Item 1 - Business
Sterling Financial Corporation is a $2.344 billion financial holding company headquartered in Lancaster, Pennsylvania. Through its banking and nonbanking subsidiaries, Sterling provides a full range of banking and financial services to individuals and businesses, through its five business segments: Community Banking and Related Services; Leasing; Commercial Finance; Trust and Investment Services; and Insurance and Related Services.
Community Banking and Related Services
The Community Banking and Related Services segment provides financial services to consumers, businesses, financial institutions and governmental units in southern Pennsylvania and northern Maryland. These services include providing various types of loans to customers, accepting deposits, mortgage banking and other typical banking services. Parent company and treasury function income is included in the community-banking segment, as the majority of effort of these functions is related to this segment. Major revenue sources include net interest income and service fees on deposit accounts. Expenses include personnel and branch network support charges.
Our Community Banking and Related Services segment is comprised of our banking affiliates, summarized below (dollars in millions).
(1)
Bank of Lancaster County conducts business through its PennSterling Bank division office.
(2)
Bank of Lancaster County conducts business through its two Bank of Lebanon County division offices.
(3)
Bank of Lancaster County conducts business through its Delaware Sterling Bank division office.
In addition to its network of 57 office locations, the Community Banking and Related Services segment delivers its services through alternative delivery channels, including the ATM network, internet and telephone banking.
The Community Banking and Related Services segment’s geographic market is among the strongest and most stable economies in Pennsylvania and Maryland, with agriculture, industry and tourism all contributing to the overall strength of the economy. No single sector dominates the region’s economy.
The affiliate banks are subject to regulation and periodic examination by their regulators, including the Office of the Comptroller of the Currency for the national banks, and the Federal Deposit Insurance Corporation and Pennsylvania Department of Banking for the state chartered bank, Bank of Hanover. The Federal Deposit Insurance Corporation, as provided by law, insures the bank’s deposits.
At December 31, 2003, the Community Banking and Related Services segment represented approximately 83% of Sterling’s consolidated assets, and contributed approximately 67% of Sterling’s net income for the year ended December 31, 2003.
Leasing
The Leasing Segment provides vehicle and equipment financing alternatives to commercial businesses. Sterling has two affiliates that comprise the leasing segment, including Town & Country Leasing LLC, a wholly owned subsidiary of Bank of Lancaster County, and T&C Leasing, Inc., a direct subsidiary of Sterling.
The Leasing segment provides fleet management and equipment financing and leasing alternatives to customers headquartered primarily in Pennsylvania and surrounding states. Through its customers’ branch offices, the Leasing segment conducts business in 46 of the 48 continental United States.
At December 31, 2003, the Leasing segment represented approximately 9% of Sterling’s consolidated assets, and contributed approximately 3% of Sterling’s net income for the year ended December 31, 2003. Major revenue sources include net interest income and rental income on operating leases. Expenses include personnel, support and depreciation charges on operating leases.
Commercial Finance
Equipment Finance LLC, which was acquired by Sterling in February 2002, represents the sole affiliate within the commercial finance segment. Equipment Finance specializes in financing forestry and land-clearing equipment through more than 150 equipment dealer locations ranging from Maine to Florida.
At December 31, 2003, the Commercial Finance Segment represented approximately 7% of Sterling’s consolidated assets, and contributed approximately 28% of Sterling’s net income for the year ended
December 31, 2003. Major revenue sources include net interest income. Expenses include personnel and support charges. Since the acquisition of Equipment Finance in 2002, finance receivables have grown from $81 million to $141 million, and represent one of Sterling’s fastest growing segments.
Trust and Investment Services
The Trust and Investment Services segment includes both corporate asset and personal wealth management services. The corporate asset management business provides retirement planning services, investment management, custody and other corporate trust services to small to medium size businesses in Sterling’s market area. Personal wealth management services include investment management, brokerage, estate and tax planning, as well as trust management and administration for high net worth individuals and their families.
Prior to October 2003, Sterling Financial Trust Company, a wholly owned subsidiary of Bank of Lancaster County, and its predecessor wealth management and investment services divisions at Bank of Lancaster County and Bank of Hanover were the only units within this segment. In 2002, the wealth management and investment services divisions of the two banks were combined into the newly created Trust Company to increase revenue generation opportunities, while increasing operating efficiencies.
In the fourth quarter of 2003, Sterling acquired Church Capital Management LLC and Bainbridge Securities, Inc. These acquisitions result in our ability to offer a wider array of financial services within the Trust and Investment Services segment. Church Capital is a SEC Registered Investment Advisor and Bainbridge Securities is a National Association of Securities Dealers (NASD) broker/ dealer that offers complementary products to the more traditional wealth management services. Sterling expects that this acquisition will enhance earnings and provide financial product diversification.
At December 31, 2003, the Trust and Investment Services Segment represented approximately 1% of consolidated assets, and contributed approximately 2% of Sterling’s net income for the year ended December 31, 2003. In addition, the Trust and Investment Services segment had assets under management of approximately $1.7 billion. Major revenue sources include management and estate fees and commissions on security transactions. Expenses primarily consist of personnel and support charges, as well as amortization of intangible assets.
Insurance and Related Services
Presently, Sterling’s affiliates offer insurance and related services to its customers including credit life and disability, through its Pennbanks Insurance Company, comprehensive personal insurance and coverages through a joint venture that it has established with a local insurance agency (Lancaster Insurance Group), and Sterling Financial Settlement Services, a settlement and title insurance agency joint venture that it has established with a local realtor agency.
As of December 31, 2003, the Insurance and Related Services segment is not considered significant to Sterling’s financial position or results of operations. In future periods, we expect this segment is expected to represent a more significant portion of our business, with the pending acquisition of Corporate Healthcare Strategies, which is scheduled to close early in the second quarter of 2004.
Corporate Healthcare Strategies, doing business as StoudtAdvisors, is located in Lancaster Pennsylvania, and provides benefit products and consulting services to medium and large-sized businesses in the Central Pennsylvania region. StoudtAdvisors annual revenues are approximately $6,600,000.
For more detailed financial information pertaining to our operating segments, please refer to Note 23 of the Consolidated Financial Statements.
Sterling’s major sources of operating funds, as a parent company, are dividends received from its subsidiary banks and reimbursement of operating expenses from the affiliates. Sterling’s expenses are primarily operating expenses. Dividends that Sterling pays to shareholders are funded, in part, by dividends paid to Sterling by its subsidiary banks.
Sterling and its subsidiaries do not have any portion of their businesses dependent on a single or limited number of customers, the loss of which would have a material adverse effect on their businesses. No substantial portion of their loans or investments are concentrated within a single industry or group of related industries, although a significant amount of loans are secured by real estate located in south central Pennsylvania, and northern Maryland. Loan exposure to the forestry industry is approximately 10%. The businesses of Sterling and its subsidiaries are not seasonal in nature.
The common stock of Sterling is listed on The NASDAQ Stock Market under the symbol SLFI.
Competition
The financial services industry in Sterling’s market area is highly competitive, including competition from commercial banks, savings banks, credit unions, finance companies and nonbank providers of financial services. Several of Sterling’s competitors have legal lending limits that exceed Sterling’s subsidiaries, as well as funding sources in the capital markets that exceeds Sterling’s availability. The increased competition has resulted from a changing legal and regulatory climate, as well as from the economic climate.
Environmental Compliance
Sterling’s and its subsidiaries’ compliance with federal, state and local environmental protection laws had no material effect on capital expenditures, earnings or their competitive position in 2003, and is not expected to have a material effect on such expenditures, earnings or competitive position in 2004.
Supervision and Regulation
Bank holding companies and banks operate in a highly regulated environment and are regularly examined by Federal and State regulatory authorities.
The following discussion concerns various Federal and State laws and regulations and the potential impact of such laws and regulations on Sterling and its subsidiaries.
To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory or regulatory provisions themselves. Proposals to change laws and regulations are frequently introduced in Congress, the state legislatures, and before the various bank regulatory agencies. Sterling cannot determine the likelihood or timing of any such proposals or legislation or the impact they may have on Sterling and its subsidiaries. A change in law, regulations or regulatory policy may have a material effect on the business of Sterling and its subsidiaries.
Bank Holding Company Regulation
Sterling is a financial holding company and, as such, is subject to the regulations of the Board of Governors of the Federal Reserve System under the Bank Holding Company Act of 1956, as amended (BHC Act). Bank holding companies are required to file periodic reports with and are subject to examination by the Federal Reserve. The BHC Act requires a financial holding company to serve as a source of financial and managerial strength to its banking subsidiaries, which may result in providing adequate capital funds to the banks during periods of financial stress or adversity.
The BHC Act prohibits Sterling from acquiring direct or indirect control of more than 5% of the outstanding voting stock of any bank, or substantially all of the assets of any bank, or merger with another bank holding company, without the prior approval of the Federal Reserve. The BHC Act allows interstate bank acquisitions and interstate branching by acquisition and consolidation in those states that had not elected out by the required deadline. The Pennsylvania Department of Banking also must approve any similar consolidation. Pennsylvania law permits Pennsylvania financial holding companies to control an unlimited number of banks.
In addition, the BHC Act restricts our nonbanking activities to those that are determined by the Federal Reserve Board to be financial in nature, incidental to such financial activity, or complementary to a financial activity. The BHC Act does not place territorial restrictions on the activities of nonbank subsidiaries of financial holding companies.
The Federal Deposit Insurance Corporation Improvement Act requires a bank holding company to guarantee the compliance of any insured depository institution subsidiary that may become “undercapitalized”, as defined by regulations, with the terms of any capital restoration plan filed by such subsidiary with its appropriate federal banking agency, up to specified limits.
Financial Services Modernization Legislation
In November 1999, the Gramm-Leach-Bliley Act of 1999, or the GLB, was enacted. As a result of GLB new opportunities became available to financial institution holding companies as it removed the restrictions that resulted from a regulatory framework that had its origin in the Great Depression of the 1930s. In addition, the GLB also contains provisions that expressly preempt any state law restricting the establishment of financial affiliations, primarily related to insurance.
The general effect of GLB is to permit banks, other depository institutions, insurance companies and securities firms to enter into combinations that result in a single financial services organization to offer customers a wider array of financial services and products, through a new entity known as a “financial holding company.” “Financial activities” is broadly defined to include not only banking, insurance and securities activities, but other activities incidental to such financial activities or complementary activities that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.
The GLB also permits national banks to engage in expanded activities through the formation of financial subsidiaries. A national bank may have a subsidiary engaged in any activity authorized for national banks directly or any financial activity, except for insurance underwriting, insurance investments, real estate investment or development, or merchant banking, which may only be conducted through a subsidiary of a financial holding company. Financial activities include all activities permitted under new sections of the BHC Act or permitted by regulation.
To the extent that the GLB permits banks, securities firms and insurance companies to affiliate, the financial services industry may experience further consolidation. The GLB is intended to grant to community banks certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis and which unitary savings and loan holding companies already possess. Nevertheless, the GLB may have the result of increasing the amount of competition that Sterling faces from larger institutions and other types of companies offering financial products, many of which may have substantially more financial resources than does Sterling.
Sarbanes-Oxley Act of 2002
On July 30, 2002, the Sarbanes-Oxley Act of 2002 was enacted. The Sarbanes-Oxley Act represents a comprehensive revision of laws affecting corporate governance, accounting obligations and corporate reporting. The Sarbanes-Oxley Act is applicable to all companies with equity securities registered or that file reports under the Securities Exchange Act of 1934. In particular, the Sarbanes-Oxley Act established: (i) new requirements for audit committees, including independence, expertise and responsibilities; (ii) additional responsibilities regarding financial statements for the Chief Executive Officer and Chief Financial Officer of the reporting company; (iii) new standards for auditors and regulation of audits; (iv) increased disclosure and reporting obligations for the reporting company and its directors and executive officers; and (v) new and increased civil and criminal penalties for violations of the securities laws. Many of the provisions were effective immediately while other provisions became effective over a period of time and are subject to rulemaking by the SEC. Because Sterling’s common stock is registered with the SEC, it is currently subject to this Act.
Throughout 2002 and 2003, the SEC and Nasdaq Stock Market issued new regulations affecting our corporate governance and heightening our disclosure requirements. Among the many new changes this year
are enhanced proxy statement disclosures on corporate governance, stricter independence requirements for the Board of Directors and its committees, and posting of various SEC reports on our website. The full impact of the Sarbanes-Oxley Act and the increased costs related to Sterling’s compliance are still uncertain and evolving.
We cannot predict what legislation might be enacted or what regulations might be adopted, or if enacted or adopted, the effect thereof on our operations.
USA Patriot Act of 2001
On October 26, 2001, the USA Patriot Act of 2001 was enacted. This act contains the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001, which sets forth anti-money laundering measures affecting insured depository institutions, broker-dealers and other financial institutions. The Act requires U.S. financial institutions to adopt new policies and procedures to combat money laundering and grants the Secretary of the Treasury broad authority to establish regulations and to impose requirements and restrictions on the operations of financial institutions.
Regulation W
Sterling and its banking affiliates are subject to Regulation W, which provides guidance on permissible activities and transactions between affiliated companies. In general, subject to certain specified exemptions, a bank or its subsidiaries are limited in their ability to engage in “covered transactions” with affiliates:
•
to an amount equal to 10% of the bank’s capital and surplus, in the case of covered transactions with any one affiliate; and
•
to an amount equal to 20% of the bank’s capital and surplus, in the case of covered transactions with all affiliates.
In addition, a bank and its subsidiaries may engage in covered transactions and other specified transactions only on terms and under circumstances that are substantially the same, or at least as favorable to the bank or its subsidiary, as those prevailing at the time for comparable transactions with nonaffiliated companies. A “covered transaction” includes:
•
a loan or extension of credit to an affiliate;
•
a purchase of, or an investment in, securities issued by an affiliate;
•
a purchase of assets from an affiliate, with some exceptions;
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the acceptance of securities issued by an affiliate as collateral for a loan or extension of credit to any party; and
•
the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate.
In addition, under Regulation W:
•
a bank and its subsidiaries may not purchase a low-quality asset from an affiliate;
•
covered transactions and other specified transactions between a bank or its subsidiaries and an affiliate must be on terms and conditions that are consistent with safe and sound banking practices; and
•
with some exceptions, each loan or extension of credit by a bank to an affiliate must be secured by collateral with a market value ranging from 100% to 130%, depending on the type of collateral, of the amount of the loan or extension of credit.
Dividends
Sterling is a legal entity separate and distinct from the subsidiary banks and nonbank subsidiaries. Our revenues, on a parent company only basis, result almost entirely from dividends paid to the corporation by its
subsidiaries. Federal and state laws regulate the payment of dividends by our subsidiaries, as outlined in the “Supervision and Regulation - Regulation of the Banks” section below.
Further, it is the policy of the Federal Reserve that bank holding companies should pay dividends only out of current earnings. Federal banking regulators also have the authority to prohibit banks and bank holding companies from paying a dividend if they should deem such payment to be an unsafe or unsound practice.
FDIC Insurance
The subsidiary banks are subject to Federal Deposit Insurance Corporation assessments. The FDIC has adopted a risk-related premium assessment system for both the Bank Insurance Fund for banks and the Savings Association Insurance Fund for savings associations. Under this system, FDIC insurance premiums are assessed based on capital and supervisory measures.
Under the risk-related premium assessment system, the FDIC, on a semiannual basis, assigns each institution to one of three capital groups, “well capitalized,” “adequately capitalized,” or “undercapitalized,” and further assigns such institution to one of three subgroups within a capital group corresponding to the FDIC’s judgment of its strength based on supervisory evaluations, including examination reports, statistical analysis, and other information relevant to gauging the risk posed by the institution. Only institutions with a total risk-based capital to risk-adjusted assets ratio of 10% or greater, a Tier 1 capital to risk-adjusted assets ratio of 6% or greater, and a Tier 1 leverage ratio of 5% or greater, are assigned to the well-capitalized group. Sterling and its subsidiary banks, at December 31, 2003, qualify as “well capitalized” under these regulatory standards.
Regulation of Banks
The operations of our banking subsidiaries are subject to the federal and state statutes, and are subject to the regulations of the Office of the Comptroller of the Currency, the Federal Reserve, the FDIC, and the Pennsylvania Department of Banking.
The Office of the Comptroller of the Currency, the primary supervisory authority over national banks, and the FDIC, the primary regulator of the state chartered bank, regularly examines banks in such areas as reserves, loans, investments, management practices, and other aspects of operations. These examinations are designed for the protection of the banks’ depositors rather than our shareholders. The subsidiary banks must file quarterly and annual reports with the FDIC.
The National Bank Act requires the subsidiary national banks to obtain the prior approval of the Office of the Comptroller of the Currency for the payment of dividends if the total of all dividends declared by the banks in one year would exceed the banks’ net profits, as defined and interpreted by regulation, for the two preceding years, less any required transfers to surplus. In addition, the banks may only pay dividends to the extent that their retained net profits, including the portion transferred to surplus, exceed statutory bad debts, as defined by regulation. Under Pennsylvania statutes, state chartered banks are restricted, unless prior regulatory approval is obtained, in the amount of dividends, which it may declare in relation to its accumulated profits, less any required transfer to surplus. These restrictions have not had, nor are they expected to have any impact on our dividend policy.
Sterling and our subsidiary banks are affected by the monetary and fiscal policies of government agencies, including the Federal Reserve and FDIC. Through open market securities transactions and changes in its discount rate and reserve requirements, the Board of Governors of the Federal Reserve exerts considerable influence over the cost and availability of funds for lending and investment. The nature of monetary and fiscal policies on future business and earnings of Sterling cannot be predicted at this time.
Other
From time to time, various federal and state legislation is proposed that could result in additional regulation of, and restrictions on, the business of Sterling and its subsidiaries, or otherwise change the business
environment. Management cannot predict whether any of this legislation will have a material effect on the business of Sterling.
Products and Services with Reputation Risk
Sterling and its subsidiaries offer a diverse range of financial and banking products and services. In the event one or more customers and/or governmental agencies become dissatisfied or object to any product or service offered by Sterling or any of its subsidiaries, negative publicity with respect to any such product or service, whether legally justified or not, could have a negative impact on Sterling’s reputation. The discontinuance of any product or service, whether or not any customer or governmental agency has challenged any such product or service, could have a negative impact on Sterling’s reputation.
Employees
As of December 31, 2003, Sterling had 835 full-time equivalent employees. None of these employees are represented by a collective bargaining agreement, and Sterling believes it enjoys good relations with its personnel.
Item 2
Item 2 - Properties
As of December 31, 2003, Sterling and its affiliates occupy 57 office locations in Lancaster, York, Adams, Lebanon, Berks, Chester and Bucks Counties, Pennsylvania, Cecil and Carroll Counties, Maryland and New Castle County, Delaware. The majority of these offices are utilized by the banking affiliates to service the needs of their retail and business customers. Offices at 34 locations are occupied under leases, and at three locations the affiliate owns the building, but leases the land. The remainder of the locations are owned by one of the bank affiliates.
In addition to the banking locations, the corporate headquarters, located in Lancaster, Pennsylvania, and operations centers located in East Petersburg, and Hanover, Pennsylvania, are owned by the bank affiliates. A certain amount of space in the Lancaster and East Petersburg buildings are leased to third parties.
All real estate owned by the subsidiary banks is free and clear of encumbrances. The leases of the subsidiary banks expire intermittently over the years through 2024 and most are subject to one or more renewal options. During 2003, aggregate annual rentals for real estate paid did not exceed 2% of our operating expenses.
Item 3
Item 3 - Legal Proceedings
As of December 31, 2003, there were no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which Sterling or its subsidiaries are a party or by which any of their property is the subject.
Various actions and proceedings arise out of routine operations and, in management’s opinion, will not have a material adverse effect on Sterling’s consolidated financial position or results of operations.
Item 4
Item 4 - Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of security holders during the fourth quarter of 2003.
Part II
Item 5
Item 5 - Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Sterling Financial Corporation’s common stock trades on the NASDAQ Stock Market under the symbol SLFI. There were 70,000,000 shares of common stock authorized at December 31, 2003, and 21,477,239
shares outstanding. As of December 31, 2003, Sterling had approximately 4,650 stockholders of record. At the 2003 Annual Meeting, the shareholders approved an amendment to the Articles of Incorporation and authorized the corporation to issue up to 10,000,000 shares of preferred stock. At December 31, 2003, no shares of preferred stock were issued.
Sterling is restricted as to the amount of dividends that it can pay to stockholders by virtue of the restrictions on the subsidiaries’ ability to pay dividends to Sterling.
The following table reflects the quarterly high and low prices of Sterling’s common stock for the periods indicated and the cash dividends declared on the common stock for the periods indicated.
All per share information has been restated for the 5-for-4 stock split, effected in the form of a 25% stock dividend declared in January 2004.
Item 6
Item 6 - Selected Financial Data
(1)
Dividends per share divided by basic earnings per share.
(2)
Excludes accumulated other comprehensive income (loss).
(3)
All per share information reflects the 5-for-4 stock split, effected in the form of a 25% stock dividend, declared in January 2004.
(4)
Calculated after netting depreciation on operating leases with related rental income.
(5)
Financial information reflects the acquisition of Equipment Finance LLC on March 1, 2002 and Church Capital Management LLC and Bainbridge Securities, Inc. on October 15, 2003. These acquisitions were accounted for under the purchase method of accounting.
Item 7
Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion provides management’s analysis of the consolidated financial condition and results of operations of Sterling Financial Corporation and its wholly-owned subsidiaries, Bank of Lancaster County, N.A., First National Bank of North East, Bank of Hanover and Trust Company, HOVB Investment Co., T&C Leasing, Inc. (T&C), Pennbanks Insurance Company, SPC, Church Capital Management LLC, Bainbridge Securities Inc. and Sterling Mortgage Services, Inc. (inactive). The consolidated financial statements also include Town & Country Leasing, LLC, Sterling Financial Trust Company and Equipment Finance, LLC, all wholly-owned subsidiaries of Bank of Lancaster County.
Management’s discussion and analysis should be read in conjunction with the audited financial statements and footnotes appearing elsewhere in this report and is intended to assist in understanding and evaluating the major changes in the financial condition and results of operations of the company with a primary focus in Sterling’s performance.
Critical Accounting Policies
Sterling’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and follow general practices within the industries in which it operates. Application of these principles require management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. When third-party information is not available, valuation adjustments are estimated in good faith by management primarily through the use of internal cash flow modeling techniques.
The most significant accounting policies followed by Sterling are presented in Note 1 to the consolidated financial statements. These policies, along with the disclosures presented in the other financial statement notes and in this financial review, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for loan losses and the evaluation of goodwill impairment to be the accounting areas that require the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.
The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated
balance sheet. Note 1 to the consolidated financial statements describes the methodology used to determine the allowance for loan losses.
With the adoption of SFAS No. 142 on January 1, 2002, Sterling is no longer required to amortize goodwill resulting from business acquisitions. Goodwill is now subject to impairment testing at least annually to determine whether write-downs of the recorded balances are necessary. Sterling tests for impairment based on the goodwill maintained at each defined reporting unit. An independent party using various market valuation methodologies determines a fair value. If the fair values of the reporting units exceed their book values, no write-downs of recorded goodwill are necessary. If the fair value of the reporting unit is less than its book value, an impairment expense may be required to be recorded to write down the related goodwill to the proper carrying value. Sterling completed its annual impairment testing and determined that no impairment write-offs were necessary. No assurance can be given that future impairment tests will not result in a charge to earnings.
Any material effect on the financial statements related to these critical accounting areas is also discussed in this management discussion and analysis.
Non-GAAP Presentations
This management’s discussion and analysis refers to the efficiency ratio, that is a non-GAAP financial measure that we believe provides readers with important information regarding Sterling’s operational efficiency. Comparison of Sterling’s efficiency ratio with other companies’ may not be appropriate, as they may calculate their efficiency ratio in a different manner.
The efficiency ratio is computed by dividing noninterest expense, less depreciation on operating leases, by the sum of tax equivalent net interest income and noninterest income, less depreciation on operating leases. Sterling nets the depreciation on operating leases against related income, as it is consistent with utilizing net interest income presentation for comparable capital leases, which nets interest expense against interest income. The efficiency ratio excludes unusual items, including gains/losses on securities activities, interest collected on charged-off loans, etc.
Sterling, in referring to its net income, is referring to income determined in conformity with accounting principles generally accepted in the United States (GAAP).
Inflation and Interest Rates
The majority of assets and liabilities of a financial institution are monetary in nature and, therefore, differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. However, inflation does have an important impact on the growth of total assets and on noninterest expenses, which tend to rise during periods of general inflation. Inflationary pressures over the last few years have been modest, although the potential for future inflationary pressure is always present given changing trends in the economy.
Fluctuations in interest rates impact financial institutions far more than inflationary factors. During the past two years, the Federal Reserve has lowered interest rates only twice, a 25 basis point reduction in June 2003 and a 50 basis point reduction in November 2002. The stability in interest rates throughout 2002-2003 was in sharp contrast to 2001, in which interest rates were cut eleven times, resulting in a reduction of the prime-lending rate by 475 b.p.
Management recognizes that asset/liability management, including the effect of rate changes on interest earning assets and interest bearing liabilities, is of critical importance.
RESULTS OF OPERATIONS
(All dollar amounts presented within tables are in thousands, except per share data.)
Executive Overview
Sterling’s executive management team and board of directors have identified three performance measurements that they feel are key elements of enhancing shareholder value. These include: a) increase in earnings per share; b) return on realized equity; and c) efficiency ratio.
The primary source of Sterling’s revenues, are net interest income derived from investments, which would include loans and investments, less their deposit and borrowing funding costs, as well as fees from financial services provided to customers, including rental income on operating leases. Revenues are influenced by general economic factors, including market interest rates, the economy of the markets served, stock market conditions, as well as competitive forces within the markets.
Despite a low interest rate environment and overall decline in the financial services industry’s net interest margin, Sterling was able to improve its net interest margin, from 3.95% and 4.38% in 2001 and 2002, to 4.65% in 2003. The improvement was primarily the result of a shift in the composition of Sterling’s interest earning assets, away from lower yielding federal funds and securities to higher yielding loans, particularly commercial loans and finance receivables. Net interest income increased to $85,918,000 in 2003, compared to $74,948,000 in 2002 and $58,642,000 in 2001.
Noninterest income, excluding securities gains and losses, has also benefited from the present market conditions as noted by the growth experience, and was $49,210,000, $45,292,000 and $41,215,000 in 2003, 2002 and 2001. As a result of the low interest rate environment, Sterling experienced an unprecedented volume of mortgage loan originations which contributed to growth in mortgage banking income, including mortgage servicing income and the gain on sale of loans, to $4,037,000 in 2003, compared to $3,103,000 in 2002 and $2,222,000 in 2001. In addition, improvement in the equity market supported growth in income from fiduciary activities and commissions and fees. Supplementing the improvement in the equity market was the acquisition of Church Capital Management LLC, a Registered Investment Advisor, and Bainbridge Securities, Inc., a NASD registered broker/dealer in the fourth quarter of 2003, which generated additional non-margin related fees. Industry projections are that mortgage loan originations are projected to fall off during 2004, which will adversely impact Sterling’s future mortgage banking revenues. A full year of fees and commissions at Church and Bainbridge should partially offset the lost mortgage production revenues.
As a result of the growth Sterling has experienced in its revenues over the past three years, noninterest expense has also increased to $92,568,000 in 2003, compared to $85,922,000 in 2002 and $75,172,000 in 2001. The increase in revenues that Sterling has experienced can be attributed to our relationship management model, which has resulted in new customer relationships, new financial services products being offered to meet their needs, and expansion of our market in to new geographic regions. These efforts have resulted in increases in salaries and employee benefits, higher occupancy and equipment charges, and other noninterest expenses.
Sterling’s overall strategy is to enhance growth in existing markets and affiliates, and complement this with new products and services, through the leveraging of existing resources. This has resulted in net income of $29,059,000, or $1.35 per diluted share in 2003, compared to $24,745,000, or $1.18 per diluted share in 2002, and $20,334,000, or $1.03 per diluted share in 2001. This represents an 14.4% increase in diluted earnings per diluted share in 2003, over 2002 results, and a 14.6% increase in 2002 over 2001 results. Sterling’s efficiency ratio, which expresses noninterest expenses a percentage of tax-equivalent net interest income and noninterest income, improved to 59.2% in 2003, compared to 60.2% and 64.5% in 2002 and 2001.
As a result of the increased earnings levels and improved efficiency ratio, returns on average realized equity also demonstrated improvement, and were 15.10%, 14.47% and 14.41% in 2003, 2002 and 2001.
A more thorough discussion of Sterling’s results of operations is included in the following pages.
Net Interest Income
The primary component of Sterling’s revenue is net interest income, which is the difference between interest income and fees on interest-earning assets and interest expense on interest-bearing funds. Earning assets include loans, securities and federal funds sold. Interest-bearing funds include deposits and borrowed funds. To compare the tax-exempt yields to taxable yields, amounts are adjusted to pretax equivalents based on a 35% federal corporate income tax rate.
Net interest income is affected by changes in interest rates, volume of interest-bearing assets and liabilities and the composition. The “interest rate spread” and “net interest margin” are two common statistics related to changes in net interest income. The interest rate spread represents the difference between the yields earned on interest-earning assets and the rates paid for interest-bearing liabilities. The net interest margin is defined as the percentage of taxable equivalent net interest income to average earning assets. Due mainly to demand deposits and stockholders’ equity, the net interest margin exceeds the interest rate spread, as these funding sources are non-interest bearing.
Table 1 presents net interest income on a fully taxable equivalent basis, interest rate spread and net interest margin for the years ending December 31, 2003, 2002, and 2001. Table 2 analyzes the changes in net interest income for the periods broken down by their rate and volume components.
Net interest income, on a tax equivalent basis, totaled $92,394,000 in 2003 compared to $80,492,000 for 2002 (excluding the interest recovery on a charged-off loan) and $64,295,000 in 2001.
The increase in net interest income of $11,902,000 from 2002 to 2003 reflects both an 8.2% increase in the average balance of interest-earning assets as well as a shift in the mix of interest-earning assets that led to a 27 b.p. increase in net interest margin.
The increase in interest-earning assets came primarily in the form of loans. In fact, the growth in loans exceeded the growth in earning assets, reflecting the funding of a portion of the loan growth with securities portfolio cash flow and overnight fed funds over the past year. Strong growth in the commercial loan and finance receivable portfolios as well as consumer loans and leases contributed to the increase in total loans. Year-over-year, average loans increased $161 million, increasing the percentage of loans to interest-earning assets from 68% in 2002 to 71% in 2003. Generally, loans carry a higher yield than alternative interest-earning assets, primarily securities and other investments.
Funding for the growth in assets came from deposits, borrowings, and earnings retained in stockholders’ equity. Strong growth was experienced in demand and savings deposits while the average balance of time deposits for the year increased at a relatively modest amount. Over the past year, Sterling experienced a significant volume of maturing CDs at high interest rates. During that time, current CD rates were consciously held at the now lower market levels.
During 2003, Sterling issued $35,000,000 of trust preferred redeemable equity securities through Sterling Capital Trust II, which qualified as regulatory capital. As a result, Sterling could leverage the increased capital by borrowing $75,000,000 from the Federal Home Loan Bank to purchase investment securities and were used for maturities of other FHLB borrowings and the continued pay-downs of third-party borrowings that had been used to fund both finance receivables and operating leases.
The increase in net interest margin from 2002 to 2003 continued for the second consecutive year, a reversal of a declining trend from the previous years. Driving this improvement was both the improving mix of earning assets in the balance sheet to higher yielding assets as well as the positive impact of generally declining interest rates. During the two and a half years from January 2001 to June of 2003, the Federal Reserve Bank lowered the federal funds rate thirteen times totaling 5.50%. This dramatic decrease in short-term interest rates resulted in a significant decrease in the cost of funds for Sterling.
Table 1 - Distribution of Assets, Liabilities and Stockholders’ Equity Interest Rates and Interest Differential-Tax Equivalent Yields
Yields on tax-exempt assets have been computed on a fully taxable equivalent basis assuming a 35% tax rate.
For yield calculation purposes, nonaccruing loans are included in the average loan balance.
The rate paid on interest bearing liabilities declined 64 b.p. from 2002 to 2003 resulting from:
•
The reduction of rates paid on deposit accounts;
•
The maturing of higher rate time deposits and borrowings;
•
Deposit growth and additional borrowings at relatively low rates of interest; and
•
Less reliance on third-party borrowings to fund growth in both finance receivables and operating leases.
At the same time, the rate earned on interest earning assets declined only 30 b.p. reflecting:
•
Growth in the loan portfolio, shifting the mix of earning assets. This growth also included the relatively higher margin finance receivables from EFI; and
•
A general lag in the effect of rapidly declining rates on loan and securities portfolio yields due to the proportion of fixed rates of interest in these portfolios.
During the second half of 2003, the downward repricing of assets accelerated relative to the repricing of liabilities, resulting in a diminishing benefit from the prolonged decline in interest rates. In addition, while the leveraging of the trust preferred proceeds increased net interest income, it reduced net interest margin.
The increase in net interest income of $16,197,000 from 2001 to 2002 reflects both a 12.8% increase in the average balance of interest-earning assets as well as a 43 b.p. increase in net interest margin.
Several factors had an impact on 2002’s results:
•
Strong growth in the commercial loan portfolio;
•
The acquisition of EFI and subsequent growth in finance receivables;
•
General decline in interest rates resulting in the reduction of rates paid on deposit accounts; and
•
The maturing of higher rate deposits and borrowings.
Table 2 - Analysis of Changes in Net Interest Income
The rate-volume variance analysis set forth in the table below, which is computed on a taxable equivalent basis, compares changes in net interest income for the periods indicated by their rate and volume components. The change in interest income/expense due to both volume and rate has been allocated to change in rate.
Provision for Loan Losses
The provision for loan losses charged against earnings was $3,697,000 in 2003, compared to $2,095,000 in 2002 and $1,217,000 in 2001. Despite the improvements in non-performing assets, Sterling increased its provision for loan losses during the last two years due to increases in net charge-offs during the period, combined with the growth in the loan portfolio and the increase in potential problem loans. Certain qualitative factors have also led to the increase in provision for loan losses, including our customer base, in which we have observed cash flows being negatively impacted by the national and local economic conditions, Sterling’s entry into new geographic markets resulting in the employment of new relationship managers, as well as turnover of experienced relationship managers. See further discussion in “Asset Quality” below.
Noninterest Income
Details of noninterest income follow:
Table 3 - Noninterest Income
Income from fiduciary activities, which includes both institutional trust and personal wealth management services, grew to $4,954,000 for the year ended December 31, 2003, up from $4,227,000, or 17.2% in 2002 and $4,166,000 in 2001. At December 31, 2003, Sterling had total assets under administration of approximately $1.058 billion compared to $918 million at the end of 2002 and $980 million at the end of 2001. These numbers include assets under management of $796 million, $671 million, and $737 million at December 31, 2003, 2002, and 2001. The positive effects of new business development, which increased the number of trust customers and related fees, combined with favorable market conditions over the past year all contributed to the overall increase in fee-based income.
Management believes that wealth management business represents a continued growth opportunity for the corporation. Through the formation of a separate trust company, Sterling Financial Trust Company, along with the acquisition of Church Capital Management LLC and Bainbridge Securities Inc. in October 2003, Sterling believes it will be able to increase revenue generation opportunities, while increasing operating efficiencies.
Other service charges, commissions and fees were $5,658,000 in 2003, a 23.8% increase over 2002’s total of $4,570,000. The acquisition of Church Capital Management and Bainbridge Securities in October 2003 contributed $905,000 of fee revenue, and is the primary reason for the increase. In addition, other service charges and fees have increased due to an increase in mutual fund and annuity commissions, as well as continued growth in customer debit card usage. The increase in income noted during 2002 and 2001 resulted from an increase in mutual fund and annuity commissions as a result of a more concentrated sales effort combined with a more competitive commission fee structure.
Mortgage banking income was $4,037,000 in 2003, compared to $3,103,000 in 2002 and $2,222,000 in 2001. Mortgage banking income has been favorably influenced by the trend noted in the financial services industry, which has seen an increased volume of mortgage loan originations/refinancings during the past three years, as interest rates have dropped significantly to 40-year lows. As a result of the rate environment,
mortgage-banking income increased during the past two years, despite accelerated amortization of mortgage servicing rights, and related impairment charges that have resulted from faster prepayment speeds.
Rental income on operating leases was $25,799,000 in 2003, compared to $25,752,000 in 2002, or a minor increase from year to year. This follows an increase of 5.9% in 2002 over 2001 results. The trend in rental income is consistent with the number of units under operating leases, which were 6,178, 6,214, and 5,864 as of December 31, 2003, 2002, and 2001. The decrease in the number of operating units during 2003 is primarily due to customers entering into more traditional financing arrangements such as commercial loans and finance leases, given the current interest rate environment combined with favorable tax treatment related to the depreciation of the assets leased/purchased.
Other operating income was $2,965,000 for the year ended December 31, 2003, an increase of $901,000 or 43.7% over 2002’s other operating income of $2,064,000. The increase in other income is primarily the result of the continued growth in insurance related revenues, which increased $140,000 over 2002, as well as increased handling charges on the lease portfolio. The 2002 increase is the result of the continued growth in insurance related revenues, as well as increased handling charges on the lease portfolio.
Securities gains and losses, all from the available-for-sale portfolio, are summarized as follows:
Gains and losses on debt securities are realized as part of ongoing investment portfolio and balance sheet management strategies. In 2003, Sterling experienced net gains on the debt security portfolio of $315,000, versus net losses of $60,000 in 2002 and net gains of $677,000 in 2001.
Equity security gains and losses are generated primarily through Sterling’s equity portfolio of financial institution sector stocks. Net securities gains on equities were $196,000 for the year ended December 31, 2003 versus securities losses of $400,000 in 2002 and net gains of $2,033,000 in 2001. Gains are taken as the result of ongoing asset liability management strategies, and capitalizing on appreciated values on certain equity security portfolio positions. During 2003, 2002 and 2001 Sterling recorded approximately $130,000, $1,160,000 and $224,000 in other than temporary impairment charges in the financial institution portfolio, which are included in losses above.
Noninterest Expense
Details of noninterest expense follow:
Table 4 - Noninterest Expense
The largest component of noninterest expense is salaries and employee benefits, which increased $2,576,000 or 7.0%, to $39,436,000 in 2003, after increasing $5,870,000 or 18.9% in 2002. In order to better understand the change in this expense category, infrequent charges of $1,785,000 should be excluded from the prior year total of $36,860,000. The infrequent charges consist of $1,140,000 in severance packages, $270,000 in the termination of the qualified non-contributory pension plan, and $375,000 in compensation expense related to the modification of terms on stock options granted to severed employees. Excluding these infrequent charges, the increase in salaries and employee benefits for the year ended December 31, 2003 is $4,361,000 or 12.4%. The increase is attributable to the following factors:
•
Normal merit increases to existing employees, coupled with replacing positions at higher wages than previously earned;
•
Increased number of employees, the result of branch expansion including the addition of PennSterling Bank and Delaware Sterling Bank, as well as the Church/ Bainbridge acquisition;
•
A full year of EFI salaries and benefits compared to ten months in 2002;
•
Additions to staff required to continue to serve our customers in light of the increased transaction volumes;
•
Higher incentive accruals resulting from the corporation’s performance levels during 2003 exceeding that achieved in 2002.
The $5,870,000 increase in salary and employee benefits in 2002 over 2001 was the result of normal merit increases; additional staffing needs for branch expansion; increases in employee benefit costs; and $1,785,000 of infrequent charges discussed above.
Furniture and equipment charges were $6,368,000, $5,762,000 and $5,081,000 for the years ended December 31, 2003, 2002 and 2001. The steady upward trend in furniture and equipment expense is the result of enhancements to the delivery channels available to deliver products to customers. Additionally, certain equipment charges are based on the number of accounts opened and their transaction volume. As Sterling’s customer base continues to grow, these types of charges grow as well. The increase in number of branch offices, and renovations made to existing branches also contributed to the increase in charges over the last two years.
Professional service expense was $3,154,000 for the year ended December 31, 2003, which represented a $309,000, or 10.9%, increase over 2002’s results. This increase followed a $433,000, or 18.0% increase, experienced in 2002 over 2001’s results. Increased professional service charges are due to increased auditor and attorney fees and expenses to ensure that Sterling continues to meet the requirements of the Sarbanes-Oxley Act of 2002. In addition, professional service expenses have increased as a result of long-term strategic
planning efforts, including evaluating potential acquisition candidates, implementing tax-planning strategies, and the evaluation of new market territories for bank affiliates.
Depreciation on operating lease assets increased to $21,438,000 in 2003, compared to $20,902,000 in 2002 and $19,217,000 in 2001. Depreciation expense on leased property as a percent of related rental income has increased from 79.0% in 2001, to 81.2% in 2002 and 83.1% in 2003. The higher depreciation as a percent of rental income is the result of the declining interest rate environment in 2002 and 2003. A correlation exists between interest rates, and the rental income charged to customers. In a lower interest rate environment, the rental income will decrease in order to compete with alternative financing sources (i.e. finance leases, commercial loans, etc.). Depreciation charges are more closely correlated to the unit’s cost, which is not impacted as much by interest rates, but rather inflation.
Other non-interest expenses were $17,246,000 in 2003, compared to $15,344,000 in 2002 and $13,646,000 in 2001. Expenses in this category consist of marketing, advertising, promotions, taxes other than income, postage, lending related expenses and telephone expenses. The largest fluctuation noted was in lending related expenses, as mortgage origination volumes during the past two years have increased the related expenses associated with this production. Additional reasons for the increase can be attributed to problem loan expense, particularly in 2003, as Sterling was able to decrease its non-performing asset balances. Marketing and advertising expenditures have increased, as Sterling entered new geographic markets and capitalized on the market disruption that occurred from larger bank mergers. The remaining increase in other non-interest expense is a function of Sterling’s overall growth, which results in higher expenses.
Operating expenses levels are often measured by the efficiency ratio, which expresses noninterest expense, excluding merger related and restructuring charges, as a percentage of tax-equivalent net interest income and other income. In calculating its efficiency ratio, Sterling nets depreciation on operating leases with the related rental income to more consistently present operating results with the banking industry.
Sterling’s efficiency ratio, excluding unusual items such as securities activities, restructuring charges, severance and other infrequent items, was 59.2%, 60.2%, and 64.5% for the years ended December 31, 2003, 2002 and 2001. The improvement noted in Sterling’s efficiency ratio is driven by the increase in net interest income experienced over the past two years. 2002’s improvement over 2001 was further enhanced by the centralization of various operations functions, which allowed for the elimination of redundant costs associated with running the three bank affiliates on different operating systems. The centralized operations functions allows for better utilization of fixed costs, such as premises and equipment, and variable costs, which includes employee resources.
Income Taxes
Sterling recognized income taxes of $10,315,000, $7,018,000 and $5,844,000 for the years ended December 31, 2003, 2002 and 2001. The increase in income tax expense is consistent with the higher levels of pre-tax income.
A more meaningful comparison is the effective tax rate, a measurement of income tax expense as a percent of pre-tax income, which was 26.2%, 22.1% and 22.3% for the years ended December 31, 2003, 2002, and 2001. Sterling’s effective tax rate is less than the 35% federal statutory rate, primarily due to tax-exempt loan and security income, and tax credits associated with low-income housing projects, offset by certain non-deductible expenses and state income taxes.
In order to understand the fluctuation, three events need to be considered. In March 2002, Sterling acquired Equipment Finance Inc. (EFI), a Pennsylvania C-corporation subject to state income taxes until April 1, 2003, when it converted to a single member limited liability company, which significantly reduced their state income tax expense. Also, effective July 1, 2002, Town and Country Leasing, a C-corporation at the time, converted to a single-member limited liability company which resulted in the reversal of a $1,200,000 deferred state tax liability. Excluding the $1,200,000 reversal, 2002’s effective tax rate would have been approximately 25.9%, an increase over 2001’s effective tax rate of 22.3%, reflective of the EFI acquisition. In 2003, tax-exempt income represented a smaller portion of pre-tax income, and therefore resulted in a higher
effective tax rate compared to 2002. This higher effective tax rate in 2003 occurred, despite the conversion of EFI and Town & Country to single-member limited liability companies.
FINANCIAL CONDITION
Average assets were $2,208,455,000 in 2003, representing 8.5% growth compared to 2002’s average assets of $2,036,291,000. Assets grew by 14.5% from 2001 to 2002. Loans experienced the most growth, as further outlined below.
Growth in average deposits funded a significant portion of the loan growth, and increased to $1,510,219,000 in 2003, compared to $1,423,379,000 in 2002 and $1,292,974,000 in 2001.
As part of an overall strategy to increase the return on equity of the corporation, the remaining growth in assets and more specifically loans, was funded by a reduction in the average level of federal funds sold and the cash flows from the investment securities portfolio. While investment securities on average increased from 2002 to 2003 by $14,895,000, this was the result of securities purchased through additional borrowed funds as part of a leveraging strategy to offset the incremental interest associated with trust preferred securities.
Investment Securities
Sterling utilizes investment securities as a primary tool for managing interest rate risk, to generate interest and dividend income and to provide liquidity to the parent company and affiliates. During 2003, the cash flows from investment securities were generally used to fund the strong loan growth generated by Sterling. Proceeds from maturities, sales, and calls totaled $195,006,000. Purchases of $183,779,000 included $80,000,000 related to the leveraging of trust-preferred proceeds. The $80,000,000 was funded by trust preferred proceeds and incremental borrowings from the Federal Home Loan Bank.
Overall, this activity shifted the mix of the portfolio by increasing agency and municipal securities and decreasing mortgage-backed and corporate securities. This shift was a result of a number of factors, including the generally low interest rate environment, a continued effort to reduce the credit risk associated with corporate securities, and a need to maintain a sufficient level of securities that are qualified to serve as collateral for public fund and other deposits requiring pledged securities.
At December 31, 2003, the securities balance included net unrealized gains on available-for-sale securities of $22,747,000 versus net unrealized gains of $23,695,000 at December 31, 2002. The continued low level of interest rates led to maintaining or even increasing the unrealized gains on a majority of the holdings in the portfolio. However, the relatively significant level of cash flow and reinvestment resulted in a greater portion of the portfolio carrying yields closer to the current level of market interest rates.
Table 5 - Investment Securities
The following table shows the amortized cost of the held-to-maturity securities owned by Sterling as of the dates indicated. Securities are stated at cost adjusted for amortization of premiums and accretion of discounts.
Included in held-to-maturity equity securities are Federal Reserve Bank stock, Federal Home Loan Bank of Pittsburgh stock, and Atlantic Central Bankers Bank stock.
The following table shows the amortized cost and fair value of the available-for-sale securities owned as of the dates indicated.
All mortgage-backed securities are those of U.S. Government agencies.
The available-for-sale equity securities are comprised of the following:
These holdings are maintained for long-term appreciation in these segments of the market.
As of December 31, 2003, amortized cost reflects a write-down for other than temporary impairment charges totaling $872,000. These charges were recognized when the market value of a specific holding had not exceeded cost at any time in the prior six months.
Sterling recognized other than temporary impairment charges of $130,000, $1,160,000 and $224,000 in 2003, 2002, and 2001.
Table 6 - Investment Securities (Yields)
The following table shows the maturities of held-to-maturity debt securities at amortized cost as of December 31, 2003, and approximate weighted average yields of such securities. Yields on states and political subdivision securities are shown on a tax equivalent basis, assuming a 35% federal income tax rate.
The following table shows the maturities of available-for-sale debt securities at fair value as of December 31, 2003, and approximate weighted average yields of such securities. Yields on states and political subdivision securities are shown on a tax equivalent basis assuming a 35% federal income tax rate.
There is no issuer of securities in which the aggregate book value of that issuer, other than securities of the U.S. Treasury, U.S. Government agencies, exceeds 10% of stockholders’ equity.
Loans
Loans outstanding increased $199,997,000, or 15.4% in 2003, compared to 18.0% growth experienced in 2002. The overall growth in loans is consistent with a stable local economy, and continued demand for loans to support existing customers’ growth. Sterling experienced growth in every loan category except real estate mortgage, which is attributable to the following factors:
•
Commercial and agricultural loans increased $37,266,000, or 13.1% from December 31, 2002. Sterling has experienced increased business loan demand during 2003 as customers capitalized on the low interest rate environment to fund their capital expenditures. Growth has also come from Sterling’s newer markets, including Berks County, Pennsylvania, and Carroll County, Maryland. Sterling expects to see continued growth in these two new markets, as it expands its geographic footprint.
•
Commercial real estate loans have increased $53,638,000 or 13.4% since December 31, 2002. The low interest rate environment, entrance to the new markets, and increased emphasis on commercial real estate lending has generated additional real estate lending opportunities.
•
Loans to financial institutions totaled $19,488,000 at December 31, 2003, a $14,788,000 increase over December 31, 2002. This is a direct result of the Correspondent Services Group, a division of Bank of Lancaster County, N.A. started in the latter half of 2002 to serve the needs of financial institutions in the Mid-Atlantic region.
•
Consumer loans have also benefited from the low interest rate environment and reported a $32,174,000 increase. Customers are using home equity loans to make improvements to their homes, buy new vehicles, and make other discretionary purchases. In addition, Sterling has been utilizing advertising campaigns in target markets to increase its retail relationships.
•
Despite the historic lows in mortgage rates and the resulting origination volume, Sterling’s real estate mortgage loan balance has decreased $22,217,000 or 21.6% since December 31, 2002. As a result of the low interest rate environment, Sterling has experienced higher levels of early payoffs, as customers are refinancing at lower interest rates.
•
Finance receivables have increased $56,533,000 from December 31, 2002 to December 31, 2003, and lease financing receivables increased $23,848,000 during the same period. This growth is the result of Sterling’s two specialty lending subsidiaries, Equipment Finance and Town & Country Leasing, which have generated a significant volume of new business.
A primary reason for Equipment Finance’s decision to be affiliated with Sterling was the funding that Sterling could provide in order to increase its market share. Since Sterling’s acquisition in February 2002, Equipment Finance has been able to capture new business and increase its finance receivables outstanding.
Town & Country has also generated growth in its lease financings, as additions to the sales force have led to new business opportunities, and similar to the growth in commercial loans, customers have made capital expenditures to benefit from the low interest rate environment. A portion of the growth experienced in lease financing receivables is the result of certain customers, who in the past would prefer an operating lease, now favoring finance leases to capitalize on bonus accelerated tax depreciation. As a result, Town & Country has experienced a decline in its operating lease balances on personal property.
Table 7 - Loan Portfolio
The following table sets forth the composition of Sterling’s loan portfolio as of the dates indicated:
Table 8 - Loan Maturity and Interest Sensitivity
The following table sets forth the maturity of the commercial loan portfolio as of December 31, 2003.
Commercial loans due after one year totaling $332,337,000 have variable interest rates. The remaining $435,178,000 in loans have fixed rates.
Asset Quality
Sterling’s loan portfolios are subject to varying degrees of credit risk. Credit risk is mitigated through prudent underwriting standards, on-going credit review, and monitoring and reporting asset quality measures. Additionally, loan portfolio diversification, limiting exposure to a single industry or borrower, and requiring collateral also reduces Sterling’s credit risk.
Sterling’s commercial, consumer and residential mortgage loans are principally to borrowers in south central Pennsylvania, northern Maryland, and northern Delaware. As the majority of Sterling’s loans are located in this area, a substantial portion of the debtor’s ability to honor their obligations may be affected by the level of economic activity in the market area. Sterling’s finance receivables are primarily to customers in the eastern part of the United States to finance forestry and land clearing equipment.
Non-performing assets include nonaccrual and restructured loans, accruing loans past due 90 days or more and other foreclosed assets. Sterling’s general policy has been to cease accruing interest on loans when management determines that a reasonable doubt exists as to the collectibility of additional interest. When management places a loan on nonaccrual status, it reverses unpaid interest credited to income in the current year, and charges unpaid interest accrued in prior years to the allowance for loan losses. Sterling recognizes income on these loans only to the extent that it receives cash payments. Sterling typically returns nonaccrual loans to performing status when the borrower brings the loan current and performs in accordance with contractual terms for a reasonable period of time. Sterling categorizes a loan as restructured if it changes the terms of the loan such as interest rate, repayment schedule or both, to terms that it otherwise would not have granted originally.
Table 9 - Nonaccrual, Past Due and Restructured Loans
The following table presents information concerning the aggregate amount of nonaccrual, past due and restructured loans:
As of December 31, 2003, non-performing assets were $5,250,000, a decrease of $6,752,000 or 56.3% from December 31, 2002. Restructured loans included in non-performing loans, represented a series of loans to one borrower in the real estate business, which were fully secured with real estate collateral and were current as to modified contractual obligations. In 2003, these loans were removed from restructured status as they remained current and met contractual obligations as required by the loan agreements.
During 2003, several favorable developments occurred, which contributed to the $7,507,000 reduction in nonaccrual loans. These developments were as follows:
•
An agreement was reached with two large commercial relationships that were classified as nonaccrual loans at December 31, 2002, which resulted in the liquidation of business assets, foreclosure by Sterling on certain remaining assets, and the charge-off of the remaining principal balance. As a result of these agreements, $3,050,000 was transferred from loans to foreclosed assets, $900,000 in business assets were liquidated by the borrower and used to reduce outstanding loan balances, and $620,000 was charged off on these loans. Subsequent to foreclosure, $2,500,000 in real estate foreclosed in 2003 was sold to a third party with external financing sources. The settlement of this transaction resulted in a minor gain on sale of real estate.
•
Two large commercial relationships in nonaccrual status had substantial principal payments during the year, including a $1,500,000 relationship that was paid off in its entirety, and a reduction of $600,000 in nonaccrual loans on a second relationship.
Potential problem loans are defined as performing loans, which have characteristics that cause management to have serious doubts as to the ability of the borrower to perform under present loan repayment terms and which may result in the reporting of these loans as nonperforming loans in the future. Total potential problem loans were approximately $7.1 million at December 31, 2003 and $1.2 million at December 31, 2002. Additionally, outstanding letter of credit commitments totaling approximately $2.3 million could result in potential problem loans, if drawn upon. The majority of these loans are secured by a combination of business assets and/or real estate with acceptable loan-to-value ratios.
Allowance for Loan Losses
Sterling maintains the allowance for loan losses at a level that management believes adequate to absorb potential losses inherent in the loan portfolio and is established through a provision for loan losses charged to earnings. Additionally, when Sterling acquires a company in a purchase business combination, the acquired allowance is combined with Sterling’s existing allowance. Quarterly, the company utilizes a defined methodology in determining the adequacy of the allowance for loan losses. This methodology considers specific credit reviews, past loan loss historical experience, and qualitative factors.
Management assigns internal risk ratings to all commercial relationships with aggregate borrowings or commitments to extend credit in excess of $100,000. Using migration analysis for the previous eight quarters, management develops a loss factor test, which it then uses to estimate losses on impaired loans, potential problem loans and non-classified loans. When management finds loans with uncertain collectibility of principal and interest, it places those loans on the “problem list,” and evaluates them on a quarterly basis in order to estimate potential losses. Management’s analysis considers:
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Adverse situations that may affect the borrower’s ability to repay;
•
Estimated value of underlying collateral; and
•
Prevailing market conditions.
If management determines that a specific reserve allocation is not required, it assigns the general loss factor based on historical performance to determine the reserve. For homogeneous loan types, such as consumer and residential mortgage loans, management bases specific allocations on the average loss ratio for the previous two years for each specific loan pool. Additionally, management adjusts projected loss ratios for other factors, including the following:
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Trends in delinquency levels;
•
Trends in non-performing and potential problem loans;
•
Trends in composition, volume and terms of loans;
•
Effects in changes in lending policies or underwriting procedures;
•
Experience ability and depth of management;
•
National and local economic conditions;
•
Concentrations in lending activities; and
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Other factors as management may deem appropriate.
Management determines the unallocated portion of the allowance for loan losses based on the following criteria:
•
Risk of error in the specific and general reserve allocations;
•
Other potential exposure in the loan portfolio;
•
Variances in management’s assessment of national and local economic conditions; and
•
Other internal or external factors that management believes appropriate at that time.
Management believes this methodology accurately reflects losses inherent in the portfolio. Management charges actual loan losses to the allowance for loan losses. Management periodically updates this methodology, which reduces the difference between actual losses and estimated losses.
Management bases the provision for loan losses on the overall analysis taking the methodology into account.
A summary of the activity in the allowance for loan losses is as follows:
Table 10 - Summary of Loan Loss Experience
The allowance for loan losses increased $1,703,000 from $12,953,000 at December 31, 2002, to $14,656,000 at December 31, 2003. The allowance represents 0.98% of loans outstanding at December 31, 2003, and continued a trend in lower reserve levels to outstanding loans.
Despite the improvements in non-performing assets, Sterling increased its provision for loan losses to $3,697,000 for 2003, as compared to $2,095,000 for 2002. The increase in the provision is consistent with the increase in net charge-offs during the period, combined with the growth in the loan portfolio and the increase in potential problem loans. Certain qualitative factors have also led to the increase in provision for loan losses, including our customer base, in which we have observed cash flows being negatively impacted by the national
and local economic conditions, Sterling’s entry into new geographic markets resulting in the employment of new relationship managers, as well as turnover of experienced relationship managers.
Table 11 - Allocation of Allowance for Loan Losses
The allocation of the allowance for loan losses between the various loan portfolios has changed over the past few years, consistent with the historical net loss experience in each of the portfolios. Additionally, management enhanced the application of the allowance methodology in 2002, which served to more appropriately reflect the risk associated with the factors and resulted in a more refined allocation methodology. Consequently, a portion of the unallocated reserve was reclassified to the allocated reserve, without an increase in probable loan losses.
The largest reserve allocation is to the commercial, financial and agricultural loan portfolio, which represents approximately 53% of the reserve balance. This reflects the increase in net charge-offs, increases in loans, entering new markets with new lenders, and changes in other factors that impact the inherent risks in the portfolio. This non-homogeneous loan portfolio, along with leases, continues to represent the greatest risk exposure to Sterling. The loans, generally, are larger than the remainder of the portfolio and the related collateral is not as marketable. Additionally, other external factors, such as competition for high rated credits, is also considered in allocating this reserve balance.
During 1998, Sterling sold its credit card portfolio, which was included in the consumer loan category in determining the allocation of the allowance for loan losses. As a result of the sale of this portfolio, Sterling has seen an improvement in charge-offs in consumer loans in 1998 through 2000, which resulted in lower historical charge-off percentages used in developing the quantitative portion of the reserve allocation. As a result, the allocation of the allowance for loan losses to the consumer loan portfolio generally lowered from 1998 - 2001. As a result of the recent downturn in the economy and management’s approach in more aggressively charging off consumer loans, Sterling has experienced a steady increase in net charge-offs during the last three years. This increase, which led to higher historical charge-off percentages, combined with an increased qualitative adjustment, resulted in an increase in the consumer loan allocation in 2002.
During 2003, the reserve allocation related to the lease portfolio has increased consistent with the trends noted in lease charge-offs during the last two years and continued uncertainty as to the impact of the economy on the slumping transportation industry and other factors that impact the inherent risks in the portfolio.
The unallocated portion of the allowance reflects estimated inherent losses within the portfolio that have not been detected. The unallocated portion of the reserve results due to risk of error in the specific and general reserve allocations, other potential exposure in the loan portfolio, variances in management’s assessment of national and local economic conditions, and other internal or external factors that management believes appropriate at the time.
While management believes Sterling’s allowance for loan losses is adequate based on information currently available, future adjustments to the reserve may be necessary due to changes in economic conditions, and management’s assumptions as to future delinquencies or loss rates.
Assets Held for Operating Leases
After several years of steady growth, Sterling’s assets held for operating leases portfolio experienced a decline during 2003. Assets held for operating leases were $57,891,000 at December 31, 2003, compared to $63,291,000 at December 31, 2002, an 8.5% decrease. The decrease can be attributed to economic conditions, in which the low interest rate environment and bonus tax depreciation on personal property has resulted in a greater willingness of customers to enter into finance leases, or more traditional commercial lending arrangements.
Operating leases have residual value risk associated with them. Operating lease terms, including monthly rental payment and length of the lease, are established based upon the residual value, or the estimate of fair value of the leased asset at the end of the lease term. If, at the end of the lease term, the fair value of the leased property is less than the residual value calculated at lease origination, a loss on disposal could result. Sterling mitigates this risk through use of anticipated values published by various industries, and in some instances, discussions with industry experts. Further, the lease terms include provisions that the lessee shares the risk of loss on disposal of equipment, up to 50% of the residual value.
Deposits
Sterling continues to rely heavily on deposit growth as a primary source of funds for lending activities. Total deposits at December 31, 2003 were $1,778,587,000, compared to $1,702,302,000 at December 31, 2002, an increase of 4.5%. Sterling has experienced growth in its demand deposit and savings accounts, while seeing a decline in its certificate of deposit portfolio.
During the past two years, the banking industry has seen customers migrate their investment funds from the equity market to safer and more liquid investments. Banks have benefited from this shift in consumer preference and have been able to grow their deposit base, particularly in the money-market indexed funds. The decrease in certificates of deposits from 2002 to 2003 is due to its reduced attractiveness in a low interest rate environment. With the recent improvement in the equity market, management anticipates it will not be able to continue to generate the deposit growth it has seen in the past two years, as investors will migrate back to the equity market. Sterling will continue to explore new products to meet the needs of its customers in order to grow its deposit balances.
Table 12 - Average Deposit Balances and Rates Paid
The following table summarizes the average amounts of deposits and rates paid for the years indicated:
Table 13 - Deposit Maturity
The following table summarizes the maturities of time deposits of $100,000 or more as of the dates indicated:
Short-Term Borrowings
Short-term borrowings are comprised primarily of securities sold under agreements to repurchase, U.S. Treasury demand notes, borrowings from other financial institutions and lines of credit. As of December 31, 2003, short-term borrowings were $43,878,000, an increase of $2,258,000 from the December 31, 2002 balance of $41,620,000. This increase is primarily attributable to Sterling borrowing $5,000,000 under a line of credit to fund finance receivables, offset by a decrease of approximately $2,326,000 of securities sold under repurchase agreements.
Long-Term Debt
Long-term debt totaled $195,762,000 at December 31, 2003, an increase of $40,284,000 over December 31, 2002’s balance of $155,478,000.
In the third quarter of 2003, Sterling entered into a leveraging strategy, in which it borrowed $75,038,000 from the Federal Home Loan Bank of Pittsburgh, and invested the proceeds in U.S. Agency and tax-free securities. The incremental borrowings have a weighted average rate of 2.46%, and weighted average maturity of 39 months.
Prior to the leveraging strategy, Sterling was meeting its scheduled maturities of long-term debt obligations with funding obtained from deposit growth. This reduction in third party borrowings offset the incremental borrowings that resulted from the leveraging strategy. In addition, the prepayment of two FHLB advances totaling, $5,000,000 occurred in December 2003, and resulted in a prepayment fee of $258,000.
Subordinated Notes Payable
In the third quarter of 2003, Sterling deconsolidated its investment in Sterling Financial Statutory Trusts I and II in accordance with the provisions of FIN 46. As permitted by the provisions of FIN 46, the December 31, 2002 balance sheet was restated as well for consistent presentation.
Sterling Financial Statutory Trusts I and II are special purpose subsidiary trusts that issued trust preferred capital securities. The proceeds from the trust preferred securities were invested in junior subordinated deferrable interest debentures of Sterling, at terms consistent with the trust preferred capital securities.
Prior to the third quarter, Sterling presented “company obligated mandatorily redeemable preferred securities of a subsidiary trust” on its balance sheet, which was the trust preferred securities being consolidated in Sterling’s balance sheet. With the adoption of FIN 46, the subsidiary trusts are no longer consolidated, and as a result, the balance sheet now presents junior subordinated debt on its balance sheet.
In June 2003, Sterling entered into a $36,083,000 junior subordinated note payable with Sterling Financial Statutory Trust II, at a fixed interest rate of 5.55%. This debenture was in addition to Sterling’s first junior subordinated debt with Sterling Financial Statutory Trust I, at a variable interest rate of 3-month
LIBOR plus 360 basis points. The proceeds of the $36,083,000 junior subordinated notes were used to fund internal growth and other corporate matters, including the funding of the cash portions of the Church Capital Management and Bainbridge Securities acquisitions.
Derivative Financial Instruments
Sterling is a party to derivative instruments in the normal course of business to reduce its own exposure to fluctuations in interest rates and to meet the financing needs of its customers.
Asset Liability Management
Sterling uses derivative instruments to assist in asset liability management to manage its exposure to earnings volatility caused by fluctuations in interest rates. Interest rate swaps are used to hedge cash flow variability related to floating rate liabilities, through the use of pay-fixed instruments. Gains and losses on derivative instruments reclassified from accumulated other comprehensive income to current-period earnings are included in the line item in which the hedged cash flows are recorded. At December 31, 2003 other comprehensive income included a deferred after-tax loss of $942,000 consisting of a loss on a pay-fixed interest rate swap used to hedge future cash flows on floating rate liabilities, versus $1,078,000 at December 31, 2002. A portion of the amount in other comprehensive income is reclassified from other comprehensive income to interest expense as net settlements occur. For the year end December 31, 2003, Sterling recognized interest expense of $918,000 related to interest rate swaps accounted for as cash flow hedges, versus $543,000 for the year ended December 31, 2002. At December 31, 2003, the notional amount of the interest rate swap was $25,000,000, and had a negative gross carrying value of $1,480 ,000. The interest rate swap matures in 2006.
Interest rate options, which include caps, are contracts that transfer, modify, or reduce interest rate risk in exchange for the payment of a premium when the contract is initiated. A premium is paid for the right, but not the obligation, to buy or sell a financial instrument at predetermined terms in the future. At December 31, 2003, the notional amount of an interest rate cap purchased was $5,000,000, and its carrying value was reduced to zero.
In May 2003, Sterling entered into two equity put options as fair value hedges to protect the company from risk that the fair value of its SLM Corporation stock might be adversely impacted by changes in market price. The two equity put options each cover 30,000 shares of SLM’s stock, one with a valuation date in May 2004 and the second with a valuation date of May 2006. If, at the valuation date, the stock price is below the reference price (May 2004 - $31.93; May 2006 - $33.81), the counter-party will pay the difference between the stock’s price on the valuation date and its reference price to Sterling. Sterling paid $258,000 for these put options, and as of December 31, 2003 their fair value was $84,000. The difference was charged to other noninterest expense and totaled $174,000 for the year ended December 31, 2003. At December 31, 2003, the trading price of the SLM Corporation stock was $37.68.
Customer Related
In the third quarter of 2003, Sterling entered into interest rate contracts; including interest rate caps and interest rate swap agreements to facilitate customer transactions in order to meet their financing needs. A summary of the customer related interest rate contracts at December 31, 2003 is as follows (in thousands):
The interest rate contract portfolio is actively managed and hedged with offsetting contracts, with identical terms, with third-party counterparties. Changes in the estimated fair value of customer related contracts and related interest settlements, net of the offsetting counterparty contracts, are recorded in
noninterest income. Through December 31, 2003, net fees of $28,000 are included in other noninterest income.
Sterling believes it has reduced market risk on its customer related derivative contracts, through offsetting contractual relationships with counterparties. However, if a customer or counterparty fails to perform, credit risk is equal to the extent of the fair value gain in a derivative. When the fair value of a derivative instrument contract is positive, this generally indicates that the counterparty or customer owes Sterling, and results in credit risk to Sterling. When the fair value of a credit risk is negative, Sterling owes the customer or counterparty, and therefore, has no credit risk. Sterling minimizes the credit risk in derivative instruments by including derivative credit risk in its credit underwriting procedures, and by entering into transactions with high-quality counterparties that are reviewed periodically by Sterling’s treasury function.
Capital
The management of capital in a regulated financial services industry must properly balance return on equity to stockholders while maintaining sufficient capital levels and related risk-based capital ratios to satisfy regulatory requirements. Additionally, capital management must also consider acquisition opportunities that may exist, and the resulting accounting treatment.
Sterling’s capital management strategies have been developed to provide attractive rates of returns to stockholders, while maintaining its “well-capitalized” position at each of the banking subsidiaries.
One capital management strategy that Sterling has employed is the use of trust preferred capital securities through its wholly owned special purpose subsidiary trusts, Sterling Financial Statutory Trust I and II. The proceeds from the preferred securities were invested in junior subordinated deferrable interest debentures of Sterling, at terms consistent with the trust preferred capital securities. Sterling’s treatment of the preferred capital securities is consistent with long-term debt, and the related dividends being presented as interest expense. Sterling’s obligations under the debentures and related documents, taken together, constitute a full and unconditional guarantee by Sterling of the Statutory Trusts’ obligations under the preferred capital securities. As of this writing, the preferred capital securities continue to qualify for Tier 1 capital treatment for Sterling.
FIN 46 has been the subject of much debate among accounting professionals, regulators, Financial Accounting Standards Board and the SEC staff. While the primary intention of FIN 46 was to require consolidation of certain “off balance sheet” special purpose affiliates for generally accepted accounting principles, one consequence is to require deconsolidation of trust subsidiaries used for purposes of issuing Trust Preferred Securities. This deconsolidation could jeopardize Tier 1 capital treatment of the trust preferred securities in regulatory capital calculations, when final clarification of the guidance is issued. In June 2003, the Board of Governors of the Federal Reserve issued interim guidance, which instructs institutions with trust preferred securities to continue reporting in their Tier 1 capital for regulatory purposes.
Sterling has $55,000,000 in trust preferred securities as of December 31, 2003, which has been included as Tier 1 capital in its regulatory capital calculations. In the event of an unfavorable outcome, which would prohibit inclusion of the trust preferred securities as Tier 1 capital in the future, Sterling’s Tier 1 ratio would be negatively impacted. However, Sterling expects its Tier 1 and total capital ratios will remain above the well-capitalized thresholds.
Earnings retention, which represents net income less dividends declared, is a primary source of additional capital to Sterling. During 2003, Sterling retained $17,130,000, or 58.9%, of its net income. The acquisition of Church and Bainbridge has provided additional capital of $7,315,000.
During the second quarter of 2003, Sterling announced that its Board of Directors authorized a plan to purchase, in open market and privately negotiated transactions, up to 1,000,000 shares of its outstanding common stock. This newly approved repurchase plan, when combined with 42,692 shares remaining to be purchased under Sterling’s repurchase plan announced in February 2001, represents approximately 4.9% of the outstanding shares of Sterling’s common stock. Through December 31, 2003, 93,750 shares have been repurchased under this program at an average price of $21.37.
Sterling and its banking subsidiaries are subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on Sterling and the subsidiary banks’ financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, Sterling and its banking subsidiaries must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and reclassifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
Quantitative measures established by regulation to ensure capital adequacy require Sterling and its banking subsidiaries to maintain minimum amounts and ratios of total and Tier 1 capital to average assets. Management believes, as of December 31, 2003 and 2002 that Sterling and the subsidiary banks met all minimum capital adequacy requirements to which they are subject.
As of December 31, 2003, the most recent notification from the Federal Deposit Insurance Corporation categorized the banks as “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as “well capitalized” institutions must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following tables. There are no conditions or events since the notification that management believes have changed the banks’ category. Sterling’s and the banks’ actual capital amounts and ratios as of December 31, 2003, and 2002 are also presented in the table.
Table 14 - Risked-Based Capital
Sterling’s actual capital amount and ratios are as follows:
The improvement in the capital ratios at December 31, 2003 from 2002, are principally attributable to the $35,000,000 trust preferred securities, issued in June 2003, which presently qualifies for Tier 1 Capital treatment.
Liquidity
Effective liquidity management ensures the cash flow requirements of depositors and borrowers, as well as the operating cash needs of Sterling are met.
Sterling’s funds are available from a variety of sources, including assets that are readily convertible to cash (federal funds sold, short-term investments), securities portfolio, scheduled repayments of loans receivable, core deposit base, short-term borrowing capacity with a number of correspondent banks and the Federal Home Loan Bank (FHLB), and the ability to package residential mortgage loans originated for sale. As of December 31, 2003, Sterling has unused funding commitments from these financial institutions and the FHLB totaling $316,900,000.
The liquidity of the parent company also represents an important aspect of liquidity management. The parent company’s net cash outflows consist principally of dividends to shareholders and unallocated corporate
expenses. The main source of funding for the parent company is the dividends it receives from its banking subsidiaries. Federal and state banking regulations place certain restrictions on dividends paid to the parent company from the subsidiary banks. The total amount of dividends that may be paid from the subsidiary banks to Sterling total $61,390,000 at December 31, 2003.
Sterling manages liquidity by monitoring projected cash inflows and outflows on a daily basis, and believes it has sufficient funding sources to maintain sufficient liquidity under varying degrees of business conditions.
Contractual Obligations, Commitments and Off-balance Sheet Arrangements
Sterling enters into contractual obligations in its normal course of business to fund loan growth, for asset/ liability management purposes, to meet required capital needs and for other corporate purposes. The following table presents significant fixed and determinable contractual obligations by payment date. Further discussion of the nature of each obligation is included in the referenced note to the consolidated financial statements.
Sterling is a party to derivative instruments in the normal course of business, to assist in asset liability management and reduce exposure in earnings volatility caused by fluctuations in interest and market conditions and to meet the financing needs of its customers. Derivative contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of the expected future cash receipts or payments based on market and interest rate conditions as of the balance sheet date. The fair values of the contracts can change daily as market and interest rate conditions fluctuate. These derivative contracts require monthly cash settlement. As the derivative liabilities recorded on the balance sheet do not represent the amounts that will ultimately be paid under the contract, they are not included in the table of contractual obligations discussed above. Further discussion of derivative instruments is included in Notes 1 and 15 to the consolidated financial statements.
A schedule of significant commitments at December 31, 2003 is as follows:
Commitments to extend credit:
Further discussion of these commitments to extend credit is included in Note 15 to the consolidated financial statements. In addition, Sterling has commitments and obligations under employee benefit plans as discussed in Note 17 to the consolidated financial statements.
Sterling has no off-balance sheet arrangements through the use of special-purpose entities.
New Financial Accounting Standards
Note 1 to the consolidated financial statements discusses the expected impact on Sterling’s financial condition or results of operations for recently issued or proposed accounting standards that have not been adopted. To the extent we anticipate a significant impact to Sterling’s financial condition or results of operations, appropriate discussion takes place in the applicable note to the consolidated financial statements.
Item 7A
Item 7A - Quantitative and Qualitative Disclosures About Market Risk
Financial institutions can be exposed to several market risks that may impact the value or future earnings capacity of an organization. These risks involve interest rate risk, foreign currency exchange risk, commodity price risk and equity market price risk. Sterling’s primary market risk is interest rate risk. Interest rate risk is inherent because as a financial institution, Sterling derives a significant amount of its operating revenue from “purchasing” funds (customer deposits and borrowings) at various terms and rates. These funds are then invested into earning assets (loans, leases, investments, etc.) at various terms and rates. This risk is further discussed below.
Equity market risk is not a significant risk to the corporation, as equity investments on a cost basis comprise less than 1% of corporate assets. Sterling does not have any exposure to foreign currency exchange risk or commodity price risk.
Interest Rate Risk
Interest rate risk is the exposure to fluctuations in the corporation’s future earnings (earnings at risk) and value (value at risk) resulting from changes in interest rates. This exposure results from differences between the amounts of interest earning assets and interest bearing liabilities that reprice within a specified time period as a result of scheduled maturities and repayment, contractual interest rate changes, or the exercise of explicit or embedded options.
The primary objective of the corporation’s asset/liability management process is to maximize current and future net interest income within acceptable levels of interest rate risk while satisfying liquidity and capital requirements. Management recognizes that a certain amount of interest rate risk is inherent and appropriate yet is not essential to the corporation’s profitability. Thus the goal of interest rate risk management is to maintain a balance between risk and reward such that net interest income is maximized while risk is maintained at a tolerable level.
Management endeavors to control the exposures to changes in interest rates by understanding, reviewing and making decisions based on its risk position. The corporate asset/liability committee is responsible for these decisions. The corporation primarily uses the securities portfolios and borrowings to manage its interest rate risk position. Additionally, pricing, promotion and product development activities are directed in an effort to emphasize the loan and deposit term or repricing characteristics that best meet current interest rate risk objectives. At present, the use of off-balance sheet instruments is not significant.
The committee operates under management policies defining guidelines and limits on the level of risk. These policies are approved by the Boards of Directors.
The corporation uses simulation analysis to assess earnings at risk and net present value analysis to assess value at risk. These methods allow management to regularly monitor both the direction and magnitude of the corporation’s interest rate risk exposure. These modeling techniques involve assumptions and estimates that inherently cannot be measured with complete precision. Key assumptions in the analyses include maturity and repricing characteristics of both assets and liabilities, prepayments on amortizing assets, other imbedded
options, non-maturity deposit sensitivity and loan and deposit pricing. These assumptions are inherently uncertain due to the timing, magnitude and frequency of rate changes and changes in market conditions and management strategies, among other factors. However, the analyses are useful in quantifying risk and provide a relative gauge of the corporation’s interest rate risk position over time.
Earnings at Risk
Simulation analysis evaluates the effect of upward and downward changes in market interest rates on future net interest income. The analysis involves changing the interest rates used in determining net interest income over the next twelve months. The resulting percentage change in net interest income in various rate scenarios is an indication of the corporation’s shorter-term interest rate risk. The analysis utilizes a “static” balance sheet approach. The measurement date balance sheet composition (or mix) is maintained over the simulation time period, with maturing and repayment dollars being rolled back into like instruments for new terms at current market rates. Additional assumptions are applied to modify volumes and pricing under the various rate scenarios. These include prepayment assumptions on mortgage assets, the sensitivity of non-maturity deposit rates, and other factors deemed significant.
The simulation analysis results are presented in Table 15a. These results indicate that the corporation would expect net interest income to increase over the next twelve months by 3.9% assuming an immediate upward shift in market interest rates of 2.00% and to decrease by 5.3% if rates shifted downward in the same manner. This profile reflects an asset sensitive short-term rate risk position and is within the guidelines set by policy. At December 31, 2002, annual net interest income was expected to increase by 1.9% in the upward scenario and to decrease by 3.3% in the downward scenario. The risk position has changed from the prior year-end to a more asset sensitive position primarily due to an increase in the volume of variable commercial and consumer loans as well as fed funds sold.
Value at Risk
The net present value analysis provides information on the risk inherent in the balance sheet that might not be taken into account in the simulation analysis due to the shorter time horizon used in that analysis. The net present value of the balance sheet is defined as the discounted present value of expected asset cash flows minus the discounted present value of the expected liability cash flows. The analysis involves changing the interest rates used in determining the expected cash flows and in discounting the cash flows. The resulting percentage change in net present value in various rate scenarios is an indication of the longer term repricing risk and options embedded in the balance sheet.
The net present value analysis results are presented in Table 15b. These results indicate that the net present value would be unchanged assuming an immediate upward shift in market interest rates of 2.00% and to decrease 1.7% if rates shifted downward in the same manner. The risk position of Sterling is within the guidelines set by policy. At December 31, 2002, the analysis indicated that the net present value would decrease 0.3% assuming an immediate upward shift in market interest rates of 2.00% and to decrease 1.1% if rates shifted downward in the same manner.
Item 8
Item 8 - Financial Statements
(a) The following audited consolidated financial statements and related documents are set forth in the Annual Report on Form 10-K on the following pages:
Report of Independent Auditors
The Board of Directors and Shareholders
Sterling Financial Corporation
We have audited the accompanying consolidated balance sheets of Sterling Financial Corporation as of December 31, 2003 and 2002, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2003. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Sterling Financial Corporation at December 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States.
As discussed in Note 1 to the Consolidated Financial Statements, in 2002, Sterling Financial Corporation changed its method of accounting for goodwill.
Philadelphia, Pennsylvania
January 27, 2004
STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets
The accompanying notes are an integral part of these consolidated financial statements.
STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
Consolidated Statements of Income
The accompanying notes are an integral part of these consolidated financial statements.
STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
Consolidated Statements of Changes in Stockholders’ Equity
The accompanying notes are an integral part of these consolidated financial statements.
STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
The accompanying notes are an integral part of these consolidated financial statements.
STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(All dollar amounts presented in the tables are in thousands, except per share data)
Note 1 - Summary of Significant Accounting Policies
Basis of Presentation and Consolidation - The consolidated financial statements include the accounts of Sterling Financial Corporation (Sterling) and its wholly-owned subsidiaries, Bank of Lancaster County, N.A. (Bank of Lancaster County), First National Bank of North East (First National), Bank of Hanover and Trust Company (Bank of Hanover), HOVB Investment Co., T&C Leasing, Inc. (T&C), Pennbanks Insurance Company, SPC, Church Capital Management, LLC, Bainbridge Securities Inc., and Sterling Mortgage Services, Inc. (inactive). The consolidated financial statements also include Town & Country Leasing, LLC (Town & Country), Sterling Financial Trust Company, and Equipment Finance, LLC, all wholly-owned subsidiaries of Bank of Lancaster County. All significant intercompany balances and transactions have been eliminated in consolidation.
Use of Estimates - In preparing consolidated financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and reported amounts of revenues and expenses during the period. Actual results could differ from those estimates.
Business - Sterling, through its subsidiaries, provides a full range of financial services to individual and corporate customers located in south central Pennsylvania, northern Maryland and Delaware. Additionally, with its acquisition of Equipment Finance, LLC in 2002, Sterling finances forestry and land clearing equipment to customers on the east coast of the United States.
Concentration of Credit Risk - Sterling operates primarily in its defined market area and, accordingly, the banks have extended credit primarily to commercial entities and individuals in this area whose ability to honor their contracts is influenced by the region’s economy. The loan portfolio is well diversified and Sterling does not have any significant concentrations of credit risk. Sterling’s exposure to the forestry industry at December 31, 2003 was $141 million. The banks are limited in extending credit by legal lending limits to any single group of borrowers.
Cash and Cash Equivalents - For purposes of the consolidated statements of cash flows, cash and cash equivalents include cash and balances due from banks and federal funds sold, generally which mature in one day.
Interest-bearing Deposits in Banks - Interest-bearing deposits in banks mature within one year and are carried at cost.
Securities - Debt securities that management has the positive intent and ability to hold to maturity are classified as “held-to-maturity” and recorded at amortized cost. Securities not classified as held to maturity, including equity securities with readily determinable fair values, are classified as “available-for-sale” and recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income.
Purchase premiums and discounts are recognized in interest income using the interest method over terms of the securities using the constant yield method. Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other-than-temporary are reflected in earnings in the period that management concludes that other than temporary impairment occurs. Sterling uses various indicators in determining whether a security is other-than-temporarily impaired, including for equity securities, if the market value is below its cost for an extended period of time or for debt securities, when it is probable that the contractual interest and principal will not be collected.
Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.
STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
Mortgage Loans Held for Sale - Loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value in aggregate. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income.
Loans - Sterling grants mortgage, commercial and consumer loans and leasing alternatives to customers. The ability of Sterling’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in the market area.
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off, generally are reported at their outstanding principal balance adjusted for charge-offs, the allowance for loan losses and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance.
Lease contracts which meet the appropriate criteria specified in Statement of Financial Accounting Standards No. 13, Accounting for Leases, are classified as direct finance leases. Direct finance leases are recorded upon acceptance of the equipment by the customer. Unearned lease income represents the excess of the gross lease investment over the cost of the leased equipment, which is recognized over the lease term at a constant rate of return on the net investment in the lease.
Loan and lease origination fees and loan origination costs are deferred and recognized as an adjustment of the related loan yield using the interest method.
The accrual of interest on loans is generally discontinued at the time the loan is 90 days delinquent unless the credit is well secured and in the process of collection. Loans are placed on nonaccrual status or charged-off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued, but not collected for loans that are placed on nonaccrual status or charged-off is reversed against interest income. The interest received on these loans is applied to reduce the carrying value of the loan or, if principal is considered fully collectible, recognized as interest income until qualifying for return to accrual status. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Allowance for Loan Losses - Sterling maintains the allowance for loan losses at a level believed adequate by management to absorb potential losses inherent in the loan portfolio. It is established and maintained through a provision for loan losses charged to earnings. Quarterly, the company utilizes a defined methodology in determining the adequacy of the allowance for loan losses, which considers specific credit reviews, past loan loss historical experience, and qualitative factors. This methodology which has remained consistent for the past several years, results in an allowance consisting of two components, “allocated” and “unallocated”.
Management assigns internal risk ratings to all commercial relationships with aggregate borrowings or commitments to extend credit in excess of $100,000. Utilizing migration analysis for the previous eight quarters, management develops a loss factor test, which it then uses to estimate losses on impaired loans, potential problem loans and non-classified loans. When management finds loans with uncertain collectibility of principal and interest, it places those loans on the “problem list”, and evaluates them on a quarterly basis in order to estimate potential losses. Management’s analysis considers adverse situations that may affect the borrower’s ability to repay, estimated value of underlying collateral, and prevailing market conditions. If management determines that a specific reserve allocation is not required, it assigns a general loss factor based on historical performance to determine the reserve necessary for each loan. For homogeneous loan types, such as consumer and residential mortgage loans, management bases specific allocations on the average loss ratio for the previous two years for each specific loan pool. Additionally, management projects loss ratios for other factors, including trends in delinquency levels, trends in non-performing and potential problem loans, trends in composition, volume and terms of loans, effects of changes in lending policies or underwriting procedures,
STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
experience ability and depth of management, national and local economic conditions, concentrations in lending activities, and other factors that management may deem appropriate.
Management determines the unallocated portion of the allowance for loan losses based on the following criteria: risk of error in the specific and general reserve allocations; other potential exposure in the loan portfolio; variances in management’s assessment of national and local economic conditions; and other internal or external factors that management believes appropriate at that time.
Management believes the above methodology accurately reflects losses inherent in the portfolio. Management charges actual losses to the allowance for loan losses. Management periodically updates the methodology discussed above, which reduces the difference between actual losses and estimated losses.
A loan is considered impaired when, based on current information and events, it is probable that Sterling will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.
Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, Sterling does not separately identify individual consumer and residential loans for impairment disclosures.
Servicing - Servicing assets are recognized as separate assets when rights are retained through the sale of financial assets. Capitalized servicing rights are reported in other assets and are amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights by predominant characteristics, such as interest rate and terms. Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market-based assumptions. Impairment is recognized through a valuation allowance for individual stratum, to the extent the fair value is less than the capitalized amount for the stratum.
Financial Instruments
Credit Related Financial Instruments - In the ordinary course of business, Sterling has entered into commitments to extend credit, commercial letters of credit and standby letters of credit. Such financial instruments are recorded when they are funded.
Derivative Financial Instruments - As part of Sterling’s asset/liability management, it uses interest rate contracts, which include swaps and cap agreements, to hedge various exposures or to modify interest rate characteristics of various balance sheet accounts. Derivatives that are used as part of the asset/liability management process are linked to specific assets or liabilities and have high correlation between the contract and the underlying item being hedged, both at inception and throughout the hedge period. Sterling formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking each hedge transaction.
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Notes to Consolidated Financial Statements - (Continued)
Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended, requires all derivative instruments to be carried at fair value on the balance sheet. Statement No. 133 provides special hedge accounting provisions, which permit the change in fair value of the hedged item related to risk being hedged to be recognized in earnings in the same period and in the same income statement line as the change in fair value of the derivative.
Sterling’s derivatives consist of cash flow hedges, which are designed to mitigate exposures to variability in expected cash flows. Cash flow hedges are accounted for by recording the fair value of the derivative instrument on the balance sheet as either a freestanding asset or liability, with a corresponding offset recorded in other comprehensive income within stockholders’ equity, net of tax. Amounts are reclassified from other comprehensive income to the income statement in period or periods the hedged forecasted transaction effects earnings. Under the cash flow hedge method, derivative gains and losses not effective in hedging the change in expected cash flows of the hedged item are recognized immediately in income in the interest expense line. At the hedge’s inception and at least quarterly thereafter, an assessment is performed to determine whether changes in the cash flows of the derivative instruments have been highly effective in offsetting changes in the cash flows of the hedged items and whether they are expected to be highly effective in the future. If it is determined a derivative instrument has not been or will not continue to be highly effective as a hedge, hedge accounting is discontinued prospectively.
Foreclosed Assets - Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at the lower of fair value or carrying value at the date of foreclosure. Any initial charge necessary is reflected as a charge to the allowance for loan losses. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenues and expenses from operations and changes in the valuation allowance are included in other non-interest expenses.
Premises and Equipment - Land is carried at cost. Buildings, furniture, equipment and leasehold improvements are stated at cost, less accumulated depreciation and amortization. Depreciation is computed primarily on the straight-line method over the estimated useful lives of the asset.
Assets Held for Operating Leases - Leases that do not meet the criteria of direct finance leases are accounted for as operating leases. Leased equipment is recorded at cost and depreciated over the lease term, to the estimated residual value at the expiration of the lease term, generally on a straight-line basis. Sterling periodically reviews estimated net realizable values and records losses in current earnings if the estimated residual balance indicates impairment.
Goodwill - Goodwill represents the excess of the cost of an acquisition over the fair value of the assets acquired. Sterling segments goodwill into two different categories, goodwill associated with business acquisitions and goodwill associated with branch purchases. As a result of the adoption of Statement No. 142, Goodwill and Other Intangible Assets, business acquisition goodwill is no longer ratably amortized into the income statement over an estimated life, but rather is tested at least annually for impairment. Consistent with the provisions of Statement No. 147, Sterling continues to amortize its branch purchase goodwill over a twenty-year period.
Intangible Assets - Intangible assets represent purchased assets that lack physical substance but can be distinguished from goodwill because of contractual or other legal rights. Sterling’s intangible assets have finite lives and are amortized over their estimated useful lives. Intangible assets are also subject to impairment testing.
Income Taxes - Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws.
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Notes to Consolidated Financial Statements - (Continued)
Advertising - Sterling expenses advertising costs as incurred. The expenses for 2003, 2002, and 2001 were $1,379,000, $1,545,000, and $1,172,000.
Stock Compensation Plan - Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, encourages all entities to adopt a fair value-based method of accounting for employee stock compensation plans, whereby compensation cost is measured at the grant date based on the value of the award and is recognized over the vesting period. However, it also allows an entity to continue to measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, whereby compensation cost is the excess, if any, of the quoted market price of the stock at the grant date over the amount an employee must pay to acquire the stock. Stock options issued under Sterling’s stock incentive plan have no intrinsic value at the grant date, and under Opinion No. 25, no compensation cost is recognized for them. Sterling has elected to continue with the accounting methodology in Opinion No. 25 and, as a result, has provided pro forma disclosures of net income, earnings per share and other disclosures, as if the fair value based method of accounting had been applied.
Earnings Per Share - Basic earnings per share represents income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if potential dilutive common shares had been issued. Potential common shares that may be issued by Sterling consist solely of outstanding stock options and are determined using the treasury stock method.
Earnings per common share have been computed based on the following:
All share and per share amounts have been properly restated to reflect the 5-for-4 stock split effected in the form of a 25% stock dividend declared in January 2004, which will be paid in February 2004.
Comprehensive Income - Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities and interest rate derivatives are reported as separate components of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income.
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Notes to Consolidated Financial Statements - (Continued)
The components of other comprehensive income and related tax effects are as follows:
The ending accumulated balances for each item included in accumulated other comprehensive income, net of related income taxes, were as follows:
Reclassifications - Certain items in the 2002 and 2001 consolidated financial statements have been reclassified to conform to the 2003 presentation format. Such reclassifications had no impact on net income.
Recent Accounting Pronouncements - On December 11, 2003, the Securities and Exchange Commission (SEC) staff announced its intention to release a Staff Accounting Bulletin that would require all registrants to account for mortgage loan interest rate lock commitments related to loans held for sale as written options, effective no later than for commitments entered into after March 31, 2004. This guidance, if issued, would require Sterling to recognize a liability on its balance sheet equal to the fair value of the commitment at the time the loan commitment is issued, and not recognize revenue related to these commitments until such time as the loan is sold. The Corporation is currently assessing the impact of this pending guidance on its results of operations and financial position. In the quarter of adoption, Sterling does not anticipate a significant impact to its financial condition or results of operations.
In December 2003, the Financial Accounting Standards Board (FASB) revised Statement No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits. This Statement retains the disclosures required by the original Statement No. 132 and requires additional disclosures about the assets, obligations, cash flows and net periodic benefit cost of defined benefit pension and postretirement plans. In addition, this Statement requires interim period disclosure of the components of net period benefit cost and contributions if significantly different from previously reported amounts. Sterling adopted the provisions of this Statement as of December 31, 2003. See Note 16 for the additional pension and other postretirement benefit disclosures.
In May 2003, the FASB issued Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity. This Statement establishes standards for classifying and measuring certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. The provisions of SFAS 150 became effective June 1, 2003, for all financial instruments created or modified after May 31, 2003, and otherwise became effective as of July 1, 2003. The adoption of this standard did not have a material impact on financial condition, the results of operations, or liquidity.
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Notes to Consolidated Financial Statements - (Continued)
In April 2003, the FASB issued Statement No. 149, Amendment of Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. This statement clarifies the definition of a derivative and incorporates certain decisions made by the Board as part of the Derivatives Implementation Group process. This statement is effective for contracts entered into or modified, and for hedging relationships designated after June 30, 2003 and should be applied prospectively. The provisions of the Statement that relate to implementation issues addressed by the Derivatives Implementation Group that have been effective should continue to be applied in accordance with their respective effective dates. Adoption of this standard is not expected to have a significant impact on Sterling’s financial condition or results of operations.
In January 2003, the FASB issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, FIN 46 provides guidance on how to identify a variable interest entity (VIE) and determine when the assets, liabilities, noncontrolling interests, and results of operations of a VIE are to be included in an entity’s consolidated financial statements. A VIE exists when either the total equity investment at risk is not sufficient to permit the entity to finance its activities by itself, or the equity investors lack one of three characteristics associated with owning a controlling financial interest. Those characteristics include the direct or indirect ability to make decisions about an entity’s activities through voting rights or similar rights, the obligation to absorb the expected losses of an entity if they occur, or the right to receive the expected residual returns of the entity if they occur.
During the third quarter of 2003, Sterling applied the provisions of FIN 46 to two wholly-owned special purpose subsidiary trusts, Sterling Financial Statutory Trust I and II that have issued preferred capital securities to third-party investors. The application of FIN 46 resulted in the deconsolidation of the two wholly-owned subsidiary trusts. The assets, which consisted entirely of a subordinated debenture in Sterling, and liabilities, which consisted solely of preferred securities held by third parties and common securities held by Sterling, of the subsidiary trusts that were deconsolidated totaled $20.633 million and $36.111 million, respectively. As allowed by the transition provisions of FIN 46, Sterling restated all previous periods presented as if FIN 46 had been adopted as of the date of the establishment of the subsidiary trusts. There was no material impact to results of operations or liquidity as of and for the year ended December 31, 2003 and 2002 as a result of applying these provisions of FIN 46. See Note 12 for further discussion of these trusts and Sterling’s related obligations.
In December 2003 the FASB made certain modifications to clarify FIN 46. Application of this guidance was effective for interests in certain VIEs commonly referred to as special-purpose entities (SPEs) as of December 31, 2003. Application for all other types of entities is required for periods ending after March 15, 2004, unless previously applied.
In November 2002, the FASB issued Interpretation No. 45 (FIN 45), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” This Interpretation expands the disclosures to be made by a guarantor in its financial statements about its obligations under certain guarantees and requires the guarantor to recognize a liability for the fair value of an obligation assumed under certain specified guarantees. FIN 45 clarifies the requirements of FASB Statement No. 5, “Accounting for Contingencies.” In general, FIN 45 applies to contracts or indemnification agreements that contingently require the guarantor to make payments to the guaranteed party based on changes in an underlying that is related to an asset, liability or equity security of the guaranteed party, which would include financial standby letters of credit. Certain guarantee contracts are excluded from both the disclosure and recognition of this Interpretation, including, among others, guarantees related to commercial letters of credit and loan commitments. The disclosure requirements of FIN 45 require disclosure of the nature of the guarantee, the maximum potential amount of future payments that the guarantor could be required to make under the guarantee and the current amount of the liability, if any, for the guarantor’s obligations under the guarantee. The accounting recognition requirements of FIN 45 are to be applied prospectively to guarantees
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Notes to Consolidated Financial Statements - (Continued)
issued or modified after December 31, 2002. Significant guarantees are disclosed in Note 15. Adoption of FIN 45 did not have a significant impact on Sterling’s financial condition or results of operations.
Standby letters of credit written are conditional commitments issued by Sterling to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as those that are involved in extending loan facilities to customers. Sterling generally holds collateral and/or guarantees supporting these commitments, if deemed necessary.
Sterling has $67,557,000 of standby letters of credit as of December 31, 2003. Management believes that the proceeds obtained through a liquidation of collateral and the enforcement of guarantees would be sufficient to cover the potential amount of future payments required under the corresponding guarantees. The current amount of the liability as of December 31, 2003 for guarantees under standby letters of credit issued after December 31, 2002 is not material.
Note 2 - Business Combinations
Equipment Finance, LLC - On February 28, 2002, Sterling acquired 100 percent of the outstanding common shares of Equipment Finance, Inc. (EFI), a Lancaster-based commercial finance company. The results of EFI’s operations have been included in the consolidated financial statements since that date. EFI specializes in financing forestry and land clearing equipment through more than 150 equipment dealer locations ranging from Maine to Florida. As a result of the acquisition, Sterling has enhanced earnings and provided financial product diversification.
The transaction was accounted for under the provisions of Statement No. 141, Business Combinations, which requires assets acquired and liabilities assumed to be recorded at their fair value on the date of the acquisition. The carrying amounts of the assets acquired, primarily loans receivables, and the liabilities assumed, primarily borrowings, on February 28, 2002, approximated their fair value. The excess of the acquisition cost over the fair value of the net assets acquired has been recorded as goodwill. Goodwill recognized in this transaction was approximately $17,220,000, which was assigned to the commercial finance segment.
The aggregate purchase price was $30,500,000 including $9,502,000 of cash and common stock valued at $20,998,000. The value of the 954,452 common shares issued was based on the closing price of Sterling common stock at the time the Agreement and Plan of Reorganization (Merger Agreement) was entered into. In accordance with the items of the Merger Agreement, there is no contingent consideration associated with this transaction. An escrow account of $1,065,000 has been established and will be released in three years after the acquisition date, upon determination that no unknown claims or liabilities existed as of the acquisition date.
Church Capital Management Inc. and Bainbridge Securities, Inc. - On October 15, 2003, Sterling acquired 100 percent of the outstanding common shares of Church Capital Management, Inc. and its affiliate, Bainbridge Securities Inc. Church Capital Management is a SEC Registered Investment Advisor with assets under management of approximately $690,000,000. Bainbridge Securities is a National Association of Securities Dealers (NASD) securities broker/dealer offering a wide array of investment services. As a result of the acquisition, Sterling plans to enhance earnings and provide financial product diversification.
In connection with the completion of the acquisition of Church and Bainbridge, Sterling issued 359,998 shares of its common stock and paid $7,920,000. In addition, 240,002 shares of Sterling’s common stock and $5,280,000 were placed in escrow, which will be released over the next five years based upon Church and Bainbridge reaching specified performance criteria and the settlement, if any, of outstanding litigation at the date of acquisition. Based on the closing price of Sterling’s common stock at the time the agreement was
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Notes to Consolidated Financial Statements - (Continued)
entered into, the 600,000 shares of common shares are valued at $12,192,000. The share information has been restated to reflect the 5-for-4 stock split effected in the form of a 25% stock dividend.
The transaction was accounted for under the provisions of Statement No. 141, Business Combinations. The purchase price allocation included $38,000 to premises and equipment and $5,110,000 to finite-lived intangible assets, including $3,700,000 to customer list, $480,000 to trademark, and $930,000 to covenants not to compete. The intangible assets have a weighted average life of approximately 7 years. The remaining portion of the purchase price, or $12,218,000, was assigned to goodwill, within the Trust and Investment Services segment. This transaction will generate additional goodwill, as the cash and shares held in escrow are released upon the satisfying of the specified performance criteria. The goodwill is not expected to be written off for tax purposes.
Note 3 - Restrictions on Cash and Due from Banks
Sterling’s subsidiary banks are required to maintain reserves, in the form of cash and balances with the Federal Reserve Bank, against their deposit liabilities. The average amount of these reserve balances for the year ended December 31, 2003 were approximately $8,370,000. Balances maintained at the Federal Reserve Bank are included in cash and due from banks.
Note 4 - Securities
The amortized cost and fair values of securities were as follows:
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Notes to Consolidated Financial Statements - (Continued)
Included in held-to-maturity equity securities are Federal Reserve Bank stock, Federal Home Loan Bank of Pittsburgh stock and Atlantic Central Bankers Bank stock.
The amortized cost and fair value of securities at December 31, 2003, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities or call dates because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
The following table presents a breakdown by consecutive months of gross unrealized losses and fair value by investment category.
Various indicators are used in determining whether a security is other-than-temporarily impaired, including for equity securities, if the market value is below its cost for an extended period of time or for debt securities, when it is probable that the contractual interest and principal will not be collected. The unrealized losses as of December 31, 2003 are primarily attributable to changes in interest rates (i.e. increase in rates since the date of acquiring the debt security). Management does not believe any individual unrealized loss represents an other-than-temporary impairment.
Securities pledged to secure government and other public deposits, trust deposits, short-term borrowings, and other balances as required or permitted by law were carried at $184,688,000 in 2003 and $157,199,000 in 2002.
Proceeds from sales of securities available-for-sale were $74,907,000, $29,150,000, and $28,107,000 for the years ended December 31, 2003, 2002, and 2001. Gross gains of $847,000, $1,520,000, and $3,170,000 were realized on these sales for the years ended December 31, 2003, 2002, and 2001. Gross losses of $336,000, $1,980,000, and $460,000 were recognized for the years ended December 31, 2003, 2002, and 2001. Gross losses include impairment charges of $130,000, $1,160,000 and $224,000 for years ended December 31, 2003, 2002 and 2001.
Note 5 - Loans
A summary of the balances of loans follows:
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Notes to Consolidated Financial Statements - (Continued)
Changes in the allowance for loan losses are as follows:
Information concerning impaired loans is as follows:
Impaired loans included $0 and $521,000 of loans that were considered troubled debt restructurings at December 31, 2003 and 2002. The remainder of the impaired loan balance consisted of nonaccrual loans at December 31, 2003 and 2002. Loans over 90 days past due still accruing interest were $1,513,000 and $545,000 at December 31, 2003 and 2002.
Note 6 - Mortgage Banking Activities
Loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid principal mortgage loans serviced for others were $499,202,000, $403,559,000 and $325,030,000 at December 31, 2003, 2002, and 2001. Sterling’s bank affiliates maintain sufficient levels of capital to meet its investors’ net worth requirements.
Changes in the mortgage servicing right asset is as follows:
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Notes to Consolidated Financial Statements - (Continued)
Information concerning the activity in the related mortgage servicing rights valuation allowance is as follows:
For valuation purposes, at December 31, 2003, Sterling assumed a weighted average discount rate of 8.5% and assumed prepayments speeds consistent with published rates for Sterling’s market area. Additional factors such as economic data, market trading information, credit risk and professional judgment were used in determining the valuation allowance.
Note 7 - Premises and Equipment
A summary of the cost and accumulated depreciation of premises and equipment follows:
The subsidiaries of Sterling lease certain facilities under operating leases which expire on various dates through 2024. Renewal options are available on these leases. Minimum future rental payments as of December 31, 2003, under non-cancelable real estate leases, are payable as follows:
Total rent expense charged to operations amounted to $1,517,000, $1,288,000 and $1,096,000 for the years ended December 31, 2003, 2002, and 2001.
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Notes to Consolidated Financial Statements - (Continued)
Note 8 - Leases
Information concerning net investment in direct financing leases, included in loans receivable:
The allowance for uncollectible lease payments, included in the allowance for loan losses, was $2,021,000 and $1,094,000 at December 31, 2003 and 2002.
Investments in property on operating lease and property held for lease by major classes is as follows:
Minimum future rentals on noncancelable finance and operating leases as of December 31, 2003, are as follows:
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Notes to Consolidated Financial Statements - (Continued)
Note 9 - Goodwill and Intangible Assets
The changes in the carrying amount of goodwill for the two years ended December 31, 2003, are as follows:
A summary of finite-lived intangible assets are as follows:
Amortization expense of finite-lived intangible assets was $148,000, $79,000, and $101,000 for the years ended December 31, 2003, 2002, and 2001. Amortization expense on finite-lived intangible assets is estimated to be $813,000, $760,000, $754,000, $747,000 and $744,000 for the years ended December 31, 2004, 2005, 2006, 2007, and 2008.
Note 10 - Deposits
The aggregate amount of time deposits in denominations of $100,000 or more at December 31, 2003 and 2002 was $140,250,000 and $141,380,000.
STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
At December 31, 2003, the scheduled maturities of time deposits are as follows:
Note 11 - Short-Term Borrowings
Short-term borrowings and weighted average interest rates consist of the following:
The securities sold under repurchase agreements represent collateral to the lending party and are obligations of U.S. agencies and corporations. These securities are maintained under Sterling’s control. As of December 31, 2003, Sterling had unused short-term funding commitments totaling $93,500,000.
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Notes to Consolidated Financial Statements - (Continued)
Note 12 - Long-Term Debt
Long-term debt consisted of the following:
The contractual maturities of long-term debt as of December 31, 2003, are shown below. Actual maturities may differ from contractual maturities due to the convertible features of the FHLB advances, which may be prepaid by Sterling, in the event the FHLB converts them to adjustable rate.
Under the terms of the notes payable to financial institutions, Sterling is required to meet certain conditions, including specific financial ratios, as measured on a periodic basis. Sterling was in compliance with these covenants during the periods presented. As of December 31, 2003, Sterling has unused funding commitments from these financial institutions and the FHLB totaling $223,400,000.
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Notes to Consolidated Financial Statements - (Continued)
Note 13 - Junior Subordinated Debentures Owed to Unconsolidated Subsidiary Trusts and Corporation-Obligated Mandatorily Redeemable Capital Securities of Subsidiary Trusts Holding Solely Debentures of the Corporation
Sterling has two non-consolidated subsidiary trusts, Sterling Financial Statutory Trust I and Sterling Financial Statutory Trust II, of which 100% of the common equity is owned by Sterling. The trusts were formed for the purpose of issuing corporation-obligated mandatorily redeemable capital securities (the capital securities) to third-party investors and investing the proceeds from the sale of such capital securities solely in junior subordinated debt securities of Sterling (the debentures). The debentures held by each trust are the sole assets of that trust. Distributions on the capital securities issued by each trust are payable semi-annually at a rate per annum equal to the interest rate being earned by the trust on the debentures held by that trust. The capital securities are subject to mandatory redemption, in whole or in part, upon repayment of the debentures. Sterling has entered into agreements which, taken collectively, fully and unconditionally guarantee the capital securities subject to the terms of each of the guarantees. The debentures held by the Statutory Trust I and II capital trusts are first redeemable, in whole or in part, by the Corporation on March 26, 2007 and June 26, 2008, respectively.
In 2003, as a result of applying the provisions of FIN 46, which represents new accounting guidance governing when an equity interest should be consolidated, Sterling was required to deconsolidate these subsidiary trusts from its financial statements. The deconsolidation of the net assets and results of operations of the trusts had virtually no impact on Sterling’s financial statements or liquidity position since Sterling continues to be obligated to repay the debentures held by the trusts and guarantees repayment of the capital securities issued by the trusts. Sterling’s total debt obligation related to the trusts did increase however from $55,000,000 to $56,702,000 upon deconsolidation with the difference representing Sterling’s common ownership interest in the trusts.
The junior subordinated debentures from Sterling to the two subsidiary trusts consist of two notes, $20,619,000 which is at a floating rate of interest of LIBOR plus 360 basis points, and matures in 2032. The second note of $36,083,000 is at a fixed rate of interest of 5.55%, and matures in 2033.
The debentures held by the trusts qualify as Tier 1 capital for Sterling under Federal Reserve Board guidelines. As a result of the issuance of FIN 46, the Federal Reserve Board is currently evaluating whether deconsolidation of the trusts will affect the qualification of the debentures as Tier 1 capital. If in the future it is determined that the debentures can no longer qualify as Tier 1 capital, it is anticipated that Sterling will continue to meet its minimum capital requirements.
STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
Note 14 - Income Taxes
The allocation of income taxes between current and deferred is as follows:
On June 28, 2002, a nonbanking affiliate of Sterling organized as a C-corporation was converted to a single member limited liability company. As a result of this conversion, the need for approximately $1.2 million in state deferred tax liabilities was eliminated and resulted in a reduction of income tax expense for the period. On March 31, 2003 a second nonbanking affiliate also organized as a C-corporation converted to a single member limited liability company, with no significant impact to deferred taxes.
The reason for the differences between the federal statutory income tax rate and the effective tax rates are summarized as follows:
The income tax provision (benefit) includes $179,000, ($161,000), and $949,000 of income taxes relating to realized securities gains (losses) for the years ended December 31, 2003, 2002, and 2001.
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Notes to Consolidated Financial Statements - (Continued)
The significant components of Sterling’s deferred tax assets and liabilities are as follows:
The net deferred tax liability is included in other liabilities.
Note 15 - Commitments and Contingent Liabilities
Credit-Related Financial Instruments - Sterling’s credit-related financial instruments include commitments to extend credit and letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the consolidated balance sheets.
Sterling’s exposure to credit loss is represented by the contractual amount of these commitments. Sterling follows the same credit policies in making commitments as it does for on-balance sheet instruments.
The following outstanding instruments have contract amounts that represent credit risk.
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 the payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Each
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Notes to Consolidated Financial Statements - (Continued)
customer’s creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management’s credit evaluation of the customer and generally consists of real estate. Excluded from these amounts are commitments to extend credit in the form of check credit or related plans.
Standby letters of credit are conditional commitments issued by Sterling to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Sterling generally holds collateral supporting those commitments if deemed necessary.
Derivative Financial Instruments - Sterling is a party to derivative instruments in the normal course of business to manage its own exposure to fluctuations in interest rates and to meet the financing needs of its customers.
Asset liability management - Sterling uses derivative instruments to assist in asset liability management to manage its exposure to earnings volatility caused by fluctuations in interest rates. Interest rate swaps are used to hedge cash flow variability related to floating rate liabilities, through the use of pay-fixed instruments. Gains and losses on derivative instruments reclassified from accumulated other comprehensive income to current-period earnings are included in the line item in which the hedged cash flows are recorded. At December 31, 2003, other comprehensive income included a deferred after-tax loss of $942,000 consisting of a loss on pay-fixed interest rate swap used to hedge future cash flows on floating rate liabilities. A portion of the amount in other comprehensive income is reclassified from other comprehensive income to interest expense as net settlements occur. For the year ended December 31, 2003, Sterling recognized interest expense of $918,000 related to interest rate swaps accounted for as cash flow hedges, versus $543,000 for the year ended December 31, 2002. At December 31, 2003, the notional amount of the interest rate swap was $25,000,000, and had a negative gross carrying value of $1,480,000. The interest rate swap matures in 2006.
Interest rate options, which include caps, are contracts that transfer, modify, or reduce interest rate risk in exchange for the payment of a premium when the contract is initiated. A premium is paid for the right, but not the obligation, to buy or sell a financial instrument at predetermined terms in the future. At December 31, 2003, the notional amount of an interest rate cap purchased was $5,000,000, and its carrying value was reduced to zero.
In May 2003, Sterling entered into two equity put options as fair value hedges to protect the company from risk that the fair value of its SLM Corporation stock might be adversely impacted by changes in market price. The two equity put options each cover 30,000 shares of SLM’s stock, one with a valuation date in May 2004 and the second with a valuation date of May 2006. If, at the valuation date, the stock price is below the reference price (May 2004 - $31.93; May 2006 - $33.81), the counter-party will pay the difference between the stock’s price on the valuation date and the reference price to Sterling. Sterling paid $258,000 for these put options, and as of December 31, 2003 their fair value was $84,000. The difference was charged to other noninterest expense and totaled $174,000 for the year ended December 31, 2003. At December 31, 2003, the trading price of the SLM Corporation stock was $37.68.
Customer Related - In the third quarter of 2003, Sterling entered into interest rate contracts; including interest rate caps and interest rate swap agreements to facilitate customer transactions in order
STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
to meet their financing needs. A summary of the customer related interest rate contracts at December 31, 2003 is as follows:
The interest rate contract portfolio is actively managed and hedged with offsetting contracts, with identical terms, with counterparties. Changes in the estimated fair value of customer related contracts and related interest settlements, net of the offsetting counterparty contracts, are recorded in noninterest income. Through December 31, 2003, net fees of $28,000 are included in other noninterest income.
Sterling believes it has reduced market risk on its customer related derivative contracts, through offsetting contractual relationships with counterparties. However, if a customer or counterparty fails to perform, credit risk is equal to the extent of the fair value gain in a derivative. When the fair value of a derivative instrument contract is positive, this generally indicates that the counterparty or customer owes Sterling, and results in credit risk to Sterling. When the fair value of a credit risk is negative, Sterling owes the customer or counterparty, and therefore, has no credit risk. Sterling minimizes the credit risk in derivative instruments by including derivative credit risk in its credit underwriting procedures, and by entering into transactions with high-quality counterparties that are reviewed periodically by Sterling’s treasury function.
Other Contingent Liabilities - From time to time, Sterling and its subsidiaries may be named as defendants in legal proceedings that arise during the normal course of business. While any litigation has an element of uncertainty, management is of the opinion that the liability, if any, resulting from these actions will not have a material effect on the consolidated financial condition or results of operations of Sterling.
Note 16 - Stockholders’ Equity and Regulatory Matters
Sterling maintains a dividend reinvestment and stock purchase plan. Under the Plan, shareholders may purchase additional shares of Sterling’s common stock at the prevailing market prices with reinvested dividends and voluntary cash payments. Sterling has reserved 2,153,320 shares of the corporation’s common stock to be issued under the dividend reinvestment and stock purchase plan. As of December 31, 2003, 1,659,307 shares were available to be issued under the plan.
Sterling also maintains a directors’ stock compensation plan (Directors’ Plan). Under the Directors’ Plan, each non-employee director is entitled to receive shares of Sterling’s common stock each July 1. Sterling has reserved 49,219 shares of the corporation’s common stock to be issued under the directors’ stock compensation plan. As of December 31, 2003, 14,406 shares were available to be issued under the plan.
During the second quarter of 2003, Sterling announced that its Board of Directors authorized a plan to purchase, in open market and privately negotiated transactions, up to 1,000,000 shares of its outstanding common stock. This newly approved repurchase plan, when combined with 42,692 shares remaining to be purchased under Sterling’s repurchase plan announced in February 2001, represents approximately 4.9% of the outstanding shares of Sterling’s common stock. Through December 31, 2003, 93,750 shares have been repurchased under this program at an average price of $21.37.
Sterling (on a consolidated basis) and its banking subsidiaries are subject to various regulatory capital requirements administered by 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 Sterling’s and the banks’ financial statements. Under capital adequacy
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Notes to Consolidated Financial Statements - (Continued)
guidelines and the regulatory framework for prompt corrective action, Sterling and its banking subsidiaries must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and reclassifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
Quantitative measures established by regulation to ensure capital adequacy require Sterling and its banking subsidiaries to maintain minimum amounts and ratios (set forth in the following table) of Total and Tier 1 capital (as defined) to average assets (as defined in the Regulations). Management believes, as of December 31, 2003, and 2002, that Sterling and the banks met all minimum capital adequacy requirements to which they are subject.
As of December 31, 2003, the most recent notification from the Federal Deposit Insurance Corporation categorized the banks as “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as “well capitalized” institutions must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following tables. There are no conditions or events since the notification that management believes have changed the banks’ category. Sterling’s and the banks’ actual capital amounts and ratios as of December 31, 2003, and 2002 are also presented in the table.
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Notes to Consolidated Financial Statements - (Continued)
Note 17 - Employee Benefit Plans
In December 2000, Bank of Lancaster County’s Board of Directors approved a resolution that terminated its qualified non-contributory pension plan in 2001, including the freezing of benefits effective February 28, 2001. All excess funds that remain after satisfaction of all liabilities of the plan will be provided to eligible active participants to provide additional retirement income benefits. As a result of the board’s action, plan assets were converted to cash equivalents in the first quarter of 2001, thereby causing the expected return on plan assets to be lowered from 9.0% to 5.5%. Further, the discount rate used in calculating the projected benefit obligation was lowered from 7.00% in 1999 to 5.50% in 2000, to more closely match the short-term nature of the settlement.
The Bank of Lancaster County also sponsored a retirement restoration plan for any officer whose compensation exceeded mandated levels. The plan was designed to “restore” the level of benefits that is lost to these employees under the qualified retirement plans because of Internal Revenue Code restrictions. Consistent with termination of the qualified non-contributory plan, the Board of Directors also terminated in 2001 the retirement restoration plan.
Sterling accounted for the settlement and termination of the qualified non-contributory and retirement restoration plans in accordance with FASB Statement No. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits. The settlement included lump-sum payments and the purchase of annuity contracts that benefited the participants.
Sterling sponsors a qualified postretirement benefit plan that provides certain health care insurance benefits for retired employees who have reached minimum age and years of service eligibility requirements.
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Notes to Consolidated Financial Statements - (Continued)
The change in benefit obligation and the change in fair value of plan assets related to the qualified pension plans, nonqualified pension and other postretirement benefits for each of the years in the two-year period ended December 31, 2003, is as follows:
STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
The components of the retirement benefits cost are presented below.
Health care cost trend rates assumed with respect to other postretirement benefits in measuring the accumulated postretirement benefit were 5.0% at December 31, 2003. The health care cost trend rate assumption has a significant effect on the amounts reported. The following table reflects the effect of a 1% point increase and a 1% point decrease in the health care cost trend rates.
The measurement date for the post retirement benefits is October 31 of each year.
In December 2003, President Bush signed into law a bill that expands Medicare benefits, primarily adding a prescription drug benefit for Medicare-eligible retirees beginning in 2006. The law also provides a federal subsidy to companies which sponsor postretirement benefit plans that provide prescription drug coverage. FASB Staff Position 106-1, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” permits deferring the recognition of the new Medicare provisions’ impact due to lack of specific authoritative guidance on accounting for the federal subsidy. Sterling has elected to defer accounting for the effects of this new legislation until the specific authoritative guidance is issued. Accordingly, the postretirement benefit obligations and net periodic costs reported in the accompanying financial statements and notes do not reflect the impact of this legislation. The
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Notes to Consolidated Financial Statements - (Continued)
accounting guidance, when issued, could require changes to previously reported financial information. Sterling anticipates its benefit costs after 2006 will be somewhat lower as a result of the new Medicare provisions, however, the adoption of this standard is not expected to have a material impact on results of operations, financial position, or liquidity.
Sterling Financial Corporation sponsors a 401(k) retirement plan for its eligible employees. Under the salary deferral feature of the plan, a participant may contribute up to 20% of their compensation. Sterling matches contributions equal to 100% of the first 2%, 50% on the next 2% and 25% on the next 4% of the employee’s contributions, which the employees may direct the investment of those contributions to one or all of the several funds available. Matching contributions are fully vested and are invested based on the employee’s direction.
Under the performance incentive feature of the plan, additional contributions are made to participant accounts for each plan year for an amount determined by the Board of Directors based on achieving certain performance objectives. The performance incentive feature is paid entirely in Sterling common stock. Total expense for the performance incentive feature and employer contributions were $1,596,000, $1,340,000 and $1,105,000 for the years ended December 31, 2003, 2002 and 2001.
The number of shares owned at December 31, 2003, in the Sterling Financial 401(k) Retirement Plan total 1,181,280 shares, with an approximate market value of $26,224,000. Dividends totaling $692,000 were reinvested in additional shares of Sterling common stock.
Note 18 - Stock Compensation
Sterling has an omnibus stock incentive plan under which incentive and nonqualified stock options, stock appreciation rights, or restricted stock may be issued. To date, only incentive and nonqualified stock options have been issued under the plan. The options are granted periodically to key employees at a price not less than the fair value of the shares at the date of grant, and have a term of ten years. As of December 31, 2003, Sterling had approximately 958,228 shares of common stock reserved for issuance under the stock incentive plans. All options issued were in connection with the omnibus stock incentive plan, which was approved by shareholders.
Sterling accounts for its stock incentive plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost for option grants are reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if Sterling had applied the fair
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Notes to Consolidated Financial Statements - (Continued)
value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.
The fair value of each option granted is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions:
A summary of the status of Sterling’s stock option plans is presented below:
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Notes to Consolidated Financial Statements - (Continued)
Information pertaining to options outstanding at December 31, 2003, is as follows:
Compensation expense of $375,000 was recorded in 2002 related to the fair value of stock options from former employees whose option terms were modified upon the change in employment status.
Note 19 - Related Party Transactions
Certain directors and officers of Sterling Financial Corporation and its subsidiaries, their immediate families and companies in which they are principal owners (more than 10%), were indebted to the subsidiary banks during 2003 and 2002. All loans were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and, in the opinion of the management of the banks, do not involve more than a normal risk of collectibility or present other unfavorable features. Total loans to these persons at December 31, 2003, and 2002 amounted to $4,942,000 and $6,678,000. During 2003, $1,800,000 of new loans were made and repayments totaled $3,536,000.
Note 20 - Restrictions on Dividends, Loans and Advances
Federal and state banking regulations place certain restrictions on dividends paid and loans or advances made to Sterling by its subsidiary banks. The amount of dividends that may be paid from the subsidiary banks to Sterling totals $61,390,000 at December 31, 2003. However, dividends paid by the subsidiary banks would be prohibited if the effect thereof would cause the banks’ capital to be reduced below applicable minimum capital requirements.
Under current Federal Reserve regulations, the subsidiary banks are limited to the amounts they may loan to their affiliates, including Sterling. Loans to a single affiliate may not exceed 10%, and the aggregate of loans to all affiliates may not exceed 20% of each bank subsidiary’s capital and surplus (as defined by regulation). At December 31, 2003, the maximum amount available for loans to Sterling totaled $22,286,000.
Note 21 - Fair Value of Financial Instruments
The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for Sterling’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. FASB Statement No. 107, Disclosures about Fair Value of
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Notes to Consolidated Financial Statements - (Continued)
Financial Instruments, excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of Sterling.
The following methods and assumptions were used by Sterling in estimating fair value disclosures for financial instruments.
Cash and cash equivalents: The carrying amounts of cash, due from banks and federal funds sold approximate fair value.
Interest-bearing deposits in banks and short-term investments: The carrying amounts of interest-bearing deposits and short-term investments maturing within 90 days approximate their fair values. Fair values of other interest-bearing deposits and short-term investments are estimated using discounted cash flow analyses based on current rates for similar type instruments.
Securities: Fair values for securities, excluding restricted equity securities, are based on quoted market prices, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. The carrying value of restricted stock approximates fair value based on the redemption provisions of the security.
Mortgage loans held for sale: Fair values of mortgage loans held for sale are based on commitments on hand from investors or prevailing market prices.
Loans receivable: Fair values for loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Lease contracts are specifically exempt from fair value reporting and are not included in this table.
Deposit liabilities: The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e. their carrying amount). Fair values for fixed-rate certificates of deposits are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.
Short-term borrowings: The carrying amounts of short-term borrowings maturing within 90 days and floating rate short-term borrowings approximate their fair values. Fair values of other short-term borrowings are estimated using discounted cash flow analyses based on Sterling’s current incremental borrowing rates for similar types of borrowing arrangements.
Long-term debt and subordinated notes payable: The fair values of Sterling’s long-term debt are estimated using discounted cash flow analyses based on current borrowing rates for similar types of borrowing arrangements.
Accrued interest: The carrying amounts of accrued interest approximate fair value.
Derivative assets and liabilities: The fair values for derivative instruments are based on cash flow projection models obtained from third parties.
Off-balance sheet instruments: Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair values of off-balance sheet instruments are not significant at December 31, 2003 and 2002.
STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
The estimated fair values and related carrying or notional amounts of Sterling’s financial instruments are as follows:
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Notes to Consolidated Financial Statements - (Continued)
Note 22 - Condensed Financial Statements of Parent Company
Financial information pertaining only to Sterling Financial Corporation is as follows:
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Notes to Consolidated Financial Statements - (Continued)
STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements - (Continued)
Note 23 - Segment Reporting
Sterling operates four major lines of business: Community Banking and Related Services; Leasing; Commercial Finance; and Trust and Investment Services. A fifth line of business, Insurance Related Services
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Notes to Consolidated Financial Statements - (Continued)
does not presently meet the thresholds for reportable segment reporting; therefore it is included in the all other category.
The Community Banking and Related Services segment provides financial services to consumers, businesses, financial institutions and governmental units in southern Pennsylvania and northern Maryland. These services include providing various types of loans to customers, accepting deposits, mortgage banking and other typical banking services. Parent company and treasury function income is included in the community-banking segment, as the majority of effort of these functions is related to this segment. Major revenue sources include net interest income and service fees on deposit accounts. Expenses include personnel and branch support network support charges.
The Leasing segment provides vehicle and equipment financing alternatives to businesses primarily located in south central Pennsylvania and northeastern Maryland, although assets are located throughout the United States. Major revenue sources include net interest income and rental income on operating leases. Expenses include personnel, support and depreciation charges on operating leases.
The Commercial Finance segment specializes in financing forestry and land-clearing equipment through more than 150 equipment dealer locations ranging from Maine to Florida. Major revenue sources include net interest income. Expenses include personnel and support charges.
The Trust and Investment Services segment includes both corporate asset and personal wealth management services. The corporate asset management business provides retirement planning services, investment management, custody and other corporate trust services to small to medium size business in Sterling market area. Personal wealth management services include investment management, brokerage, estate and tax planning, as well as trust management and administration for high net worth individuals and their families. Major revenue sources include management and estate fees and commissions on security transactions. Expenses primarily consist of personnel and support charges, as well as amortization of intangible assets. Prior year information for this segment has been segregated from the all other segment for consistent presentation with 2003.
The accounting policies of the segments are the same as those described in the summary of significant accounting policies. Transactions between segments, principally loans, were at terms consistent with that which would be obtained from a third party.
Sterling’s reportable segments are strategic business units that offer different products and services. They are managed separately because each segment appeals to different markets and, accordingly, requires different technology and marketing strategies. Sterling’s chief operating decision maker utilizes interest income, interest expense, non-interest income, non-interest expense, and the provision for income taxes in making decisions and determining resources to be allocated to the segments.
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Notes to Consolidated Financial Statements - (Continued)
Information about reportable segments, and reconciliation of such information to the consolidated financial statements follows (in thousands):
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Notes to Consolidated Financial Statements - (Continued)
Note 24 - Quarterly Financial Data (Unaudited)
The following is a summary of the quarterly results of operations:
Note 25 - Subsequent Events
On January 12, 2004, Sterling entered into a definitive agreement to purchase Corporate Healthcare Strategies, Inc., doing business as The Stoudt Companies, a Lancaster, Pennsylvania, based firm that provides benefit products and benefit consulting services to medium and large-sized businesses in the Central Pennsylvania region. Stoudt consists of three divisions, StoudtAdvisors (employee benefits insurance consulting and brokerage services), CapRisk (provides financial protection nationally to employers who self-fund their medical, dental and prescription plans), and the Lancaster Chamber Health Plan (a joint partnership with the Lancaster Chamber of Commerce which includes over 1,200 employer groups in Lancaster County, Pennsylvania).
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Notes to Consolidated Financial Statements - (Continued)
Sterling has agreed to issue up to 338,461 shares of its common stock and pay $8.800 million in cash to acquire the Stoudt Companies. Up to 30% of the merger consideration is subject to performance criteria for payment over the next four years. Assuming that all conditions are satisfied without delay, it is anticipated that the effective date of the merger will occur early in the second quarter of 2004.
Item 9
Item 9 - Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not applicable.
Item 9A
Item 9A - Controls and Procedures
Disclosure Controls and Procedures are controls and other procedures that are designed to ensure that information required to be disclosed in Sterling’s reports filed or submitted under the Securities and Exchange Act of 1934 (“the Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure Controls and Procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in Sterling’s reports filed under the Exchange Act is accumulated and communicated to management, including Sterling’s Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
At the end of the period covered by this annual report, Sterling conducted an evaluation of the effectiveness of the design and operation of Sterling’s disclosure controls and procedures, as required by Rule 13a-15 under the Exchange Act. This evaluation was carried out under the supervision and with the participation of Sterling’s management, including its Chief Executive Officer and Chief Financial Officer. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that Sterling’s controls and procedures are effective. There have been no changes in Sterling’s internal control over financial reporting that materially affected, or are reasonably likely to materially affect, internal control over financial reporting.
Item 10
Item 10 - Directors and Executive Officers of the Registrant
Incorporated by reference is the information appearing under the headings “Information about Nominees and Continuing Directors, Executive Officers” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the 2004 Annual Meeting Proxy Statement.
Sterling has adopted a Code of Ethics, which applies to Sterling’s directors and senior officers, including its Chief Executive Officer and President, Chief Financial Officer, and Chief Accounting Officer. This Code of Ethics has been included as Exhibit 14 to Sterling’s 2003 Annual Report on Form 10-K. We intend to disclose any amendments to our waivers of a required provision of the Code of Ethics on our website.
Item 11
Item 11 - Executive Compensation
Incorporated by reference is the information under the headings “Executive Compensation” and “Sterling Financial Corporation Directors’ Compensation” in the 2004 Annual Meeting Proxy Statement.
Item 12
Item 12 -
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Incorporated by reference is the information appearing under the headings “Principal Holders” and “Beneficial Ownership of Executive Officers, Directors and Nominees” in the 2004 Annual Meeting Proxy Statement.
Item 13
Item 13 - Certain Relationships and Related Transactions
Incorporated by reference is the information appearing under the heading “Transactions with Directors and Executive Officers” in the 2004 Annual Meeting Proxy Statement and under “Notes to Consolidated Financial Statements - Note 18 - Related Party Transactions” located elsewhere in this Form 10-K.
Item 14
Item 14 - Principal Accountant Fees and Services
Incorporated by reference is the information appearing under the heading “Report of the Audit Committee” in the 2004 Annual Meeting Proxy Statement.
Item 15
Item 15 - Exhibits, Financial Statements and Reports on Form 8-K
10.10
Change in Control Agreement, dated as of July 27, 2000, between Sterling Financial Corporation, Bank of Hanover, and Chad M. Clabaugh (Incorporated by reference to Exhibit 10.10 to Registrant’s Annual Report on Form 10-K, dated December 31, 2002, and filed with the Commission on March 27, 2003).
10.11
Employment Agreement, dated as of December 1, 2000, between Sterling Financial Corporation, Bank of Lancaster County, N.A., and Gregory S. Lefever.
Code of Ethics
Subsidiaries of the Registrant
Consent of Ernst & Young LLP
Rule 13a-14(a)/15d-14(a) Certifications
31.1
- Certification of CEO Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
- Certification of CFO Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Section 1350 Certifications
32.1
- Certification of CEO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to 906 of the Sarbanes Oxley Act of 2002
32.2
- Certification of CFO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to 906 of the Sarbanes Oxley Act of 2002
Copies of the Exhibits referenced above will be provided to Shareholders without charge by writing to Shareholder Relations, Sterling Financial Corporation, 101 North Pointe Boulevard, Lancaster, PA 17601-4133.
(b) Reports on Form 8-K
During the quarter ended December 31, 2003, the registrant filed the following reports on Form 8-K.
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.
STERLING FINANCIAL CORPORATION
By:
/s/ J. ROGER MOYER, JR.
J. Roger Moyer, Jr.
President and Chief Executive Officer