
The allowance for loan losses consists of a formula allowance for various loan portfolio classifications and a valuation allowance for loans identified as impaired, if necessary. The allowance is an estimate, and ultimate losses may vary from current estimates. Changes in the estimate are recorded in the results of operations in the period in which they become known, along with provisions for estimated losses incurred during that period.
A loan is considered to be impaired when it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans, as defined, may be measured based on the present value of expected future cash flows, discounted at the loan's original effective interest rate or on the loan's observable market price or the fair value of the collateral if the loan is collateral-dependent. When the measurement of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through a valuation allowance.
For the years ended December 31, 2000, 1999 and 1998, an analysis of the allowance for loan losses is as follows (in thousands):
(6) NONPERFORMING ASSETS
Nonperforming assets include loans for which the Bank does not accrue interest ("nonaccrual loans"), loans 90 days past due and still accruing interest and other real estate owned. Nonaccrual loans and loans 90 days past due and still accruing interest represent the Bank's impaired loans. For the years ended December 31, 2000, 1999 and 1998, the average recorded investment in impaired loans was approximately $9,390,000, $6,417,000 and $2,200,000, respectively. As of December 31, 2000 and 1999, nonperforming assets were (in thousands):
For the years ended December 31, 2000, 1999 and 1998, had interest income been accrued on nonaccrual loans at contractual rates, interest income would have increased by approximately $568,000, $635,000 and $136,000, respectively. For the years ended December 31, 2000, 1999 and 1998, interest income on impaired loans of approximately $60,000, $125,000 and $80,000, respectively, was recognized. As of years ended December 31, 2000, 1999 and 1998, no significant additional funds were committed to customers whose loans were nonperforming.
As of December 31, 2000 and 1999, the Bank had impaired loans of approximately $6,773,000 and $11,485,000, respectively, for which a valuation allowance of $771,000 and $1,430,000, respectively, was required. For the years ended December 31, 2000 and 1999, $269,000 and $700,000 was charged off on nonaccrual loans, respectively. For the year ended December 31, 1998, no chargeoffs occurred on impaired loans.
(7) DEPOSITS
As of December 31, 2000 and 1999, deposits consisted of the following (in thousands):
For the years ended December 31, 2000, 1999 and 1998, interest expense on time deposits in denominations greater than $100,000 was approximately $3,078,000, $2,587,000 and $2,921,000, respectively.
(8) ADVANCES FROM FEDERAL HOME LOAN BANK AND SHORT-TERM BORROWED FUNDS
As of December 31, 2000 and 1999, SBM had the following borrowings from Federal Home Loan Bank of Boston (FHLB) (dollars in thousands):
SBM's FHLB stock collateralizes these advances. In addition, mortgage loans and otherwise unencumbered investment securities qualified as collateral available to the FHLB were pledged to secure these advances, unused credit lines and letters of credit issued by the FHLB. As of December 31, 2000, SBM had the ability to borrow a total of approximately $447.29 million from FHLB.
SBM maintains a line of credit of $34,000,000 with the FHLB which accrues interest at variable rates determined by the FHLB on a daily basis. Amounts drawn against the line of credit are due within one day of withdrawal; however, such amounts are automatically renewed provided that SBM has sufficient cash balances deposited with the FHLB. Borrowings under the line of credit are secured by U.S. Government treasury and/or agency bonds. There were no outstanding borrowings on the FHLB line of credit at December 31, 2000 or 1999. The Bank also maintains a $15,000,000 line of credit with a correspondent bank. No amounts were outstanding on the correspondent line as of December 31, 2000 or 1999.
Short-term borrowed funds primarily represents commercial transactional repurchase accounts (business checking accounts, which are not Federal Deposit Insurance Corporation insured).
(9) PENSION PLANS
The Bank has a non-contributory defined benefit pension plan ("the Plan") covering substantially all employees. The benefits are based on years of service and average compensation, as defined in the Plan. The Bank's funding policy is to contribute annually the maximum amount allowed by federal tax regulations.
The following table sets forth the change in benefit obligation, change in plan assets and the funded status of the Bank's pension plan for the years ended December 31, 2000 and 1999. The table also provides a reconciliation of the plan's funded status and the amounts recognized in the Bank's consolidated statements of condition (in thousands):
The components of net periodic pension cost for the years ended December 31, 2000, 1999 and 1998 were as follows (in thousands):
Significant actuarial assumptions used in determining the actuarial present value of the projected benefit obligation and the net periodic pension cost were as follows:
The Bank has entered into supplemental retirement agreements with certain officers and outside directors. The following table sets forth the change in benefit obligation and the funded status of the obligations for the years ended December 31, 2000 and 1999. The table also provides a reconciliation of the obligation's funded status and the amounts recognized in the Bank's consolidated statements of condition (in thousands):
The components of net periodic pension cost for the years ended December 31, 2000, 1999 and 1998 were as follows (in thousands):
Significant actuarial assumptions used in determining the actuarial present value of the projected benefit obligation and the net periodic pension cost were as follows:
In addition to providing pension benefits, the Bank provides certain health care benefits for retired employees (the Health Care Plan). Only employees retiring before January 1, 1989 are eligible for these benefits, provided they attain age 55 while working for the Bank. In addition, all employees who have attained age 55 and have ten years of vested service are covered under the Health Care Plan until age 65. Effective January 1, 1993, the Bank began to accrue for the estimated costs of these benefits through charges to expense during the years that the employees earn these benefits. The following table reconciles the Health Care Plan's funded status to the accrued obligation as of December 31, 2000 and 1999 (in thousands):
For the years ended December 31, 2000, 1999 and 1998, net postretirement health care cost included the following components (in thousands):
Significant actuarial assumptions used in determining the actuarial present value of the projected benefit obligation and the net postretirement health care cost are as follows:
The health care cost trend rate used to measure the accumulated postretirement benefit obligation is 7.0% as of December 31, 2000. Increasing the health care cost trend rate by 1% would increase the accumulated postretirement benefit cost by approximately $70,000, and the net postretirement benefit cost by approximately $17,000, (pretax) annually as of December 31, 2000.
In connection with the Plan of Conversion, the Bank established an ESOP which acquired 8%, or 898,560, of the shares which were issued in the conversion at a price of $10.36 per share. The purchase of the shares by the ESOP was funded by a loan of $9,305,000 from the Company. The loan is to be repaid in fifteen equal annual installments of principal and interest of $1,122,622. Interest on the loan is fixed at 8.75%. ESOP expense for the year ended December 31, 2000 was $855,000. ESOP expense is based on the market value of the Company's common stock at the time shares are allocated to employees, which may differ from the $10.36 cost of those shares.
(10) INCOME TAXES
For the years ended December 31, 2000, 1999 and 1998, the provision (benefit) for income taxes consisted of the following (in thousands):
As of December 31, 2000 and 1999, the components of the net deferred income tax asset (liability) included in current and deferred income taxes in the accompanying consolidated statements of condition were (in thousands):
Effective for taxable years commencing after December 31, 1998, financial service companies are permitted to establish in the State of Connecticut a passive investment company ("PIC") to hold and manage loans secured by real property. Income earned by the PIC is exempt from Connecticut corporation business tax and dividends received by the financial service company from the PIC are not taxable. In 1999, SBM established a PIC, as a wholly-owned subsidiary, and transferred a portion of its real estate mortgage portfolio from SBM to the PIC.
During 1999, the deferred state tax assets for which the valuation allowance was established were written off upon the transfer to the PIC, and the valuation allowance was eliminated. Prior to 1999, all state deferred tax assets were reserved for due to uncertainty of realization.
For the years ended December 31, 2000, 1999 and 1998, the provision for income taxes differed from the amount computed by applying the statutory federal income tax rate (35%) to income before provision for income taxes for the following reasons (in thousands):
As of December 31, 2000, the Bank's allowance for loan losses for federal income tax return purposes was approximately $12,560,000. If any portion of this allowance is used for purposes other than to absorb loan losses and write-downs of other real estate owned, such amounts will become subject to income tax at the then current tax rate. Management does not anticipate that capital will be used in such a way so as to require the payment of taxes on taxable income resulting from the recapture of the tax allowance. As a result, in accordance with SFAS No. 109, no provision for such tax has been recorded in the accompanying consolidated financial statements.
(11) STOCK-BASED COMPENSATION
In connection with the conversion to stock form of ownership (see Note 2), the Company established the Connecticut Bancshares, Inc. 2000 Stock-Based Incentive Plan (the "Stock Plan") to attract and retain qualified personnel in key positions and to provide employees with an interest in the Company as an incentive to contribute to its success. The Stock Plan authorizes the granting of options to purchase common stock of the Company and awards of restricted shares of common stock. All employees and non-employee directors of the Company are eligible to receive awards under the Stock Plan. The Stock Plan is administered by a committee (the Committee). Subject to certain regulatory conditions, the Committee has the authority to determine the amount of options granted to any individual and the dates on which each option will become exercisable. The exercise price of all options is determined by the Committee but is at least 100% of the fair market value of the underlying common stock at the time of the grant. In addition, subject to certain regulatory conditions, the Committee has the authority to determine the amounts of restricted stock awards granted to any individual and the dates on which restricted stock awards granted will vest or any other conditions which must be satisfied before vesting. On December 15, 2000, the Bank granted options to purchase 1,017,776 shares of common stock at an exercise price of $17.625 per share, the fair value on the date of grant. The options expire 10 years from the date of grant and vest over 5 years. At December 31, 2000, no options were exercisable. As of December 31, 2000, no shares of restricted stock had been granted.
The Company applies APB No. 25 and related Interpretations in accounting for the Stock Plan. Accordingly, no compensation cost has been recognized for the Stock Plan. Had compensation cost for the Company's Stock Plan been determined consistent with SFAS No. 123, the Company's pro forma net income and basic and diluted net income per share for the ten months ended December 31, 2000, would have been $6,078,000, $0.59 and $0.59, respectively.
The fair value on the grant date of $7.28 was estimated using the Black- Scholes option pricing model with the following assumptions:
Risk free interest rate 5.24% Expected life 7 years Expected volatility 26.25% Dividend yield -
(12) SELECTED QUARTERLY CONSOLIDATED FINANCIAL INFORMATION (UNAUDITED)
The following table presents quarterly consolidated financial information for the Bank for 2000 and 1999 (in thousands):
(1) Includes losses on sales of securities, net of $1,755,000. (2) Includes expense of $8,316,000 related to securities contributed to SBM Charitable Foundation, Inc.
(13) COMMITMENTS AND CONTINGENCIES
Cash and due from banks withdrawal and usage reserve requirements
The Bank is required to maintain reserves against its transaction accounts and non-personal time deposits. As of December 31, 2000 and 1999, cash and due from banks withdrawal/usage reserve requirements of approximately $2,144,000 and $11,060,000, respectively, existed as a result of Federal Reserve requirements to maintain certain average balances.
Lease commitments
The Bank leases certain of its premises and equipment under lease agreements which expire at various dates through June 2010. The Bank has the option to renew certain of the leases at fair rental values. Rental expense was approximately $1,134,000, $1,132,000 and $1,120,000 for the years ended December 31, 2000, 1999 and 1998, respectively.
As of December 31, 2000, minimum rental commitments under noncancellable operating leases were (in thousands):
Year
2001 $ 904,311 2002 902,620 2003 873,694 2004 807,759 2005 735,040 Thereafter 3,438,405 -------------
$ 7,661,829 =============
Loan commitments and letters of credit
The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments included commitments to extend credit of approximately $176,670,000 and $155,180,000 as of December 31, 2000 and 1999, respectively, and standby letters of credit of approximately $7,361,000 and $6,216,000 as of December 31, 2000 and 1999, respectively.
These consolidated financial instruments involve, to varying degrees, elements of credit and interest rate risk. The Bank's exposure to credit loss in the event of non-performance by the other party to the financial instrument is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments as it does for existing loans. Management believes that the Bank controls the credit risk of these financial instruments through credit approvals, lending limits, monitoring procedures and the receipt of collateral when deemed necessary.
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 many of the commitments could expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Bank management evaluates each customer's credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank, upon extension of credit is based on management's credit evaluation of the customer. Collateral held varies but may include income producing commercial properties, accounts receivable, inventory and property, plant and equipment.
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in existing loan facilities to customers. The Bank holds real estate and marketable securities as collateral supporting those commitments for which collateral is deemed necessary.
Interest rate cap agreement
At December 31, 1999, SBM was party to an interest rate cap agreement with a notional principal amount of $25 million. Under the terms of the cap agreement, SBM paid a premium totalling $123,000 which was included in other assets and was amortized over the three years term of the agreement. Amortization for the year ended December 31, 1999 totaled $38,000 and is recorded as an interest expense on advances. In March 2000, the Bank realized a gain of approximately $72,000 on the sale of the interest rate cap.
(14) PARENT COMPANY FINANCIAL INFORMATION
Summarized information relative to the statements of condition as of December 31, 2000 and 1999 and statements of operations and cash flows for the years ended December 31, 2000, 1999 and 1998 of Connecticut Bancshares, Inc. (parent company only) are presented as follows (in thousands):
(15) DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS
SFAS No. 107, "Disclosures About Fair Value of Financial Instruments," requires entities to disclose the estimated fair value of financial instruments, both assets and liabilities recognized and not recognized in the consolidated statements of condition, for which it is practicable to estimate fair value.
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value.
Cash and due from banks and accrued interest receivable
The carrying amount is a reasonable estimate of fair value.
Securities
For marketable equity securities and other securities held for investment purposes, fair values are based on quoted market prices or dealer quotes, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.
Loans held for sale
The fair value of residential mortgage loans held for sale is estimated using quoted market prices provided by government agencies.
Loans
The fair value of the net loan portfolio is estimated by discounting the loans' future cash flows using the prevailing interest rates as of year-end at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.
The book and fair values of unrecognized commitments to extend credit and standby letters of credit were not significant as of December 31, 2000 and 1999.
Deposits
The fair value of savings, NOW, demand and certain money market deposits is the amount payable on demand as of year-end. The fair value of certificates of deposit is estimated by discounting the future cash flows using the rates offered for deposits of similar remaining maturities as of yearend.
Advances from Federal Home Loan Bank
The fair value of the advances is based on the estimated costs to prepay the debt (prior to maturity) as of year-end.
Values not determined
SFAS No. 107 excludes certain financial, as well as non-financial, instruments from its disclosure requirements, including premises and equipment, the intangible value of the Bank's portfolio of loans serviced (both for itself and for others) and related servicing network, and the intangible value inherent in the Bank's deposit relationships (i.e., core deposits), among other assets and liabilities. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Bank.
As of December 31, 2000 and 1999, the estimated fair values and recorded book balances of the Bank's financial instruments were (in thousands):
At December 31, 1999, the Bank had an interest rate cap with a notional value of $25,000,000 and a book asset value of $85,000 representing the unamortized portion of the premium paid for the cap, which is included in other assets in the accompanying consolidated statements of condition. The interest rate cap had an estimated market value of $143,000 at December 31, 1999.
(16) SUBSEQUENT EVENT
On February 7, 2001, the Bank and First Federal Savings and Loan Association of East Hartford ("First Federal") entered into a definitive agreement (the "Agreement") under which the Bank will acquire all of the outstanding common stock of First Federal for cash equal to approximately $110.00 million. Immediately after the completion of the acquisition, First Federal will be merged into The Savings Bank of Manchester, a wholly-owned subsidiary of the Company. The Board of Directors of the Company expects the transaction to close in the third quarter of 2001. The transaction is subject to approval by First Federal shareholders and federal and state regulatory agencies.
Under certain circumstances, if the Agreement is terminated by the Bank for the reasons set forth in the Agreement before the consummation of the merger, First Federal may be required to pay the Bank cash of $4.5 million plus out-of-pocket expenses.