Item 1.
Business
Forward-Looking Statements: This report contains forward-looking statements that are based on assumptions and may describe future plans, strategies and expectations of Legacy Bancorp, Inc. (the “Company”) and Legacy Banks (the “Bank”). These forward-looking statements are generally identified by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project” or similar expressions. Legacy Bancorp and Legacy Banks’ ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to, changes in interest rates, national and regional economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Company’s market area, changes in real estate market values in the Company’s market area, and changes in relevant accounting principles and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, the Company does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions which may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events.
Financial Statements: Effective as of October 26, 2005, Legacy Bancorp, Inc., a Delaware corporation became the holding company of Legacy Banks, a Massachusetts-chartered stock savings bank, in connection with the conversion of the holding company structure of Legacy Banks from mutual to stock form. Prior to October 26, 2005, Mutual Bancorp of the Berkshires, Inc., a Massachusetts-chartered mutual holding company (referred to herein as the “Predecessor”), owned all of the outstanding common stock of Legacy Group, Inc., the Massachusetts-chartered mid-tier bank holding company of Legacy Banks (the “Mid-Tier”), and the Mid-Tier owned all of the outstanding common stock of Legacy Banks. Effective as of October 26, 2005, the Predecessor and the Mid-Tier merged out of existence, and the Company consummated the sale of 9,545,000 shares of its common stock to the public at a price of $10.00 per share, and contributed an additional 763,600 shares of its outstanding common stock to The Legacy Banks Foundation. Also on October 26, 2005, Legacy Banks issued all of its shares of common stock to the Company in exchange for 50% of the net proceeds of the public offering. During any period prior to October 26, 2005 the Company was newly organized and owned no assets. Therefore, the financial information for any period prior to October 26, 2005 presented in this report is that of Mutual Bancorp of the Berkshires, Inc. and its direct and indirect subsidiaries.
General: Legacy Banks is a full-service, community-oriented financial institution offering products and services to individuals, families and businesses through ten offices located in Berkshire County in Massachusetts and one loan production office located in Colonie, New York. Predecessors to Legacy Banks were originally organized as Massachusetts state-charted mutual savings banks dating back to 1890. Legacy Banks’ business consists primarily of making loans to its customers, including residential mortgages, commercial real estate loans, commercial loans and consumer loans, and investing in a variety of investment and mortgage-backed securities. Legacy Banks funds these lending and investment activities with deposits from the general public, funds generated from operations and select borrowings. Legacy Banks also provides insurance and investment products and services, investment portfolio management, debit and credit card products and online banking.
Market Area and Competition: We offer a variety of financial products and services designed to meet the needs of the communities we serve. Our primary deposit-gathering area is concentrated in the Massachusetts towns of Great Barrington, Lee, Lenox, North Adams, Otis and Pittsfield. Our lending area is broader than our deposit-gathering area and includes all of Berkshire County, Massachusetts as well as portions of eastern New York, although the majority of our loans are made to customers located in our primary deposit-gathering market area.
Legacy Banks is one of the largest banks in Berkshire County, Massachusetts in deposits and mortgage recordings. We are headquartered in Pittsfield, Massachusetts, located 120 miles west of Boston. All of Legacy Banks’ full-service offices are located in Berkshire County. The county in which Legacy Banks currently operates
includes a mixture of rural, suburban and urban markets. The economies of these areas were historically based on manufacturing, but similar to many areas of the country, have now evolved into more service-oriented and tourism-based economies with employment in most large economic sectors including wholesale/retail trade, service, manufacturing, finance, health-care, real estate and government.
As part of our business strategy we intend to expand geographically into areas contiguous to our existing markets, including into the State of New York, and to increase our loan volume in all areas. We have a national commercial real estate lending program which is not limited to our existing markets, and intend to focus on growth of this program as well. As of December 31, 2006, loans from this program amounted to $79.5 million, 46.5% of the gross commercial real estate portfolio and 9.8% of the Company’s total assets. These loans were made in 18 states and $64.3 million of these loans were made in states other than Massachusetts and New York. In January 2004, we introduced and aggressively marketed our relationship banking package, LifePath Investment Savings Accounts, or LifePath, to pursue our strategy of deposit growth. We also offer a selection of certificates of deposit with competitive interest rates that are tiered to the amount of the deposit. We are continuing to promote LifePath accounts and tiered certificates of deposit, and to expand into new markets to generate deposit growth to fund our lending activity. In addition to loan and deposit growth rates, to the extent possible, we track our market share or market presence to monitor our growth.
We face substantial competition in our efforts to originate loans and attract deposits and other fee-based business, particularly in Berkshire County, our primary market and the only market where we have full-service offices and accept deposits. Achieving meaningful growth is very challenging given the number of competitors and the overall decline in the population in our primary market area. The major risks associated with our competitive environment in Berkshire County are that it is relatively small and over-banked, which results in limited asset and funding diversification. We face direct competition from a significant number of financial institutions, many with a state-wide, regional or national presence. Many of these financial institutions are significantly larger and have greater financial resources than Legacy Banks. Following is a list of local financial institutions with whom we compete, including their asset size as of December 31, 2006: Berkshire Bank ($2.1 billion); Greylock Federal Credit Union ($907 million); Hoosac Bank ($388 million); and Lee Bank ($282 million). We also compete with five smaller community banks. Regional and national banks which have offices in our area include Citizens Bank of Massachusetts and TD Banknorth. We compete with these institutions through competitive pricing coupled with superior service and expertise in both commercial and retail banking. We also combine these same attributes to our expanded commercial lending in New York and to our national commercial real estate lending program. In Berkshire County, in addition to the local banks and credit unions, our competitors are brokerage houses, life insurance agents, and mortgage brokers. In our national commercial real estate lending program, our major competitors are life insurance companies and to a lesser extent pension funds and other banks.
Our business outside Berkshire County is predominantly commercial real estate lending, and comes from two sources. First, for several years lenders from our commercial banking group have developed contacts and clients in the Albany-Schenectady-Troy MSA and traveled there regularly. The opening of the loan production office during 2006 now provides a base of operations for the New York commercial lending activity. Second, our national commercial lending program, Legacy Real Estate Finance or LREF, is targeted and specialized, and operates separately from our commercial banking group. LREF program guidelines are first mortgage loans on high quality, institutional grade income property generally ranging in size from $500,000 to $5.0 million, with preference in the $500,000 to $3.0 million size range. LREF works exclusively through a group of ten well-established mortgage banking correspondents who are designated and contracted to originate and service loans on behalf of Legacy Banks in approximately 20 major metropolitan markets, 16 of which are located in the eastern half of the United States.
Lending Activities
General: Legacy Banks’ gross loan portfolio aggregated $582.6 million at December 31, 2006, representing 72.1% of the Company’s total assets at that date. In its lending activities, Legacy Banks originates residential real estate loans secured by one-to-four-family residences, commercial real estate loans, residential and commercial construction loans, commercial loans, home equity lines-of-credit, fixed rate home equity loans and other personal consumer loans. While Legacy Banks makes loans throughout Massachusetts, most of its lending activities are concentrated in its market area. Loans originated totaled $154.0 million in the year ended 2006. Residential
mortgage loans sold into the secondary market, on a servicing-retained basis, totaled $7.1 million during 2005. No residential mortgage loans were sold on a servicing-retained basis in 2006.
Loans originated by Legacy Banks are subject to federal and state laws and regulations. Interest rates charged by Legacy Banks on its loans are influenced by the demand for such loans, the amount and cost of funding available for lending purposes, current asset/liability management objectives and the interest rates offered by competitors. As of December 31, 2006, there were no loan concentrations exceeding 10% of total loans. A loan concentration is defined as amounts loaned to a multiple number of borrowers engaged in similar activities which would cause the borrowers to be similarly impacted by economic or other conditions.
The following table summarizes the composition of Legacy Banks’ loan portfolio as of the dates indicated:
Residential Real Estate Loans: Legacy Banks offers fixed-rate and adjustable-rate residential mortgage loans with maturities of up to 30 years and maximum loan amounts generally of up to $3.0 million. As of December 31, 2006, this portfolio totaled $325.4 million, or 55.8% of the total gross loan portfolio on that date, and had an average yield of 5.72%. Of the residential mortgage loans outstanding on that date, $139.0 million were adjustable-rate loans with an average yield of 5.52% and $186.4 million were fixed-rate mortgage loans with an average yield of 5.87%. Residential mortgage loan originations totaled $55.2 million and $86.2 million for 2006 and 2005, respectively.
The decision to originate loans for portfolio or for sale into the secondary market is made by the Bank’s Asset/Liability Management Committee, and is based on the market rates for such loans and the organization’s interest rate risk and liquidity profile. Current practice is to sell almost all newly originated fixed-rate 10, 15 and 30 year monthly payment loans, while 25 year fixed rate bi-weekly loans are generally held in the Bank’s portfolio. At December 31, 2006, 10, 15, 25 and 30 year fixed rate monthly payment loans held in the Bank’s portfolio totaled $186.4 million, or 57.3% of total residential real estate mortgage loans at that date. Legacy Banks services loans sold to Freddie Mac and Fannie Mae and earns a fee equal to 0.25% of the loan amounts outstanding for providing these services. The total of loans serviced for others as of December 31, 2006 is $8.6 million.
At December 31, 2006, adjustable-rate mortgage (ARM) loans totaled $139.0 million or 42.7% of total residential loans outstanding at that date. ARMs are offered for terms of up to 30 years with initial interest rates that are fixed for 1, 3, 5, 7 or 10 years. After the initial fixed-rate period, the interest rates on the loans are generally reset based on the relevant U.S. Treasury CMT (Constant Maturity Treasury) Index plus add-on margins of varying amounts, for periods of 1 year. Interest rate adjustments on such loans typically range from 2.0% to 3.0% during any adjustment period and 5.0% to 6.0% over the life of the loan. Periodic adjustments in the interest rate charged on ARM loans help to reduce Legacy Banks’ exposure to changes in interest rates. However, ARM loans generally possess an element of credit risk not inherent in fixed-rate mortgage loans, in that borrowers are potentially exposed to increases in debt service requirements over the life of the loan in the event market interest rates rise. Higher payments may increase the risk of default, though this risk has not had a materially adverse effect on Legacy Banks to date.
In its residential mortgage loan originations held in portfolio, Legacy Banks lends up to a maximum loan-to-value ratio of 100% for first-time home buyers and 95% for other buyers on mortgage loans secured by owner-occupied property, with the general condition that private mortgage insurance is required for loans with a loan-to-value ratio in excess of 85%. Title insurance, hazard insurance and, if appropriate, flood insurance are required for all properties securing real estate loans made by Legacy Banks. A licensed appraiser appraises all properties securing residential first mortgage purchase loans and all real estate transactions greater than $250,000.
In an effort to provide financing for low and moderate-income first-time home buyers, Legacy Banks originates and services residential mortgage loans with private mortgage insurance provided by the Mortgage Insurance Fund (MIF) of the Massachusetts Housing Finance Agency, or Mass Housing. The program provides mortgage payment protection as an enhancement to mortgage insurance coverage. This no-cost benefit, known as ’MI Plus,’ provides up to six monthly principal and interest payments in the event of a borrower’s job loss.
Commercial Real Estate Loans: Legacy Banks originated $50.2 million and $52.3 million of commercial real estate loans in 2006 and 2005, respectively, and had $171.0 million of commercial real estate loans, with an average yield of 7.20%, in its portfolio as of December 31, 2006. We have placed increasing emphasis on commercial real estate lending over the past several years, and as a result such loans have grown from 15.2% of the total loan portfolio at December 31, 2001 to 29.3% as of December 31, 2006. Legacy Banks intends to further grow this segment of its loan portfolio, both in absolute terms and as a percentage of its total loan portfolio.
Legacy Banks generally originates commercial real estate loans for terms of up to 10 years with amortization schedules of up to 25 years, typically with interest rates that adjust over periods of one to seven years based on various rate indices. Commercial real estate loans are generally secured by multi-family income properties, small office buildings, retail facilities, warehouses, industrial properties and owner-occupied properties used for business. Generally, commercial real estate loans do not exceed 80% of the appraised value of the underlying collateral.
The national commercial real estate lending program, LREF, which was started in 2002, accounts for approximately 46.5%, 43.3%, 46.6%, 41.5% and 20.1% of our total commercial real estate loans as of December 31, 2006, 2005, 2004, 2003 and 2002, respectively. As of December 31, 2006, loans from this program amounted to $79.5 million. We intend to continue to focus on careful growth of this program as part of our business strategy, and in alignment with our overall growth strategy.
In its evaluation of a commercial real estate loan application, Legacy Banks considers the net operating income of the borrower’s business, the borrower’s expertise, credit history, and the profitability and value of the underlying property. In addition, for loans secured by rental properties, Legacy Banks will also consider the terms of the leases and the quality of the tenants. Legacy Banks generally requires that the properties securing these loans have debt service coverage ratios (the ratio of cash flow before debt service to debt service) of at least 1.20x.
Commercial real estate loans generally have larger balances and involve a greater degree of risk than residential mortgage loans. Loan repayment is often dependent on the successful operation and management of the properties, as well as on the collateral value of the commercial real estate securing the loan. Economic events and changes in government regulations could have an adverse impact on the cash flows generated by properties securing Legacy Banks’ commercial real estate loans and on the value of such properties. As of December 31, 2006 Legacy Banks had $22.4 million in commercial real estate loans concentrated in the hospitality industry, representing 13.1% of the total commercial real estate loan portfolio.
Home Equity Lines-of-Credit and Loans: Legacy Banks offers home equity lines-of-credit and home equity term loans. Legacy Banks originated $29.0 million and $35.4 million of home equity lines-of-credit and loans during 2006 and 2005 respectively, and at December 31, 2006 had $56.9 million of home equity lines-of-credit and loans outstanding, representing 9.8% of the loan portfolio, with an average yield of 8.07% at that date.
Home equity lines-of-credit and loans are secured by first or second mortgages on one-to-four family owner occupied properties, and are made in amounts such that the combined first and second mortgage balances generally do not exceed 80% of the value of the property serving as collateral at time of origination. The lines-of-credit are available to be drawn upon for 10 years, at the end of which time they become term loans amortized over 10 years. Interest rates on home equity lines normally adjust based on the prime rate of interest as published by the Wall Street Journal. The undrawn portion of home equity lines-of-credit totaled $67.2 million at December 31, 2006.
Commercial Loans: Legacy Banks originates secured and unsecured commercial and industrial loans to business customers in its market area for the purpose of financing equipment purchases, working capital, expansion and other general business purposes. Legacy Banks originated $17.3 million and $10.8 million in commercial loans during 2006 and 2005, respectively, and as of December 31, 2006 had $22.9 million in commercial loans in its portfolio, representing 3.9% of such portfolio, with an average yield of 8.56%. Legacy Banks intends to continue to grow this segment of its lending business in the future.
Legacy Banks’ commercial loans are generally collateralized by equipment, accounts receivable and inventory, supported by personal guarantees. Legacy Banks offers both term and revolving commercial loans. The former have either fixed or adjustable-rates of interest and generally fully amortize over a term of between three and seven years. Revolving loans are renewable annually, with floating interest rates that are generally indexed to the Wall Street Journal Prime Rate of interest. When making commercial loans, Legacy Banks considers the financial statements of the borrower, the borrower’s payment history with respect to both corporate and personal debt, the debt service capabilities of the borrower, the projected cash flows of the business, the viability of the industry in which the borrower operates and the value of the collateral. Legacy Banks’ commercial loans are not concentrated in any one industry.
Commercial loans generally bear higher interest rates than residential mortgage loans of like duration because they involve a higher risk of default since their repayment is generally dependent on the successful operation of the borrower’s business and the sufficiency of collateral. The repayment of commercial loans is often dependent on the successfully operation of the business and may be affected by adverse changes in the economy and other external factors affecting the business. Collateral securing such loans may fluctuate in value and for that reason, may be difficult to appraise or liquidate.
Consumer and Other Loan: Legacy Banks offers a variety of consumer and other loans, including auto loans, manufactured housing loans and loans secured by passbook savings or certificate accounts. Legacy Banks originated $2.2 million and $1.6 million of consumer and other loans during 2006 and 2005, respectively, and at December 31, 2006 had $6.5 million of consumer and other loans outstanding, representing 1.1% of the loan portfolio at that date, with an average yield of 8.69%.
Loan Origination and Underwriting: Loan originations come from a variety of sources. The primary source of originations are our salaried and commissioned loan personnel, and to a lesser extent, local mortgage brokers, advertising and referrals from customers. Legacy Banks occasionally purchases participation interests in commercial real estate loans from banks located outside of Berkshire County. Legacy Banks underwrites such residential and commercial purchased loans using its own underwriting criteria.
Legacy Banks issues loan commitments to prospective borrowers conditioned on the occurrence of certain events. Commitments are made in writing on specified terms and conditions and are generally honored for up to 60 days from approval. At December 31, 2006, Legacy Banks had loan and other financial commitments totaling $129.0 million. For information about Legacy Banks’ loan commitments outstanding as of December 31, 2006, see “Management’s Discussion and Analysis of Financial Conditions and Results of Operations - Quantitative and Qualitative Disclosures About Risk Management - Loan Commitments”.
Legacy Banks charges origination fees, or points, and collects fees to cover the costs of appraisals and credit reports on most residential mortgage loans originated. Legacy Banks also collects late charges on real estate loans, and origination fees and prepayment penalties on commercial mortgage loans. For information regarding Legacy Banks’ recognition of loan fees and costs, please refer to Note 1 to the Consolidated Financial Statements of Legacy Bancorp, Inc. and Subsidiaries.
The following table sets forth certain information concerning Legacy Banks’ portfolio loan originations, inclusive of loan purchases:
Residential mortgage loans are underwritten by Legacy Banks’ staff of residential loan underwriters. Residential mortgage loans less than the Fannie Mae (FNMA) limit, to be held in portfolio require the approval of a residential loan underwriter. Residential mortgage loans greater than the FNMA limit but less than $1,000,000 require the approval of a senior manager of the loan committee. Residential mortgage loans greater than $1,000,000 but less than $3.0 million require the approval of the Loan Committee. Residential mortgage loans greater than $3.0 million but less than Legacy Banks’ legal lending limit require the approval of the Executive Committee of the board of directors of the Bank.
Commercial real estate and commercial loans are underwritten by commercial credit analysts. For commercial real estate loans, loan officers may approve loans up to their individual lending limits, which range from $200,000 to $600,000, while loans up to $650,000 may be approved by the Senior Commercial Loan Officer. Commercial real estate loans of up to $3.0 million may be approved by the management Credit Committee. The Senior Commercial Loan Officer may approve commercial loans of up to $650,000, while the Loan Committee may approve loans of up to $6.0 million. Loans over these limits require the approval of the Executive Committee of the board of directors of the Bank. LREF loans may generally be approved up to $5.0 million, with any loan over $3.0 million requiring the approval of at least two executive level officers.
Consumer loans are underwritten by consumer loan underwriters, including loan officers and branch managers who have approval authorities ranging from $20,000 to $40,000 for these loans. Senior loan committee officers may approve consumer loans of up to $75,000 while the management credit committee may approve loans of up to $1,500,000. Other than overdraft lines of credit which are generally limited to a maximum of $1,000, Legacy Banks
does not make unsecured personal loans. All consumer loans in excess of these limits require the approval of the Executive Committee of the board of directors of the Bank.
Pursuant to its loan policy, Legacy Banks generally will not make loans aggregating more than 10% of the Banks’ surplus and capital stock accounts or $9.9 million as of December 31, 2006 to one borrower (or related entity). Exceptions to this limit require the approval of the Executive Committee of the board of directors of the Bank prior to loan origination. Legacy Banks’ internal lending limit is lower than the Massachusetts legal lending limit, which is 20.0% of a bank’s surplus and capital stock accounts, or $19.7 million for Legacy Banks as of December 31, 2006.
Legacy Banks has established a risk rating system for its commercial real estate and commercial loans. This system evaluates a number of factors useful in indicating the risk of default and risk of loss associated with a loan. These ratings are performed by commercial credit analysts who do not have responsibility for loan originations. See “- Asset Quality - Classification of Assets and Loan Review”.
Loan Maturity. The following table summarizes the scheduled repayments of Legacy Banks’ loan portfolio at December 31, 2006. Demand loans, loans having no stated repayment schedule, and overdraft loans are reported as being due in one year or less:
The following table sets forth, at December 31, 2006, the dollar amount of total loans, net of unadvanced funds on loans, contractually due after December 31, 2007 and whether such loans have fixed interest rates or adjustable interest rates.
Asset Quality
General: One of Legacy Banks’ most important operating objectives is to maintain a high level of asset quality. Management uses a number of strategies in furtherance of this goal including maintaining sound credit standards in loan originations, monitoring the loan portfolio through internal and third-party loan reviews, and employing active collection and workout processes for delinquent or problem loans.
Delinquent Loans.: Management performs a monthly review of all delinquent loans. The actions taken with respect to delinquencies vary depending upon the nature of the delinquent loans and the period of delinquency. Generally, the Bank’s requirement is that a delinquency notice be mailed no later than the 10 th or 16 th day, depending on loan type, after the payment due date. A late charge is assessed on loans where the scheduled payment remains unpaid after a 10 or 15 day grace period. After mailing delinquency notices, Legacy Banks’ loan collection personnel call the borrower to ascertain the reasons for delinquency and the prospects for repayment. On loans secured by one- to four-family owner-occupied property, Legacy Banks initially attempts to work out a payment schedule with the borrower in order to avoid foreclosure. Any such loan restructurings must be approved by the level of officer authority required for a new loan of that amount. If these actions do not result in a satisfactory resolution, Legacy Banks refers the loan to legal counsel and counsel initiates foreclosure proceedings. For commercial real estate, construction and commercial loans, collection procedures may vary depending on individual circumstances.
Other Real Estate Owned: Legacy Banks classifies property acquired through foreclosure or acceptance of a deed in lieu of foreclosure as other real estate owned (“OREO”) in its consolidated financial statements. When property is placed into OREO, it is recorded at the lower of the carrying value or the fair value less estimated costs to sell at the date of foreclosure or acceptance of deed in lieu of foreclosure. At the time of transfer to OREO, any excess of carrying value over fair value is charged to the allowance for loan losses. Management inspects all OREO property periodically. Holding costs and declines in fair value result in charges to expense after the property is acquired. At December 31, 2006, Legacy Banks had no property classified as OREO.
Classification of Assets and Loan Review: Legacy Banks uses an internal rating system to monitor and evaluate the credit risk inherent in its loan portfolio. At the time a loan is approved, all commercial real estate and commercial loans are assigned a risk rating based on all of the factors considered in originating the loan. The initial risk rating is recommended by the credit analyst charged with underwriting the loan, and subsequently approved by the relevant loan approval authority. Current financial information is sought for all commercial real estate and commercial borrowing relationships, and is evaluated on at least an annual basis to determine whether the risk rating classification is appropriate. This determination as to the classification of assets and the amount of the loss allowances established are subject to review by regulatory agencies, which can order the establishment of additional loss allowances. See “Asset Quality - Allowance for Loan Losses” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Allowance for Loan Losses”.
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Impaired loans are generally maintained on a non-accrual basis. Impairment is measured on a loan by loan basis for commercial loans and commercial real estate 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. At December 31, 2006, loans which have been determined to possess an increased level of risk totaled $8.1 million, consisting of $6.8 million in commercial real estate loans and $1.3 million in other commercial loans.
Legacy Banks engages an independent third party to conduct an annual review of its commercial mortgage and commercial loan portfolios. These loan reviews provide a credit evaluation of individual loans to determine whether the risk ratings assigned are appropriate. Independent loan review findings are presented directly to the Audit Committee of the board of directors of the Bank.
Non-Performing Assets. The table below sets forth the amounts and categories of our non-performing assets at the dates indicated. At December 31, 2006 the Bank had five troubled debt restructurings (a loan for which a portion of interest or principal has been forgiven or the loan is modified at an interest rate less than current market rates) to one borrower with a combined balance of $943,000. The interest income recorded from these loans
amounted to approximately $15,000 and $60,000 for the three and twelve month periods ended December 31, 2006, respectively. At December 31, 2005 Legacy Banks had no troubled debt restructurings.
If the non-accrual loans had been current, the gross interest income that would have been recorded for the year ended December 31, 2006 is equal to approximately $61,000. No interest income from these loans was recorded in net income for the year ended December 31, 2006.
Loans are placed on non-accrual status either when reasonable doubt exists as to the full timely collection of interest and principal, or when a loan becomes 90 days past due unless an evaluation by the management Credit Committee clearly indicates that the loan is well-secured and in the process of collection. Restructured loans represent performing loans for which concessions were granted due to a borrower’s financial condition. Such concessions may include reductions of interest rates to below-market terms and/or extension of repayment terms.
Allowance for Loan Losses. In originating loans, Legacy Banks recognizes that losses will be experienced on loans and that the risk of loss will vary with many factors, including the type of loan being made, the creditworthiness of the borrower over the term of the loan, general economic conditions and, in the case of a secured loan, the quality of the security for the loan over the term of the loan. Legacy Banks maintains an allowance for loan losses to absorb losses inherent in the loan portfolio, and as such, this allowance represents management’s best estimate of the probable known and inherent credit losses in the loan portfolio as of the date of the financial statements.
The Board and management take the following into consideration when determining the adequacy of the allowance for loan losses for each loan category or sub-category: (i) changes in the trend of the volume and severity of past due and classified loans, and trends in the volume of non-accrual loans, troubled debt restructurings and other loan modifications, (ii) changes in the trend of loan charge offs and recoveries, (iii) changes in the nature, volume or terms of the loan portfolios, (iv) changes in lending policies or procedures, including the Banks’ loan review system, underwriting standards and collection, charge-off and recovery practices, and the degree of oversight by the Board, (v) changes in the experience, ability, and depth of lending management and staff, (vi) changes in national and local economic and business conditions and developments, including the condition of
various industry and market segments, (vii) the existence and effect of any concentrations of credit and changes in the level of such concentrations, and (viii) the effect of external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the portfolios. The allowance for loan losses is evaluated on a regular basis by management and is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
The allowance consists of allocated, general and unallocated components. The allocated component relates to loans classified as impaired, for which an allowance is established when the discounted cash flows or collateral value or observable market price of the impaired loan is lower than the carrying value of the loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors, as outlined above. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating allocated and general losses in the portfolio.
A loan is considered impaired when, based on current information and events, it is probable that Legacy Banks 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. Impairment is measured on a loan-by-loan basis for commercial loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate 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, Legacy Banks generally does not separately identify individual consumer and residential loans for impairment disclosures. At December 31, 2006, impaired loans totaled $2.3 million with a valuation allowance of approximately $374,000.
While Legacy Banks believes that it has established adequate allocated and general allowances for losses on loans, adjustments to the allowance may be necessary if future conditions differ substantially from the information used in making the evaluations. In addition, as an integral part of their examination process, Legacy Banks’ regulators periodically review the allowance for loan losses. These regulatory agencies may require the Bank to recognize additions to the allowance based on their judgments of information available to them at the time of their examination, thereby negatively affecting Legacy Banks’ financial condition and earnings.
The following table sets forth activity in Legacy Banks’ allowance for loan losses for the periods indicated:
Our allowance for loan losses to total loans was above 0.90% through December 31, 2003 primarily due to an increase in non-performing loans. This increase in non-performing loans was attributable to the provision for one large commercial loan, which was restructured in 2003, thereby reducing the allowance in the subsequent years. Since December 31, 2003, loans have increased to $582.6 million and non-performing loans have decreased to $879,000, resulting in a lower ratio. Our allowance for loan losses to total loans was 0.80% at December 31, 2006, a slight increase from 0.77% at December 31, 2005.
The following tables set forth Legacy Banks’ percent of allowance by loan category and the percent of the loans to total loans in each of the categories listed at the dates indicated. The allowance for loan losses allocated to each category is not necessarily indicative of future losses in any particular category and does not restrict the use of the allowance to absorb losses in other categories:
Investment Activities
General. Our investment policy is established by the board of directors of the Bank. The Chief Executive Officer and Chief Financial Officer of the Bank, as authorized by the board, implement this policy based on the established guidelines within the written policy. The primary objective of the investment portfolio is to achieve a competitive rate of return without incurring undue interest rate and credit risk, to complement Legacy Banks’ lending activities, to provide and maintain liquidity, and to assist in managing the interest rate sensitivity of its balance sheet. Individual investment decisions are made based on the safety of the investment, liquidity requirements, potential returns, cash flow targets, and consistency with Legacy Banks’ asset/liability management
objectives. Certain investment securities are held by Legacy Bancorp, which follows the same investment guidelines as Legacy Banks. The information about investments herein under “Business - Investment Activities” includes the investment securities of Legacy Bancorp.
Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities, requires Legacy Banks to designate its securities as held to maturity, available for sale or trading, depending on Legacy Banks’ intent with regard to its investments at the time of purchase. At December 31, 2006, $162.2 million or 92.1% of the portfolio was classified as available for sale, and $97,000 or 0.06% of the portfolio was classified as held to maturity. At December 31, 2006, the net unrealized gain on securities classified as available for sale was $684,000. Legacy Banks does not currently maintain a trading portfolio of securities. At December 31, 2006, Legacy Banks did not hold securities of any issuers, as defined in Section 2(4) of the Securities Act, in which the aggregate book value of such securities exceeded 10% of equity.
Government Sponsored Enterprises. At December 31, 2006, Legacy Banks’ Government Sponsored Enterprises portfolio totaled $90.9 million, or 51.6% of the total portfolio on that date. This portfolio decreased $3.5 million, or 3.7% over the December 31, 2005 amount of $94.4 million as some cash flows were used to fund loan growth.
Municipal Bonds. At December 31, 2006, Legacy Banks’ Municipal Bond portfolio totaled $7.2 million, or 4.1% of the total portfolio on that date. This portfolio increased $1.2 million, or 19.5% over the December 31, 2005 amount of $6.0 million as the Bank took advantage of available bonds with an attractive tax-equivalent yield.
Corporate Obligations. At December 31, 2006, Legacy Banks’ portfolio of corporate obligations totaled $3.0 million, or 1.7% of the portfolio at that date. Legacy Banks’ policy requires that investments in corporate obligations be restricted only to those obligations that are readily marketable and rated “Investment Grade” by a nationally recognized rating agency. At December 31, 2006, all investments in corporate obligations were rated “Investment Grade”.
Mortgage-Backed Securities. At December 31, 2006, Legacy Banks’ portfolio of mortgage-backed securities totaled $53.8 million, or 30.6% of the portfolio on that date, and consisted of pass-through securities totaling $24.4 million and collateralized mortgage obligations totaling $29.4 million directly insured or backed by Freddie Mac, Fannie Mae, Government National Mortgage Association (Ginnie Mae), and certain private issuers. In its purchase of collateralized mortgage obligations, Legacy Banks has targeted instruments in the three to five year weighted average life tranches. The objective of this strategy has been to receive a competitive rate of return with a steady cash flow used for reinvestment and liquidity.
Marketable Equity Securities. At December 31, 2006, Legacy Banks’ portfolio of marketable equity securities totaled $7.3 million, or 4.2% of the portfolio at that date, and consisted entirely of common and preferred stock of various corporations. Legacy Banks’ investment policy requires stocks within this portfolio to be diversified into several different business segments, actively traded and of high quality.
Restricted Equity Securities and Other investments. At December 31, 2006, Legacy Banks’ portfolio of restricted equity securities and other investments totaled $13.8 million or 7.8% of the portfolio at that date. These securities consisted primarily of stock in the Federal Home Loan Bank of Boston (FHLBB) totaling $9.0 million, which must be held as a condition of membership in the Federal Home Loan Bank System and as a condition to Legacy Banks’ borrowing under the FHLBB advance program. The remaining $4.8 million consisted of certain other equity investments in Savings Bank Life Insurance of Massachusetts, Community Investment Fund, Depositors Insurance Fund and other investments.
The following table sets forth certain information regarding the amortized cost and market values of Legacy Banks’ investment securities at the dates indicated:
The table below sets forth certain information regarding the amortized cost, weighted average yields and contractual maturities of Legacy Banks’ debt securities portfolio at December 31, 2006. In the case of mortgage-backed securities, the table shows the securities by their contractual maturities, however there are scheduled principal payments for these securities and there will also be unscheduled prepayments prior to their contractual maturity:
Sources of Funds
General. Deposits are the primary source of Legacy Banks’ funds for lending and other investment purposes. In addition to deposits, Legacy Banks obtains funds from the amortization and prepayment of loans and mortgage-backed securities, the sale or maturity of investment securities, advances from the Federal Home Loan Bank of Boston, and cash flows generated by operations.
Deposits. Consumer and commercial deposits are gathered primarily from Legacy Banks’ primary market area through the offering of a broad selection of deposit products including checking, regular savings, money market deposits and time deposits, including certificate of deposit accounts and individual retirement accounts. The FDIC insures deposits up to certain limits (generally, $100,000 per depositor) and the Depositors Insurance Fund, or DIF, fully insures amounts in excess of such limits.
The maturities of Legacy Banks’ certificate of deposit accounts range from one month to five years. In addition, Legacy Banks offers a variety of commercial business products to small businesses operating within its primary market area. Legacy Banks will on occasion negotiate interest rates to attract jumbo certificates of deposit, and accepts deposits of $100,000 or more from customers based on posted rates. Legacy Banks also generates certificates of deposit through the use of brokers and internet-based network deposits. Brokered deposits and network deposits totaled $20.6 million and $5.9 million, respectively at December 31, 2006.
Legacy Banks relies primarily on competitive pricing of its deposit products, customer service and long-standing relationships with customers to attract and retain deposits. Market interest rates, rates offered by financial service competitors, the availability of other investment alternatives, and general economic conditions significantly affect Legacy Banks’ ability to attract and retain deposits.
The following tables set forth certain information relative to the composition of Legacy Banks’ average deposit accounts and the weighted average interest rate on each category of deposits:
The following table sets forth the time deposits of Legacy Banks classified by interest rate as of the dates indicated:
The following table sets forth the amount and maturities of time deposits at December 31, 2006:
As of December 31, 2006, the aggregate amount of outstanding certificates of deposit in amounts greater than or equal to $100,000 was approximately $91.3 million. The following table sets forth the maturity of those certificates as of December 31, 2006:
Borrowings. Legacy Banks utilizes advances from the Federal Home Loan Bank of Boston, or FHLBB, primarily in connection with the funding of growth in its assets. FHLBB advances are secured primarily by certain of Legacy Banks’ mortgage loans, certain investment securities and by Legacy Banks’ holding of FHLBB stock. As of December 31, 2006, Legacy Banks had outstanding $127.4 million in FHLBB advances, and had the ability to borrow up to a total of $247.7 million based on available collateral. The following table sets forth certain information concerning balances and interest rates on Legacy Banks’ FHLBB advances at the dates and for the periods indicated:
Of the $127.4 million in advances outstanding at December 31, 2006, $23.5 million, bearing a weighted-average interest rate of 4.76%, are callable by the FHLBB at its option and in its sole discretion. In the event the FHLBB calls these advances, Legacy Banks will evaluate its liquidity and interest rate sensitivity position at that time and determine whether to replace the called advances with new borrowings.
Personnel. As of December 31, 2006, the Bank had 160 full-time equivalent employees. The employees are not represented by a collective bargaining unit and the Bank considers its relationship with its employees to be excellent.
Segment Reporting: Management monitors the revenue streams of the various products and services in evaluating the Company’s operations and financial performance. All of the Company’s operations are considered by management to be aggregated in one reportable operating segment.
Subsidiary Activities and Portfolio Management Services
Legacy Bancorp conducts its principal business activities through its wholly-owned subsidiary, Legacy Banks. The Bank has two operating subsidiaries, Legacy Insurance Services of the Berkshires and Legacy Securities Corporation.
Legacy Insurance Services of the Berkshires. Legacy Insurance Services of the Berkshires (“LISB”) is a Delaware limited liability company and is wholly-owned by Legacy Banks. LISB is an insurance agency that specializes in providing our clients with non-deposit insurance and investment products. LISB has been in operation since September 2001, however, the Bank has been associated with and selling Savings Bank Life Insurance (SBLI) since 1910.
Legacy Securities Corporation. Legacy Securities Corporation (LSC) is a Massachusetts securities corporation and a wholly owned subsidiary of Legacy Banks. LSC is an investment company that engages in buying, selling and holding securities on its own behalf. At December 31, 2006, LSC had total assets of approximately $69.7 million consisting primarily of government sponsored enterprises obligations and mortgage backed securities. As a Massachusetts securities corporation LSC has a lower state income tax rate compared to other corporations.
Portfolio Management Services. Legacy Banks offers portfolio management services through its trust division known as Legacy Portfolio Management (“LPM”). At December 31, 2006, LPM had total assets under management of $150.8 million.
Legacy Bancorp, Inc’s subsidiaries, in addition to Legacy Banks, are described below. The company is incorporated in Massachusetts and is wholly owned by Legacy Bancorp, Inc.
LB Funding Corporation. LB Funding Corporation was established in 2005 to lend funds to Legacy Banks Employee Stock Ownership Plan (“ESOP”) to purchase shares of Legacy Bancorp, Inc. common stock in the open market subsequent to the initial public offering.
Discontinued Operations: None
Regulation And Supervision
General: As a savings and loan holding company, Legacy Bancorp is required to file reports with, and otherwise comply with the rules and regulations of, the Office of Thrift Supervision (OTS). As a savings bank chartered by the Commonwealth of Massachusetts, Legacy Banks is subject to extensive regulation, examination and supervision by the Massachusetts Commissioner of Banks, as its primary regulator, and the Federal Deposit Insurance Corporation (FDIC), as the deposit insurer. Legacy Banks is a member of the Federal Home Loan Bank (FHLB) system and, with respect to deposit insurance, of the Bank Insurance Fund managed by the FDIC. Legacy Banks must file reports with the Commissioner of Banks and the FDIC concerning its activities and financial condition in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with, or acquisitions of other savings institutions. The Commissioner of Banks and /or the FDIC conduct periodic examinations to test Legacy Banks’ safety and soundness and compliance with various regulatory requirements. The description of statutory provisions and regulations applicable to savings institutions and their holding companies set forth in this Form 10-K does not purport to be a complete description of such statutes and regulations and their effects on Legacy Banks and Legacy Bancorp and is qualified in its entirety by reference to the actual laws and regulations.
Massachusetts Banking Laws and Supervision: Massachusetts savings banks are regulated and supervised by the Massachusetts Commissioner of Banks. The Massachusetts Commissioner of Banks is required to regularly examine each state-chartered bank. The approval of the Massachusetts Commissioner of Banks is required to establish or close branches, to merge with another bank, to form a holding company, to issue stock or to undertake many other activities. Any Massachusetts bank that does not operate in accordance with the regulations, policies and directives of the Massachusetts Commissioner of Banks may be sanctioned. The Massachusetts Commissioner of Banks may suspend or remove directors or officers of a bank who have violated the law, conducted a bank’s business in a manner that is unsafe, unsound or contrary to the depositors’ interests, or been negligent in the performance of their duties. In addition, the Massachusetts Commissioner of Banks has the authority to appoint a receiver or conservator if it is determined that the bank is conducting its business in an unsafe or unauthorized manner, and under certain other circumstances.
All Massachusetts-chartered savings banks are required to be members of the Depositors Insurance Fund, a private deposit insurer, which insures all deposits in member banks in excess of FDIC deposit insurance limits. Member banks are required to pay the assessments of the fund.
The powers that Massachusetts-chartered savings banks can exercise under these laws are summarized as follows:
Lending Activities: A Massachusetts-chartered savings bank may make a wide variety of mortgage loans including fixed-rate loans, adjustable-rate loans, variable-rate loans, participation loans, graduated payment loans, construction and development loans, condominium and co-operative loans, second mortgage loans and other types of loans that may be made in accordance with applicable regulations. Commercial loans may be made to corporations and other commercial enterprises with or without security. Consumer and personal loans may also be made with or without security. Loans to individual borrowers generally must be limited to 20% of the total of a bank’s capital accounts and stockholders’ equity.
Insurance Sales: Massachusetts banks may engage in insurance sales activities if the Massachusetts Commissioner of Banks has approved a plan of operation for insurance activities and the bank obtains a license from the Massachusetts Division of Insurance. A bank may be licensed directly or indirectly through an affiliate or a subsidiary corporation established for this purpose. Legacy Banks has a subsidiary, Legacy Insurance Services of the Berkshires, that is licensed to sell insurance products.
Investment Activities: In general, Massachusetts-chartered savings banks may invest in preferred and common stock of any corporation organized under the laws of the United States or any state provided such investments do not involve control of any corporation and do not, in the aggregate, exceed 4.0% of the bank’s deposits. Massachusetts-chartered savings banks may in addition invest an amount equal to 1.0% of their deposits in stocks of Massachusetts corporations or companies with substantial employment in the Commonwealth which have pledged to the Massachusetts Commissioner of Banks that such monies will be used for further development within the Commonwealth. At the present time, Legacy Banks does have authority to invest in equity securities.
Dividends: A Massachusetts stock bank may declare from net profits cash dividends not more frequently than quarterly and non-cash dividends at any time. No dividends may be declared, credited or paid if the bank’s capital stock is impaired. The approval of the Massachusetts Commissioner of Banks is required if the total of all dividends declared in any calendar year exceeds the total of its net profits for that year combined with its retained net profits of the preceding two years. Net profits for this purpose means the remainder of all earnings from current operations plus actual recoveries on loans and investments and other assets after deducting from the total thereof all current operating expenses, actual losses, accrued dividends on preferred stock, if any, and all federal and state taxes.
Parity Regulation: Effective November 19, 2002, Massachusetts law was amended to increase the powers of Massachusetts banks under certain conditions. As a result of such amendment, a Massachusetts bank may engage in any activity or offer any product or service if the activity, product or service is engaged in or offered in accordance with regulations promulgated by the Massachusetts Commissioner of Banks and has been authorized for national banks, federal thrifts or state banks in a state other than Massachusetts; provided that the activity is permissible under applicable federal and Massachusetts law and subject to the same limitations and restrictions imposed on the national bank, federal thrift or out-of-state bank that had previously been granted the power.
Federal Regulations
Capital Requirements. Under FDIC regulations, federally insured state-chartered banks that are not members of the Federal Reserve System (“state non-member banks”), such as Legacy Banks, are required to comply with minimum leverage capital requirements. For an institution determined by the FDIC to not be anticipating or experiencing significant growth and to be, in general, a strong banking organization rated composite 1 under the Uniform Financial Institutions Ranking System established by the Federal Financial Institutions Examination Council, the minimum capital leverage requirement is a ratio of Tier 1 capital to total assets of 3.0%. For all other institutions, the minimum leverage capital ratio is not less than 4.0%. Tier 1 capital is the sum of common stockholders’ equity, noncumulative perpetual preferred stock (including any related surplus) and minority investments in certain subsidiaries, less intangible assets (except for certain servicing rights and credit card relationships) and certain other specified items.
The FDIC regulations require state non-member banks to maintain certain levels of regulatory capital in relation to regulatory risk-weighted assets. The ratio of regulatory capital to regulatory risk-weighted assets is referred to as a bank’s “risk-based capital ratio.” Risk-based capital ratios are determined by allocating assets and specified off-balance sheet items (including recourse obligations, direct credit substitutes and residual interests) to four risk-weighted categories ranging from 0.0% to 100.0%, with higher levels of capital being required for the categories perceived as representing greater risk.
State non-member banks must maintain a minimum ratio of total capital to risk-weighted assets of at least 8.0%, of which at least one-half must be Tier 1 capital. Total capital consists of Tier 1 capital plus Tier 2 or supplementary capital items, which include allowances for loan losses in an amount of up to 1.25% of risk-weighted assets, cumulative preferred stock and certain other capital instruments, and a portion of the net unrealized gain on equity securities. The includable amount of Tier 2 capital cannot exceed the amount of the institution’s Tier 1 capital. Banks that engage in specified levels of trading activities are subject to adjustments in their risk based capital calculation to ensure the maintenance of sufficient capital to support market risk.
The Federal Deposit Insurance Corporation Improvement Act (the “FDICIA”) required each federal banking agency to revise its risk-based capital standards for insured institutions to ensure that those standards take adequate account of interest-rate risk, concentration of credit risk, and the risk of nontraditional activities, as well as to reflect the actual performance and expected risk of loss on multi-family residential loans. The FDIC, along with the other federal banking agencies, has adopted a regulation providing that the agencies will take into account the exposure of a bank’s capital and economic value to changes in interest rate risk in assessing a bank’s capital adequacy. The FDIC also has authority to establish individual minimum capital requirements in appropriate cases upon determination that an institution’s capital level is, or is likely to become, inadequate in light of the particular circumstances.
Standards for Safety and Soundness. As required by statute, the federal banking agencies adopted final regulations and Interagency Guidelines Establishing Standards for Safety and Soundness to implement safety and soundness standards. The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. The guidelines address internal controls and information systems, internal audit system, credit underwriting, loan documentation, interest rate exposure, asset growth, asset quality, earnings and compensation, fees and benefits. Most recently, the agencies have established standards for safeguarding customer information. If the appropriate federal banking agency determines that an institution fails to meet any standard prescribed by the guidelines, the agency may require the institution to submit to the agency an acceptable plan to achieve compliance with the standard.
Investment Activities. Since the enactment of FDICIA, all state-chartered FDIC insured banks, including savings banks, have generally been limited in their investment activities to principal and equity investments of the type and in the amount authorized for national banks, notwithstanding state law. FDICIA and the FDIC permit exceptions to these limitations. For example, state chartered banks may, with FDIC approval, continue to exercise state authority to invest in common or preferred stocks listed on a national securities exchange or the Nasdaq Global Market and in the shares of an investment company registered under the Investment Company Act of 1940, as amended. The maximum permissible investment is 100.0% of Tier 1 Capital, as specified by the FDIC’s regulations, or the maximum amount permitted by Massachusetts law, whichever is less. Legacy Banks received approval from the FDIC to retain and acquire such equity instruments equal to the lesser of 100% of Legacy Banks’ Tier 1 capital or the maximum permissible amount specified by Massachusetts law. Any such grandfathered authority may be terminated upon the FDIC’s determination that such investments pose a safety and soundness risk. In addition, the FDIC is authorized to permit such institutions to engage in state authorized activities or investments not permissible for national banks (other than non-subsidiary equity investments) if they meet all applicable capital requirements and it is determined that such activities or investments do not pose a significant risk to the Bank Insurance Fund. The FDIC has adopted revisions to its regulations governing the procedures for institutions seeking approval to engage in such activities or investments. The Gramm-Leach-Bliley Act of 1999 specifies that a nonmember bank may control a subsidiary that engages in activities as principal that would only be permitted for a national bank to conduct in a “financial subsidiary” if a bank meets specified conditions and deducts its investment in the subsidiary for regulatory capital purposes.
Interstate Banking and Branching. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, or the Interstate Banking Act, permits adequately capitalized bank holding companies to acquire banks in any state subject to specified concentration limits and other conditions. The Interstate Banking Act also authorizes the interstate merger of banks. In addition, among other things, the Interstate Banking Act permits banks to establish new branches on an interstate basis provided that such action is specifically authorized by the law of the host state.
Prompt Corrective Regulatory Action. Federal law requires, among other things, that federal bank regulatory authorities take “prompt corrective action” with respect to banks that do not meet minimum capital requirements. For these purposes, the law establishes five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized.
The FDIC has adopted regulations to implement the prompt corrective action legislation. An institution is deemed to be “well capitalized” if it has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater and a leverage ratio of 5.0% or greater. An institution is “adequately capitalized” if it has a total risk-based capital ratio of 8.0% or greater, a Tier 1 risk-based capital ratio of 4.0% or greater, and generally a leverage ratio of 4.0% or greater. An institution is “undercapitalized” if it has a total risk-based capital ratio of less than 8.0%, a Tier 1 risk-based capital ratio of less than 4.0%, or generally a leverage ratio of less than 4.0%. An institution is deemed to be “significantly undercapitalized” if it has a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 3.0%, or a leverage ratio of less than 3.0%. An institution is considered to be “critically undercapitalized” if it has a ratio of tangible equity (as defined in the regulations) to total assets that is equal to or less than 2.0%. As of December 31, 2006, Legacy Banks was classified as a “well capitalized” institution.
“Undercapitalized” banks must adhere to growth, capital distribution (including dividend) and other limitations and are required to submit a capital restoration plan. A bank’s compliance with such a plan is required to be guaranteed by any company that controls the undercapitalized institution in an amount equal to the lesser of 5.0% of the institution’s total assets when deemed undercapitalized or the amount necessary to achieve the status of adequately capitalized. If an “undercapitalized” bank fails to submit an acceptable plan, it is treated as if it is “significantly undercapitalized.” “Significantly undercapitalized” banks must comply with one or more of a number of additional restrictions, including but not limited to an order by the FDIC to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets, cease receipt of deposits from correspondent banks or dismiss directors or officers, and restrictions on interest rates paid on deposits, compensation of executive officers and capital distributions by the parent holding company. “Critically undercapitalized” institutions are subject to additional measures including, subject to a narrow exception, the appointment of a receiver or conservator within 270 days after it obtains such status.
Transaction with Affiliates and Regulation W of the Federal Reserve Regulations. Transactions between banks and their affiliates are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a bank is any company or entity that controls, is controlled by or is under common control with the bank. In a holding company context, the parent bank holding company and any companies which are controlled by such parent holding company are affiliates of the bank. Generally, Sections 23A and 23B of the Federal Reserve Act and Regulation W (i) limit the extent to which the bank or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10.0% of such institution’s capital stock and surplus, and contain an aggregate limit on all such transactions with all affiliates to an amount equal to 20.0% of such institution’s capital stock and surplus and (ii) require that all such transactions be on terms substantially the same, or at least as favorable, to the institution or subsidiary as those provided to a non-affiliate. The term “covered transaction” includes the making of loans, purchase of assets, issuance of a guarantee and other similar transactions. In addition, loans or other extensions of credit by the financial institution to the affiliate are required to be collateralized in accordance with the requirements set forth in Section 23A of the Federal Reserve Act.
The Gramm-Leach-Bliley Act amended several provisions of Sections 23A and 23B of the Federal Reserve Act. The amendments provide that so-called “financial subsidiaries” of banks are treated as affiliates for purposes of Sections 23A and 23B of the Federal Reserve Act, but the amendment provides that (i) the 10.0% capital limit on transactions between the bank and such financial subsidiary as an affiliate is not applicable, and (ii) the investment by the bank in the financial subsidiary does not include retained earnings in the financial subsidiary. Certain anti-
evasion provisions have been included that relate to the relationship between any financial subsidiary of a bank and sister companies of the bank: (1) any purchase of, or investment in, the securities of a financial subsidiary by any affiliate of the parent bank is considered a purchase or investment by the bank; or (2) if the Federal Reserve Board determines that such treatment is necessary, any loan made by an affiliate of the parent bank to the financial subsidiary is to be considered a loan made by the parent bank.
In addition, Sections 22(h) and (g) of the Federal Reserve Act place restrictions on loans to executive officers, directors and principal stockholders. Under Section 22(h) of the Federal Reserve Act, loans to a director, an executive officer and to a greater than 10.0% stockholder of a financial institution, and certain affiliated interests of these, may not exceed, together with all other outstanding loans to such person and affiliated interests, the financial institution’s loans to one borrower limit, generally equal to 15.0% of the institution’s unimpaired capital and surplus. Section 22(h) of the Federal Reserve Act also requires that loans to directors, executive officers and principal stockholders be made on terms substantially the same as offered in comparable transactions to other persons and also requires prior board approval for certain loans. In addition, the aggregate amount of extensions of credit by a financial institution to insiders cannot exceed the institution’s unimpaired capital and surplus. Furthermore, Section 22(g) of the Federal Reserve Act places additional restrictions on loans to executive officers.
Enforcement. The FDIC has extensive enforcement authority over insured savings state banks, including Legacy Banks. This enforcement authority includes, among other things, the ability to assess civil money penalties, issue cease and desist orders and remove directors and officers. In general, these enforcement actions may be initiated in response to violations of laws and regulations and unsafe or unsound practices. The FDIC has authority under federal law to appoint a conservator or receiver for an insured bank under limited circumstances. The FDIC is required, with certain exceptions, to appoint a receiver or conservator for an insured state non-member bank if that bank was “critically undercapitalized” on average during the calendar quarter beginning 270 days after the date on which the institution became “critically undercapitalized.” The FDIC may also appoint itself as conservator or receiver for an insured state non-member institution under specific circumstances on the basis of the institution’s financial condition or upon the occurrence of other events, including: (1) insolvency; (2) substantial dissipation of assets or earnings through violations of law or unsafe or unsound practices; (3) existence of an unsafe or unsound condition to transact business; and (4) insufficient capital, or the incurring of losses that will deplete substantially all of the institution’s capital with no reasonable prospect of replenishment without federal assistance.
Insurance of Deposit Accounts. The Bank is a member of the Deposit Insurance Fund. The FDIC has adopted a risk-based insurance assessment system. The FDIC assigns an institution to one of four risk categories based on capitalization, supervisory factors, and the institution’s CAMELS rating. The supervisory subgroup to which an institution is assigned is based on a supervisory evaluation provided to the FDIC by the institution’s primary federal regulator and information which the FDIC determines to be relevant to the institution’s financial condition and the risk posed to the deposit insurance funds. An institution’s assessment rate depends on the category to which it is assigned. Assessment rates for insurance fund deposits are determined semi-annually by the FDIC and currently range from 5 basis points of assessable deposits for the healthiest institution to 43 basis points for the riskiest. In addition to the assessment for deposit insurance, institutions are also required to assist in the repayment of bonds issued by the Financing Corporation (“FICO”) in the late 1980’s to recapitalize the Federal Savings and Loan Insurance Corporation. During 2006, FICO payments approximated 1.28 basis points.
The Bank’s total assessments paid in 2006 (including the FICO assessment) were approximately $86,000. The FDIC is authorized to raise the assessment rates. The FDIC has exercised this authority several times in the past and may raise insurance premiums in the future. If such action is taken by the FDIC, it could have an adverse effect on the earnings of Legacy Banks. Management cannot predict what insurance assessment rates will be in the future.
The FDIC may terminate insurance of deposits if it finds that the institution is in an unsafe or unsound condition to continue operations, has engaged in unsafe or unsound practices, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. The management of Legacy Banks does not know of any practice, condition or violation that might lead to termination of deposit insurance.
Federal Deposit Insurance Reform Act of 2005. As a result of the Federal Deposit Insurance Reform Act of 2005, the Bank Insurance Fund and Savings Association Insurance Fund have been merged into a new combined fund, called the Deposit Insurance Fund (“DIF”). The Federal Deposit Insurance Reform Act also (i) increased
deposit insurance coverage for retirement accounts to $250,000, (ii) indexes the current $100,000 insurance coverage limit for standard accounts and the new $250,000 limit for retirement accounts to reflect inflation (with adjustments for inflation every five years, commencing January 1, 2011, (iii) requires the Federal Deposit Insurance Corporation to assess annual deposit insurance premiums on all banks and savings institutions, (iv) gives a one-time insurance assessment credit totaling $4.7 billion to banks and savings institutions in existence on December 31, 1996 that can be used to offset premiums otherwise due, (v) imposes a cap on the level of the Deposit Insurance Fund and provides for dividends or rebates when the DIF grows beyond a specified threshold, (vi) adopts a historical basis concept for distributing the aforementioned one-time credit and dividends (with each institution’s historical basis to be determined by a formula that looks back to the institution’s assessment base in 1996 and adds premiums paid since that time) and (vii) authorizes revisions to the current risk-based system for assessing premiums, including replacing the current fixed reserve ratio requirement of 1.25% with a range of between 1.15% and 1.5% of insured deposits.
The FDIC established the designated reserve ratio for the DIF at 1.25% for 2007. In addition, the risk based assessment framework was revised to permit the FDIC to assess premiums that more closely match the risk of the institution to the fund. All insured depositories will be assessed a premium for deposit insurance beginning in 2007. The current range is 5 to 43 basis points. This assessment may be offset by the assessment credit.
Privacy Regulations. Pursuant to the Gramm-Leach-Bliley Act, the FDIC has published final regulations implementing the privacy protection provisions of the Gramm-Leach-Bliley Act. The new regulations generally require that Legacy Banks disclose its privacy policy, including identifying with whom it shares a customer’s “non-public personal information,” to customers at the time of establishing the customer relationship and annually thereafter. In addition, Legacy Banks is required to provide its customers with the ability to “opt-out” of having their personal information shared with unaffiliated third parties and not to disclose account numbers or access codes to non-affiliated third parties for marketing purposes. Legacy Banks currently has a privacy protection policy in place and believes that such policy is in compliance with the regulations.
Community Reinvestment Act. Under the Community Reinvestment Act, or CRA, as amended and as implemented by FDIC regulations, a bank has a continuing and affirmative obligation, consistent with its safe and sound operation, to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA does require the FDIC, in connection with its examination of a bank, to assess the institution’s record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by such institution, including applications to acquire branches and other financial institutions. The CRA requires the FDIC to provide a written evaluation of an institution’s CRA performance utilizing a four-tiered descriptive rating system. Legacy Banks’ latest FDIC CRA rating was “Outstanding.”
Massachusetts has its own statutory counterpart to the CRA which is also applicable to Legacy Banks. The Massachusetts version is generally similar to the CRA but utilizes a five-tiered descriptive rating system. Massachusetts law requires the Massachusetts Commissioner of Banks to consider, but not be limited to, a bank’s record of performance under Massachusetts law in considering any application by the bank to establish a branch or other deposit-taking facility, to relocate an office or to merge or consolidate with or acquire the assets and assume the liabilities of any other banking institution. Legacy Banks’ most recent rating under Massachusetts law was “Outstanding.”
Consumer Protection and Fair Lending Regulations. Massachusetts savings banks are subject to a variety of federal and Massachusetts statutes and regulations that are intended to protect consumers and prohibit discrimination in the granting of credit. These statutes and regulations provide for a range of sanctions for non-compliance with their terms, including imposition of administrative fines and remedial orders, and referral to the Attorney General for prosecution of a civil action for actual and punitive damages and injunctive relief. Certain of these statutes authorize private individual and class action lawsuits and the award of actual, statutory and punitive damages and attorneys’ fees for certain types of violations.
The USA PATRIOT Act. Legacy Banks is subject to the USA PATRIOT Act, which gives the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. By way of amendments to the Bank Secrecy Act, Title III of the USA PATRIOT Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions, including banks, thrifts, brokers, dealers, credit unions, money transfer agents, and parties registered under the Commodity Exchange Act.
Federal Reserve System
The Federal Reserve Board regulations require depository institutions to maintain non-interest-earning reserves against their transaction accounts (primarily NOW and regular checking accounts). The Federal Reserve Board regulations generally require that reserves be maintained against aggregate transaction accounts as follows: for that portion of transaction accounts aggregating $45.8 million or less (which may be adjusted by the Federal Reserve Board) the reserve requirement is 3.0%; and the amounts greater than $45.8 million require a 10.0% reserve (which may be adjusted by the Federal Reserve Board between 8.0% and 14.0%). The first $8.5 million of otherwise reservable balances (which may be adjusted by the Federal Reserve Board) are exempted from the reserve requirements. Legacy Banks is in compliance with these requirements.
Federal Home Loan Bank System
The Bank is a member of the Federal Home Loan Bank (FHLB) system, which consists of 12 regional Federal Home Loan Banks. The FHLB provides a central credit facility primarily for member institutions. Legacy Banks, as a member of the FHLB of Boston, is required to acquire and hold shares of capital stock in the FHLB of Boston. Legacy Banks was in compliance with this requirement with an investment in FHLB of Boston stock at December 31, 2006 of $9.0 million.
The Federal Home Loan Banks are required to provide funds for certain purposes including contributing funds for affordable housing programs. These requirements could reduce the amount of dividends that the FHLB pay to their members and result in the FHLB imposing a higher rate of interest on advances to their members. For the years ended 2006, 2005, and 2004, cash dividends from the FHLB of Boston to Legacy Banks amounted to approximately $498,000, $392,000, and $209,000, respectively. Further, there can be no assurance that the impact of recent or future legislation on the FHLB will not also cause a decrease in the value of the FHLB stock held by the Bank.
Holding Company Regulation
General: Federal law allows a state savings bank that qualifies as a “Qualified Thrift Lender,” discussed below, to elect to be treated as a savings association for purposes of the savings and loan holding company provisions of federal law. Such election allows its holding company to be regulated as a savings and loan holding company by the OTS rather than as a bank holding company by the Federal Reserve Board. Legacy Banks made such election and the Company is a non-diversified unitary savings and loan holding company within the meaning of federal law. As such, the Company is registered with the OTS and has adhered to the OTS’s regulations and reporting requirements. In addition, the OTS may examine and supervise the Company and the OTS has enforcement authority over the Company and its non-savings institution subsidiaries. Among other things, this authority permits the OTS to restrict or prohibit activities that are determined to be a serious risk to the subsidiary savings institution. Additionally, Legacy Banks is required to notify the OTS at least 30 days before declaring any dividend to the Company. By regulation, the OTS may restrict or prohibit the Bank from paying dividends.
The Gramm-Leach-Bliley Act of 1999 expanded the authority of bank holding companies to affiliate with other financial services companies such as insurance companies and investment banking companies. The Gramm-Leach-Bliley Act, however, provided that unitary savings and loan holding companies, such as the Company, may only engage in activities permitted to a financial holding company under the legislation and those permitted for a multiple savings and loan holding company. Upon any non-supervisory acquisition by the Company of another savings association as a separate subsidiary, the Company would become a multiple savings and loan holding company. Federal law limits the activities of a multiple savings and loan holding company and its non-insured
institution subsidiaries primarily to activities permissible for bank holding companies under Section 4(c)(8) of the Bank Holding Company Act, provided the prior approval of the OTS is obtained, to other activities authorized by OTS regulation and to those permitted for financial holding companies. Multiple savings and loan holding companies are generally prohibited from acquiring or retaining more than 5% of a non-subsidiary company engaged in activities other than those permitted by federal law.
Federal law prohibits a savings and loan holding company from, directly or indirectly, acquiring more than 5% of the voting stock of another savings association or savings and loan holding company or from acquiring such an institution or company by merger, consolidation or purchase of its assets, without prior written approval of the OTS. In evaluating applications by holding companies to acquire savings associations, the OTS considers the financial and managerial resources and future prospects of the Company and the institution involved, the effect of the acquisition on the risk to the insurance funds, the convenience and needs of the community and competitive factors.
To be regulated as a savings and loan holding company by the OTS (rather than as a bank holding company by the Federal Reserve Board), the Bank must qualify as a Qualified Thrift Lender. To qualify as a Qualified Thrift Lender, the Bank must maintain compliance with the test for a “domestic building and loan association,” as defined in the Internal Revenue Code, or with a Qualified Thrift Lender Test. Under the Qualified Thrift Lender Test, a savings institution is required to maintain at least 65% of its “portfolio assets” (total assets less: (1) specified liquid assets up to 20% of total assets; (2) intangibles, including goodwill; and (3) the value of property used to conduct business) in certain “qualified thrift investments” (primarily residential mortgages and related investments, including certain mortgage-backed and related securities) in at least 9 months out of each 12 month period. As of December 31, 2006, Legacy Banks maintained 88% of its portfolio assets in qualified thrift investments.
Acquisition of the Company: Under the Federal Change in Bank Control Act, a notice must be submitted to the OTS if any person (including a company), or group acting in concert, seeks to acquire “control” of a savings and loan holding company. Under certain circumstances, a change in control may occur, and prior notice is required, upon the acquisition of 10% or more of the Company’s outstanding voting stock, unless the OTS has found that the acquisition will not result in a change of control of the Company. Under the Change in Bank Control Act, the OTS has 60 days from the filing of a complete notice to act, taking into consideration certain factors, including the financial and managerial resources of the acquirer and the anti-trust effects of the acquisition. Any company that acquires control would then be subject to regulation as a savings and loan holding company.
Massachusetts Holding Company Regulation: In addition to the federal holding company regulations, a bank holding company organized or doing business in Massachusetts must comply with any regulation under the Massachusetts law. The term “bank holding company,” for the purposes of Massachusetts law, is defined generally to include any company which, directly or indirectly, owns, controls or holds with power to vote more than 25% of the voting stock of each of two or more banking institutions, including commercial banks and state co-operative banks, savings banks and savings and loan associations and national banks, federal savings banks and federal savings and loan associations. In general, a holding company controlling, directly or indirectly, only one banking institution will not be deemed to be a bank holding company for the purposes of Massachusetts law. Under Massachusetts law, the prior approval of the Board of Bank Incorporation is required before the following: any company may become a bank holding company; any bank holding company acquires direct or indirect ownership or control of more than 5% of the voting stock of, or all or substantially all of the assets of, a banking institution; or any bank holding company merges with another bank holding company. Although the Company is not a bank holding company for purposes of Massachusetts law, any future acquisition of ownership, control, or the power to vote 25% or more of the voting stock of another banking institution or bank holding company would cause it to become such.
Federal Securities Laws: The Company’s common stock is registered with the Securities and Exchange Commission under Section 12(b) of the Securities Exchange Act of 1934. The Company is subject to the information, proxy solicitation, insider trading restrictions and other requirements under the Exchange Act.
Financial Privacy: In accordance with the Gramm-Leach-Bliley Financial Modernization Act of 1999, federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain
personal information to a nonaffiliated third party. The privacy provisions of the Act affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.
Taxation
Federal taxes: In general the Company and Legacy Banks report their income on a calendar year basis using the accrual method of accounting. The federal income tax laws apply to the Company and Legacy Banks in the same manner as to other corporations with some exceptions, including particularly Legacy Bank’s reserve for bad debts discussed below. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to Legacy Bank or the Company. Legacy Bank’s federal income tax returns have been either audited or closed under the statute of limitations through tax year 2000. For its 2006 tax year, Legacy Banks maximum federal income tax rate was 34%.
Bad Debt Reserves: For fiscal years beginning before December 31, 1995, thrift institutions which qualified under certain definitional tests and other conditions of the Internal Revenue Code of 1986, as amended, were permitted to use certain favorable provisions to calculate their deductions from taxable income for annual additions to their bad debt reserve. A reserve could be established for bad debts on qualifying real property loans, generally secured by interests in real property improved or to be improved, under the percentage of taxable income method or the experience method. The reserve for non-qualifying loans was computed using the experience method. Federal legislation enacted in 1996 repealed the reserve method of accounting for bad debts and the percentage of taxable income method for tax years beginning after 1995 and required savings institutions to recapture or take into income certain portions of their accumulated bad debt reserves. Approximately $5.4 million of the Bank’s accumulated bad debt reserves will not be recaptured into taxable income unless the Bank makes a “nondividend distribution” to the Company as described below.
Distributions: If the Bank makes “nondividend distributions” to the Company, they will be considered to have been made from the Bank’s unrecaptured tax bad debt reserves, including the balance of its reserves as of December 31, 1987, to the extent of the “nondividend distributions,” and then from the Bank’s supplemental reserve for losses on loans, to the extent of those reserves, and an amount based on the amount distributed, but not more than the amount of those reserves, will be included in the Bank’s taxable income. Nondividend distributions include distributions in excess of the Bank’s current and accumulated earnings and profits, as calculated for federal income tax purposes, distributions in redemption of stock, and distributions in partial or complete liquidation. Dividends paid out of the Bank’s current or accumulated earnings and profits will not be included in the Bank’s taxable income. The amount of additional taxable income triggered by a nondividend distribution is an amount that, when reduced by the tax attributable to the income, is equal to the amount of the distribution. Therefore, if the Bank makes a nondividend distribution to the Company, approximately one and one-half times the amount of the distribution not in excess of the amount of the reserves would be includable in income for federal income tax purposes, assuming a 35% federal corporate income tax rate. The Bank does not intend to pay dividends that would result in a recapture of any portion of its bad debt reserves.
Massachusetts Taxation: The Massachusetts excise tax rate for savings banks is currently 10.5% of federal taxable income, adjusted for certain items. Taxable income includes gross income as defined under the Internal Revenue Code, plus interest from bonds, notes and evidences of indebtedness of any state, including Massachusetts, less deductions, but not the credits, allowable under the provisions of the Internal Revenue Code, except no deduction is allowed for bonus depreciation or for taxes paid to the state which are based on income. Carryforwards and carrybacks of net operating losses are not allowed.
A financial institution or business corporation is generally entitled to special tax treatment as a “securities corporation,” provided that: (a) its activities are limited to buying, selling, dealing in or holding securities on its own behalf and not as a broker; and (b) it has applied for, and received, classification as a “securities corporation” by the Commissioner of the Massachusetts Department of Revenue. A securities corporation that is also a bank holding company under the Code must pay a tax equal to 0.33% of its gross income. A securities corporation that is not a bank holding company under the Code must pay a tax equal to 1.32% of its gross income. Legacy Bancorp, Inc., as well as one of the Bank’s subsidiaries, Legacy Securities Corporation. Inc., are considered securities corporations for Massachusetts excise tax purposes.
Delaware Taxation: As a Delaware holding company not earning income in Delaware, the Company is exempt from Delaware corporate income tax but is required to file an annual report with and pay an annual franchise tax to the State of Delaware.
Available Information: The Company’s website is http://www.LegacyBanks.com. The Company makes available free of charge through its website, its annual reports on Form 10-K; quarterly reports on Form 10-Q; current reports on Form 8-K; and any amendments to those reports led or furnished pursuant to the Securities Exchange Act of 1934 as soon as reasonably practicable after such material is electronically filed with, or furnished to the SEC. The reference to our website does not constitute incorporation by reference of the information contained in the website and should not be considered part of this document.
Item 1a.
Item 1a.
Risk Factors
The following risk factors are relevant to our future results and financial success, and should be read with care.
Risks Related to Our Business
Our Commercial Real Estate and Commercial Loans Expose Us to Increased Credit Risks, and These Risks Will Increase if We Succeed in Increasing These Types of Loans.
We intend to grow commercial real estate and commercial loans further as a proportion of our portfolio over the next several years. In general, commercial real estate loans and commercial loans generate higher returns, but also pose greater credit risks, than do owner-occupied residential mortgage loans. As our various commercial loan portfolios increase, the corresponding risks and potential for losses from these loans will also increase.
We make both secured and some short-term unsecured commercial loans. Unsecured loans generally involve a higher degree of risk of loss than do secured loans because, without collateral, repayment is wholly dependent upon the success of the borrowers’ businesses. Secured commercial loans are generally collateralized by equipment, leases, inventory and accounts receivable. Compared to real estate, that type of collateral is more difficult to monitor, its value is harder to ascertain, it may depreciate more rapidly and it may not be as readily saleable if repossessed.
Our Continuing Concentration of Loans in Our Primary Market Area May Increase Our Risk.
Our success depends primarily on the general economic conditions in the counties in which we conduct business. Unlike larger banks that are more geographically diversified, we provide banking and financial services to customers primarily in Berkshire County, in Western Massachusetts. The local economic conditions in our market area have a significant impact on our loans, the ability of the borrowers to repay these loans and the value of the collateral securing these loans. A significant decline in general economic conditions caused by inflation, recession, unemployment or other factors beyond our control would affect these local economic conditions and could adversely affect our financial condition and results of operations. Additionally, because we have a significant amount of commercial real estate loans, decreases in tenant occupancy may also have a negative effect on the ability of many of our borrowers to make timely repayments of their loans, which would have an adverse impact on our earnings.
Changes in Market Interest Rates Could Adversely Affect Our Financial Condition and Results of Operations.
Our profitability, like that of most financial institutions, depends to a large extent upon our net interest income, which is the difference, or spread, between our gross interest income on interest-earning assets, such as loans and securities, and our interest expense on interest-bearing liabilities, such as deposits and borrowed funds. Accordingly, our results of operations and financial condition depend largely on movements in market interest rates and our ability to manage our interest-rate-sensitive assets and liabilities in response to these movements, including our adjustable-rate mortgage loans, which represent a large portion of our residential loan portfolio. Changes in interest rates could have a material adverse effect on our business, financial condition, results of operations and cash flows. Because, as a general matter, our interest-bearing liabilities re-price or mature more quickly than our interest-
earning assets, an increase in interest rates generally would result in a decrease in our interest rate spread and net interest income. See “Item 7a: Quantitative and Qualitative Disclosures About Risk Management”.
We are also subject to reinvestment risk relating to interest rate movements. Decreases in interest rates can result in increased prepayments of loans and mortgage-related securities, as borrowers refinance to reduce their borrowing costs. Under these circumstances, we are subject to reinvestment risk to the extent that we are not able to reinvest funds from such prepayments at rates that are comparable to the rates on the prepaid loans or securities. On the other hand, increases in interest rates on adjustable-rate mortgage loans result in larger mortgage payments due from borrowers, which could potentially increase our level of loan delinquencies and defaults.
We May Have Difficulty Meeting Our Branch Expansion Goals, and Our Branch Expansion Strategy May Not Be Accretive to Earnings.
Our growth plans include the opening of new branch offices in communities served by Legacy Banks as well as in other communities contiguous to those currently served by Legacy Banks. Our ability to establish new branches will depend upon whether we can identify suitable sites and negotiate acceptable lease or purchase and sale terms, and we may not be able to do so, or it may take longer than we expect. Moreover, once we establish a new branch, numerous factors will contribute to its performance, such as a suitable location, qualified personnel and an effective marketing strategy. Additionally, it takes time for a new branch to gather significant loans and deposits to generate enough income to offset its expenses, some of which, like salaries and occupancy expense, are relatively fixed costs. There can be no assurance that our branch expansion strategy will be accretive to our earnings, or that it will be accretive to earnings within a reasonable period of time.
Our Ability to Grow May Be Limited if We Cannot Make Acquisitions.
In an effort to increase our loan and deposit growth, we will continue to seek to expand our banking franchise, including through acquisitions of other financial institutions or branches if opportunities arise. Our ability to grow through selective acquisitions of other financial institutions or branches will depend on successfully identifying, acquiring and integrating them. We compete with other financial institutions with respect to proposed acquisitions. We cannot assure you that we will be able to identify attractive acquisition candidates or make acquisitions on favorable terms. In addition, we cannot assure you that we can successfully integrate any acquired financial institutions or branches into our banking organization in a timely or efficient manner, that we will be successful in retaining existing customer relationships or that we can achieve anticipated operating efficiencies.
Strong Competition Within Our Market Area May Limit Our Growth and Profitability.
We face significant competition both in attracting deposits and in the origination of loans. Savings banks, credit unions, savings and loan associations and commercial banks operating in our primary market area have historically provided most of our competition for deposits. In addition, and particularly in times of high interest rates, we face additional and significant competition for funds from money-market mutual funds and issuers of corporate and government securities. Competition for the origination of real estate and other loans comes from other thrift institutions, commercial banks, insurance companies, finance companies, other institutional lenders and mortgage companies. Many of our competitors have substantially greater financial and other resources than us. Moreover, we may face increased competition in the origination of loans if competing thrift institutions convert to stock form, because such converting thrifts would likely seek to invest their new capital into loans. Finally, credit unions do not pay federal or state income taxes and are subject to fewer regulatory constraints than savings banks and as a result, they may enjoy a competitive advantage over us. This advantage places significant competitive pressure on the prices of our loans and deposits.
We Operate in a Highly Regulated Environment and May Be Adversely Affected by Changes in Law and Regulations.
We are subject to extensive regulation, supervision and examination as outlined in the “Regulation And Supervision” section of this report. Any change in the laws or regulations applicable to us, or in banking regulators’ supervisory policies or examination procedures, whether by the Massachusetts Commissioner of Banks, the FDIC,
the Federal Reserve Board, the Office of Thrift Supervision, other state or federal regulators, the United States Congress or the Massachusetts legislature could have a materially adverse effect on our business, financial condition, results of operations and cash flows.
Item 1b.
Item 1b.
Unresolved Staff Comments
None
Item 2.
Item 2.
Properties
Legacy Banks conducts its business through its main office located in Pittsfield, Massachusetts, nine other full-service branch offices located in Berkshire County, Massachusetts, and one loan production office in Colonie, New York. The Bank is scheduled to open two new branches in early 2007. One is located in North Adams, Massachusetts and will replace the current branch in that community, while the other is located in Great Barrington, Massachusetts. The following table sets forth information about our offices as of December 31, 2006:
(1)
Legacy bank has an option to renew for 5 years
(2)
Legacy bank has an option to renew for two additional 5 year terms
(3)
Legacy bank has an option to renew for 3 years
Item 3.
Item 3.
Legal Proceedings
We are not involved in any legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Management believes that those routine legal proceedings involve, in the aggregate, amounts that are immaterial to our financial condition and results of operations.
Item 4.
Item 4.
Submission Of Matters To A Vote Of Security Holders
On November 1, 2006, Legacy Bancorp, Inc. (the “Company”), held a special meeting of stockholders at which a quorum of the stockholders, present either in person or by proxy, voted to approve the 2006 Equity Incentive Plan by the following vote:
Part II
Item 5.
Item 5.
Market For Registrant’s Common Equity, Related Stockholder Matters And Issuer Purchases Of Equity Securities
The common stock is traded on the NASDAQ Stock Market, LLC under the symbol “LEGC.” As of March 7, 2006, the Company had approximately 1160 holders of record. The following table sets forth, for the quarters indicated, the daily high and low sales price for the common stock and the dividends declared. The closing price of the Company’s common stock on March 9, 2006 was $15.74. The Company is subject to the requirements of Delaware law, which generally limits dividends to an amount equal to the excess of the net assets of the Company (the amount by which total assets exceed total liabilities) over its statutory capital or, if there is no excess, to its net profits for the current and/or immediately preceding two fiscal years.
The Company did not repurchase any shares in the quarter or year ended December 31, 2006. On January 31, 2007 the Company announced that to fund the Company’s 2006 Equity Incentive Plan, a trust was established which has been authorized to purchase shares of the Company’s common stock in the open market with funds contributed by the Company. On February 23, 2007 the Company announced the independent trustee completed these purchases, all of which were made from time to time at the discretion of the independent trustee of the trust and amounted to 412,344 shares, or 4.0% of the Company’s issued and outstanding common stock. Stockholders approved the 2006 Equity Incentive Plan at the Company’s Special Meeting of Stockholders in November 2006, as described in Part I, Item 4. Information regarding securities authorized for issuance under equity compensation plans appears in Part III, Item 12(d) of this report.
Stock Performance Graph: The following graph shows a comparison of cumulative total shareholder return (including reinvested dividends) on the Company’s common stock, with the cumulative total returns of both a broad-market index and a peer group index for the period October 26, 2005 (the date of the Company’s initial public offering) through December 31, 2006. The broad-market index chosen was the Nasdaq Market Index, and the peer group index chosen was the Nasdaq Bank Index and the SNL Thrift Index for Thrifts with Assets Between $500 million and $1 billion. The shareholder returns are measured based on an assumed investment of $100 on October 26, 2005.
Comparison Of Cumulative Total Return Among Legacy Bancorp,
Peer Group Index And Nasdaq Market Index
A. The lines represent yearly index levels derived from compounded returns that include all dividends.
B. If the fiscal year end is not a trading day, the preceding day is used.
C. The Index level for all series was set to $100.00 on 10/26/05.
There can be no assurance that the Company’s common stock or the indices included above will continue in the future with the same or similar trend depicted in the graph. The Company will not make or endorse any predictions as to future stock performance.
Item 6.
Item 6.
Selected Financial Data
The following summary data is based in part on the consolidated financial statements and accompanying notes, and other schedules appearing elsewhere in this Form 10-K. Historical data is also based in part on, and should be read in conjunction with, prior filings with the SEC. Because shares had not been issued and outstanding during the entire year, earnings per share have not been reported for the year ended December 31, 2005 and prior.
(1)
Includes loans held for sale.
(2)
Net income divided by average total assets.
(3)
Net income divided by average total equity.
(4)
Net interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average cost of interest-bearing liabilities.
(5)
Net interest margin represents net interest income as a percentage of average interest-earning assets for the year.
(6)
The efficiency ratio represents non-interest expense for the year less expenses related to the amortization of intangibles divided by the sum of net interest income (before loan loss provision) plus non-interest income.
(7)
All capital ratios are as of the end of the year.
Item 7.
Item 7.
Management’s Discussion And Analysis Of Financial Condition And Results Of Operation
General: Management’s discussion and analysis of financial condition and results of operations is intended to assist in understanding the financial condition and results of operations of the Company. The information contained in this section should be read in conjunction with the consolidated financial statements and accompanying notes contained in this report.
Overview: Legacy Bancorp, Inc. reported a net loss of $591,000, or $0.06 per diluted share for the quarter ended December 31, 2006, and net income of $2.8 million for the twelve months ended December 31, 2006. The fourth quarter loss is primarily a result of a partial balance sheet restructuring through the sale of approximately $64.5 million of bonds which were yielding an average of 3.89%. The Company incurred an after-tax loss of
approximately $1.3 million on the sale of these bonds. Proceeds from the sale were reinvested in securities averaging 5.57%, and the transaction is expected to increase interest income by approximately $1.0 million in 2007. Furthermore, the Company incurred an additional $659,000 in tax expense in the fourth quarter of 2006 as a result of a reevaluation of the realizability of the deferred tax benefit resulting from the contribution of 763,600 shares of common stock to The Legacy Banks Foundation (the “Foundation”) in 2005. These non-core items were partially offset by a gain of $605,000 on the termination of the Bank’s defined benefit plan in the fourth quarter of 2006. The total shares outstanding resulted in a book value per share and tangible book value per share of $14.55 and $14.25, respectively, at December 31, 2006.
Dividend: On March 8, 2007 the Company announced that its Board of Directors had declared a cash dividend of $0.04 per common share. The dividend will be paid on April 2, 2007 to stockholders of record as of March 20, 2007.
Stock-based compensation: In accordance with the Company’s 2006 Equity Incentive Plan, approved by shareholders on November 1, 2006, the Company’s Compensation Committee awarded 892,200 stock options with an exercise price of $16.03 per share and 346,500 shares of restricted stock with a grant date fair value of $16.03 per share to directors and certain employees on November 29, 2006. The Stock Incentive Plan provides for total awards of 1,030,860 stock options and 412,344 shares of restricted stock, leaving 138,660 stock options and 65,844 shares of restricted stock available for future awards. The shares of common stock underlying any awards that are forfeited, cancelled, reacquired by Legacy Bancorp or otherwise terminated (other than by exercise), shares that are tendered or withheld in payment of the exercise price of any award, and shares that are tendered or withheld for tax withholding obligations will be added back to the shares of common stock with respect to which new awards may be granted under the plan.
Stock options awarded are for a term of ten years and will vest over a period of five years. Upon a change in control (as defined in the plan) or the death or disability of the individual to whom options or shares were awarded, all options and restricted shares awarded immediately vest. Of the options awarded, 274,940 were incentive stock options and 617,260 were non-statutory options. All 892,200 options granted during the fourth quarter remain outstanding at December 31, 2006, and no options have yet vested. The exercise price of all options outstanding is $16.03 and the weighted average remaining contractual life at the end of the period is 9.92 years. The following table presents the fair value and related assumptions using the Black-Scholes Option Pricing Model for stock options granted:
All of the 346,500 shares awarded on November 29, 2006 vest over a five year period, and all remain unvested as of the end of the year. Additionally, there have been no forfeitures through December 31, 2006. The grant date fair value of these shares was $16.03.
For the quarter and year ended December 31, 2006, the Company recognized compensation cost on stock options of $237,985. The Company is employing an accelerated method of expense recognition for options, whereby compensation cost is measured on a straight-line basis over the requisite service period for each separately vesting portion of the award, as if the award was, in-substance, multiple awards. For restricted stock awards, the cost recognized during the quarter and year amounted to $179,174. The estimated amount and timing of compensation cost to be recognized for awards made to date under the plan is as follows
Growth Strategy and Challenges: Long term growth is an essential element in our business plan. Lending is the major driver of revenue and we are committed to supporting our loan growth. We recognize that loan and deposit growth are interdependent, and over the long term both must grow consistently. One of our biggest challenges is to grow our customer base and to grow the depth and breadth of our customer relationships. We address this challenge by maintaining our focus on anticipating, understanding and assisting our customers in achieving their financial goals.
Our deposit pricing strategy is two fold. First, our LifePath product is important to our deposit mix. It requires customers to maintain a checking account as part of the relationship, the goal being to create multiple relationships with our customers to aid both profitability and customer retention. The LifePath savings product is structured and priced like a money market deposit or fund, except that it does not offer check writing. LifePath deposits amounted to $93.0 million as of December 31, 2006. Our experience with money market type deposit accounts has been that they become a long term, stable funding source at reasonable cost. The second component in our pricing strategy is to continuously offer a selection of special certificates of deposit with competitive interest rates that are tiered to the amount of the customer deposits.
Another challenge is being able to maintain sufficient asset size or scale to provide the marketing, technology, service and other support functions so that we will continue to be relevant and competitive. It is for these reasons that management emphasizes and monitors growth in terms of customers, customer households, customer relationships, assets, revenue per employee, and efficiency. We also know that to successfully grow, our employees must be extremely well trained and experienced. We regularly monitor training hours per employee, employee turnover and employee (and customer) satisfaction surveys. We also engage a mystery shopping firm that sends representatives into each of our locations to experience and witness what the customer experiences and then provide us with constructive feedback.
Critical Accounting Policies: The Company has established various accounting policies, which govern the application of generally accepted accounting principles in the preparation of the financial statements. Certain accounting policies involve significant judgments and assumptions by management that have a material impact on the carrying value of certain assets and liabilities. Management considers such accounting policies to be critical accounting policies. The judgments and assumptions used by management are based on historical experience and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of assets and liabilities and the results of operations of the Company. Refer to Footnote 1 to the Consolidated Financial Statements, “Summary of Significant Accounting Policies”. We consider the following to be critical accounting policies:
Allowance for Loan Losses: The determination of the allowance for loan losses is considered critical due to the high degree of judgment involved, the subjectivity of the underlying assumptions used, and the potential for changes in the economic environment that could result in material changes in the amount of the allowance for loan losses considered necessary. The allowance is evaluated on a regular basis by management and is based on a periodic review of the collectibility of the loans in light of historical experience, the nature and size of the loan portfolio, adverse situations that may affect borrowers’ ability to repay, the estimated value of any underlying collateral and prevailing economic conditions. For a full discussion of the allowance for loan losses, please refer to “Business of Legacy Bancorp and Subsidiaries - Asset Quality”.
Income Taxes: Legacy Bancorp uses the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. A valuation allowance related to deferred tax assets is established when, in management’s judgment, it is more likely than not that all or a portion of such deferred tax assets will not be realized. Deferred tax assets applicable to capital loss carryforwards of $536,000, $464,000 of which expires in 2007, and $72,000 of which expires in 2008, are recoverable only to the extent that capital gains can be realized during the carryforward period. The judgments applied by management consider the likelihood that capital gain income will be realized within the carryforward period in light of our tax planning strategies and changes in market conditions. As of December 31, 2005 a valuation allowance of $830,000 was established against deferred tax assets related to the uncertain utilization of the charitable contribution carryforward created primarily by the donation to The Legacy Banks
Foundation as part of the conversion. This allowance was increased by $659,000 to $1.5 million as of December 31, 2006, reflecting additional uncertainty of the utilization of the carryforward.
This discussion has highlighted those accounting policies that management considers to be critical; however all accounting policies are important, and therefore you are encouraged to review each of the policies included in Note 1 to the consolidated financial statements to gain a better understanding of how our financial performance is measured and reported.
Net Interest Income: Legacy Bancorp’s results of operations, or net income, are dependent mainly on net interest income, which is the difference between the income earned on its loan and investment portfolios and interest expense incurred on its deposits and borrowed funds. Net interest income represented 87.2% and 86.7% of our total revenue for the years ended December 31, 2006 and 2005, respectively. Our net interest margin was 3.15% and 3.22% for the year ended December 31, 2006 and 2005, respectively. The overall interest rate environment and changes in interest rates have a direct impact on net interest income. We utilize a rigorous asset and liability management process to manage interest rate risk. We monitor the interest rate environment and set interest rates on our deposit and loan products to effectively manage interest rate risk. To this end, we are aided by a quarterly review of critical assumptions, modeling projections, back testing of the model’s previous projections against actual results, analysis of changes, opportunities and risks associated with changes in market interest rates, and liquidity analysis. For a more detailed description of our asset and liability management process, see Item 7a:
Item 7a: Quantitative and Qualitative Disclosures About Risk Management - Management of Market Risk”.
Non-Interest Expense: Legacy Bancorp’s non-interest expense consists primarily of compensation and employee benefits, office occupancy, technology, marketing, general administrative expenses and income tax expense. We use the efficiency ratio (non-interest expense for the period minus expenses related to the amortization of intangible assets divided by the sum of net interest income (before the loan loss provision) plus non-interest income) and the expense ratio (non-interest expense to total average assets) as the primary measurements to monitor and control non-interest expense. For the year ended December 31, 2006, the efficiency and expense ratios were 74.2% and 2.70%, respectively. For the year ended December 31, 2005, the efficiency and expense ratios were 104.2% and 3.56%, respectively. The decrease in both ratios was primarily a result of the non-core expense items occurring in the fourth quarter of 2005, including the donation of Company stock to the Legacy Banks Foundation.
Net income: Return on average assets (ROAA) is a primary measurement of net income relative to peer banks. It has been low in recent years relative to peer banks, but has shown improvement from 2002 through 2004. In 2005, the ROAA was negative, as expected, primarily as a result of the contribution to the Foundation as part of the mutual to stock conversion. In 2006, the ROAA was significantly impacted by the increase in operating expenses and pressure on the net interest margin due to the flat to partially inverted yield curve for much of the year. For the years ended December 31, 2006 and 2005 the ROAA was 0.36% and (0.31%), respectively. In addition to net interest income and non-interest expense, results of operations are also affected by fee income from banking and non-banking operations, provisions for loan losses, gains (losses) on sales of loans and securities available for sale, loan servicing income and other miscellaneous income.
Comparison of Financial Condition at December 31, 2006 and December 31, 2005
Total Assets: Total assets increased by $30.0 million, or 3.9%, from $778.3 million at December 31, 2005 to $808.3 million at December 31, 2006. This increase was largely the result of loan growth as described below.
Cash and Short-term Investments: Overall, cash and short-term investments increased by $2.4 million, or 12.5%. Cash and correspondent bank balances decreased by $1.8 million, or 15.0% to $10.4 million as of December 31, 2006 compared to $12.3 million at December 31, 2005. Over the same period, short-term investments, comprised of federal funds sold and FHLB overnight deposits, increased $4.3 million, or 61.2%, from $7.0 million at December 31, 2005 to $11.2 million at December 31, 2006, mainly due to the receipt of funds on the last day of the year.
Securities: Our investment portfolio aggregated $176.1 million at December 31, 2006, a decrease of $3.8 million, or 2.1%, from $179.9 million at December 31, 2005. This decrease was primarily related some security cash flow being used to fund loan growth, as well as the partial balance sheet restructuring undertaken at the
end of 2006 where the Bank sold approximately $64.5 million of bonds which were yielding an average of 3.89% and incurred an after-tax loss of approximately $1.3 million, or $0.14 per share, on this sale. Proceeds from the sale were reinvested in securities averaging 5.57%, and the transaction is expected to increase interest income by approximately $1.0 million in 2007.
Net Loans: Net loans as of December 31, 2006 were $578.8 million, an increase of $31.3 million, or 5.7%, over net loan balances of $547.5 million as of December 31, 2005. In particular, residential mortgage balances increased by $17.4 million, or 5.6% to $325.4 million, and the commercial real estate loan balances, including both loans within our market area as well as national commercial real estate loans increased $10.3 million, or 6.4% to $171.0 million. The Company opened a loan production office in Colonie, New York in the third quarter of 2006 as part of its committed to the further expansion of its commercial lending business over the next several years.
Deposits: Deposit growth continued in 2006 as deposits increased by $43.8 million to $518.2 million at December 31, 2006, an increase of 9.2% over a balance of $474.5 million at December 31, 2005. The largest increases came in certificates of deposit which increased by $39.6 million and LifePath Savings accounts which increased by $19.9 million. These increases were offset partially by decreases in regular savings, NOW accounts and certain demand accounts. The deposit increases overall were the result of the Bank’s continued marketing and promotional efforts in its market area, including the promotion of CD specials.
Borrowed Funds: The Company relies on borrowings from the Federal Home Loan Bank of Boston (FHLBB) as an additional funding source as liquidity needs dictate. The balance of these borrowings will fluctuate depending on the Bank’s ability to grow deposits as well as the amount of loan demand in the market. Funds borrowed from the FHLBB decreased by $18.5 million, or 12.7% to $127.4 million at December 31, 2006 from a balance of $145.9 million as of December 31, 2005. The overall decline was primarily a result of the Bank success in growing deposits, as described above.
Retained Earnings: Retained earnings increased by $3.8 million to $150.0 million at December 31, 2006, an increase of 2.6% from a balance of $146.2 million as of December 31, 2005. This increase was driven primarily by a contribution of $2.8 million from net income, as well as a decrease of $0.9 million in the unrealized loss on available for sale investment securities, primarily due to the restructuring of this portfolio, as previously discussed. These increases to equity were offset somewhat by the payment of four separate dividends of $286,000 each. Stockholders Equity was also impacted by the release of 54,979 shares of common stock within the Company’s ESOP.
Comparison of Operating Results For the Years Ended December 31, 2006 and 2005
Analysis of Net Interest Income: Net interest income represents the difference between income on interest-earning assets and expense on interest-bearing liabilities. Net interest income depends upon the relative amounts of interest-earning assets and interest-bearing liabilities and the interest rates earned or paid on them.
The following tables set forth average balance sheets, average yields and costs, and certain other information for the periods indicated. All average balances are daily average balances. The yields set forth below include the effect of deferred fees, and discounts and premiums that are amortized or accreted to interest income or expense. Legacy does not accrue interest on loans on non-accrual status, however, the balance of these loans is included in the total average balance, which has the effect of lowering average loan yields.
(1)
Yields and rates for the years ended December 31, 2006, 2005 and 2004 are actual.
(2)
Includes loans held for sale.
(3)
Net interest rate spread represents the difference between the yield on total average interest-earning assets and the cost of total average interest-bearing liabilities for the twelve months ended December 31, 2006, 2005 and 2004.
(4)
Net interest-earning assets represents total interest-earning assets less total interest-bearing liabilities.
(5)
Net interest margin represents net interest income divided by average total interest-earning assets.
The following table presents the dollar amount of changes in interest income and interest expense for the major categories of the Bank’s interest-earning assets and interest-bearing liabilities. Information is provided for each category of interest-earning assets and interest-bearing liabilities with respect to (i) changes attributable to changes in volume (i.e., changes in average balances multiplied by the prior-period average rate) and (ii) changes attributable to rate (i.e., changes in average rate multiplied by prior-period average balances).
Net Income: Net income for the year ended December 31, 2006 was $2.8 million, a bottom line increase of $5.0 million over 2005. Increases in net interest income and non-interest expense were further enhanced by decreases in non-interest expenses. The results for the year ended December 31, 2005 were significantly impacted by certain conversion related charges, including the contribution to the Legacy Banks Foundation and a $2.4 million FHLB prepayment restructuring charge, as discussed below.
Net Interest Income: The tables above set forth the components of the Company’s net interest income, yields on interest earning assets and interest bearing liabilities, and the effect on net interest income arising from changes in volume and rate. Net interest income increased from $21.9 million in 2005 to $23.6 million in 2006. The increase of $1.7 million, or 7.5%, is due to a $61.8 million, or 61.6%, increase in average net interest-earning assets. This increase, primarily the result of the effects of the October 2005 mutual-to-stock conversion impacting 2006 for a full year, coupled with the 2006 loan growth, resulted in an increase in net interest income of $2.1 million. Additionally, a decrease of 7 basis points, or 2.2%, in the net interest margin had the effect of decreasing net interest income by $494,000.
Interest Income: Interest and dividend income increased $6.9 million, or 18.8%, to $43.9 million for the year ended December 31, 2006 from $37.0 million for the year ended December 31, 2005. The increase was caused by a $68.8 million increase in average interest-earning assets, which had the effect of increasing interest income by $3.0 million. Loans increased on average by $40.8 million between the two periods, along with an increase in the average balances of investment securities of $37.8 million, partially offset by a decrease in short-term investments of $9.8 million. The average yield on loans increased from 5.92% for the year ended December 31, 2005 to 6.36% for the same period in 2006, and the overall yield on interest earning assets increased from 5.44% to 5.86% for the 2005 and 2006 periods, respectively, due to the general increase in market interest rates.
Interest Expense: Interest expense for the year ended December 31, 2006 increased by $5.3 million or 35.1% to $20.3 million compared to interest expense of $15.1 million for the year ended December 31, 2005. The effect of an increase in interest-bearing liabilities, which grew by an average of $7.1 million in 2006, was to increase interest expense by $842,000, while an increase of 87 basis points, or 33.5%, in the average rates paid on interest-bearing liabilities increased interest expense by $4.4 million. The increase in interest-bearing liabilities was due to the Bank’s aggressive pursuit of deposits through higher rates being offered on certificate of deposits and success of the LifePath product, offset somewhat by decreases in the average balance of regular savings accounts and Federal Home Loan Bank borrowings for the periods. These additional deposits were utilized to fund loan growth.
Provision for Loan Losses: The Bank records a provision for loan losses as a charge to its earnings when necessary in order to maintain the allowance for loan losses at a level sufficient to absorb losses inherent in the loan portfolio. Refer to “Business - Asset Quality” for additional information about the Bank’s methodology for establishing its allowance for loan losses. The Bank recorded $233,000 and $841,000 in loan loss provisions during the years ended December 31, 2006 and 2005, respectively, representing a decrease of $608,000, or 72.3%. Provisions in both years were reflective of the realization of recoveries of $387,000 in 2006 and $147,000 in 2005. This decrease was also a reflection of both the amount and mix of loan growth as well as a continuous evaluation of the Bank’s methodology for the establishment of the allowance. At December 31, 2006, the allowance for loan losses totaled $4.7 million, or 0.80% of the loan portfolio, compared to $4.2 million, or 0.77%, of total loans at December 31, 2005.
Non-interest Income: Non-interest income for the year ended December 31, 2006 increased by $75,000, or 2.2% to $3.5 million as compared to $3.4 million in 2005. There were several non-recurring items within non-interest income in both years. In 2006, the Bank incurred a $1.7 million loss on the sales of securities, primarily as a result of the partial balance sheet restructuring in the fourth quarter as described earlier. Non-interest income in 2005 was impacted by the $2.4 million restructuring charge to the FHLB on the prepayment of $19.5 million of longer-term advances. Additionally, the Company realized a gain on the curtailment and termination of the Bank’s defined benefit plan of $905,000 and $605,000 for the years ended December 31, 2005 and 2006, respectively. Customer service fees decreased by $512,000, or 15.3% primarily due to decreased commercial loan prepayment fees. Other changes include a $111,000 increase in portfolio management fees and a $51,000 increase in miscellaneous income, more than offsetting a decrease of $26,000 on the gain on sale of mortgages.
Non-interest Expense: Non-interest expense decreased by $5.1 million or 19.2%, to $21.3 million for the year ended December 31, 2006, compared to $26.4 million for the same period in 2005. This decrease was primarily due to the 2005 charge of $7.6 million for the contribution to the Legacy Banks Foundation as part of the mutual to stock conversion. Absent this contribution in 2005, non-interest expenses would have increased by $2.6 million, or 13.7%. The Company experienced increases in most salaries and benefit categories and occupancy expenses, and expenses associated with being a public company, including audit, legal and consulting fees and fees related to complying with the provisions of the Sarbanes-Oxley Act of 2002.
Additionally, during the fourth quarter of 2006, the Company’s Compensation Committee awarded 892,200 stock options with an exercise price of $16.03 per share and 346,500 shares of restricted stock with a grant date fair value of $16.03 per share to directors and certain officers on November 29, 2006. These options and stock awards were granted in accordance with the Company’s 2006 Equity Incentive Plan approved by the shareholders on November 1, 2006. For more information regarding the 2006 Equity Incentive Plan refer to “Management’s Discussion and Analysis of Financial Conditions and Results of Operations - Stock Based Compensation”.
Income Taxes: Income tax expense was $2.7 million for the year ended December 31, 2006, an increase of $2.4 million, or 793.3%, compared to $297,000 for the year ended December 31, 2005. The combined federal and state effective tax rate changed significantly between the two years, from (15.3%) in 2005 to 48.6% in 2006 due to the improvement in net income, the disallowance of the 2005 net operating loss carryforwards in the state of Massachusetts, and an additional $659,000 in tax expense in the fourth quarter of 2006 as a result of a reevaluation of the realizability of the deferred tax benefit resulting from the contribution of 763,600 shares of common stock to The Legacy Banks Foundation in 2005.
Comparison of Operating Results For the Years Ended December 31, 2005 and December 31, 2004
Net Income: The net loss for the year ended December 31, 2005 was $2.2 million, a decrease of $5.8 million from net income of $3.6 million for the year ended December 31, 2004. The contribution to the Legacy Banks Foundation, the $2.4 million FHLB prepayment restructuring charge and an increase in the provision for loan losses significantly offset increases to net interest income, as discussed below.
Net Interest Income: The tables above set forth the components of the Company’s net interest income, yields on interest earning assets and interest bearing liabilities, and the effect on net interest income arising from changes in volume and rate. Net interest income increased from $19.5 million in 2004 to $21.9 million in 2005. The increase of $2.4 million, or 12.2%, is due to a $25.2 million, or 33.6%, increase in average net interest-earning assets. This increase, primarily the result of the mutual-to-stock conversion coupled with loan growth, resulted in an increase in net interest income of $1.6 million. Additionally, an increase of 4 basis points, or 1.3%, in the net interest margin had the effect of increasing net interest income by $764,000.
Interest Income: Interest and dividend income increased $5.3 million, or 16.9%, to $37.0 million for the year ended December 31, 2005 from $31.6 million for the year ended December 31, 2004. The increase was caused primarily by a $64.9 million increase in interest-earning assets, which had the effect of increasing interest income by $3.0 million. Net loans increased on average by $36.2 million between the two periods, along with an increase in the average balances of investment securities of $15.9 million and short-term investments of $12.9 million. The average yield on loans increased from 5.62% for the year ended December 31, 2004 to 5.92% for the same period in 2005, and the overall yield on interest earning assets increased from 5.14% to 5.44% for the 2004 and 2005 periods, respectively, due to the general increase in interest rates.
Interest Expense: Interest expense for the year ended December 31, 2005 increased by $3.0 million or 24.4% to $15.1 million compared to interest expense of $12.1 million for the year ended December 31, 2004. The effect of an increase in interest-bearing liabilities, which grew by an average of $39.7 million in the 2005 period, was to increase interest expense by $1.3 million, while an increase of 36 basis points, or 16.1%, in the average rates paid on interest-bearing liabilities increased interest expense by $1.6 million. The increase in non-interest-bearing liabilities was due to the Bank’s aggressive pursuit of deposits through higher rates being offered on certificate of deposits, the success of the LifePath product, and increases in the average balance of Federal Home Loan Bank borrowings for the periods. These additional deposits and borrowings were utilized to fund loan growth.
Provision for Loan Losses: The Bank records a provision for loan losses as a charge to its earnings when necessary in order to maintain the allowance for loan losses at a level sufficient to absorb losses inherent in the loan portfolio. Refer to “Business - Asset Quality” for additional information about the Bank’s methodology for establishing its allowance for loan losses. The Bank recorded $841,000 and $212,000 in loan loss provisions during the years ended December 31, 2005 and 2004, respectively. Provisions in both years were reflective of the realization of recoveries of $147,000 and $153,000 in the years ended December 31, 2005 and 2004, respectively. This increase was also a reflection of both the mix and amount of loan growth as well as a continuous evaluation of the Bank’s methodology for the establishment of the allowance. This evaluation led to the Bank increasing the loss provision for its growing national commercial real estate loan portfolio by 25 basis points in the fourth quarter of 2005. At December 31, 2005, the allowance for loan losses totaled $4.2 million, or 0.77% of the loan portfolio, compared to $3.9 million, or 0.76%, of total loans at December 31, 2004.
Non-interest Income: Non-interest income for the year ended December 31, 2005 decreased by $1.1 million, or 23.9% to $3.4 million as compared to $4.4 million in 2004. The decrease was due to the $2.4 million prepayment restructuring charge to the FHLB on the prepayment of $19.5 million of longer-term advances. This expense was offset by a $0.9 million curtailment gain on the freezing of the Bank’s defined benefit plan in the fourth quarter of 2005. Customer service fees increased by $695,000, or 26.2% primarily due to increased commercial loan prepayment fees. This increase, along with a $201,000 increase in income from Bank-Owned Life Insurance more than offset decreases of $57,000 in insurance and annuity income and $255,000 in miscellaneous income.
Non-interest Expense: Non-interest expense increased by $8.4 million or 47.1%, to $26.4 million for the year ended December 31, 2005, compared to $17.9 million for the same period in 2004. This increase was primarily due to the $7.7 million contribution to the Legacy Banks Foundation as part of the mutual to stock conversion. Salaries
and employee benefits expenses increased $800,000, or 7.9%, to $11.0 million for year ended December 31, 2005. The increase was primarily due to the implementation of the Bank’s ESOP in the fourth quarter of 2005. Decreases in other general and administrative costs were generally offset by increases in occupancy, data processing, professional fees and advertising expenses.
Income Taxes: Income tax expense was $297,000 for the year ended December 31, 2005, a decrease of $2.0 million, or 86.8%, compared to $2.3 million for the year ended December 31, 2004. The combined federal and state effective tax rate changed significantly between the two years, from 38.8% 2004 to (15.3%) in 2005 due to the loss incurred in 2005 as well as the disallowance of net operating loss carryforwards in the state of Massachusetts.
Item 7a:
Quantitative and Qualitative Disclosures About Market Risk
Management recognizes that taking and managing risk is fundamental to the business of banking. Through the development, implementation and monitoring of its policies with respect to risk management, the Bank strives to measure, evaluate and control the risks it faces. Management understands that an effective risk management system is critical to the safety and soundness of the Bank. Chief among the risks faced by Legacy Banks are credit risk, market risk including interest rate risk, liquidity risk, operational (transaction) risk and compliance risk.
Within management, the responsibility for risk management rests with the Risk Management department, headed by the Vice President and General Counsel, other members of the department, and the senior officers responsible for lending, retail banking and human resources. The Risk Management department continually reviews the status of our risk management efforts, including reviews of internal and external audit findings, loan review findings, and the activities of the Asset/Liability Committee with respect to monitoring interest rate and liquidity risk. The Committee tracks any open items requiring corrective action with the goal of ensuring that each is addressed on a timely basis. The Vice President and General Counsel reports all findings of the Risk Management department directly to the Audit Committee of the Bank.
Management of Credit Risk: Legacy Banks considers credit risk to be the most significant risk it faces, in that it has the greatest potential to affect the financial condition and operating results of Legacy Banks. Credit risk is managed through a combination of policies established by the board of directors of the Bank, the monitoring of compliance with these policies, and the periodic evaluation of loans in the portfolio, including those with problem characteristics. In general, the Bank’s policies establish maximums on the amount of credit that may be granted to a single borrower (including affiliates), the aggregate amount of loans outstanding by type in relation to total assets and capital, and loan concentrations. Collateral and debt service coverage ratios, approval limits and other underwriting criteria are also specified. Policies also exist with respect to performing periodic credit reviews, the rating of loans, when loans should be placed on non-performing status and factors that should be considered in establishing the Bank’s allowance for loan losses.
Management of Market Risk: Market risk is the risk of loss due to adverse changes in market prices and rates, and typically encompasses exposures such as sensitivity to changes in market interest rates, foreign currency exchange rates, and commodity prices. The Bank has no exposure to foreign currency exchange or commodity price movements. Because net interest income is the Bank’s primary source of revenue, interest rate risk is a significant market risk to which the Bank is exposed.
Interest rate risk is the exposure of the Bank’s net interest income to adverse movements in interest rates. Net interest income is affected by changes in interest rates as well as by fluctuations in the level and duration of the Bank’s assets and liabilities. Over and above the influence that interest rates have on net interest income, changes in rates may also affect the volume of lending activity, the ability of borrowers to repay variable rate loans, the volume of loan prepayments and refinancings, the flow and mix of deposits, and the market value of the Bank’s assets and liabilities.
Exposure to interest rate risk is managed by the Bank through periodic evaluations of the current interest rate risk inherent in its rate-sensitive assets and liabilities, primarily deposits, borrowings, loans and securities, coupled with determinations of the level of risk considered appropriate given the Bank’s capital and liquidity requirements, business strategy and performance objectives. Through such management, the Bank seeks to manage the vulnerability of its net interest income to changes in interest rates.
Strategies used by the Bank to manage the potential volatility of its earnings may include:
•
Emphasizing the origination and retention of adjustable-rate mortgage loans, variable rate commercial loans and variable rate home equity lines-of-credit;
•
Investing in securities with relatively short maturities and/or expected average lives;
•
Classifying nearly all of the investment portfolio as “available for sale” in order to provide for flexibility in liquidity management; and
•
Lengthening liabilities such as certificates of deposits and Federal Home Loan Bank of Boston borrowings when appropriate.
Legacy Banks’ Asset/Liability Committee, comprised of several members of senior management, is responsible for managing interest rate risk. On a quarterly basis, the Committee reviews with the board of directors its analysis of the Bank’s exposure to interest rate risk, the effect subsequent changes in interest rates could have on the Bank’s future net interest income, its strategies and other activities, and the effect of those strategies on the Bank’s operating results. The Committee is also actively involved in the Bank’s planning and budgeting process as well as in determining pricing strategies for deposits and loans.
The Committee’s primary method for measuring and evaluating interest rate risk is income simulation analysis. This analysis considers the maturity and interest rate repricing characteristics of interest-bearing assets and liabilities, as well as the relative sensitivities of these balance sheet components over a range of interest rate scenarios. Interest rate scenarios tested generally include parallel and flattening/steepening rate changes over a one year period, and static (or flat) rates. The simulation analysis is used to measure the exposure of net interest income to changes in interest rates over specified time horizon, usually one and two year periods. The simulations also show the net interest income volatility for up to five years.
The table below sets forth, as of December 31, 2006, the estimated changes in the Bank’s net interest income that would result from the designated twelve-month changes in the U.S. Treasury yield curve. Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions including relative levels of market interest rates, loan prepayments and deposit run-off, and should not be relied upon as indicative of actual results.
As indicated in the table above, the result of a 200 basis point parallel increase in interest rates is estimated to decrease net interest income by 4.3% over a 12-month horizon, when compared to the flat rate scenario. For a 400 basis point parallel increase in the level of interest rates, net interest income is estimated to decline by 8.36% over a 12-month horizon, when compared against the flat rate scenario. Inherent in these estimates is the assumption that certain transaction and savings account deposit rates would not increase while certain money market and LifePath accounts would increase by 90 to 100 basis points for each 100 basis point increase in market interest rates. These assumptions are based on the Bank’s past experience with the changes in rates paid on these non-maturity deposits coincident with changes in market interest rates.
The estimated change in net interest income from the flat rate scenario for a 200 basis point parallel decline in the level of interest rates is an increase of 3.71%, which assumes little, if any, decrease in savings and interest-bearing checking rates, and an average decrease of 90 to 100 basis points in money market and LifePath rates, respectively, for each 100 basis point decrease in market interest rates. For a 200 basis point steepening decrease (the shorter end of the yield curve decreasing more than the longer end) in the level of interest rates, net interest
income is estimated to increase by 5.01% over a 12-month horizon, when compared against the flat rate scenario. Effectively, in the declining interest rate scenario, Legacy Banks begins to reap some potential benefit of lower rates because the rates on its core deposit accounts decrease somewhat faster than the rates on interest earning assets. This simulation also incorporates the assumption that shorter-term FHLBB borrowings at December 31, 2006 are replaced mainly with borrowings with maturities averaging 2.5 years.
There are inherent shortcomings in income simulation, given the number and variety of assumptions that must be made in performing the analysis. The assumptions relied upon in making these calculations of interest rate sensitivity include the level of market interest rates, the shape of the yield curve, the degree to which certain assets and liabilities with similar maturities or periods to repricing react to changes in market interest rates, the degree to which non-maturity deposits (e.g. checking) react to changes in market rates, the expected prepayment rates on loans and mortgage-backed securities, the degree to which early withdrawals occur on certificates of deposit and the volume of other deposit flows. As such, although the analysis shown above provides an indication of the Bank’s sensitivity to interest rate changes at a point in time, these estimates are not intended to and do not provide a precise forecast of the effect of changes in market interest rates on the Bank’s net interest income and will differ from actual results.
In its management of interest rate risk, the Bank also relies on the analysis of its interest rate “gap,” which is the measure of the mismatch between the amount of Legacy’s interest-earning assets and interest-bearing liabilities that mature or reprice within specified timeframes. An asset-sensitive position (positive gap) exists when there are more rate-sensitive assets than rate-sensitive liabilities maturing or repricing within a particular time horizon, and generally signifies a favorable effect on net interest income during periods of rising interest rates and a negative effect during periods of falling interest rates. Conversely, a liability-sensitive position (negative gap) would generally indicate a negative effect on net interest income during periods of rising rates and a positive effect during periods of falling rates. Certain factors may serve to limit the usefulness of the measurement of the interest rate gap. For example, interest rates on certain assets and liabilities are discretionary and may change in advance of, or may lag behind, changes in market rates. The gap analysis does not give effect to changes Legacy may undertake to mitigate interest rate risk. Certain assets, such as adjustable-rate loans, have features that may restrict the magnitude of changes in interest rates both on a short-term basis and over the life of the assets. Further, in the event of changes in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in the gap analysis. Lastly, should interest rates increase, the ability of borrowers to service their debt may decrease.
Liquidity Risk Management: Liquidity risk, or the risk to earnings and capital arising from an organization’s inability to meet its obligations without incurring unacceptable losses, is managed by the Bank’s Chief Financial Officer, who monitors on a daily basis the adequacy of the Bank’s liquidity position. Oversight is provided by the Asset/Liability Committee, which reviews the Bank’s liquidity on a weekly basis, and by the board of directors of the Bank, which reviews the adequacy of our liquidity resources on a monthly basis.
Our primary sources of funds are from deposits, amortization of loans, loan prepayments and the maturity of loans, mortgage-backed securities and other investments, and other funds provided by operations. While scheduled payments from amortization of loans and mortgage-backed securities and maturing loans and investment securities are relatively predictable sources of funds, deposit flows and loan prepayments can be greatly influenced by general interest rates, economic conditions and competition. We maintain excess funds in cash and short-term interest-bearing assets that provide additional liquidity. At December 31, 2006, cash and due from banks, short-term investments and debt securities maturing within one year totaled $65.9 million or 8.2% of total assets.
We also rely on outside borrowings from the Federal Home Loan Bank of Boston, as an additional funding source. Over the past several years, the Bank has expanded its use of Federal Home Loan Bank of Boston borrowings to fund growth in the loan portfolio and to assist in the management of its interest rate risk. Since December 31, 2005, Legacy has decreased Federal Home Loan Bank of Boston borrowings by $18.5 million to a total of $127.4 million outstanding as of December 31, 2006. On that date, we had the ability to borrow an additional $110.3 million from the Federal Home Loan Bank of Boston.
As described within this report, the Bank intends to grow its loan assets. The cash flow required to fund those potential increases in loans will likely be provided primarily by increases in deposits, as we implement our strategy to expand our franchise geographically and to increase our deposit market share in the areas served by the Bank at
present. To the extent that cash flow provided by our deposit-gathering efforts does not completely fund increases in assets, we will likely borrow funds from the FHLBB to provide the necessary cash flow. The capital necessary to support future growth in assets is anticipated to be provided by our capital resources in hand, augmented over time by increases from net income, net of dividends paid, if any.
Contractual Obligations: The following tables present information indicating various contractual obligations and commitments of the Bank as of December 31, 2006 and the respective maturity dates:
Loan Commitments: 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 and generally have fixed expiration dates or other termination clauses. The following table presents certain information about Legacy Banks’ loan commitments outstanding as of December 31, 2006:
(1)
Commitments for loans are extended to customers for up to 60 days after which they expire.
(2)
Unused portions of home equity loans are available to the borrower for up to 10 years.
(3)
Unused portions of construction loans are available to the borrower for up to one year for development loans and up to one year for other construction loans.
(4)
Unused portion of checking overdraft lines-of-credit are available to customers in “good standing” indefinitely.
(5)
Unused portion of personal lines-of-credit are available to customers in “good standing” indefinitely.
(6)
Standby letters of credit are generally available for less than one year.
Management of Other Risks: Two additional risk areas that receive significant attention by management and the board are operational risk and compliance risk. Operational risk is the risk to earnings and capital arising from control deficiencies, problems with information systems, fraud, error or unforeseen catastrophes. Compliance risk is the risk arising from violations of, or nonconformance with, laws, rules, regulations, prescribed practices, internal policies and procedures or ethical standards. Compliance risk can expose us to fines, civil money penalties, payment of damages and the voiding of contracts.
The Bank addresses such risks through the establishment of comprehensive policies and procedures with respect to internal control, the management and operation of its information and communication systems, disaster recovery, and compliance with laws, regulations and banking “best practice.” Monitoring of the effectiveness of such policies and procedures is performed through a combination of the Bank’s internal audit program, through periodic internal and third-party compliance reviews, and through the ongoing attention of its managers charged with supervising compliance and operational control. Oversight of these activities is provided by the Risk Management department and the Audit Committee of the board of directors of the Bank.
Off-Balance Sheet Arrangements
Other than loan commitments, the Bank does not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on its financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Impact of Inflation and Changing Prices
The financial statements, accompanying notes, and related financial data presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollar amounts without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations. Most of our assets and liabilities are monetary in nature, and therefore the impact of interest rates has a greater impact on its performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.
Impact of Recent Accounting Pronouncements
Please refer to the note on Recent Accounting Pronouncements in Note 1 to the consolidated financial statements in Item 8
Item 8 for a detailed discussion of new accounting pronouncements.
Item 8:
Financial Statements And Supplemental Data
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM - ON
CONSOLIDATED FINANCIAL STATEMENTS
To the Board of Directors and Stockholders of Legacy Bancorp, Inc.
We have audited the accompanying consolidated balance sheets of Legacy Bancorp, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, changes in stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (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 consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Legacy Bancorp, Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Legacy Bancorp, Inc. internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 13, 2007 expressed an unqualified opinion on management’s assessment of the effectiveness of Legacy Bancorp, Inc.’s internal control over financial reporting and an unqualified opinion on the effectiveness of Legacy Bancorp, Inc.’s internal control over financial reporting.
/s/ Wolf & Company, P.C.
Boston, Massachusetts
March 13, 2007
LEGACY BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in Thousands)
See accompanying notes to consolidated financial statements
LEGACY BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in Thousands)
See accompanying notes to consolidated financial statements
LEGACY BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
Years Ended December 31, 2006, 2005 AND 2004
(Dollars in Thousands)
See accompanying notes to consolidated financial statements
LEGACY BANCORP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in Thousands)
See accompanying notes to consolidated financial statements.
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2006, 2005 and 2004
(Dollars in Thousands)
1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of presentation
The consolidated financial statements include the accounts of Legacy Bancorp, Inc. (“Company”), and its wholly-owned subsidiaries, Legacy Banks (“Bank”) and LB Funding Corp. The accounts of Legacy Banks include all of its wholly-owned subsidiaries, Legacy Securities Corporation, Legacy Insurance Services of the Berkshires and CSB Service Corporation.
Stock conversion
Pursuant to an Amended and Restated Plan of Conversion (the “Plan”) as approved by the Board of Directors on June 15, 2005, on October 26, 2005, Legacy Bancorp, Inc., a Delaware corporation became the holding company of Legacy Banks, a Massachusetts-chartered stock savings bank, in connection with the conversion of the holding company structure of Legacy Banks from mutual to stock form. Prior to October 26, 2005, Mutual Bancorp of the Berkshires, Inc., a Massachusetts-chartered mutual holding company (referred to herein as the “Predecessor”), owned all of the outstanding common stock of Legacy Group, Inc., the Massachusetts-chartered, mid-tier bank holding company of Legacy Banks (the “Mid-Tier”), and the Mid-Tier owned all of the outstanding common stock of Legacy Banks. Effective as of October 26, 2005, the Predecessor and the Mid-Tier merged out of existence, and the Company consummated the sale of 9,545,000 shares of its common stock to the public at a price of $10.00 per share, and contributed an additional 763,600 shares of its outstanding common stock to The Legacy Banks Foundation. Also on October 26, 2005, Legacy Banks issued all of its shares of common stock to the Company in exchange for 50% of the net proceeds of the public offering. Conversion costs of $2.8 million reduced the proceeds from the shares sold in the Conversion. During any period prior to October 26, 2005 the Company was newly organized and owned no assets. Therefore, the financial information for any period prior to October 26, 2005 presented in this report is that of Mutual Bancorp of the Berkshires, Inc. and its direct and indirect subsidiaries.
All significant intercompany balances and transactions have been eliminated in consolidation.
Use of estimates
In preparing consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the consolidated balance sheet and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, valuation of deferred tax assets and other-than-temporary impairment losses.
Business
The Company provides a variety of financial services to individuals and businesses through its full service offices in Berkshire County and loan production office in Colonie, New York. Its primary deposit products are savings, checking and term certificate accounts and its primary lending products are consumer, residential and commercial mortgage loans. The Company also provides trust and investment management services through its portfolio management division, and offers insurance services through the Bank’s subsidiary, Legacy Insurance Services.
Significant Group Concentrations of Credit Risk
Most of the Company’s activities are with customers located within the Northeast region of the United States; specifically Western Massachusetts and Eastern New York. Notes 3 and 4 discuss the types of securities that the
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (Continued)
Company invests in. Note 5 discusses the types of lending that the Company engages in. The Company does not have any significant concentrations to any one industry or customer.
Operating segments
Statement of Financial Accounting Standards (“SFAS”) No. 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for the way that public business enterprises report information about operating segments in annual and interim financial statements. It also establishes standards for related disclosures about products and services, geographical areas, and major customers. Generally, financial information is to be reported on the basis that is used internally for evaluating segment performance and deciding how to allocate resources to segments. Management evaluates the Company’s performance and allocates resources based on a single segment concept. Accordingly, there are no separately identified material operating segments for which discrete financial information is available. The Company does not derive revenues from, or have assets located in foreign countries, nor does it derive revenues from any single customer that represents 10% or more of the Bank’s total revenues.
Reclassifications
Certain amounts in the 2005 and 2004 consolidated financial statements have been reclassified to conform to the 2006 presentation.
Cash and cash equivalents
For purposes of the consolidated statements of cash flows, cash and cash equivalents include cash and balances due from banks, interest-bearing deposits in banks and short-term investments with maturities of ninety days or less.
Securities
Debt securities that management has the positive intent and ability to hold to maturity are classified as “held to maturity” and reflected at amortized cost, less principal payments received. 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.
Federal Home Loan Bank of Boston (“FHLB”) stock is reflected at cost. Savings Bank Life Insurance Company of Massachusetts (“SBLI”) stock was recorded at fair value at acquisition as determined by an appraisal performed by independent investment consultants retained by SBLI.
Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (Continued)
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 the aggregate. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income.
Loans
The Company grants mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio is represented by mortgage loans in Western Massachusetts. The ability of the Company’s debtors to honor their loans is affected by the local economy and the local real estate market.
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 unpaid principal balances 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. Loan origination costs, net of certain direct origination fees, and loan purchase premiums, are deferred and recognized as an adjustment of the related loan yield using the interest method.
The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days past due unless the credit is well-secured and in process of collection. Personal loans are typically charged off no later than 180 days past due. Past due status is based on contractual terms of the loan. In all cases, loans are placed on non-accrual 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 non-accrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. 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
The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
The allowance consists of allocated, general and unallocated components. The allocated component relates to loans that are classified as impaired. For such loans, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating allocated and general losses in the portfolio.
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Impaired loans are generally maintained on a non-accrual basis. Impairment is measured on a
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (Continued)
loan by loan basis for commercial loans and commercial real estate 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, the Company generally does not separately identify individual consumer loans or residential mortgage loans for impairment disclosures
Other real estate owned
Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at lower of cost or fair value at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less costs to sell. Revenue and expenses from operations and changes in the valuation allowance are included in net expenses from other real estate owned.
Premises and equipment
Land is carried at cost. Buildings, improvements and equipment are carried at cost, less accumulated depreciation and amortization computed primarily on the straight-line method over the shorter of the lease term or estimated useful lives of the assets. Expected terms include lease option periods to the extent that the exercise of such options is reasonably assured.
Goodwill
The Company recorded goodwill in connection with the purchase of a financial institution in 1997. Goodwill is evaluated for impairment on an annual basis. Impairment is charged to earnings in the period identified.
Bank-owned Life Insurance
Bank-owned life insurance policies are reflected on the consolidated balance sheet at cash surrender value. Changes in cash surrender value are reflected in non-interest income on the consolidated statement of operations.
Transfers of financial assets
Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
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. A valuation allowance related to deferred tax assets is established when, in the judgement of management, it is more likely than not that all or a portion of such deferred tax assets will not be realized (See Note 10.)
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (Continued)
Pension plan
In prior years, the Company had a non-contributory defined benefit plan providing pension benefits through membership in the Savings Banks Employees Retirement Association covering substantially all employees who meet certain age and service requirements. The compensation cost was recognized on the net periodic cost method over the employees’ approximate service period. The aggregate cost method was utilized for funding purposes. As of October 31, 2005, the Company elected to freeze the non-contributory defined benefit plan and the final distribution of assets was completed in the fourth quarter of 2006. See Note 13, Employee Benefit Plans.
Postretirement benefits other than pensions
The Company sponsors a master healthcare, dental and life insurance plan for a small group of current retirees. The cost of providing retiree healthcare and other postretirement benefits is recognized over the period the employee rendered service to the Company.
In September 2006, the Financial accounting Standards Board (“FASB”) issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (“SFAS 158”), which requires employers to (a) recognize in its statement of financial position the funded status of a benefit plan, (b) measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year, (c) recognize, through other comprehensive income, net of tax changes in the funded status of the benefit plan that are not recognized as net periodic benefit cost, and (d) disclose additional information about certain affects on net periodic benefit cost for the next fiscal year that relate to the delayed recognition of certain benefit cost elements. The requirement to recognize the funded status of a benefit plan and provide additional disclosures is effective as of December 31, 2006. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end is effective for the year ending December 31, 2008.
The following table illustrates the incremental effect of applying SFAS 158 on individual line items in the consolidated balance sheet as of December 31, 2006:
Advertising costs
Advertising costs are charged to earnings when incurred.
Portfolio management assets
Portfolio management assets held in fiduciary or agent capacity are not included in the accompanying consolidated balance sheets because they are not assets of the Company.
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (Continued)
Earnings per share
Basic earnings per share is determined by dividing net income by the average number of net outstanding common shares for the period. The net outstanding common shares equals the gross number of common shares issued less unallocated shares of the Legacy Banks Employee Stock Ownership Plan (ESOP). Diluted earnings per share is determined by dividing net income by the average number of net outstanding common shares computed as if all potential common shares have been issued by the Company. Potential common shares to be issued would include those related to outstanding options and unvested stock awards. Because shares were not issued until October 26, 2005, earnings per share have not been reported for the years ended December 31, 2005 and 2004.
Earnings per common share have been computed based upon the following:
Comprehensive income/loss
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, are reported as a separate component of the stockholders equity section of the consolidated balance sheet, such items, along with net income, are components of comprehensive income.
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (Continued)
Comprehensive income/loss (concluded)
The components of the change in other comprehensive income/loss and related tax effects are as follows:
The components of other comprehensive income/loss and related tax effects are as follows:
The following amounts, included in accumulated other comprehensive income at December 31, 2006, are expected to be recognized as components of net periodic pension costs for the year ended December 31, 2007:
Recent accounting pronouncements
In March 2006, the FASB issued Statement No. 156, Accounting for Servicing of Financial Assets, which amends FASB Statement No. 140. This Statement requires that all separately recognized servicing rights be initially measured at fair value, if practicable. For each class of separately recognized servicing assets and liabilities, this Statement permits an entity to choose either of the following subsequent measurement methods: (1) amortize
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (Concluded)
servicing assets or liabilities in proportion to and over the period of estimated net servicing income or net servicing loss, or (2) report servicing assets or liabilities at fair value at each reporting date and report changes in fair value in earnings in the period in which the changes occur. This Statement also requires additional disclosures for all separately recognized servicing rights, is effective for new transactions occurring and for subsequent measurement at the beginning of the Company’s 2007 calendar year. This Statement is not expected to have a material impact on the Company’s consolidated financial statements.
In July 2006, the FASB issued Financial Accounting Standards Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes”. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures and transitions. FIN 48 is effective for fiscal years beginning after December 15, 2006 and is not expected to have a material impact on the Company’s consolidated financial Statements.
In September 2006, the FASB issued Statement No. 157, Fair Value Measurements. This Statement defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. This Statement is effective for the Company on January 1, 2008 and is not expected to have a material impact on the Company’s consolidated financial statements.
In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin (“SAB”) No. 108. SAB No. 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a potential current year misstatement. Prior to SAB No. 108, companies might evaluate the materiality of financial statement misstatements using either the income statement or balance sheet approach, with the income statement approach focusing on new misstatements added in the current year, and the balance sheet approach focusing on the cumulative amount of misstatement present in the company’s balance sheet. Misstatements that would be material under one approach could be viewed as immaterial under another approach, and not be corrected. SAB 108 now requires that companies view financial statement misstatements as material if they are material according to either the income statement or balance sheet approach. SAB No. 108 is applicable to all financial statements issued by the Company for the year ended December 31, 2006.
On February 15, 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, which provides companies with an option to report selected financial assets and liabilities at fair value. Statement No. 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. This Statement is effective for the Company’s 2008 calendar year. This Statement is not expected to have a material impact on the Company’s consolidated financial statements.
2.
RESTRICTIONS ON CASH AND AMOUNTS DUE FROM BANKS
The Bank is required to maintain average balances on hand or with the Federal Reserve Bank of Boston. At December 31, 2006 and 2005 these reserve balances amounted to $1,000,000.
The bank is also required to maintain a minimum balance with a company that provides official and treasury check services to customers of the bank. The minimum balance requirement at December 31, 2006 and 2005 was $633,000 and $841,000, respectively.
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
3.
SHORT-TERM INVESTMENTS
Short-term investments consist of the following:
4.
SECURITIES
Securities and other investments consist of the following:
The amortized cost and estimated fair value of securities, with gross unrealized gains and losses, follows:
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
4.
SECURITIES - (Continued)
The amortized cost and estimated fair value of debt securities, excluding mortgage-backed securities, by contractual maturity at December 31, 2006 is as follows. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
For the years ended December 31, 2006, 2005 and 2004, proceeds from the sale of securities available for sale amounted to $69,414,000, $4,551,000 and $2,323,000 respectively. Gross gains of $296,000, $253,000 and $204,000, respectively, and gross losses of $2,032,000, $93,000 and $68,000, respectively, were realized on those sales.
At December 31, 2006 and 2005, the Company has pledged securities with an amortized cost of $7,408,000 and $8,237,000 respectively, and a fair value of $7,394,000 and $8,062,000 respectively, to a commercial bank, as collateral for repurchase agreements, and for its treasury tax and loan account.
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
4.
SECURITIES - (Concluded)
Information pertaining to securities with gross unrealized losses aggregated by investment category and length of time that individual securities have been in a continuous loss position, follows:
Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation.
At December 31, 2006, several debt securities have unrealized losses with aggregate depreciation of 0.6% from the Company’s amortized cost basis. These unrealized losses relate principally to government sponsored enterprises and mortgage backed securities. In analyzing an issuer’s financial condition, management considers whether the securities are issued by the government sponsored agencies, whether downgrades by bond rating agencies have occurred, and industry analysts’ reports. As the unrealized losses are primarily interest rate related and management has the ability to hold debt securities until maturity or the foreseeable future, no declines are deemed to be other than temporary.
At December 31, 2006, fourteen marketable equity securities have unrealized losses with aggregate depreciation of 6.3% from the Company’s cost basis. Although some issuers may have shown declines in earnings as a result of the weakened economy, no credit issues have been identified that cause management to believe the declines in market value are other than temporary. In analyzing an issuer’s financial condition, management considers industry analysts’ reports as well as financial performance. Unrealized losses on marketable securities that are in excess of 40% of cost, and that have been sustained for more than six months, are generally recognized by management as being other than temporary and charged to earnings.
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
5.
LOANS
A summary of the balances of loans follows:
An analysis of the allowance for loan losses follows:
The following is a summary of information pertaining to impaired and non-accrual loans:
There were no loans past-due ninety days or more and still accruing at December 31, 2006, 2005 and 2004.
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
5.
LOANS - (Concluded)
No additional funds are committed to be advanced in connection with impaired loans.
The Company has sold loans in the secondary market and has retained the servicing responsibility and receives fees for the services provided. Loans sold and serviced for others amounted to $8,603,000 and $10,444,000 at December 31, 2006 and 2005, respectively.
6.
PREMISES AND EQUIPMENT
A summary of the cost and accumulated depreciation and amortization of premises and equipment is as follows:
Depreciation and amortization expense for the years ended December 31, 2006, 2005 and 2004 amounted to $1,014,000, $966,000 and $922,000, respectively.
Construction in process represents costs incurred to date in connection with the construction of two new branch locations in North Adams and Great Barrington, Massachusetts. Total additional committed expenditures for these projects amount to approximately $1,695,000 at December 31, 2006. The Company had no construction in process as of December 31, 2005.
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
7.
DEPOSITS
A summary of deposit balances, by type, is as follows:
A summary of certificate accounts by maturity, is as follows:
At December 31, 2006 and 2005, brokered certificates of deposit in the amount of $20,591,000 and $20,106,000, respectively, with a weighted average rate of 4.61% and 3.32%, respectively, are included in certificates of deposits.
8.
SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
Securities sold under agreements to repurchase (“repurchase agreements”) are funds borrowed from customers on an overnight basis that are secured by securities.
A summary of repurchase agreements is as follows:
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
9.
FEDERAL HOME LOAN BANK ADVANCES
A summary of outstanding advances from the Federal Home Loan Bank of Boston, by maturity, is as follows at December 31, 2006 and 2005:
*
Includes amortizing advances requiring $69,000 in combined monthly principal and interest payments at December 31, 2006.
Certain advances have early call provisions in 2006 through 2012.
The Company also has an Ideal Way line of credit at the Federal Home Loan Bank in an amount up to $10,000,000. There were no advances under this line of credit as of December 31, 2006 or 2005. All borrowings from the Federal Home Loan Bank of Boston are secured by a blanket lien on certain qualified collateral, defined principally as 75% of the carrying value of certain first mortgage loans on owner-occupied residential property, and 90% of the market value of U.S. Government-sponsored enterprises.
10.
INCOME TAXES
Allocation of federal and state income taxes between current and deferred portions is as follows:
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
10.
INCOME TAXES - (Continued)
The reasons for the differences between the statutory federal income tax rate and the effective tax rates are summarized as follows:
The components of the net deferred tax asset are as follows:
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
10.
INCOME TAXES - (Concluded)
The tax effects of each type of item that gives rise to deferred taxes are as follows:
A summary of the change in the valuation reserve for deferred tax assets is as follows:
A federal income tax reserve of $830,000 was established in the fourth quarter of 2005 and increased by $659,000 in the fourth quarter of 2006 to reflect the uncertainty of fully utilizing a five-year charitable contribution carryforward of approximately $7,200,000. The carryforward was created primarily by the contribution of 763,600 shares of the Company’s common stock to the Legacy Banks Foundation as part of the mutual to stock conversion in 2005.
The federal income tax reserve for loan losses at the Company’s base year is $5,416,000. If any portion of the reserve is used for purposes other than to absorb loan losses, approximately 150% of the amount actually used (limited to the amount of the reserve) would be subject to taxation in the year in which used. As the Company intends to use the reserve only to absorb loan losses, a deferred tax liability of $2,221,000 has not been provided.
11.
COMMITMENTS AND CONTINGENCIES
In the normal course of business, there are outstanding commitments and contingencies which are not reflected in the accompanying consolidated financial statements.
Loan and other financial commitments
The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the accompanying consolidated balance sheets.
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
11.
COMMITMENTS AND CONTINGENCIES - (Continued)
The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument is represented by the contractual amount of these commitments. The Company uses the same credit policies in making commitments as it does for on-balance-sheet instruments. A summary of financial instruments outstanding whose contract amounts represent credit risk is as follows at December 31, 2006 and 2005:
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for lines-of-credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s credit worthiness on a case-by-case basis. Funds disbursed for mortgage loans, construction loans and home equity lines-of-credit are collateralized by real estate. Commercial lines-of-credit are generally secured by business assets.
Standby letters-of-credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. These letters-of-credit are primarily issued to support borrowing arrangements. The credit risk involved in issuing letters-of-credit is essentially the same as that involved in extending loan facilities to customers. Other commitments relate primarily to potential additional capital calls the Company is committed to contribute as part of its investment in certain limited partnerships.
FASB Interpretation (“FIN”) No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, requires a guarantor to recognize, at the inception of a guarantee, a liability in an amount equal to the fair value of the obligation undertaken in issuing the guarantee. The Company considers standby letters of credit to be guarantees under FIN No. 45. The amount of the liability related to guarantees at December 31, 2006 and 2005 was not material.
Operating lease commitments
Pursuant to the terms of noncancelable lease agreements in effect at December 31, 2006, pertaining to banking premises and equipment, future minimum rent commitments are as follows:
Total rent expense for the years ended December 31, 2006, 2005 and 2004 amounted to $217,000, $181,000 and $158,000, respectively.
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
11.
COMMITMENTS AND CONTINGENCIES - (Concluded)
Legal claims
Various legal claims also arise from time to time in the normal course of business which, in the opinion of management, will have no material effect on the Company’s consolidated financial statements.
Employment and change of control agreements
In connection with the Conversion in 2005, the Company entered into employment and change of control agreements with certain senior officers. The agreements provide for an annual base salary, subject to increase, and certain other benefits. They also guarantee customary corporate indemnification and insurance coverage under a standard directors’ and officers’ insurance policy throughout the employment term. The initial term of the agreements range from two to three years.
Commencing on the first anniversary date of the agreement, and continuing on each anniversary date thereafter, the term automatically renews for a successive term of three years or two years, unless either party gives notice not to renew. Following termination of the executive’s employment, the executive must adhere to non-competition and non-disclosure restrictions for one year, or for a period of time equal to the officer’s severance benefit, whichever is longer.
12.
MINIMUM REGULATORY CAPITAL REQUIREMENTS
The Bank is subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimal capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of its assets, liabilities and certain off balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weighting and other factors. Prompt corrective action provisions are not applicable to savings and loan holding companies.
Qualitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 capital to average assets (as defined). As of December 31, 2006 and 2005, the Bank met the capital adequacy requirements.
As of December 31, 2006 and 2005, Legacy Banks met the condition to be classified as “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tire 1 risked-based, and Tier 1 leverage ratios as set forth in the following
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
12.
MINIMUM REGULATORY CAPITAL REQUIREMENTS - (Concluded)
tables. There are no conditions or events since the notification that management believes have changed the Bank’s category.
A reconciliation of the Company’s year-end total stockholders’ equity to the Bank’s regulatory capital is as follows:
The principal source of revenue for the Holding Company is dividends received from the Bank as well as interest from short-term investment securities. The Bank cannot pay any dividends that would cause it to have insufficient capital under regulatory guidelines.
13.
EMPLOYEE BENEFIT PLANS
Defined Benefit plan
The Company froze its defined benefit pension plan effective October 31, 2005. During 2005, the Company recorded a gain of $905,000 as a result of the curtailment of the plan. In 2006, the Company voted to terminate the plan with final settlement, including the distribution of all plan assets, which was completed in the fourth quarter of 2006. The Company recorded a gain of $605,000 as a result of the termination of the plan. Prior to this curtailment and termination, the Company provided pension benefits for eligible employees through a defined benefit pension
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
13.
EMPLOYEE BENEFIT PLANS - (Continued)
plan. Substantially all employees participated in the retirement plan on a non-contributing basis, and were fully vested after three years of service. Information pertaining to the activity in the plan is as follows:
At October 31, 2005, the discount rate assumption used to determine the benefit obligation was 4.47%. The components of net periodic pension cost for the plan are as follows:
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
13.
EMPLOYEE BENEFIT PLANS - (Continued)
Significant actuarial assumptions used in determining net periodic pension cost were as follows:
The discount rate was selected to reflect the expected long-term rate of return based on prevailing yields on high quality fixed income investments.
The Company’s pension plan weighted average asset allocations at October 31, 2005, were as follows:
The Bank is a member of the Savings Banks Employees Retirement Association (“SBERA”) within which it maintained a defined benefit pension plan prior to termination in 2006. SBERA offered a common and collective trust as the underlying investment structure for pension plans participating in the Association. The target allocation mix for the common and collective trust portfolio called for an equity-based investment deployment range from 55% to 75% of total portfolio assets. The remainder of the portfolio was allocated to fixed income. The Trustees of SBERA, through the Association’s Investment Committee, selected investment managers for the common and collective trust portfolio. A professional investment advisory firm was retained by the Investment Committee to provide allocation analysis, performance measurement and to assist with manager searches. The overall investment objective was to diversify equity investments across a spectrum of investment types (e.g., small cap, large cap, international, etc.) and styles (e.g., growth, value, etc.).
Total defined benefit pension plan expense for the years ended December 31, 2005 and 2004 amounted to $503,000 and $451,000 respectively.
Defined contribution plan
The Company has a 401(k) plan whereby each employee reaching the age of 21 and having completed at least 1,000 hours of service in one twelve-month period, beginning with such employee’s date of hire, automatically becomes a participant in the plan. The plan provides for voluntary contributions by participating employees up to 75% of their compensation, subject to certain limitations. The Company matches up to 100% of the first 5% contributed by the employee. Participants become fully vested in the Company paid portion after five years of service. Total defined contribution pension plan expense for the years ended December 31, 2006, 2005 and 2004 amounted to $278,000, $265,000, and $253,000 respectively.
Supplemental executive plans
The Bank adopted a Supplemental Executive Retirement Plan in 2004 for the benefit of the Company’s Chief Executive Officer and Chief Operating Officer which provides for monthly benefits upon retirement, subject to certain limitations as set forth in the Plan. The present value of these future benefits is accrued over the executives’ required service periods, and the expense for the years ended December 31, 2006, 2005 and 2004 amounted to $669,000, $431,000 and $428,000, respectively.
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
13.
EMPLOYEE BENEFIT PLANS - (Continued)
Employee Stock Ownership plan
As part of the mutual to stock conversion in 2005, the Bank established an Employee Stock Ownership (“ESOP”) Plan. The plan awards shares of the Company’s common stock to eligible employees primarily based on their compensation. The Company contributed funds to a subsidiary to enable it to grant a 15-year loan to the ESOP to enable it to purchase shares of the Company’s common stock in the open market following completion of the offering. As of December 31, 2005, the ESOP completed its open market purchases bringing the total shares purchased to 824,688, or 8% of the 10,308,600 shares outstanding on that date. During 2005 the Company’s Board of Directors elected to fund a full year’s payment on this loan. This plan is a tax-qualified retirement plan for the benefit of all Company employees.
At December 31, 2006, the remaining principal balance on the ESOP debt is payable as follows:
The Bank has committed to make contributions to the ESOP sufficient to support the debt service of the loan. The loan is secured by the shares purchased, which are held in a suspense account for allocation among participants as the loan is repaid. Cash dividends paid on allocated shares are distributed to participants and cash dividends paid on unallocated shares are used to repay the outstanding debt of the ESOP.
Shares held by the ESOP include the following:
Unearned ESOP shares are not considered outstanding for calculating net income per common share and are presented as unallocated common shares held by ESOP, as a reduction in stockholders’ equity in the statement of financial condition. As ESOP shares are earned by participants, the Company recognizes compensation expense equal to the fair value of the earned ESOP shares. Total compensation expense recognized in connection with the ESOP for the year ended December 31, 2006 and 2005 was $833,000 and $736,000, respectively.
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
13.
EMPLOYEE BENEFIT PLANS - (Concluded)
Director fee continuation plan
Effective October 26, 2005, the Company established an unfunded director fee continuation plan which provides certain benefits to all eligible non-employee members of the boards of directors of the Company and Bank upon retirement. Information pertaining to the activity in the plan follows:
The assumptions used to determine the benefit obligation and the benefit cost are as follows:
The components of net periodic cost are as follows:
Total expense recognized in connection with the Director fee continuation plan for the years ended December 31, 2006 and 2005 was $269,000 and $43,000, respectively.
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
14.
POSTRETIREMENT HEALTH AND LIFE INSURANCE BENEFITS
The Company provides certain health and dental care and life insurance benefits for current retired employees. The components of net periodic postretirement costs follows:
The following table sets forth the components of the accrued postretirement benefit obligation recognized in the Company’s consolidated balance sheets:
The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation was an average of 5% at December 31, 2006, 2005 and 2004. The assumed discount rate used in determining the accumulated postretirement benefit obligation was an average of 5.75% at December 31, 2006, 2005 and 2004, respectively. The health care cost trend rate assumption has an effect on the amount reported; as an example a 1% increase in health care costs would increase expenses by approximately $4,000 in 2006, 2005 and 2004.
Estimated future benefit payments for the Plan year beginning January 1 are as follows:
Total postretirement benefit plan expense for the years ended December 31, 2006, 2005 and 2004 amounted to $70,000, $76,000, and $68,000, respectively.
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
15.
EQUITY INCENTIVE PLAN
Stock options
Under the Company’s 2006 Equity Incentive Plan, approved by the Company’s shareholders at a special meeting on November 1, 2006, the Company may grant options to its directors, officers and employees for up to 1,030,860 shares of common stock. Both incentive stock options and non-qualified stock options may be granted under the Plan. The exercise price of each option equals the market price of the Company’s stock on the date of grant and the maximum term of each option is 10 years. The vesting period is approximately five years from the date of grant.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions:
The expected volatility is based on historical volatility. The risk-free interest rate for periods within the contractual life of the awards is based on the U.S. Treasury yield curve in effect at the time of the grant. The expected life of 6.5 years is based on the simplified method calculation allowed for “plain-vanilla” share options granted prior to December 31, 2007. The dividend yield assumption is based on the Company’s history and expectation of dividend payouts.
A summary of options under the Plan as of December 31, 2006, and changes during the year then ended, is presented below:
The weighted-average grant-date fair value of options granted during 2006 was $3.98. For the year ended December 31, 2006, share-based compensation expense applicable to the Plan was $238,000, and the recognized tax benefit related to this expense was approximately $66,000. As of December 31, 2006, unrecognized stock-based compensation expense related to nonvested options amounted to $3,182,000. This amount is expected to be recognized over a weighted average period of 2.0 years.
Stock awards
Under the Company’s Employee Stock Award Plan, approved by the Company’s shareholders at a special meeting on November 1, 2006, the Company may grant stock awards to its directors, officers and employees for up to 412,344 shares of common stock. The stock awards vest at 20% per year. The fair market value of the stock allocations, based on the market price at the date of grant, is recorded as unearned compensation. Unearned
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
15.
EQUITY INCENTIVE PLAN - (Concluded)
compensation is amortized over the applicable vesting period. The Company recorded compensation cost related to stock awards of approximately $179,000 in 2006 and the recognized tax benefit related to this expense was approximately $65,000.
A summary of the status of the Company’s stock awards is presented below:
As of December 31, 2006, there was approximately $5,554,000 of total unrecognized compensation cost related to nonvested stock awards granted under the Plan. That cost is expected to be recognized over a weighted-average period of 4.9 years.
16.
RELATED PARTY TRANSACTIONS
In the ordinary course of business, the Company has granted loans to directors and executive officers and their affiliates. All loans and commitments included in such transactions were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons. All loans to directors and executive officers of the Company and their affiliates are performing in accordance with the contractual terms of the loans as of December 31, 2006 and 2005.
An analysis of activity of such loans on an individual basis to directors and executive officers of the Company and their affiliates is as follows:
17.
RESTRICTIONS ON DIVIDENDS, LOANS AND ADVANCES
Federal and state banking regulations place certain restrictions on dividends paid and loans or advances made by the Bank to the Company. The total amount of dividends which may be paid at any time is generally limited to the retained earnings of the Bank, and loans or advances are limited to 10 percent of the Bank’s capital stock and surplus on a secured basis.
At December 31, 2006, the Bank’s retained earnings available for the payment of dividends was approximately $64,428,000. Accordingly, $34,310,000 of the Company’s equity in the net assets of the Bank was restricted at
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
17.
RESTRICTIONS ON DIVIDENDS, LOANS AND ADVANCES - (Concluded)
December 31, 2006. Funds available for loans or advances by the Bank to the Company amounted to approximately $6,443,000.
In addition, dividends paid by the Bank to the Company would be prohibited if the effect thereof would cause the Bank’s capital to be reduced below applicable minimum capital requirements.
18.
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 the Company’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. SFAS 107 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 the Company.
The following methods and assumptions were used by the Company in estimating fair value disclosures for financial instruments:
Cash and cash equivalents: The carrying amounts of cash and short-term investments approximate fair values.
Securities and other investments: Fair values for securities, excluding FHLB and SBLI stock, are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. The carrying value of FHLB stock approximates fair value based on the redemption provisions of the Federal Home Loan Bank and SBLI stock was recorded at fair value at acquisition as determined by an appraisal performed by independent investment consultants retained by SBLI. The carrying amount of closely held stocks and other investments approximate fair value.
Loans, net and loans held for sale: For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Fair values for all other 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. The fair value of loans held for sale are based on commitments on hand from investors or prevailing market prices.
Deposits: The fair values for non-certificate accounts are, by definition, equal to the amount payable on demand at the reporting date which is their carrying amount. Fair values for certificates of deposit 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.
Securities sold under agreements to repurchase: The carrying amount of repurchase agreements approximates fair value. Repurchase agreements generally mature or “roll over” on a daily basis.
Federal Home Loan Bank advances: The fair values of Federal Home Loan Bank advances are estimated using discounted cash flow analyses based on the Bank’s current incremental borrowing rates for similar types of borrowing arrangements.
Accrued interest and mortgagors’ escrow accounts: The carrying amounts of these instruments approximate fair value.
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
18.
FAIR VALUE OF FINANCIAL INSTRUMENTS - (Concluded)
Off-balance-sheet instruments: The fair values of off-balance sheet instruments are immaterial.
The carrying amounts and estimated fair values of the Company’s financial instruments are as follows:
19.
PARENT COMPANY-ONLY CONDENSED FINANCIAL STATEMENTS
On October 26, 2005 the Company became the holding company of Legacy Banks in connection with the conversion of the holding company structure of the Bank from mutual to stock form. As part of this conversion, the predecessor mutual holding company, Mutual Bancorp of the Berkshires, and the former mid-tier holding company, Legacy Group, were merged into the Bank. Operating results for the Company in 2005 were insignificant. The condensed year end financial statement information pertaining only to the parent, Legacy Bancorp, Inc., is as follows:
BALANCE SHEETS
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
19.
PARENT COMPANY-ONLY CONDENSED FINANCIAL STATEMENTS - (Continued)
CONDENSED STATEMENT OF OPERATIONS
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(Dollars in Thousands)
19.
PARENT COMPANY-ONLY CONDENSED FINANCIAL STATEMENTS - (Concluded)
CONDENSED STATEMENT OF CASH FLOWS
LEGACY BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Concluded)
(Dollars in Thousands)
20.
QUARTERLY DATA (UNAUDITED)
Quarterly results of operations for the years ended December 31, 2006 and 2005 are as follows:
Results for the fourth quarter of 2006 were significantly impacted by a partial balance sheet restructuring through the sale of approximately $64.5 million of bonds which were yielding an average of 3.89%. The Company incurred an after-tax loss of approximately $1.3 million on the sale of these bonds. Furthermore, the Company incurred an additional $659,000 in tax expense in the fourth quarter of 2006 as a result of a reevaluation of the realizability of the deferred tax benefit resulting from the contribution of 763,600 shares of common stock to The Legacy Banks Foundation (the “Foundation”) in 2005. These items were partially offset by a gain of $605,000 on the termination of the Bank’s defined benefit plan in the fourth quarter of 2006. The Company began amortizing the costs of the 2006 Equity Incentive Plan in the fourth quarter of 2006.
Results for the fourth quarter of 2005 were significantly impacted by the conversion of the holding company structure of Legacy Banks from mutual to stock form. Non-interest income was reduced due to the Company’s prepayment of $19.5 million of advances from the Federal Home Loan Bank of Boston which resulted in a $2.4 million restructuring charge. Non-interest expenses were increased as a result of a $7.6 million expense relating to the Company’s donation of 763,600 shares of its outstanding common stock to the Legacy Banks Foundation.
Quarterly data may not sum to annual data due to rounding.
Item 9.
Item 9.
Changes In And Disagreements With Accountants On Accounting And Financial Disclosure
None.
Item 9a.
Item 9a.
Controls And Procedures
The Company’s management, including the Company’s principal executive officer and principal financial officer, have evaluated the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”). Based upon their evaluation, the principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective for the purpose of ensuring that the information required to be disclosed in the reports that the Company files or submits under the Exchange Act with the Securities and Exchange Commission (the “SEC”) (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
No change in the Company’s internal control over financial reporting occurred during the quarter ended December 31, 2006 that has materially affected, or is reasonably likely to affect, the Company’s internal control over financial reporting.
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The internal control process has been designed under our supervision to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States of America.
Management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, utilizing the framework established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, management has determined that the Company’s internal control over financial reporting as of December 31, 2006 is effective.
Our internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that accurately and fairly reflect, in reasonable detail, transactions and dispositions of assets; and provide reasonable assurances that: (1) transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America; (2) receipts and expenditures are being made only in accordance with authorizations of management and the directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the Company’s financial statements.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006 has been audited by Wolf & Company, P.C., an independent registered public accounting firm, as stated in their report, which follows. This report expresses an unqualified opinion on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM - ON INTERNAL CONTROL OVER FINANCIAL REPORTING
To the Board of Directors and Shareholders of Legacy Bancorp, Inc.
We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting, that Legacy Bancorp, Inc. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Legacy Bancorp Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Legacy Bancorp, Inc. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also in our opinion, Legacy Bancorp, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of Legacy Bancorp, Inc. and our report dated March 13, 2007 expressed an unqualified opinion.
/s/ Wolf & Company, P.C.
Boston, Massachusetts
March 13, 2007
Item 9b.
Item 9b.
Other Information
None.
PART III
Item 10.
Item 10.
Directors, Executive Officers and Corporate Governance
For information concerning the directors of the Company, the information contained under the sections captioned “Proposal 1 - Election of Directors” in the Legacy Bancorp, Inc. Proxy Statement for the 2007 Annual Meeting of Stockholders is incorporated by reference. For information regarding the Company’s Code of Conduct, see “Exhibit 14 - Code of Ethics”.
The following table sets forth certain information regarding the executive officers of Legacy Bancorp and Legacy Banks.
J. Williar Dunlaevy is the Chief Executive Officer and Chairman of the Board of Legacy Bancorp and Legacy Banks. He has served in this capacity for Legacy Bancorp since its inception in 2005, and for its predecessor, Mutual Bancorp since its inception in 1997. At the bank level he has served in this capacity since 1995 when the Bank’s name was City Savings Bank. The Bank changed its name to Legacy Banks in 2002 when Lenox Savings Bank merged with and into City Savings Bank. He has worked for Legacy Banks or its predecessors since 1969.
Michael A. Christopher is the Chief Operating Officer and President of Legacy Bancorp and Legacy Banks. He has served in this capacity for Legacy Bancorp since its inception in 2005, and for its predecessor, Mutual Bancorp since 1999 when Lenox Financial Services, Inc. merged with and into Mutual Bancorp, and formed the subsidiary stock mid-tier holding company, Legacy Group, Inc. Prior to that he was Chief Executive Officer of Lenox Financial Services, Inc. since its formation in 1998. He has served as Chief Operating Officer at the Bank since January 2002 when Lenox Savings Bank merged with and into City Savings Bank, and was renamed Legacy Banks. Prior to that he served as Chief Executive Officer and President of Lenox Savings Bank since 1993.
Steven F. Pierce is the Executive Vice President of Legacy Bancorp and Legacy banks. He has also been Executive Vice President and a Director of Legacy Banks since 1995, which at that time was City Savings Bank. He is the executive group leader of the Consumer Group and also has past experience leading the Commercial Group. He has been employed at the Bank since 1973.
Stephen M. Conley is the Chief Financial Officer, Senior Vice President and Treasurer of Legacy Bancorp and Legacy Banks. He has served in this capacity for Legacy Bancorp since its inception in 2005 and its predecessor, Mutual Bancorp since its inception in 1997, and at the Bank since 1996 when the bank’s name was City Savings Bank. He is the Executive Group Leader of the Finance Group and has been employed by the Bank since 1975.
Richard M. Sullivan is Senior Vice President of Legacy Bancorp and Legacy Banks. He has also been a Vice President of Legacy Banks since he joined the Bank in 2001. He is Division Executive of Legacy Real Estate Finance, the Bank’s national commercial real estate lending group. He also serves as President of The Legacy Banks Foundation.
Item 11.
Item 11.
Executive Compensation
The information contained under the sections captioned “Executive Compensation” and “Directors’ Compensation” in the Proxy Statement is incorporated herein by reference.
Item 12.
Item 12.
Security Ownership Of Certain Beneficial Owners And Management And Related Stockholder Matters
(a) Security Ownership of Certain Beneficial Owners
Information required by this item is incorporated herein by reference to the section captioned “Stock Ownership” in the Proxy Statement.
(b) Security Ownership of Management
Information required by this item is incorporated herein by reference to the section captioned “Stock Ownership” in the Proxy Statement.
(c) Changes in Control
Management of Legacy Bancorp knows of no arrangements, including any pledge by any person of securities of Legacy Bancorp, the operation of which may at a subsequent date result in a change in control of the Company.
(d) Changes in Control Equity Incentive Plan Information
The following table sets forth information, as of December 31, 2006, about Company common stock that may be issued upon exercise of options under stock-based benefit plans maintained by the Company.
Item 13.
Item 13.
Certain Relationships And Related Transactions, and Director Independence
The information required by this item is incorporated herein by reference to the section captioned “Transactions with Management” in the Proxy Statement.
Item 14.
Item 14.
Principal Accountant Fees And Services
The information required by this item is incorporated herein by reference to the section captioned “Proposal 2 - Ratification of Independent Registered Public Accounting Firm” in the Proxy Statement.
PART IV
Item 15.
Item 15.
Exhibits And Financial Statement Schedules
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons behalf of the registrant and in the capacities and on the dates indicated.
LEGACY BANCORP, INC.
/s/ J. Williar Dunlaevy
J. Williar Dunlaevy
Chief Executive Officer and Chairman of the Board
Date: March 16, 2007
/s/ Michael A. Christopher
Michael A. Christopher
Chief Operating Officer and President
Date: March 16, 2007
/s/ Stephen M. Conley
Stephen M. Conley
Senior Vice President, Chief Financial Officer and
Treasurer (Principal Accounting Officer)
Date: March 16, 2007
/s/ Eugene A. Dellea
Eugene A,. Dellea
Director
Date: March 16, 2007
/s/ David L. Klausmeyer
David L. Klausmeyer
Director
Date: March 16, 2007
/s/ Gary A. Lopenzina
Gary A. Lopenzina
Director
Date: March 16, 2007
/s/ Anne W. Pasko
Anne W. Pasko
Director
Date: March 16, 2007
/s/ Robert B. Trask
Robert B. Trask
Director
Date: March 16, 2007
/s/ Dorothy B. Winsor
Dorothy B. Winsor
Director
Date: March 16, 2007
INDEX TO EXHIBITS
(1)
Incorporated by reference from the Registrants Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2005 filed October 27, 2005.
(2)
Incorporated by reference from the Registration Statement on Form S-1 (No. 333-126481) filed July 8, 2005, as amended.