Item 1. Business.
General
The Company was incorporated under the laws of Maryland on December 10, 1996 and is a financial holding company registered under the Bank Holding Company Act of 1956, as amended (the “BHC Act”). The Company’s sole business is acting as the parent company to The Peoples Bank, a Maryland-chartered bank (the “Bank”), and Fleetwood, Athey, Macbeth & McCown, Inc., a Maryland insurance agency (the “Insurance Subsidiary”).
On January 2, 2007, the Company acquired the Insurance Subsidiary and began operating in the insurance products and services business segment. Prior to that date, we operated in only one business segment: community banking.
Location and Service Area
We offer a variety of services to consumer and commercial customers in our primary service area, which encompasses all of Kent County, northern Queen Anne’s County, and southern Cecil County, Maryland.
The principal components making up the economy for our service area are agriculture and light industry. Kent County is also growing as a tourist and retirement area. The tourist business is centered primarily in Chestertown and Rock Hall. There is a large retirement community, Heron Point, located in Chestertown. The seafood business, once prominent, is in decline. There are three health-care facilities located in Chestertown. Agriculture and agricultural-related businesses are the largest overall employers in the service area. There are several light industry companies in Kent County.
Banking Products and Services
Through the Bank’s five branches located throughout Kent County, Maryland and two branches in Queen Anne’s County, Maryland, we offer a full range of deposit services that are typically offered by most depository institutions in our service area, including checking accounts, NOW accounts, savings accounts and other time deposits of various types, ranging from daily money market accounts to longer-term certificates of deposit. The transaction accounts and time certificates are tailored to our principal service area and have rates that are competitive with those offered by other institutions in the area. In addition, we offer certain retirement account services, such as Individual Retirements Accounts. All deposits are insured by the Federal Deposit Insurance Corporation (the “FDIC”) up to the maximum amount allowed by law. We solicit these accounts from individuals, businesses, associations and organizations, and governmental authorities.
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We also offer a full range of short- to medium-term commercial and personal loans. Commercial loans include both secured and unsecured loans for working capital (including inventory and receivables), business expansion (including acquisition of real estate and improvements), and purchase of equipment and machinery. Consumer loans include secured and unsecured loans for financing automobiles, home improvements, education, and personal investments. We also originate mortgage loans and real estate construction and acquisition loans.
Other services include cash management services, safe deposit boxes, travelers checks, internet banking, direct deposit of payroll and social security checks, and automatic drafts for various accounts. The Bank is associated with a regional network of automated teller machines that may be used by our customers throughout Maryland and other regions. We also offer credit card services through a correspondent bank and non-deposit investment products, such as insurance and securities products, through broker-dealer relationships.
Information about our revenues, net income and assets derived from our operations in the community banking segment for each of the years ended December 31, 2008 and 2007 may be found in our Consolidated Financial Statements and Notes thereto, which are included in Item 8 of Part II of this annual report.
Investment Activities
We maintain a portfolio of investment securities to provide liquidity and income. The current portfolio amounts to approximately 5.61% of our total assets and is invested primarily in U.S. government agency and mortgage-backed securities.
A key objective of the investment portfolio is to provide a balance in our asset mix of loans and investments consistent with our liability structure, and to assist in management of interest rate risk. The investments augment our capital positions, providing the necessary liquidity to meet fluctuations in credit demand of the community and fluctuations in deposit levels. In addition, the portfolio provides collateral for pledging against public funds and repurchase agreements and a reasonable allowance for control of tax liabilities. Finally, the investment portfolio is designed as a source of income. In view of the above objectives, management treats the portfolio conservatively and generally only purchases securities that meet conservative investment criteria.
Insurance Activities
The Insurance Subsidiary is located in Chestertown, Kent County, Maryland. The Insurance Subsidiary offers a full range of property and casualty insurance products and services to customers in our market area.
Seasonality
Management does not believe that our business activities are seasonal in nature. Demand for our products and services may vary depending on local and national economic conditions, but management believes that any variation will not have a material impact on our planning or policy-making strategies.
Employees
At March 1, 2009, we employed 80 persons, of which 68 were employed on a full-time basis.
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COMPETITION
The banking business, in all of its phases, is highly competitive. Within our service area and the surrounding area, we compete with commercial banks (including local banks and branches or affiliates of other larger banks), savings and loan associations and credit unions for loans and deposits, with consumer finance companies for loans, with money market mutual funds and other investment vehicles for deposits, with insurance companies, agents and brokers for insurance products, and with other financial institutions for various types of financial products and services. There is also competition for commercial and retail banking business from banks and financial institutions located outside of our market area. Many of these financial institutions offer services, such as trust services, that we do not offer and have greater financial resources or have substantially higher lending limits than us.
The primary factors in competing for deposits are interest rates, personalized services, the quality and range of financial services, convenience of office locations and office hours. The primary factors in competing for loans are interest rates, loan origination fees, the quality and range of lending services and personalized services.
To compete with other financial services providers, we rely principally upon local promotional activities, personal relationships established by officers, directors and employees with our customers and specialized services tailored to meet our customers’ needs. In those instances in which we are unable to accommodate a customer’s needs, we will arrange for those services to be provided by other financial services providers with which we have a relationship. We offer many personalized services and attract customers by being responsive and sensitive to the needs of the community. We rely not only on the goodwill and referrals of satisfied customers, as well as traditional media advertising to attract new customers, but also on individuals who develop new relationships to build our customer base. To enhance our image in the community, we support and participate in many local events. Our employees, officers and directors represent us on many boards and local civic and charitable organizations.
The following table sets forth deposit data for Kent County, Maryland as of June 30, 2008, the most recent date for which comparative information is available (the Bank’s Sudlersville branch in Queen Anne’s County was not operational on or prior to June 30, 2008:
Source: FDIC Deposit Market Share Report
SUPERVISION AND REGULATION
The following is a summary of the material regulations and policies applicable to us and is not intended to be a comprehensive discussion. Changes in applicable laws and regulations may have a material effect on our business, financial condition and results of operation.
General
The Company is a financial holding company registered with the Board of Governors of the Federal Reserve System (the “FRB”) under the BHC Act and, as such, is subject to the supervision, examination and reporting requirements of the BHC Act and the regulations of the FRB.
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The Bank is a Maryland commercial bank subject to the banking laws of Maryland and to regulation by the Commissioner of Financial Regulation of Maryland, who is required by statute to make at least one examination in each calendar year (or at 18-month intervals if the Commissioner determines that an examination is unnecessary in a particular calendar year).
The Insurance Subsidiary is subject to examination by the FRB, and, as an affiliate of the Bank, may be subject to examination by the Bank’s regulators from time to time. In addition, the Insurance Subsidiary is subject to licensing and regulation by the insurance authorities of the states in which it does business. Retail sales of insurance products by the Insurance Subsidiary to customers of the Bank are also subject to the requirements of the Interagency Statement on Retail Sales of Nondeposit Investment Products promulgated in 1994, as amended, by the federal banking regulators, including the FDIC and the FRB.
Regulation of Financial Holding Companies
In November 1999, the federal Gramm-Leach-Bliley Act (the “GLB Act”) was signed into law. Effective in pertinent part on March 11, 2000, the GLB Act revised the BHC Act and repealed the affiliation provisions of the Glass-Steagall Act of 1933, which, taken together, limited the securities, insurance and other non-banking activities of any company that controls an FDIC insured financial institution. Under the GLB Act, a bank holding company can elect, subject to certain qualifications, to become a “financial holding company”. The GLB Act provides that a financial holding company may engage in a full range of financial activities, including insurance and securities sales and underwriting activities, and real estate development, with new expedited notice procedures.
Under FRB policy, the Company is expected to act as a source of strength to its subsidiary bank, and the FRB may charge the Company with engaging in unsafe and unsound practices for failure to commit resources to a subsidiary bank when required. In addition, under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), depository institutions insured by the FDIC can be held liable for any losses incurred by, or reasonably anticipated to be incurred by, the FDIC in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default. Accordingly, in the event that any insured subsidiary of the Company causes a loss to the FDIC, other insured subsidiaries of the Company could be required to compensate the FDIC by reimbursing it for the estimated amount of such loss. Such cross guaranty liabilities generally are superior in priority to obligations of a financial institution to its stockholders and obligations to other affiliates.
Regulation of the Bank
Federal and state banking regulators may prohibit the institutions over which they have supervisory authority from engaging in activities or investments that the agencies believe are unsafe or unsound banking practices. These banking regulators have extensive enforcement authority over the institutions they regulate to prohibit or correct activities that violate law, regulation or a regulatory agreement or which are deemed to be unsafe or unsound practices. Enforcement actions may include the appointment of a conservator or receiver, the issuance of a cease and desist order, the termination of deposit insurance, the imposition of civil money penalties on the institution, its directors, officers, employees and institution-affiliated parties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the removal of or restrictions on directors, officers, employees and institution-affiliated parties, and the enforcement of any such mechanisms through restraining orders or other court actions.
The Bank is subject to the provisions of Section 23A and Section 23B of the Federal Reserve Act. Section 23A limits the amount of loans or extensions of credit to, and investments in, the Company and its nonbank affiliates by the Bank. Section 23B requires that transactions between any of the Bank and the Company and its nonbank affiliates be on terms and under circumstances that are substantially the same as with non-affiliates.
The Bank is also subject to certain restrictions on extensions of credit to executive officers, directors, and principal stockholders or any related interest of such persons, which generally require that such credit extensions be made on substantially the same terms as are available to third parties dealing with the Bank and not involve more than the normal risk of repayment. Other laws tie the maximum amount that may be loaned to any one customer and its related interests to capital levels.
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As part of the Federal Deposit Insurance Company Improvement Act of 1991 (“FDICIA”), each federal banking regulator adopted non-capital safety and soundness standards for institutions under its authority. These standards include internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, and compensation, fees and benefits. An institution that fails to meet those standards may be required by the agency to develop a plan acceptable to meet the standards. Failure to submit or implement such a plan may subject the institution to regulatory sanctions. We believe that the Bank meets substantially all standards that have been adopted. FDICIA also imposes new capital standards on insured depository institutions.
The Community Reinvestment Act (“CRA”) requires that, in connection with the examination of financial institutions within their jurisdictions, the federal banking regulators evaluate the record of the financial institution in meeting the credit needs of their communities including low and moderate income neighborhoods, consistent with the safe and sound operation of those banks. These factors are also considered by all regulatory agencies in evaluating mergers, acquisitions and applications to open a branch or facility. As of the date of its most recent examination report, the Bank had a CRA rating of “Outstanding.”
On October 14, 2008, the FDIC announced the creation of the Temporary Liquidity Guarantee Program (the “TLGP”) to decrease the cost of bank funding and, hopefully, normalize lending. This program is comprised of two components. The first component guarantees senior unsecured debt issued between October 14, 2008 and June 30, 2009. The guarantee will remain in effect until June 30, 2012 for such debts that mature beyond June 30, 2009. The second component provides full coverage for non-interest bearing transaction deposit accounts, IOLTAs, and NOW accounts with interest rates of 0.50 percent or less, regardless of account balance, until December 31, 2009. We elected to participate in both programs and expect FDIC premiums to increase in 2009 as a result.
The GLB Act permits certain qualified national banks to form “financial subsidiaries”, which have broad authority to engage in all financial activities except insurance underwriting, insurance investments, real estate investment or development, and merchant banking, and expands the potential financial activities of subsidiaries of state banks, subject to applicable state law. Maryland law generally permits Maryland state-chartered banks, including the Bank, to engage in those activities, directly or through an affiliate, in which a national bank may engage.
Deposit Insurance
The deposits at the Bank are insured to a maximum of $100,000 per depositor through the Deposit Insurance Fund, which is administered by the FDIC, and the Bank is required to pay semi-annual deposit insurance premium assessments to the FDIC. The Deposit Insurance Fund was created pursuant to the Federal Deposit Insurance Reform Act of 2005, which was signed into law on February 8, 2006. Under this new law, (i) the current $100,000 deposit insurance coverage will be indexed for inflation (with adjustments every five years, commencing January 1, 2011), and (ii) deposit insurance coverage for retirement accounts was increased to $250,000 per participant subject to adjustment for inflation. In addition, the FDIC will be given greater latitude in setting the assessment rates for insured depository institutions which could be used to impose minimum assessments. The law also allows “eligible insured depository institutions” to share in a one-time assessment credit pool. The Bank’s portion of the one time credit assessment was $132,329. This credit was used up in 2008. Effective October 3, 2008, the Emergency Economic Stabilization Act of 2008 (the “EESA”) was enacted to temporarily raise the basic limit on federal deposit insurance coverage from $100,000 to $250,000 per depositor. The legislation states the limit will return to $100,000 after December 31, 2009. The coverage for retirement accounts did not change and remains at $250,000. The Bank expensed a total of $100,907 in FDIC premiums during 2008. Further information about deposit insurance premiums is provided in Item 7 of Part II of this report under the heading “Recent Developments”.
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Capital Requirements
Under Maryland law, the Bank must meet certain minimum capital stock and surplus requirements before it may establish a new branch office. With each new branch located outside the municipal area of the Bank’s principal banking office, these minimal levels are subject to upward adjustment based on the population size of the municipal area in which the branch will be located. Prior to establishment of the branch, the Bank must obtain Maryland Commissioner and FDIC approval. If establishment of the branch involves the purchase of a bank building or furnishings, the total investment in bank buildings and furnishings cannot exceed, with certain exceptions, 50% of the Bank’s unimpaired capital and surplus.
FDICIA established a system of prompt corrective action to resolve the problems of undercapitalized institutions. Under this system, federal banking regulators are required to rate supervised institutions on the basis of five capital categories: “well -capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized;” and to take certain mandatory actions, and are authorized to take other discretionary actions, with respect to institutions in the three undercapitalized categories. The severity of the actions will depend upon the category in which the institution is placed. A depository institution is “well capitalized” if it has a total risk based capital ratio of 10% or greater, a Tier 1 risk based capital ratio of 6% or greater, and a leverage ratio of 5% or greater and is not subject to any order, regulatory agreement, or written directive to meet and maintain a specific capital level for any capital measure. An “adequately capitalized” institution is defined as one that has a total risk based capital ratio of 8% or greater, a Tier 1 risk based capital ratio of 4% or greater and a leverage ratio of 4% or greater (or 3% or greater in the case of an institution with a composite CAMELS rating of 1). Tier 1 capital consists of common stockholders’ equity, qualifying perpetual preferred stock, and minority interests in equity accounts of consolidated subsidiaries, less certain intangibles.
FDICIA generally prohibits a depository institution from making any capital distribution, including the payment of cash dividends, or paying a management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans. For a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee (subject to certain limitations) that the institution will comply with such capital restoration plan.
Significantly undercapitalized depository institutions may be subject to a number of other requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized and requirements to reduce total assets and stop accepting deposits from correspondent banks. Critically undercapitalized depository institutions are subject to the appointment of a receiver or conservator, generally within 90 days of the date such institution is determined to be critically undercapitalized.
As of December 31, 2008, the Company and the Bank were deemed to be “well capitalized”. For more information regarding the capital condition of the Company and the Bank, see Item 7 of Part II of this annual report under the caption “Capital”.
Limitations on Dividends
Holders of shares of the Company’s common stock are entitled to dividends if, when, and as declared by the Company’s Board of Directors out of funds legally available for that purpose, and the Board’s ability to declare dividends is subject to certain restrictions imposed under federal banking law and state banking and corporate law. These restrictions are discussed in more detail below in Item 1A
Item 1A. Risk Factors.
The following factors should be considered carefully in evaluating an investment in shares of common stock of the Company.
Risks Relating to the Business of the Company and its Affiliates
The Company’s future depends on the successful growth of its Affiliates.
The Company’s primary business activity for the foreseeable future will be to act as the holding company of the Bank and the Insurance Subsidiary. Therefore, the Company’s future profitability will depend on the success and growth of these subsidiaries. In the future, part of the Company’s growth may come from buying other banks and buying or establishing other companies. Such entities may not be profitable after they are purchased or established, and they may lose money, particularly at first. A new bank or company may bring with it unexpected liabilities, bad loans, or bad employee relations, or the new bank or company may lose customers.
The majority of our business is concentrated in Maryland; a significant amount of our business is concentrated in real estate lending.
Because most of our loans are made to customers who reside on Maryland’s upper Eastern Shore, a decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose loan portfolios are geographically diverse. Further, we make many real estate secured loans, including construction and land development loans, all of which are in greater demand when interest rates are low and economic conditions are good. The national and local economies have significantly weakened during the past two years in part due to the widely-reported problems in the sub-prime mortgage loan market. As a result, real estate values across the country, including in our market areas, have decreased and the general availability of credit, especially credit to be secured by real estate, has also decreased. These conditions have made it more difficult for real estate owners and owners of loans secured by real estate to sell their assets at the times and at the prices they desire. In addition, these conditions have increased the risk that the market values of the real estate securing our loans may deteriorate, which could cause us to lose money in the event a borrower fails to repay a loan and we are forced to foreclose on the property. There can be no guarantee as to when or whether economic conditions will improve.
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Additionally, the FRB and the FDIC, along with the other federal banking regulators, issued final guidance on December 6, 2006 entitled “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices” directed at institutions that have particularly high concentrations of commercial real estate loans within their lending portfolios. This guidance suggests that institutions whose commercial real estate loans exceed certain percentages of capital should implement heightened risk management practices appropriate to their concentration risk and may be required to maintain higher capital ratios than institutions with lower concentrations in commercial real estate lending. Based on our commercial real estate concentration as of September 30, 2008, we may be subject to further supervisory analysis during future examinations. We cannot guarantee that any risk management practices we implement will be effective to prevent losses relating to our commercial real estate portfolio. Management cannot predict the extent to which this guidance will impact our operations or capital requirements.
The Bank may experience loan losses in excess of its allowance.
The risk of credit losses on loans varies with, among other things, general economic conditions, the type of loan being made, the creditworthiness of the borrower over the term of the loan and, in the case of a collateralized loan, the value and marketability of the collateral for the loan. Management maintains an allowance for loan losses based upon, among other things, historical experience, an evaluation of economic conditions and regular reviews of delinquencies and loan portfolio quality. Based upon such factors, management makes various assumptions and judgments about the ultimate collectability of the loan portfolio and provides an allowance for loan losses based upon a percentage of the outstanding balances and for specific loans when their ultimate collectability is considered questionable. If management's assumptions and judgments prove to be incorrect and the allowance for loan losses is inadequate to absorb future losses, or if the bank regulatory authorities require us to increase the allowance for loan losses as a part of its examination process, our earnings and capital could be significantly and adversely affected. Although management uses the best information available to make determinations with respect to the allowance for loan losses, future adjustments may be necessary if economic conditions differ substantially from the assumptions used or adverse developments arise with respect to our non-performing or performing loans. Material additions to the allowance for loan losses would result in a decrease in our net income and capital, and could have a material adverse effect on our financial condition.
Interest rates and other economic conditions will impact our results of operations.
Our results of operations may be materially and adversely affected by changes in prevailing economic conditions, including declines in real estate values, rapid changes in interest rates and the monetary and fiscal policies of the federal government. Our profitability is in part a function of the spread between the interest rates earned on assets and the interest rates paid on deposits and other interest-bearing liabilities (i.e., net interest income), including advances from the Federal Home Loan Bank (the “FHLB”). Interest rate risk arises from mismatches (i.e., the interest sensitivity gap) between the dollar amount of repricing or maturing assets and liabilities and is measured in terms of the ratio of the interest rate sensitivity gap to total assets. More assets repricing or maturing than liabilities over a given time period is considered asset-sensitive and is reflected as a positive gap, and more liabilities repricing or maturing than assets over a given time period is considered liability-sensitive and is reflected as negative gap. An asset-sensitive position (i.e., a positive gap) could enhance earnings in a rising interest rate environment and could negatively impact earnings in a falling interest rate environment, while a liability-sensitive position (i.e., a negative gap) could enhance earnings in a falling interest rate environment and negatively impact earnings in a rising interest rate environment. Fluctuations in interest rates are not predictable or controllable. We have attempted to structure our asset and liability management strategies to mitigate the impact on net interest income of changes in market interest rates, but there can be no assurance that these attempts will be successful in the event of such changes.
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The market value of our investments could decline.
As of December 31, 2008, we had classified 28.85% of our investment securities as available-for-sale pursuant to Statement of Financial Accounting Standards No. 115 (“SFAS 115”) relating to accounting for investments. SFAS 115 requires that the available-for-sale portfolio be “marked to market” and that unrealized gains and losses be reflected as a separate item in stockholders’ equity (net of tax) as accumulated other comprehensive income. The remaining investment securities are classified as held-to-maturity in accordance with SFAS 115, and are stated at amortized cost.
In the past, gains on sales of investment securities have not been a significant source of income for us. There can be no assurance that future market performance of our investment portfolio will enable us to realize income from sales of securities. Stockholders’ equity will continue to reflect the unrealized gains and losses (net of tax) of these investments. There can be no assurance that the market value of our investment portfolio will not decline, causing a corresponding decline in stockholders’ equity.
The Bank is a member of the FHLB of Atlanta. A member of the FHLB system is required to purchase stock issued by the relevant FHLB bank based on how much it borrows from the FHLB and the quality of the collateral pledged to secure that borrowing. Accordingly, we maintain investments in stock issued by the FHLB of Atlanta. In recent months, the banking industry has become concerned about the financial strength of the banks in the FHLB system, and some FHLB banks have stopped paying dividends on and redeeming FHLB stock. On January 30, 2009, the FHLB of Atlanta announced that it was deferring the declaration of a dividend on its stock for the quarter ended December 31, 2008 until it completes its year-end analysis of other-than-temporary impairment which is critical to its net income determination. The FHLB of Atlanta stated that it anticipates a decision regarding the dividend to be made in March 2009. Accordingly, there can be no guaranty that the FHLB of Atlanta will declare future dividends. Moreover, accounting guidance indicates that an investor in FHLB stock should recognize impairment if it concludes that it is not probable that it will ultimately recover the par value of its shares. The decision of whether impairment exists is a matter of judgment that should reflect the investor's view of an FHLB’s long-term performance, which includes factors such as its operating performance, the severity and duration of declines in the market value of its net assets related to its capital stock amount, its commitment to make payments required by law or regulation and the level of such payments in relation to its operating performance, the impact of legislation and regulatory changes on the FHLB, and accordingly, on the members of the FHLB and its liquidity and funding position. After evaluating all of these considerations, we believe the par value of our FHLB stock will be recovered, but future evaluations of the above mentioned factors could result in the Company recognizing an impairment charge.
Management believes that several factors will affect the market values of our investment portfolio. These include, but are not limited to, changes in interest rates or expectations of changes, the degree of volatility in the securities markets, inflation rates or expectations of inflation and the slope of the interest rate yield curve (the yield curve refers to the differences between shorter-term and longer-term interest rates; a positively sloped yield curve means shorter-term rates are lower than longer-term rates). Also, the passage of time will affect the market values of our investment securities, in that the closer they are to maturing, the closer the market price should be to par value. These and other factors may impact specific categories of the portfolio differently, and management cannot predict the effect these factors may have on any specific category.
We operate in a competitive environment.
We operate in a competitive environment, competing for loans, deposits, insurance products and customers with commercial banks, savings associations and other financial entities. Competition for deposits comes primarily from other commercial banks, savings associations, credit unions, money market and mutual funds and other investment alternatives. Competition for loans comes primarily from other commercial banks, savings associations, mortgage banking firms, credit unions and other financial intermediaries. Competition for other products, such as insurance and securities products, comes from other banks, securities and brokerage companies, insurance companies, insurance agents and brokers, and other nonbank financial service providers in our market areas. Many of these competitors are much larger in terms of total assets and capitalization, have greater access to capital markets, and/or offer a broader range of financial services than those offered by us. In addition, banks with a larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the needs of larger customers. Our growth and profitability will depend upon our ability to attract and retain skilled managerial, marketing and technical personnel. Competition for qualified personnel in the financial services industry is intense, and there can be no assurance that we will be successful in attracting and retaining such personnel.
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In addition, current banking laws facilitate interstate branching, merger activity among banks, and expanded activities in which banks, their holding companies and their affiliates may engage. These laws may increase the competition we face in our market areas in the future, although management cannot predict the degree to which such competition will impact our financial condition or results of operations.
The banking industry is heavily regulated; significant regulatory changes could adversely affect our operations.
Our operations will be impacted by current and future legislation and by the policies established from time to time by various federal and state regulatory authorities. The Company is subject to supervision by the FRB and the Bank is subject to supervision and periodic examination by the Maryland Commissioner and the FDIC. Banking regulations, designed primarily for the safety of depositors, may limit a financial institution's growth and the return to its investors by restricting such activities as the payment of dividends, mergers with or acquisitions by other institutions, investments, loans and interest rates, interest rates paid on deposits, expansion of branch offices, and the offering of securities or trust services. The Company and the Bank are also subject to capitalization guidelines established by federal law and could be subject to enforcement actions to the extent that either is found by regulatory examiners to be undercapitalized. It is not possible to predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on our future business and earnings prospects. Management also cannot predict the nature or the extent of the effect on our business and earnings of future fiscal or monetary policies, economic controls, or new federal or state legislation. Further, the cost of compliance with regulatory requirements may adversely affect our ability to operate profitably.
Our regulatory expenses will likely increase due to the enactment of the Emergency Economic Stabilization Act and related government programs.
Among other things, the EESA included a provision to increase the amount of deposits insured by FDIC to $250,000. The TLGP provides, until December 31, 2009, unlimited deposit insurance on funds in non-interest-bearing transaction deposit accounts and certain IOLTAs and NOW accounts not otherwise covered by the existing deposit insurance limit of $250,000, as well as a 100% guarantee of the newly issued senior debt of all FDIC-insured institutions and their holding companies issued between October 14, 2008 and June 30, 2009. All eligible institutions were covered under the TLGP for the first 30 days without incurring any costs. After the initial period, participating institutions will be assessed a charge of 10 basis points per annum for the additional insured deposits and a charge of 75 basis points per annum for guaranteed senior unsecured debt. We elected to participate in both portions of the TLGP, so we expect to incur additional regulatory fees associated with our participation.
Customer concern about deposit insurance may cause a decrease in deposits held at the Bank.
With recent increased concerns about bank failures, customers increasingly are concerned about the extent to which their deposits are insured by the FDIC. Customers may withdraw deposits from the Bank in an effort to ensure that the amount they have on deposit with us is fully insured. Decreases in deposits may adversely affect our funding costs and net income.
Our funding sources may prove insufficient to replace deposits and support our future growth.
We rely on customer deposits, advances from the FHLB, and lines of credit at other financial institutions to fund our operations. Although we have historically been able to replace maturing deposits and advances if desired, no assurance can be given that we would be able to replace such funds in the future if our financial condition or the financial condition of the FHLB or market conditions were to change. Our financial flexibility will be severely constrained and/or our cost of funds will increase if we are unable to maintain our access to funding or if financing necessary to accommodate future growth is not available at favorable interest rates. Finally, if we are required to rely more heavily on more expensive funding sources to support future growth, our revenues may not increase proportionately to cover our costs. In this case, our profitability would be adversely affected.
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The loss of key personnel could disrupt our operations and result in reduced earnings.
Our growth and profitability will depend upon our ability to attract and retain skilled managerial, marketing and technical personnel. Competition for qualified personnel in the financial services industry is intense, and there can be no assurance that we will be successful in attracting and retaining such personnel. Our current executive officers provide valuable services based on their many years of experience and in-depth knowledge of the banking industry and our market area. Due to the intense competition for financial professionals, these key personnel would be difficult to replace and an unexpected loss of their services could result in a disruption to the continuity of operations and a possible reduction in earnings.
Our lending activities subject us to the risk of environmental liabilities.
A significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require us to incur substantial expenses and may materially reduce the affected property’s value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. Although we have policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations.
We may be subject to other claims and the costs of defensive actions.
Our customers may sue us for losses due to alleged breaches of fiduciary duties, errors and omissions of employees, officers and agents, incomplete documentation, our failure to comply with applicable laws and regulations, or many other reasons. Also, our employees may knowingly or unknowingly violate laws and regulations. Management may not be aware of any violations until after their occurrence. This lack of knowledge may not insulate us from liability. Claims and legal actions may result in legal expenses and liabilities that may reduce our profitability and hurt our financial condition.
We may be adversely affected by other recent legislation.
As discussed above, the GLB Act repealed restrictions on banks affiliating with securities firms and permits bank holding companies that become financial holding companies to engage in additional financial activities, including insurance and securities underwriting and agency activities, merchant banking, and insurance company portfolio investment activities that are currently not permitted for bank holding companies. Although the Company is a financial holding company, this law may increase the competition we face from larger banks and other companies. It is not possible to predict the full effect that this law will have on us.
The Sarbanes-Oxley Act of 2002 requires management of publicly-traded companies to perform an annual assessment of their internal control over financial reporting and to report on whether the system is effective as of the end of the Company’s fiscal year. Disclosure of significant deficiencies or material weaknesses in internal controls could cause an unfavorable impact to stockholder value by affecting the market value of our stock.
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The Patriot Act reinforced the importance of implementing and following procedures required by the Bank Secrecy Act and money laundering issues. Non-compliance with this act or failure to file timely and accurate documentation could expose the Company to adverse publicity as well as fines and penalties assessed by regulatory agencies.
Periodically, the federal and state legislatures consider bills with respect to the regulation of financial institutions. Some of these proposals could significantly change the regulation of banks and the financial services industry. We cannot predict whether such proposals will be adopted or the impact on our business, earnings or operations of such future legislation.
We may not be able to keep pace with developments in technology.
We use various technologies in conducting our businesses, including telecommunication, data processing, computers, automation, internet-based banking, and debit cards. Technology changes rapidly. Our ability to compete successfully with other financial institutions may depend on whether we can exploit technological changes. We may not be able to exploit technological changes, and any investment we do make may not make us more profitable.
Risks Related to the Company’s Common Stock
Our ability to pay dividends is limited.
The Company’s stockholders are entitled to dividends on their shares of common stock if, when, and as declared by the Company’s Board of Directors out of funds legally available for that purpose. The Company’s ability to pay dividends to stockholders is largely dependent upon the receipt of dividends from the Bank. Both federal and state laws impose restrictions on the ability of the Bank to pay dividends. Federal law prohibits the payment of a dividend by an insured depository institution if the depository institution is considered “undercapitalized” or if the payment of the dividend would make the institution “undercapitalized”. For a Maryland state-chartered bank, dividends may be paid out of undivided profits or, with the prior approval of the Maryland Commissioner, from surplus in excess of 100% of required capital stock. If, however, the surplus of a Maryland bank is less than 100% of its required capital stock, then cash dividends may not be paid in excess of 90% of net earnings. In addition to these specific restrictions, bank regulatory agencies also have the ability to prohibit proposed dividends by a financial institution that would otherwise be permitted under applicable regulations if the regulatory body determines that such distribution would constitute an unsafe or unsound practice. Because of these limitations, there can be no guarantee that the Company’s Board will declare dividends in any fiscal quarter.
Shares of the Company’s common stock are not insured.
Investments in shares of the Company’s common stock are not deposits and are not insured against loss by the government.
Shares of the Company’s common stock are not heavily traded.
There is no established trading market for the shares of common stock of the Company, and transactions are infrequent and privately negotiated by the buyer and seller in each case. See Item 5 of Part II of this annual report for further market information. Management cannot predict the extent to which an active public market for these securities will develop or be sustained in the future. Securities that are not heavily traded can be more volatile than stock trading in an active public market. Factors such as our financial results, the introduction of new products and services by us or our competitors, and various factors affecting the banking industry generally may have a significant impact on the market price of our common stock. In recent years, the stock market has experienced a high level of price and volume volatility, and market prices for the securities of many companies have experienced wide price fluctuations that have not necessarily been related to their operating performance. Accordingly, the Company’s stockholders may not be able to sell their shares at the volumes, prices, or times that they desire.
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The Company’s Articles of Incorporation and Maryland law may discourage a corporate takeover.
The Company’s Articles of Incorporation, as amended, requires that any proposed merger, share exchange, consolidation, reverse stock split, sale, exchange, lease of all or substantially all of the assets of the Company or any similar transaction be approved by the affirmative vote of 75% of the outstanding shares of the Company’s common stock.
The Maryland Business Combination Act generally prohibits, subject to certain limited exceptions, corporations from being involved in any “business combination” (defined as a variety of transactions, including a merger, consolidation, share exchange, asset transfer or issuance or reclassification of equity securities) with any “interested shareholder” for a period of five years following the most recent date on which the interested shareholder became an interested shareholder. An interested shareholder is defined generally as a person who is the beneficial owner of 10% or more of the voting power of the outstanding voting stock of the corporation after the date on which the corporation had 100 or more beneficial owners of its stock or who is an affiliate or associate of the corporation and was the beneficial owner, directly or indirectly, of 10% percent or more of the voting power of the then outstanding stock of the corporation at any time within the two-year period immediately prior to the date in question and after the date on which the corporation had 100 or more beneficial owners of its stock. The Maryland Control Share Acquisition Act applies to acquisitions of “control shares”, which, subject to certain exceptions, are shares the acquisition of which entitle the holder, directly or indirectly, to exercise or direct the exercise of the voting power of shares of stock of the corporation in the election of directors within any of the following ranges of voting power: one-tenth or more, but less than one-third of all voting power; one-third or more, but less than a majority of all voting power or a majority or more of all voting power. Control shares have limited voting rights.
Although these provisions do not preclude a takeover, they may have the effect of discouraging, delaying or deferring a tender offer or takeover attempt that a stockholder might consider in his or her best interest, including those attempts that might result in a premium over the market price for the common stock. These provisions could potentially adversely affect the market price of the Company’s common stock.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties.
Other than for our operating purposes, we do not invest in real estate. We own and operate branches at the following locations:
Location
Type of Office
Square Footage
Spring Avenue in Chestertown, Maryland 21620
Main Office
16,000
Washington Avenue, Chestertown, Maryland 21620
Branch
3,500
North Main Street, Galena, Maryland 21635
Branch
2,000
Rock Hall Avenue, Rock Hall, Maryland 21661
Branch
2,000
River Road, Millington, Maryland 21651
Branch
2,584
Sudlersville Road, Church Hill, Maryland 21623
Branch
2,584
East Main Street, Sudlersville, MD 21668
Branch
2,584
Talbot Boulevard, Chestertown, Maryland 21620
Insurance Agency
3,000
We also own property located off of Route 544 in Chestertown, Maryland which is being held for possible future expansion purposes.
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Item 3.
Item 3. Legal Proceedings
As previously reported, Edwin and Rosalie Kuechler filed a complaint against the Bank in the Circuit Court for Kent County, Maryland on or about June 26, 2008. The suit related to a commercial loan made by the Bank that was guaranteed by the plaintiffs, which guaranty is secured by an indemnity deed of trust on the plaintiffs’ personal residence. The commercial loan is in default and the Bank is attempting to seek recourse against the plaintiffs, as guarantors. The plaintiffs alleged, among other things, various violations by the Bank of the federal Truth-in-Lending Act and that the plaintiffs are entitled to rescission of the guaranty, and to recover for illegal banking practices arising from the Bank’s demands for payment, intentional infliction of emotional distress arising from the Bank’s demands for payment, and professional negligence and intentional and negligent misrepresentation relating to alleged oral and written representations made to the plaintiffs by the Bank outside the written transaction documents. In addition to rescission, the plaintiffs requested compensatory and punitive damages in the amount of $950,000. The Bank removed this case to the United States District Court for the District of Maryland on or about July 3, 2008. On March 9, 2009, the United States District Court for the District of Maryland issued an order granting the Bank’s motion for summary judgment and entered judgment in favor of the Bank and against the plaintiffs on all counts. On March 18, 2009, the plaintiffs filed a motion with the Court asking it to reconsider the judgment.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
PART II
Item 5.
Item 5. Market for Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
As of March 1, 2009, the Company had 632 stockholders of record. Although certain brokers make a market in the shares of the Company’s common stock through the over-the-counter market, which are reported on the Pink Sheets, LLC (symbol: “PEBC.PK”), we believe there is no established trading market for the shares of common stock, that transactions are infrequent, and that most transactions are privately negotiated. Management cannot predict whether any market will develop in the near future. The following table sets forth, to the best knowledge of the Company, the high and low sales prices for the shares of the Company’s common stock, along with the cash dividends paid, for each quarterly period of 2007 and 2008. There may have been sales during these periods of which the Company is not aware. These prices do not include retail mark-ups, markdowns or commissions, and may not necessarily represent actual transactions. The last sale known to the Company occurred on March 17, 2009 and the price was reported on the Pink Sheets as $54.00 per share.
In 2007 and 2008, the Company paid cash dividends to stockholders totaling $1,314,674 and $1,639,366, respectively. Cash dividends are typically declared on a quarterly basis and are at the discretion of the Board of Directors, based upon such factors as operating results, financial condition, capital adequacy, regulatory requirements, and stockholder return. The Company’s ability to pay dividends is limited by federal and Maryland law and is generally dependent on the ability of the Bank to declare and pay dividends to the Company, which is also limited by law. For more information regarding these limitations, see Item 1A of Part I of this annual report under the caption, “Our ability to pay dividends is limited”. There can be no assurance that dividends will be declared in any fiscal quarter.
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The transfer agent for the shares of common stock of the Company is:
The Peoples Bank
100 Spring Ave
Chestertown, MD 21620
410-778-3500
The Company and its affiliates (as defined by Exchange Act Rule 10b-18) did not purchase any shares of the Company’s common stock during the three-month period ended December 31, 2008.
The Company has not adopted any compensation plan or arrangement pursuant to which our executive officers may receive shares of the Company’s common stock.
Item 6.
Item 6. Selected Financial Data.
The Company is a smaller reporting company and, as such, is not required to include the information required by this item.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation.
The following discussion of our consolidated financial condition and results of operations should be read in conjunction with the our consolidated financial statements and related notes and other statistical information included in Item 8 of Part II of this annual report.
Recent Developments
On February 27, 2009, the FDIC announced a proposed rule outlining its plan to implement an emergency special assessment of 20 basis points on all insured depository institutions in order to restore the Deposit Insurance Fund to an acceptable level. The assessment, which would be payable on September 30, 2009, would be in addition to a planned increase in premiums and a change in the way regular premiums are assessed which the FDIC also approved on February 27, 2009. In addition, the proposed rule provides that, after June 30, 2009, if the reserve ratio of the Deposit Insurance Fund is estimated to fall to a level that that the FDIC believes would adversely affect public confidence or to a level which is close to or less than zero at the end of a calendar quarter, then an additional emergency special assessment of up to 10 basis points may be imposed on all insured depository institutions. If this rule is adopted as proposed, it will significantly increase the Bank’s FDIC premiums in 2009.
As discussed above, the FDIC recently announced the TLGP that provides unlimited deposit insurance on funds in noninterest-bearing transaction deposit accounts not otherwise covered by the existing deposit insurance limit of $250,000, as well as a 100% guarantee of the newly issued senior debt of all FDIC-insured institutions and their holding companies. All eligible institutions were covered under the program for the first 30 days without incurring any costs. After the initial period, participating institutions will be assessed a charge of 10 basis points per annum for the additional insured deposits and a charge of 75 basis points per annum for guaranteed senior unsecured debt. We have elected to participate in the TLGP, and we anticipate that our regulatory costs will increase as a result.
Overview
We recorded a 44.53% decrease in net income for 2008 over 2007. Basic net income per share for 2008 was $2.77, compared to $4.96 for 2007, which represents a decrease of 44.15%.
Return on average assets decreased to .85% for 2008 from 1.55% for 2007. Return on average stockholders’ equity for 2008 was 7.59%, compared to 14.74% for 2007. Average assets increased to $254,748,849 in 2008, or a 1.19% increase over 2007. Average loans net of loan loss increased .76% in 2008 to $215,730,819. During 2008, average deposits increased 4.02% to $167,112,744 when compared to 2007. Average stockholders’ equity increased 7.78% for the year ended December 31, 2008 totaling $28,504,565, compared to 2007.
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Critical Accounting Policies
Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and follow general practices within the industries in which we operate. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available.
The most significant accounting policies that we follow are presented in Note 1 to the Consolidated Financial Statements. These policies, along with the disclosures presented in the other financial statement notes and in this financial review, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for loan losses to be the accounting area that requires the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.
The allowance for loan losses represents management’s estimate of probable loan losses inherent in the loan portfolio as of the balance sheet date. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheets. Note 1 to Consolidated Financial Statements describes the methodology used to determine the allowance for loan losses, and a discussion of the factors driving changes in the amount of the allowance for loan losses is included below under the caption “FINANCIAL CONDITION-Market Risk Management”.
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RESULTS OF OPERATIONS
We reported net income of $2,162,877, or $2.77 per share, for the year ended December 31, 2008, compared to $3,899,495, or $4.96 per share, for the year ended December 31, 2007. This represents a decrease for 2008 of $1,736,618 or 44.53% when compared to 2007.
Net Interest Income
The primary source of our income is net interest income, which is the difference between revenue on interest-earning assets, such as investment securities and loans, and interest incurred on interest-bearing sources of funds, such as deposits and borrowings. The level of net interest income is determined primarily by the average balance of interest-earning assets and funding sources and the various rate spreads between our interest-earning assets and our interest-bearing funding sources. The table “Average Balances, Interest, and Yields” that appears below shows our average volume of interest-earning assets and interest-bearing liabilities for 2008 and 2007, and related income/expense and yields. Changes in net interest income from period to period result from increases or decreases in the volume of interest-earning assets and interest-bearing liabilities, and increases or decreases in the average rates earned and paid on such assets and liabilities. The volume of interest-earning assets and interest-bearing liabilities is affected by the ability to manage the earning-asset portfolio (which includes loans), and the availability of particular sources of funds, such as noninterest bearing deposits. The table “Analysis of Changes in Net Interest Income” shows the amount of net interest income change from rate changes and from volume changes.
For the year ended December 31, 2008, net interest income decreased $1,089,401, or 10.13%, to $9,665,277 from $10,754,678 for the year ended December 31, 2007. The decrease in net interest income in 2008 was the result of a $1,851,515 decrease in interest income offset by a $762,114 decrease in interest expense. In 2008, deposits decreased moderately and our borrowed funds decreased with loan demand. Net income decreased because the yield earned on loans declined faster than yields on deposits and borrowed funds. The yield on interest-earning assets on a fully taxable equivalent basis was 7.37% in 2007 and 6.54% in 2008, with the combined effective rate on deposits and borrowed funds following the same fluctuation by decreasing from 3.47% in 2007 to 3.09% in 2008.
The key performance measure for net interest income is the “net margin on interest-earning assets”, or net interest income divided by average interest-earning assets. Our net interest margin for 2008 on a fully taxable equivalent basis was 4.08%, compared to 4.57% for 2007. Management attempts to maintain a net margin on interest-earning assets of 4.50% or higher. The net margin may decline, however, if competition increases, loan demand decreases, or the cost of funds rises faster or declines slower than the return on loans and securities. Although such expectations are based on management’s judgment, actual results will depend on a number of factors that cannot be predicted with certainty, and fulfillment of management’s expectations cannot be assured.
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Average Balances, Interest, and Yields
Interest on tax-exempt loans and investments are reported on a fully taxable equivalent basis (a non GAAP financial measure).
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Analysis of Changes in Net Interest Income
Interest on tax-exempt loans and investments are reported on fully taxable equivalent basis (a non GAAP financial measure).
The variance that is due both to rate and volume is divided proportionally between the rate and volume variance.
Noninterest Revenue
Noninterest revenue for the 12 months ended December 31, 2008 was $2,531,167, compared to $2,444,800 in 2007. This increase resulted primarily from insurance commissions and increases in service charge income and overdraft checking fees during 2008 when compared to 2007. The Insurance Subsidiary’s insurance commissions accounted for $66,414 of the increase when compared to 2007. A significant portion of the service charges represented debit card fees, which totaled $193,374 (a 5.43% increase over 2007). These cards are gaining increased acceptance among our customer base.
The following table presents the principal components of noninterest revenue for the years ended December 31, 2008 and 2007:
Noninterest Revenue
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Noninterest Expense
Noninterest expense for the 12-month period ended December 31, 2008 increased by $641,820, or 10.02%, to $7,048,557, from $6,406,737 in 2007. The largest components of these increases were to the Bank’s regulatory assessment and to other expenses. We recognized a $209,829, or 55.75%, increase in other expenses to $588,199 from $376,371 in 2007, as a direct result of costs associated with the collection of delinquent loans. Regulatory assessments increased $83,581, or 216.83%, as the result of increased FDIC insurance premiums. The opening of the Bank’s new branches in Church Hill, Maryland and Sudlersville, Maryland contributed to the 20.64% increase in occupancy expense to $443,281 and the 11.26% increase in furniture and equipment expense to $287,923. The Church Hill office opened in late August of 2007 and the Suddlersville office opened December of 2008.
The following table presents the principal components of noninterest expense for the years ended December 31, 2008 and 2007:
Noninterest Expense
Income Taxes
Our effective income tax rate was 37.0% in 2008 and 37.2% in 2007.
Results for the Fourth Quarter of 2008
Net income for the three months ended December 31, 2008 was $182,669, compared to $614,258 for the corresponding period in 2007. Earnings per share for the fourth quarters of 2008 and 2007 were $0.23 and $0.78, respectively. Decreases in gross revenues combined with increases in noninterest expenses and a substantial increase in the provisions for loan loss, offset by decreased income taxes, contributed to the decline in net income for the fourth quarter of 2008 when compared to the same period last year.
Before provisions for loan losses, the net interest income decrease of $457,961, from $2,661,686 for the three months ended December 31, 2007 to $2,203,725 for the three months ended December 31, 2008, was due primarily to loan revenues and interest expense reducing in direct corralation to the reduction in loan and deposit account balances. Comparing the fourth quarter of 2008 to the fourth quarter of 2007, interest revenue decreased $858,735 while interest expense decreased $400,774, with $199,857 of the decrease related to borrowed funds. The provision for loan losses was increased by $135,000 to $675,000 during the fourth quarter of 2008, compared to $540,000 in 2007.
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Noninterest income for the fourth quarter of 2008 increased $24,244 over the same period of 2007 to $541,819. This increase was due primarily to an increase of insurance commissions of $22,495 for the fourth quarter of 2008 over the fourth quarter of 2007.
Total noninterest expense increased $96,739 to $1,774,109 for the quarter ended Decermber 31, 2008, from $1,677,370 for the corresponding quarter of 2007. This increase is primarily the result of a $41,165 increase in our FDIC insurance premiums which is part of our regulatory assessment to $45,738 for the fourth quarter of 2008 from $4,573 for the fourth quarter of 2007. Other expense inceased $74,062 to $234,207 for the fourth quarter of 2008 from $160,145 for the same period in 2007. This expense increased as a direct result of costs associated with the collection of delinquent loans.
FINANCIAL CONDITION
Assets
Total assets decreased 3.79% to $251,894,235 at December 31, 2008 when compared to assets at December 31, 2007. Average total assets for 2008 were $254,748,849, an increase of 1.19% over 2007. The loan portfolio represented 90.03% of average earning assets in 2008, compared to 89.97% in 2007, and was the primary source of income for the Company.
Funding for loans is provided primarily by core deposits, fed funds, and FHLB borrowings. Total deposits decreased 1.96% to $165,738,573 at December 31, 2008 when compared to 2007.
Composition of Loan Portfolio
Because loans are expected to produce higher yields than investment securities and other interest-earning assets (assuming that loan losses are not excessive), the absolute volume of loans and the volume as a percentage of total earning assets is an important determinant of net interest margin. Average loans, net of the allowance for loan losses, were $215,730,819 and $214,100,395 for 2008 and 2007, respectively, which constituted 90.03% and 89.97% of average interest-earning assets for the respective years. At December 31, 2008, our loan to deposit ratio was 129.53%, compared to 130.39% at December 31, 2007, while the ratio of average loans to average deposits was 129.09 % and 133.27% for 2008 and 2007, respectively. The securities sold under agreements to repurchase function like deposits with the securities providing collateral in place of the FDIC insurance. The Bank also borrows from correspondent banks and the FHLB to fund loans. Our ratio of average loans to average deposits plus borrowed funds was 96.17% for the year December 31, 2008, compared to 96.02% for the year ended December 31, 2007. We extend loans primarily to customers located in and near Kent County, Queen Anne’s County and Cecil County in Maryland. There are no industry concentrations in our loan portfolio. A substantial portion of our loans are, however, secured by real estate and, accordingly, the real estate market in the region will influence the performance of our loan portfolio.
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The following table sets forth the composition of our loan portfolio at December 31, 2008 and 2007:
The following table sets forth the maturity distribution, classified according to sensitivity to changes in interest rates, for selected components of our loan portfolio at December 31, 2008:
Loan Maturity Schedule and Sensitivity to Changes in Interest Rates
At December 31, 2008, $137,860,665, or 63.67%, of the total loans were either variable-rate loans or loans written on demand.
Off-Balance Sheet Arrangements
In the normal course of business, to meet the financing needs of our customers, we are a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. Our exposure to credit loss in the event of nonperformance by the other party to these financial instruments is represented by the contractual amount of the instruments. We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments. We generally require collateral or other security to support the financial instruments with credit risk. The amount of collateral or other security is determined based on management’s credit evaluation of the counterparty. We evaluate each customer’s creditworthiness on a case-by-case basis.
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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. Letters of credit are conditional commitments that we issue to guarantee the performance of a customer to a third party. Letters of credit and other commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Because many of the letters of credit and commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. See Note 4 to the Consolidated Financial Statements, which is included in Item 8 of Part II of this annual report, for further information about these commitments.
Loan Quality
The allowance for loan losses represents a reserve for probable losses in the loan portfolio. The adequacy of the allowance for loan losses is evaluated monthly based on a review of all significant loans, with a particular emphasis on non-accruing, past due, and other loans that management believes require attention. The determination of the reserve level rests upon management’s judgment about factors affecting loan quality and assumptions about the economy. Management considers the year-end allowance appropriate and adequate to cover probable losses in the loan portfolio; however, management’s judgment is based upon a number of assumptions about future events, which are believed to be reasonable, but which may or may not prove valid. Thus, there can be no assurance that charge-offs in future periods will not exceed the allowance for loan losses or that additional increases in the loan loss allowance will not be required.
For significant problem loans, management’s review consists of evaluation of the financial strengths of the borrowers and guarantors, the related collateral, and the effects of economic conditions. The overall evaluation of the adequacy of the total allowance for loan losses is based on an analysis of historical loan loss ratios, loan charge-offs, delinquency trends, and previous collection experience, along with an assessment of the effects of external economic conditions.
Risk Elements of Loan Portfolio
The following table, “Allocation of Allowance for Loan Losses”, shows the specific allowance applied by loan type and also the general allowance included in the allowance for loan losses at December 31, 2008 and 2007:
Allocation of Allowance for Loan Losses
(1)
Percentage of loans in category to total loans
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The provision for loan losses is a charge to earnings in the current period to replenish the allowance and maintain it at a level management has determined to be adequate. The provision for loan loss was $1,715,000 in 2008, which represents an increase of $1,135,000 over the $580,000 that was funded in 2007. We added to our reserves in anticipation of potential losses in connection with the higher than normal balances of nonaccrual loans and loans accruing 90 days or more past due. The following table shows information about the allowance for loan losses for each of the last two years:
Allowance for Loan Losses
As a result of management’s ongoing review of the loan portfolio, loans are classified as nonaccrual when it is not reasonable to expect collection of interest under the original terms. These loans are classified as nonaccrual even though the presence of collateral or the borrower’s financial strength may be sufficient to provide for ultimate repayment. Interest on nonaccrual loans is recognized only when received. A delinquent loan is generally placed in nonaccrual status when it becomes 90 days or more past due. When a loan is placed in nonaccrual status, all interest that had been accrued on the loan but remains unpaid is reversed and deducted from earnings as a reduction of reported interest income. No additional interest is accrued on the loan balance until the collection of both principal and interest becomes reasonably certain.
We had nonperforming loans of $5,162,535 and $5,449,838 at December 31, 2008 and 2007, respectively. As of December 31, 2008, we had $1,407,000 in foreclosed other real estate, which is considered nonperforming assets. Nonperforming asset totals at December 31, 2007 were the same as nonperforming loan totals. Loans are classified as impaired when the collection of contractual obligations, including principal and interest, is doubtful. Management considers the nonaccrual loans as of December 31, 2008 to be impaired loans.
Investment Securities
Our security portfolio is categorized as available-for-sale and held to maturity. Investment securities classified as available-for-sale are held for an indefinite period of time and may be sold in response to changing market and interest rate conditions or for liquidity purposes as part of our overall asset/liability management strategy. Available-for-sale securities are carried at market value, with unrealized gains and losses excluded from earnings and reported as a separate component of other comprehensive income included in stockholders’ equity, net of applicable income taxes. We do not currently follow a strategy of making security purchases with a view of near-term resales and, therefore, do not own any securities classified as trading securities. Investment securities classified as held-to-maturity are held until they mature. Held-to maturity securities are held at amortized cost value. For additional information about the investment portfolio, see Note 3 to Consolidated Financial Statements, which is included in Item 8 of Part II of this annual report.
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The following table sets forth the maturities and weighted average yields of the investment portfolio as of December 31, 2008.
Liquidity Management
Liquidity describes our ability to meet financial obligations that arise during the normal course of business. Liquidity is primarily needed to meet the borrowing and deposit withdrawal requirements of customers and to fund current and planned expenditures. Liquidity is derived through increased customer deposits, maturities in the investment portfolio, loan repayments and income from earning assets. To the extent that deposits are not adequate to fund customer loan demand, liquidity needs can be met in the short-term funds markets. The funds invested in federal funds sold also provide liquidity, as do lines of credit, overnight federal funds, and reverse repurchase agreements available from correspondent banks. The aggregate amount available from correspondent banks under all lines of credit at December 31, 2008 was $21,500,000. Additionally, the Bank has a partially funded line of credit from the FHLB of Atlanta. This line is secured by the Bank’s residential mortgage loan portfolio.
Average liquid assets (cash and amounts due from banks, interest bearing deposits in other banks, federal funds sold, and investment securities) were 17.04% of average deposits for 2008, compared to 17.84% for 2007.
We have various financial obligations, including contractual obligations and commitments, that may require future cash payments. Management does not believe that any of the foregoing arrangements have or are reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.
Market Risk Management
Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates, exchange rates or equity pricing. Our principal market risk is interest rate risk that arises from our lending, investing and deposit taking activities. Our profitability is primarily dependent on the Bank’s net interest income. Interest rate risk can significantly affect net interest income to the degree that interest-bearing liabilities mature or reprice at different intervals than interest-earning assets. The degree to which these different assets mature or reprice is known as interest rate sensitivity.
The primary objective of asset/liability management is to ensure the steady growth of net interest income. To lessen the impact of these margin swings, the balance sheet should be structured so that repricing opportunities exist for both assets and liabilities in roughly equivalent amounts at approximately the same time intervals. Interest rate sensitivity may be controlled on either side of the balance sheet. On the asset side, management can exercise some control on maturities. Also, loans may be structured with rate floors and ceilings on variable rate notes and by providing for repricing opportunities on fixed rate notes. Our investment portfolio, including federal funds sold, provides the most flexible and fastest control over rate sensitivity since it can generally be restructured more quickly than the loan portfolio. On the liability side, deposit products can be restructured so as to offer incentives to attain the maturity distribution desired. Competitive factors sometimes make control over deposits more difficult and less effective.
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The rate-sensitive position, or gap, is the difference in the volume of rate-sensitive assets and liabilities at a given time interval. The general objective of gap management is to actively manage rate-sensitive assets and liabilities to reduce the impact of interest rate fluctuations on the net interest margin. Management generally attempts to maintain a balance between rate-sensitive assets and liabilities as the exposure period is lengthened to minimize our overall interest rate risk.
Several aspects of the asset mix of the balance sheet are continually evaluated: yield; credit quality; appropriate funding sources; and liquidity. Management of the liability mix of the balance sheet focuses on expanding the various funding sources.
The interest rate sensitivity position at December 31, 2008 is presented in the table “Interest Sensitivity Analysis”. The difference between rate-sensitive assets and rate-sensitive liabilities, or the interest rate sensitivity gap, is shown at the bottom of the table. We were asset-sensitive for all time horizons except for the after five year time frame in which we were liability-sensitive. For asset-sensitive institutions, if interest rates should decrease, the net interest margins should decline. Because all interest rates and yields do not adjust at the same velocity, the gap is only a general indicator of rate sensitivity.
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Interest Sensitivity Analysis
In addition to gap analysis, we use simulation models to quantify the effect a hypothetical immediate plus or minus 200 basis point change in rates would have on net interest income and the fair value of capital. The model takes into consideration the effect of call features of investments as well as prepayments of loans in periods of declining rates. When actual changes in interest rates occur, the changes in interest earning assets and interest bearing liabilities may differ from the assumptions used in the model. As of December 31, 2008, the models produced higher sensitivity profiles than those for net interest income and the fair value of capital in 2007. They are provided below.
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Deposits and Other Interest-Bearing Liabilities
Average interest-bearing liabilities decreased $1,127,120, or 0.59%, to $190,396,845 in 2008, compared to $191,523,966 in 2007. Average interest-bearing deposits increased $3,987,866, or 3.09%, to $133,187,872 in 2008 compared to $129,200,006 in 2007. Correspondingly, average demand deposits increased $2,472,810, or 7.86%, to $33,924,871 in 2008 from $31,452,061 in 2007.
Total deposits at December 31, 2008 were $165,738,573, a decrease of 1.96% when compared to deposits of $169,052,249 at December 31, 2007.
The following table sets forth the Company’s deposits by category at December 31, 2008 and 2007:
.
Core deposits, which exclude certificates of deposit of $100,000 or more, provide a relatively stable funding source for our loan portfolio and other earning assets. Our core deposits decreased $3,113,667 during 2008 primarily due to recent conditions in the economy. In the past, deposits, particularly core deposits, have been our primary source of funding and have enabled us to meet our short-term liquidity needs. In recent years, we have borrowed from correspondent banks and the FHLB of Atlanta to meet liquidity needs. The maturity distribution of our time deposits over $100,000 at December 31, 2008 is shown in the following table.
Maturities of Certificates of Deposit and Other Time Deposits of $100,000 or More
Large certificate of deposit customers tend to be extremely sensitive to interest rates, making these deposits less reliable sources of funding for liquidity planning purposes than core deposits. Some financial institutions partially fund their balance sheets using large certificates of deposit obtained through brokers. These brokered deposits are generally expensive and are unreliable as long-term funding sources. Accordingly, we do not typically purchase brokered deposits.
The average balance of borrowings decreased $5,114,987, or 8.21%, in 2008, compared to an increase of $7,799,208, or 14.30%, in 2007. The decrease in 2008 over 2007 was due primarily to the fact that the Bank has reduced investment securities to reduce our lines of credit particularly at the FHLB of Atlanta during 2008.
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Short-term Borrowings
The following table sets forth our position with respect to short-term borrowings for each of the last two years ended December 31:
The Bank may borrow up to approximately 30% of total assets from the FHLB of Atlanta through any combination of notes or line of credit advances. Both the notes payable and the line of credit are secured by a floating lien on all of the Bank’s real estate mortgage loans. The Bank was required to purchase shares of capital stock in the FHLB of Atlanta as a condition to obtaining the line of credit.
We provide collateral of 105% of the repurchase agreement balances by pledging U.S. Government Agency securities.
The Bank has lines of credit of $16,500,000 in unsecured overnight federal funds and $5,000,000 in secured overnight federal funds with correspondent banks at December 31, 2008.
Capital
Under the capital adequacy guidelines of the FRB and the FDIC, the Company and the Bank are required to maintain minimum capital ratios. These requirements are described above in Item 1 or Part I under “Regulation and Supervision-Capital Requirements”. At December 31, 2008 and 2007, the Company and the Bank were considered “well-capitalized”. The table below compares the capital ratios of the Bank with the regulatory minimums. The Company’s only assets in 2008 other than its equity interest in the Bank were its equity interest in the Insurance Subsidiary and a small amount of cash. The value of the equity interest in the Insurance Subsidiary at December 31, 2008 did not cause the Company’s capital ratios as of December 31, 2008 to materially differ from the Bank’s ratios.
Analysis of Capital
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Accounting Rule Changes
In September 2006, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") 157, Fair Value Measurements. SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. It clarifies that fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts. This Statement does not require any new fair value measurements, but rather, it provides enhanced guidance to other pronouncements that require or permit assets or liabilities to be measured at fair value. This Statement is effective for fiscal years beginning after November 15, 2007, with earlier adoption permitted. In February 2008, the FASB issued FASB Staff Position ("FSP") FAS 157-2, Effective Date of FASB Statement No. 157. This FSP defers the effective date of SFAS 157 for nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), to years beginning after November 15, 2008, and interim periods within those fiscal years. The adoption of this Statement did not have a material impact on the Company's financial position, results of operations or cash flows.
In December 2007, the FASB issued SFAS 141, Revised 2007 (SFAS 141R), Business Combinations. SFAS 141R's objective is to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business combination and its effects. SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after December 31, 2008. The Company does not expect the implementation of SFAS 141R to have a material impact on its consolidated financial statements.
In February 2007, the FASB issued SFAS 159, The Fair Value Option for Financial Assets and Liabilities. This Statement permits entities to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This pronouncement became effective as of the beginning of an entity's first fiscal year beginning after November 15, 2007. The Company has not elected to measure any of its financial instruments at fair value other than securities available for sale and foreclosed real estate.
In December 2007, the FASB issued SFAS 160, Noncontrolling Interests in Consolidated Financial Statements. SFAS 160's objective is to improve the relevance, comparability, and transparency of the financial information that a reporting entity provides in its consolidated financial statements by establishing accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 shall be effective for fiscal years and interim periods within those fiscal years, beginning on or after December 15, 2008. The Company does not expect the implementation of SFAS 160 to have a material impact on its consolidated financial statements.
In March 2008, the FASB issued SFAS 161, Disclosures about Derivative Instruments and Hedging Activities, an amendment of SFAS 133. SFAS 161 establishes, among other things, the disclosure requirements for derivative instruments and for hedging activities. SFAS 161 amends and expands the disclosure requirements of SFAS 133 with the intent to provide users financial statements with enhanced understanding of: (a) How and why an entity uses derivatives instruments; (b) How derivative instruments and related hedged items are accounted for under SFAS 133 and its related interpretations; and (c) how derivative instruments and related hedged items affect an entity's financial position, financial performance, and cash flows. SFAS 161 shall be effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The Company does not expect the implementation of SFAS 161 to have a material impact on its consolidated financial statements.
In May 2008, the FASB issued SFAS 162, The Hierarchy of Generally Accepted Accounting Principles. SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles in the United States. The implementation of SFAS 162 did not have a material impact on its consolidated financial statements.
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Item 7A.
Item 7A. Quantitative and Qualitative Disclosure About Market Risk.
The information required by this item may be found in Item 7 of this Part II under the caption “FINANCIAL CONDITION-Market Risk Management”, which is incorporated herein by reference.
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Item 8.
Item 8. Financial Statements and Supplementary Data.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
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Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Peoples Bancorp, Inc.
Chestertown, Maryland
We have audited the accompanying consolidated balance sheets of Peoples Bancorp, Inc. and Subsidiaries as of December 31, 2008 and 2007, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the years in the two year period ended December 31, 2008. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Peoples Bancorp, Inc. and Subsidiaries as of December 31, 2008 and 2007, and the results of its operations and its cash flows for each of the years in the two year period ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America.
/s/ Rowles & Company, LLP
Baltimore, Maryland
March 17,
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CONSOLIDATED BALANCE SHEETS
The notes to the consolidated financial statements are an integral part of these statements.
- 35 -
CONSOLIDATED STATEMENTS OF INCOME
The notes to the consolidated financial statements are an integral part of these statements.
- 36 -
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 2008 and 2007
The notes to the consolidated financial statements are an integral part of these statements.
- 37 -
CONSOLIDATED STATEMENTS OF CASH FLOWS
The notes to the consolidated financial statements are an integral part of these statements.
- 38 -
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
YEARS ENDED DECEMBER 31,
The notes to the consolidated financial statements are an integral part of these statements.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.
Summary of Significant Accounting Policies
The accounting and reporting policies reflected in the accompanying financial statements conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry.
Principles of consolidation
Peoples Bancorp, Inc. and its subsidiaries, The Peoples Bank, a financial institution and Fleetwood, Athey, MacBeth & McCown, Inc., an insurance agency, operate primarily in Kent and Queen Anne’s Counties, Maryland. The consolidated financial statements include the accounts of the Company, the Bank, and the Insurance Subsidiary. Intercompany balances and transactions have been eliminated. References in these notes to "the Company" are intended to mean Peoples Bancorp, Inc. and, as the context requires, the Bank or the Insurance Subsidiary.
Nature of business
The Bank which includes a Main office and six branches, offers deposit services and loans to individuals, small businesses, associations, and government entities. Other services include direct deposit of payroll and social security checks, automatic drafts from accounts, automated teller machine services, cash management services, safe deposit boxes, money orders, travelers cheques, and on-line banking with bill payment service. The Bank also offers credit card services and discount brokerage services through a correspondent.
The Insurance Subsidiary operates from one location in Kent County and provides a full range of insurance products to businesses and consumers. Product lines include property, casualty, life, marine, long-term care and health insurance.
Use of estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. These estimates and assumptions may affect the reported amounts of revenue and expenses during the reporting period. Actual results could differ from these estimates.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.
Summary of Significant Accounting Policies (Continued)
Cash and cash equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, and federal funds sold. Generally, federal funds are purchased and sold for one-day periods.
Investment securities
As securities are purchased, management determines if the securities should be classified as held to maturity or available for sale. Securities which management has the intent and ability to hold to maturity are classified as held to maturity and recorded at amortized cost which is cost adjusted for amortization of premiums and accretion of discounts to maturity, or over the expected life in the case of mortgage-backed securities. Amortization and accretion are recorded using the interest method. Securities which may be sold before maturity are classified as available for sale and carried at fair value with unrealized gains and losses excluded from earnings and reported in other comprehensive income.
Gains and losses on the sale of securities are determined using the specific identification method.
Loans and allowance for loan losses
Loans are stated at their outstanding unpaid principal balance adjusted for deferred origination costs, deferred origination fees, and the allowance for loan losses.
Interest on loans is accrued based on the principal amounts outstanding. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method. The accrual of interest is discontinued when any portion of the principal or interest is ninety days past due and collateral is insufficient to discharge the debt in full. When the accrual of interest is discontinued, loans are reviewed for impairment. Past due status is based on contractual terms of the loan. All interest accrued but not collected for loans that are placed on nonaccrual status is reversed against interest revenue.
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 a loan is uncollectible. 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 specific, general, and unallocated components. The specific component relates to loans that are classified as either doubtful, substandard, or special mention. The general component covers nonclassified 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 in the underlying assumptions used in the methodologies for estimating specific 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. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is collateral dependent.
Premises and equipment
Premises and equipment are recorded at cost less accumulated depreciation. Depreciation is computed using the straight-line method over estimated useful lives of three to ten years for furniture and equipment and ten to forty years for premises.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.
Summary of Significant Accounting Policies (Continued)
Foreclosed real estate
Real estate acquired through foreclosure is recorded at the lower of cost or fair market value on the date acquired. In general, cost equals the Company's investment in the property at the time of foreclosure. Losses incurred at the time of acquisition of the property are charged to the allowance for loan losses. Subsequent reductions in the estimated value of the property are included in other operating expense.
Goodwill and intangible assets
Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. Other intangible assets represent purchased assets that lack physical substance but can be distinguished from goodwill because of contractual or other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract, asset or liability. Goodwill is not ratably amortized into the income statement over an estimated life, but rather is tested at least annually for impairment. Intangible assets that have finite lives are amortized over their estimated useful lives and are also subject to impairment testing. The Company’s intangible assets have finite lives and are amortized on a straight-line basis over periods not exceeding 10 years.
Advertising
Advertising costs are expensed over the life of ad campaigns. General purpose advertising is charged to expense as incurred.
Income taxes
The provision for income taxes includes taxes payable for the current year and deferred income taxes. Deferred income taxes are provided for the temporary differences between financial and taxable income.
The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse.
Per share data
Earnings per common share are determined by dividing net income by the weighted average number of shares of common stock outstanding. The weighted average number of shares outstanding were 781,578 and 786,950 for 2008 and 2007, respectively. There are no dilutive shares.
2.
Cash and Due from Banks
The Company normally carries balances with other banks that exceed the federally insured limit. The average balances carried in excess of the limit, including unsecured federal funds sold to the same banks, were $4,411,589 for 2008 and $5,421,260 for 2007.
Banks are required to carry noninterest-bearing cash reserves at specified percentages of deposit balances. The Company's normal amount of cash on hand and on deposit with other banks is sufficient to satisfy the reserve requirements.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3.
Investment Securities
Investment securities are summarized as follows:
Contractual maturities and the amount of pledged securities are shown below. Actual maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
Investments are pledged to secure the deposits of federal and local governments and as collateral for repurchase agreements.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3.
Investment Securities (Continued)
Securities in a continuous unrealized loss position at December 31, 2008, are as follows:
All unrealized losses on securities as of December 31, 2008, are considered to be temporary losses. Each security will be redeemed at face value at, or prior to, maturity. In most cases, the temporary impairment in value is caused by market interest rate fluctuations.
4.
Loans and Allowance for Loan Losses
Major classifications of loans as of December 31, are as follows:
The rate repricing and maturity distribution of the loan portfolio is as follows:
Transactions in the allowance for loan losses were as follows:
Management has identified no significant impaired loans.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4.
Loans and Allowance for Loan Losses (Continued)
Loans on which the accrual of interest has been discontinued or reduced, and the interest that would have been accrued at December 31, are as follows:
Amounts past due 90 days or more at December 31, still accruing interest, are as follows:
Outstanding loan commitments, unused lines of credit, and letters of credit as of December 31, are as follows:
Loan commitments and lines of credit are agreements to lend to a customer as long as there is no violation of any condition to the contract. Loan commitments generally have interest rates fixed at current market rates, fixed expiration dates, and may require payment of a fee. Lines of credit generally have variable interest rates. Such lines do not represent future cash requirements because it is unlikely that all customers will draw upon their lines in full at any time.
Letters of credit are commitments issued to guarantee the performance of a customer to a third party.
Loan commitments, lines of credit, and letters of credit are made on the same terms, including collateral, as outstanding loans. The Company's exposure to credit loss in the event of nonperformance by the borrower is represented by the contract amount of the commitment. Management is not aware of any accounting loss the Company will incur by the funding of these commitments.
The Company lends to customers located primarily in and near Kent County, Queen Anne’s County, and Cecil County, Maryland. Although the loan portfolio is diversified, its performance will be influenced by the economy of the region.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5.
Premises and Equipment
A summary of premises and equipment and related depreciation expense as of December 31, is as follows:
Computer software included in other assets and the related amortization are as follows:
6.
Other Time Deposits
Maturities of other time deposits as of December 31, are as follows:
Included in other time deposits are certificates of deposit in amounts of $100,000 or more of $26,258,114 and $26,458,123, as of December 31, 2008 and 2007, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
7.
Securities Sold Under Repurchase Agreements
Securities sold under repurchase agreements represent borrowings from customers. The government agency securities that are the collateral for these agreements are owned by the Company and maintained in the custody of a nonaffiliated bank. Additional information is as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
8.
Notes Payable and Lines of Credit
The Company may borrow up to approximately 30% of total assets from the Federal Home Loan Bank (FHLB) through any combination of notes or line of credit advances. Both the notes payable and the line of credit are secured by a floating lien on all of the Company’s real estate mortgage loans. As of December 31, 2008, the Company had $939,172 of mortgage loans available to pledge as collateral to the FHLB. The Company was required to purchase shares of capital stock in the FHLB as a condition to obtaining the line of credit.
The Company’s borrowings from the Federal Home Loan Bank as of December 31, 2008 and 2007, are summarized as follows:
The outstanding advances require interest payments monthly or quarterly with principle due at maturity.
In addition to the line from the FHLB, the Company has lines of credit of $16,500,000 in unsecured overnight federal funds and $5,000,000 in secured overnight federal funds at December 31, 2008. As of December 31, 2008, the Company had $2,170,000 in borrowings under these federal funds lines of credit.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9.
Income Taxes
The components of income tax expense are as follows:
The components of the deferred income tax expense are as follows:
The components of the net deferred income tax asset are as follows:
A reconciliation of the provisions for income taxes from statutory federal rates to effective rates follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
10.
Profit Sharing Plan
The Company has a profit sharing plan qualifying under section 401(k) of the Internal Revenue Code that covers all employees with one year of service who have attained age 21. The Company matches 15% of employee contributions to the Plan, up to a maximum of 2% of pay. The Company may make discretionary contributions to the Plan in amounts approved by the Board of Directors. The Company’s contributions to the plan, included in employee benefits expense for 2008 and 2007, were $6,897 and $55,895, respectively.
11.
Pension
The Company has a defined benefit pension plan covering substantially all of the employees. Benefits are based on years of service and the employee's highest average rate of earnings for five consecutive years during the final ten full years before retirement. The Company's funding policy is to contribute annually the maximum amount that can be deducted for income tax purposes, determined using the projected unit credit cost method.
The following table sets forth the financial status of the plan at December 31:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
11.
Pension (Continued)
Net pension expense includes the following components:
Assumptions used in the accounting for net pension expense were:
The Company intends to contribute approximately $272,000 to the Plan in 2009.
Benefits expected to be paid from the Plan are as follows:
The long-term rate of return on assets assumption considers the current earnings on assets of the Plan as well as the effects of asset diversification. The Plan's investment strategy is to earn a reasonable return while safeguarding the benefits promised to employees. All assets of the Plan are invested in deposit accounts at the Company.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
12.
Other Operating Expenses
Other operating expenses consist of the following:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13.
Related Party Transactions
In the normal course of banking business, loans are made to senior officers and directors of the Company as well as to companies and individuals affiliated with those officers and directors. The terms of these transactions are substantially the same as the terms provided to other borrowers entering into similar loan transactions. In the opinion of management, these loans are consistent with sound banking practices, are within regulatory lending limitations, and do not involve more than normal credit risk.
A summary of these loans is as follows:
In addition to the outstanding balances listed above, the officers and directors and their related interests have $2,778,340 in unused loans committed but not funded as of December 31, 2008.
A director is a partner in a law firm that provides services to the Company. Payments of $11,000 and $10,875 were made to that firm during 2008 and 2007, respectively.
Deposits from senior officers and directors and their related interests were $2,496,245 as of December 31, 2008 and $2,471,646 as of December 31, 2007.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
14.
Capital Standards
The Federal Reserve Board and the Federal Deposit Insurance Corporation have adopted risk-based capital standards for banking organizations. These standards require ratios of capital to assets for minimum capital adequacy and to be classified as well capitalized under prompt corrective action provisions. The table below sets forth the capital ratios of the Bank as of December 31, 2008 and 2007. Because the Company's only asset other than its equity interest in the Bank and Insurance Agency is a small amount of cash, its capital ratios do not differ materially from those of the Bank.
Tier 1 capital consists of common stock, additional paid on capital, and undivided profits. Total capital includes a limited amount of the allowance for loan losses. In calculating risk-weighted assets, specified risk percentages are applied to each category of asset and off-balance sheet items.
Failure to meet the capital requirements could affect the Bank's ability to pay dividends and accept deposits and may significantly affect the operations of the Bank.
In the most recent regulatory report, the Bank was categorized as well capitalized under the prompt corrective action regulations. Management knows of no events or conditions that should change this classification.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
15.
Fair Value of Financial Instruments
On January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements. The adoption had no effect on the Company's December 31, 2007 balance sheet or the statement of income for the year ended December 31, 2008. The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. SFAS No. 157 defines the fair value, establishes a framework for measuring fair value, and expands disclosures about fair values. SFAS No. 157 also establishes a hierarchy for determining fair value measurements. The hierarchy includes three levels and is based upon the valuation techniques used to measure assets and liabilities.
Level one uses inputs of quoted prices, unadjusted, for identical assets or liabilities in active markets. Level two inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. Level three assumes inputs to the valuation methodology that are unobservable and significant to the fair value measurement.
Securities available for sale - If quoted prices are available in an active market, securities are classified within level 1 of the hierarchy. Level 1 includes securities that have quoted prices in an active market for identical assets. If quoted market prices are not available, then fair values are estimated using pricing models, quoted prices of securities with similar characteristics or discounted cash flows. The Company has categorized its securities available for sale as follows:
Foreclosed real estate - The Company measures its foreclosed real estate at fair value less cost to sell. As of December 31, 2008, the fair value of foreclosed real estate was based on offers and/or appraisals. Cost to sell the real estate was based on standard market factors. The Company has categorized its foreclosed real estate as level three.
The Company does not measure the fair value of any of its other financial assets or liabilities on a recurring or nonrecurring basis. The estimated fair values of the Company's other financial instruments were as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
15.
Fair Value of Financial Instruments (Continued)
The fair value of fixed-rate loans is estimated to be the present value of scheduled payments discounted using interest rates currently in effect. The fair value of variable-rate loans, including loans with a demand feature, is estimated to equal the carrying amount. The valuation of loans is adjusted for possible loan losses.
The fair value of interest-bearing checking, savings, and money market deposit accounts is equal to the carrying amount. The fair value of fixed-maturity time deposits and borrowings is estimated based on interest rates currently offered for deposits and borrowings of similar remaining maturities.
It is not practicable to estimate the fair value of outstanding loan commitments, unused lines of credit, and letters of credit.
16.
Parent Company Financial Information
The balance sheets, statements of income, and statements of cash flows for Peoples Bancorp, Inc. (Parent Only) follow:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
16.
Parent Company Financial Information (Continued)
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
17.
Quarterly Results of Operations (Unaudited)
18.
Insurance Agency Acquisition
On January 2, 2007, the Company purchased all of the outstanding stock of Fleetwood, Athey, MacBeth, and McCown, Inc. (FAM&M), an insurance agency with an office located in Chestertown, Maryland. The agency is now a wholly-owned subsidiary of the Company. The principal and sole shareholder of FAM&M agreed to a two year consulting agreement as part of the acquisition agreement.
The purchase price of approximately $1,000,000 was paid in cash. The Company recorded approximately $273,000 of goodwill and approximately $550,000 of other intangible assets as a result of the acquisition. The goodwill will not be amortized for financial statement purposes but will be reviewed annually for impairment. The intangible assets will be amortized over 10 years for financial statement purposes. The goodwill and intangible assets will be amortized over 15 years for income tax purposes.
The consolidated financial statements include the results of operations of FAM&M since the date of purchase.
19.
Segment Reporting
The Company operates two primary businesses: community banking and insurance products and services. Through the community banking business, the Company provides services to consumers and small businesses on the upper Eastern Shore of Maryland through its seven branches. Community banking activities include serving the deposit needs of small business and individual consumers by providing banking products and services to fit their needs. Loan products available to consumers include mortgage, home equity, automobile, marine, and installment loans and other secured and unsecured personal lines of credit. Small business lending includes commercial mortgages, real estate development loans, equipment and operating loans, as well as secured and unsecured lines of credit, accounts receivable financing arrangements, and merchant card services.
Through the insurance products and services business, the Company provides a full range of insurance products and services to businesses and consumers in the Company’s market areas. Products include property and casualty, life, marine, individual health and long-term care insurance.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
19.
Segment Reporting (Continued)
Selected financial information by line of business for the year ended December 31 2008 and 2007, are included in the following table:
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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 maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports filed under the Exchange Act with the Securities and Exchange Commission, such as this annual report, is recorded, processed, summarized and reported within the time periods specified in those rules and forms, and that such information is accumulated and communicated to the Company’s management, including the Chief Executive Officer, who also serves as the Company’s Chief Financial Officer (“CEO”), as appropriate, to allow for timely decisions regarding required disclosure. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.
An evaluation of the effectiveness of these disclosure controls as of December 31, 2008 was carried out under the supervision and with the participation of the Company’s management, including the CEO. Based on that evaluation, the Company’s management, including the CEO, has concluded that the Company’s disclosure controls and procedures are, in fact, effective at the reasonable assurance level.
During the fourth quarter of 2008, there was no change in the Company’s internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
As required by Section 404 of the Sarbanes-Oxley Act of 2002, management has performed an evaluation and testing of the Company’s internal control over financial reporting as of December 31, 2008. Management’s report on the Company’s internal control over financial reporting is included on the following page.
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Management’s Report on Internal Control Over Financial Reporting
Management of Peoples Bancorp, Inc. (the “Company”) is responsible for the preparation, integrity and fair presentation of the consolidated financial statements included in this annual report. The Company’s consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and, as such, include some amounts that are based on the best estimates and judgments of management.
This annual report on Form 10-K does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting because management’s report was not subject to attestation pursuant to temporary rules of the SEC that permit the Company to provide only this management’s report.
The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting. This internal control system is designed to provide reasonable assurance to management and the Board of Directors regarding the reliability of the Company’s financial reporting and the preparation and presentation of financial statements for external reporting purposes in conformity with accounting principles generally accepted in the United States of America, as well as to safeguard assets from unauthorized use or disposition. The system of internal control over financial reporting is evaluated for effectiveness by management and tested for reliability through a program of internal audit with actions taken to correct potential deficiencies as they are identified. Because of inherent limitations in any internal control system, no matter how well designed, misstatement due to error or fraud may occur and not be detected, including the possibility of the circumvention or overriding of controls. Accordingly, even an effective internal control system can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, internal control effectiveness may vary over time.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2008 based upon criteria set forth in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Based on this assessment and on the foregoing criteria, management has concluded that, as of December 31, 2008, the Company’s internal control over financial reporting is effective.
March 25,
/s/ Thomas G. Stevenson
Thomas G. Stevenson,
President, Chief Executive Officer, and
Chief Financial Officer
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Item 9B.
Item 9B.
Other Information.
None.
PART III
Item 10.
Item 10.
Directors, Executive Officers and Corporate Governance.
The Company has adopted a Code of Ethics that applies to all of its directors, officers, and employees, including its principal executive officer, principal financial officer, principal accounting officer, or controller, or persons performing similar functions. A written copy of the Company’s Code of Ethics will be provided to stockholders, free of charge, upon request to: Stephanie Usilton, Peoples Bancorp, Inc., 100 Spring Avenue, Chestertown, Maryland 21620 or (410) 778-3500.
All other information required by this item is incorporated herein by reference to the Company’s definitive proxy statement to be filed in connection with the 2009 Annual Meeting of Stockholders.
Item 11.
Item 11.
Executive Compensation.
The information required by this item is incorporated herein by reference to the Company’s definitive proxy statement to be filed in connection with the 2009 Annual Meeting of Stockholders.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related StockholderMatters.
The information required by this item is incorporated herein by reference to the Company’s definitive proxy statement to be filed in connection with the 2009 Annual Meeting of Stockholders.
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 Company’s definitive proxy statement to be filed in connection with the 2009 Annual Meeting of Stockholders.
Item 14.
Item 14.
Principal Accountant Fees and Services.
The information required by this item is incorporated herein by reference to the Company’s definitive proxy statement to be filed in connection with the 2009 Annual Meeting of Stockholders.
PART IV
Item 15.
Item 15.
Exhibits and Financial Statement Schedules.
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(a)(3) and (b). Exhibits required to be filed by Item 601 of Regulation S-K:
The exhibits filed or furnished with this annual report are shown on the Exhibit List that follows the signatures to this annual report, which list is incorporated herein by reference.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Exchange Act, the registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Date:
March 25, 2009
By:
/s/ E. Jean Anthony
E. Jean Anthony, Director
Date:
March 25, 2009
By:
/s/ Robert W. Clark, Jr.
Robert W. Clark, Jr., Director
Date:
March 25, 2009
By:
LaMonte E. Cooke, Director
Date:
March 25, 2009
By:
/s/ Gary B. Fellows
Gary B. Fellows, Director
Date:
March 25, 2009
By:
/s/ Herman E. Hill, Jr.
Herman E. Hill, Jr., Director
Date:
March 25, 2009
By:
/s/ Patricia Joan Ozman Horsey
Patricia Joan Ozman Horsey, Director
Date:
March 25, 2009
By:
/s/ P. Patrick McCleary
P. Patrick McCleary, Director
Date:
March 25, 2009
By:
/s/ Alexander P. Rasin, III
Alexander P. Rasin, III, Director
Date:
March 25, 2009
By:
/s/ Stefan R. Skipp
Stefan R. Skipp, Director
Date:
March 25, 2009
By:
/s/ Thomas G. Stevenson
Thomas G. Stevenson, President, CEO,
CFO and Director
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Date:
March 25, 2009
By:
/s/ Elizabeth A. Strong
Elizabeth A. Strong, Director
Date:
March 25, 2009
By:
/s/ William G. Wheatley
William G. Wheatley, Director
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EXHIBIT INDEX
Exhibit No.
Description
3.1
Articles of Incorporation of the Company, as corrected and amended (incorporated by reference to Exhibit 3.1 of the Company’s Current Report on Form 8-K filed on January 24, 2005)
3.2
Bylaws of the Company, as amended (incorporated by reference to Exhibit 3.2 of the Company’s Annual Report on Form 10-KSB for the year ended December 31, 2004)
Subsidiaries of the Company (filed herewith)
31.1
Certifications of the CEO/CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith)
32.1
Certifications of the CEO/CFO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished herewith)
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