ITEM 1. BUSINESS
DESCRIPTION OF BUSINESS
Northway Financial, Inc. (the "Company") was incorporated on March 7, 1997, under the laws of the State of New Hampshire, for the purpose of becoming the holding company of The Berlin City Bank, a New Hampshire chartered bank headquartered in Berlin, New Hampshire ("BCB"), pursuant to a reorganization transaction (the "BCB Reorganization") by and among the Company, BCB, and a subsidiary of BCB, and, thereafter, effecting the merger (the "Merger") by and among the Company, BCB, Pemi Bancorp, Inc. ("PEMI"), and PEMI's wholly owned subsidiary, The Pemigewasset National Bank of Plymouth, New Hampshire, a national bank headquartered in Plymouth, New Hampshire ("PNB"). The BCB Reorganization and the Merger became effective on September 30, 1997. As of such date, BCB and PNB (collectively the "Banks"), became wholly owned subsidiaries of the Company. Unless the context otherwise requires, references herein to the "Company" include Northway Financial, Inc. and its consolidated subsidiaries.
The Company derives substantially all of its revenue and income from the furnishing of bank and bank-related services, principally to individuals and small and medium sized companies in New Hampshire. BCB and PNB operate as typical community banking institutions and do not engage in any specialized finance or capital market activities. The Company functions primarily as the holder of stock of its subsidiaries and assists the management of its subsidiaries as appropriate.
The Company is subject to regulation by the New Hampshire Bank Commissioner (the "Commissioner"), the Federal Deposit Insurance Corporation (the "FDIC"), the Comptroller of the Currency of the United States (the "OCC"), and the Board of Governors of the Federal Reserve System. See "Supervision and Regulation."
BCB, which was first organized in 1891, and PNB, which was first organized in 1881, are engaged in a general commercial banking business and offer commercial and construction loans, real estate mortgages, consumer loans, including personal secured and unsecured loans, and lines of credit. During 1998, the Company, through the BCB subsidiary, established an indirect lending business unit in Concord, New Hampshire. The unit has substantially increased the volume of secured consumer installment loans originated for the Banks and for sale to third parties. The Banks accept savings, time, demand, NOW and money market deposit accounts, and offer a variety of banking services including safe deposit boxes, credit card accounts, official checks and money orders, overdraft lines of credit and wire transfer services.
The Company is a legal entity separate and distinct from its subsidiaries. The right of the Company to participate in any distribution of assets or earnings of any subsidiary is subject to the prior claims of creditors of the subsidiary, except to the extent that claims, if any, of the Company itself as a creditor may be recognized. See "Supervision and Regulation".
The following information concerning the Company's investment activities, lending activities, asset quality and allowance for loan losses should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations," appearing under Item 7 of this report and the Company's Consolidated Financial Statements and Notes thereto.
INVESTMENT ACTIVITIES
The following table presents the carrying amount of the Company's securities available-for-sale as of December 31, 2003, 2002 and 2001 (dollars in thousands):
2003 2002 2001 ------- ------- ------- US Treasury and other US government agency securities $37,840 $36,188 $10,977 Mortgage-backed securities(1) 2,903 12,646 21,097 Marketable equity securities 2,766 2,377 3,255 Corporate bonds 21,983 33,848 14,230 State and political subdivision bonds and notes 8,224 6,338 6,005 ------- ------- ------- Total securities $73,716 $91,397 $55,564 ======= ======= =======
(1) Includes collateralized mortgage obligations
The following table sets forth the amortized cost of the Company's investment in debt securities maturing within stated periods and their related weighted average yields, reported on a tax equivalent basis, as of December 31, 2003 (dollars in thousands):
Maturities ----------------------------------------------------- One to Five to Over Total Within five ten ten amortized one year years years years cost -------- -------- --------- ------- --------- Available-for-sale: US Treasury and other US government agency securities $ - $25,023 $12,922 $ - $37,945 Mortgage-backed securities (1) 62 1,090 1,220 446 2,818 Corporate bonds 1,805 14,584 4,468 - 20,857 State and political subdivision bonds and notes 196 220 3,274 4,376 8,066 ------ ------- ------- ------ ------- Total amortized cost $2,063 $40,917 $21,884 $4,822 $69,686 ====== ======= ======= ====== =======
Market value $2,097 $41,828 $22,177 $4,848 $70,950 ====== ======= ======= ====== =======
Weighted average yield 5.44% 4.48% 4.96% 7.44% 4.86%
(1) Includes collateralized mortgage obligations
LENDING ACTIVITIES
The following table sets forth information with respect to the composition of the Company's loan portfolio, excluding loans held for sale, as of December 31, 2003, 2002, 2001, 2000 and 1999 (dollars in thousands):
December 31, ---------------------------------------------------- 2003 2002 2001 2000 1999 ---- ---- ---- ---- ---- Real estate: Residential $129,493 $114,526 $109,261 $129,805 $139,389 Commercial 120,366 111,941 111,642 100,608 93,061 Construction 3,851 6,330 1,581 5,752 4,360 Commercial 24,528 23,885 22,727 22,270 28,833 Installment 30,291 40,169 28,210 28,177 24,147 Indirect installment 150,807 139,477 120,761 98,919 75,781 Other 8,896 6,031 6,303 7,881 7,369 -------- -------- -------- -------- -------- Total loans 468,232 442,359 400,485 393,412 372,940 Less: Unearned income 247 207 169 154 174 Allowance for loan losses 5,036 4,920 4,642 4,354 4,887 -------- -------- -------- -------- -------- Total unearned income and allowance for loan losses 5,283 5,127 4,811 4,508 5,061 -------- -------- -------- -------- -------- Net loans $462,949 $437,232 $395,674 $388,904 $367,879 ======== ======== ======== ======== ========
The following table presents the maturity distribution of the Company's real estate construction and commercial loans at December 31, 2003 (dollars in thousands):
Percent of Amount Total Within one year $ 10,917 38.47% One to five years 8,922 31.44 Over five years 8,540 30.09 ------- ------ $28,379 100.00% ======= ======
The Company's real estate construction and commercial loans due after one year at December 31, 2003 were comprised of the following (dollars in thousands):
Amount Fixed interest rate $ 7,311 Adjustable interest rate 10,151 ------- $17,462
ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES
The following table reflects activity in the Company's allowance for loan losses for the years ended December 31, 2003, 2002, 2001, 2000 and 1999 (dollars in thousands):
Years ended December 31, ---------------------------------------------- 2003 2002 2001 2000 1999 ------ ------ ------ ------ ------
Balance at the beginning of period $4,920 $4,642 $4,354 $4,887 $4,404 Charge-offs: Real estate - 83 110 213 159 Commercial 120 12 95 1,006 25 Installment loans to individuals 750 729 529 424 120 Credit card - - - - - Other - - - - - ------ ------ ------ ------ ------ Total 870 824 734 1,643 304 ------ ------ ------ ------ ------ Recoveries: Real estate 25 64 35 32 213 Commercial 11 4 - - 21 Installment loans to individuals 145 134 87 96 12 Credit card - - - 2 1 Other - - - - - ------ ------ ------ ------ ------ Total 181 202 122 130 247 ------ ------ ------ ------ ------ Net charge-offs 689 622 612 1,513 57 Provision charged to expense 805 900 900 980 540 ------ ------ ------ ------ ------ Balance at the end of period $5,036 $4,920 $4,642 $4,354 $4,887 ====== ====== ====== ====== ======
Ratio of net charge-offs to average loans 0.15% 0.15% 0.15% 0.39% 0.02%
ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
The following table sets forth the breakdown of the Company's allowance for loan losses in the Company's portfolio by category of loan and the percentage of loans in each category to total loans in the respective portfolios at the dates indicated (dollars in thousands):
DEPOSITS
See "Financial Statements and Supplementary Data" in Item 8 of this report.
SUPERVISION AND REGULATION
The business in which the Company is engaged is subject to extensive supervision, regulation and examination by various bank regulatory authorities and other governmental agencies. State and federal banking laws have as their principal objective either the maintenance of the safety and soundness of financial institutions and the federal deposit insurance system or the protection of consumers or classes of consumers, and depositors in particular, rather than the specific protection of stockholders of a bank or its parent company.
Set forth below is a brief description of certain laws and regulations that relate to the regulation of the Company. To the extent the following material describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statute or regulation.
Regulation of the Company
General. As a registered bank holding company, the Company is subject to regulation under the Bank Holding Company Act of 1956, as amended, ("BHCA") and to inspection, examination and supervision by the Board of Governors of the Federal Reserve System, ("FRB"). The Company is also subject to the laws of the State of New Hampshire.
The FRB has the authority to issue orders to bank holding companies to cease and desist from unsound banking practices and violations of conditions imposed by, or violations of agreements with, the FRB. The FRB is also empowered to assess civil money penalties against companies or individuals who violate the BHCA or orders or regulations thereunder, to order termination of non-banking activities of non-banking subsidiaries of bank holding companies, and to order termination of ownership and control of a non-banking subsidiary by a bank holding company. Under the BHCA, the Company may not generally engage in activities or acquire more than 5% of any class of voting securities of any company engaged in activities other than banking or activities that are closely related to banking. However, if the Company elects to be treated as a financial holding company, the Company may engage in activities that are financial in nature or incidental or complimentary to such financial activities, as determined by the FRB and the Secretary of the Department of the Treasury. The Company has not elected financial holding company status. Under certain circumstances, the Company may be required to give notice to or seek approval of the FRB before engaging in activities other than banking.
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 ("Riegle-Neal"). Riegle-Neal permits adequately capitalized and adequately managed bank holding companies, as determined by the FRB, to acquire banks in any state subject to certain concentration limits and other conditions. Riegle-Neal also generally authorizes the interstate merger of banks. In addition, among other things, Riegle-Neal permits banks to establish new branches on an interstate basis provided that the law of the host state specifically authorizes such action. However, as a bank holding company, we are required to obtain prior FRB approval before acquiring more than 5% of a class of voting securities, or substantially all of the assets of a bank holding company, bank or savings association.
Control Acquisitions. The Change in Bank Control Act prohibits a person or group of persons from acquiring "control" of a bank holding company, such as the Company, unless the FRB has been notified and has not objected to the transaction. Under a rebuttable presumption established by the FRB, the acquisition of 10% or more of a class of voting securities of a bank holding company with a class of securities registered under Section 12 of the Securities Exchange Act of 1934, as amended, would, under the circumstances set forth in the presumption, constitute acquisition of control of the bank holding company. In addition, a company is required to obtain the approval of the FRB under the BHCA before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of any class of outstanding voting securities of a bank holding company, or otherwise obtaining control or a "controlling influence" over that bank holding company.
Bank Holding Company Dividends. The FRB has authority to prohibit bank holding companies from paying dividends if such payment is deemed to be an unsafe or unsound practice. The FRB has indicated generally that it may be an unsafe or unsound practice for bank holding companies to pay dividends unless the bank holding company's net income over the preceding year is sufficient to fund the dividends and the expected rate of earnings retention is consistent with the organization's capital needs, asset quality and overall financial condition. The Company depends in part upon dividends received from its subsidiary banks to fund its activities, including the payment of dividends. As described below, the Federal Deposit Insurance Corporation ("FDIC") and the Banks' regulatory agencies may regulate the amount of dividends payable by the subsidiary banks. The inability for the bank to pay the dividend may have an adverse effect on the Company.
Regulation of the Banks
General. PNB is a national banking association, organized under the National Bank Act. As such, its primary regulatory authority is the OCC. The OCC regularly examines national banks and their operations. In addition, operations of national banks are subject to federal statutes and regulations. Such statutes and regulations relate to required capital and reserves, investments, loans, mergers, payment of dividends, issuance of securities and many other aspects of operations. Capital requirements applicable to PNB are substantially similar to those adopted by the FRB regarding bank holding companies as described above.
The OCC's approval is required for a national bank to pay dividends if the total dividends declared by a national bank in any year will exceed the total of its net profits for that year combined with its retained net profits for the preceding two years, less any required transfer to surplus. The OCC also has authority to approve or disapprove mergers, consolidations, the establishment of branches and similar corporate actions. The OCC also has the power to prevent a national bank from engaging in unsafe or unsound practices or violating applicable laws in conducting its business.
Under the Gramm-Leach-Bliley Act (1999) ("GLBA"), the OCC permits national banks, to the extent permitted under state law, to engage in certain new activities which are permissible for subsidiaries of a financial holding company. Further, it expressly preserves the ability of national banks to retain all existing subsidiaries.
PNB is also subject to applicable provisions of New Hampshire law insofar as they do not conflict with or are not otherwise preempted by federal banking law.
BCB is organized under New Hampshire law and is subject to the regulations of the Commissioner and the FDIC. BCB's operations are subject to various requirements and restrictions under the laws of the United States and the State of New Hampshire, including those related to the maintenance of adequate levels of capital, the payment of dividends, investments, the nature and amount of loans which can be originated and the rate of interest that can be charged thereon, and other activities. Capital requirements applicable to BCB are substantially similar to those adopted by the FRB regarding bank holding companies as described above.
Insurance of Accounts and FDIC Regulation. The Banks pay deposit insurance premiums to the FDIC based on an assessment rate established by the FDIC for Bank Insurance Fund-member institutions. The FDIC has established a risk-based premium system under which the FDIC classifies institutions based on their capital ratios and on other relevant factors and generally assesses higher rates on those institutions that tend to pose greater risks to the federal deposit insurance funds. The Federal Deposit Insurance Act ("FDIA") does not require the FDIC to charge all banks deposit insurance premiums when the ratio of deposit insurance reserves to insured deposits is maintained above specified levels. However, as a result of general economic conditions and bank failures, it is possible that the ratio of deposit insurance reserves to insured deposits could fall below the minimum ratio that FDIA requires, which would result in the FDIC setting deposit insurance assessment rates sufficient to increase deposit insurance reserves to the required ratio. We cannot predict whether the FDIC will be required to increase deposit insurance assessments above their current levels.
Bank Holding Company Support of Subsidiary Banks. Under FRB policy, a bank holding company is expected to act as a source of financial and managerial strength to each of its subsidiary banks and to commit resources to their support. This support may be required at times when the bank holding company may not have the resources to provide it. Similarly, under the cross-guarantee provisions of FDIA, the FDIC can hold any FDIC-insured depository institution liable for any loss suffered or anticipated by the FDIC in connection with (1) the "default" of a commonly controlled FDIC-insured depository institution; or (2) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution "in danger of default." Both BCB and PNB are FDIC-insured depository institutions.
Regulatory Capital Requirements. The FRB and the FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to United States banking organizations. In addition, these regulatory agencies may from time to time require that a banking organization maintain capital above the minimum levels, whether because of its financial condition or actual or anticipated growth.
The FRB risk-based guidelines define a three-tier capital framework. Tier 1 capital includes common stockholders' equity and qualifying preferred stock, less goodwill and other adjustments. Tier 2 capital consists of preferred stock not qualifying as Tier 1 capital, mandatory convertible debt, limited amounts of subordinated debt, other qualifying term debt and the allowance for loan losses up to 1.25 percent of risk-weighted assets. Tier 3 capital includes subordinated debt that is unsecured, fully paid, has an original maturity of at least two years, is not redeemable before maturity without prior approval by the FRB and includes a lock-in clause precluding payment of either interest or principal if the payment would cause the issuing bank's risk-based capital ratio to fall or remain below the required minimum. The sum of Tier 1 and Tier 2 capital less investments in unconsolidated subsidiaries represents qualifying total capital. Risk-based capital ratios are calculated by dividing Tier 1 and total capital by risk-weighted assets. Assets and off-balance sheet exposures are assigned to one of four categories of risk-weights, based primarily on relative credit risk. The minimum Tier 1 capital ratio is four percent and the minimum total capital ratio is eight percent. The Company's tier 1 calculation equals 9.66% and its total capital ratio is 12.81%.
The leverage ratio is determined by dividing Tier 1 capital by adjusted average total assets. Although the stated minimum ratio is 100 to 200 basis points above three percent, banking organizations are required to maintain a ratio of at least five percent to be classified as well capitalized. The Company's leverage ratio is 7.22%.
The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), among other things, identifies five capital categories for insured depository institutions (well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized) and requires the federal bank regulatory agencies to implement systems for "prompt corrective action" for insured depository institutions that do not meet minimum capital requirements within such categories. FDICIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the category in which an institution is classified. Failure to meet the capital guidelines could also subject a banking institution to capital raising requirements. An "undercapitalized" bank must develop a capital restoration plan and its parent holding company must guarantee that bank's compliance with the plan. The liability of the parent holding company under any such guarantee is limited to the lesser of five percent of the bank's assets at the time it became "undercapitalized" or the amount needed to comply with the plan. Furthermore, in the event of the bankruptcy of the parent holding company, such guarantee would take priority over the parent's general unsecured creditors. In addition, FDICIA requires the various regulatory agencies to prescribe certain non-capital standards for safety and soundness relating generally to operations and management, asset quality and executive compensation and permits regulatory action against a financial institution that does not meet such standards.
The various regulatory agencies have adopted substantially similar regulations that define the five capital categories identified by FDICIA, using the total risk-based capital, Tier 1 risk-based capital and leverage capital ratios as the relevant capital measures. Such regulations establish various degrees of corrective action to be taken when an institution is considered undercapitalized. Under the regulations, a "well capitalized" institution must have a Tier 1 risk-based capital ratio of at least six percent, a total risk-based capital ratio of at least ten percent and a leverage ratio of at least five percent and not be subject to a capital directive order. Regulators also must take into consideration (a) concentrations of credit risk; (b) interest rate risk (when the interest rate sensitivity of an institution's assets does not match the sensitivity of its liabilities or its off-balance-sheet position); and (c) risks from non-traditional activities, as well as an institution's ability to manage those risks, when determining the adequacy of an institution's capital. This evaluation will be made as a part of the institution's regular safety and soundness examination. In addition, the Company, and any Bank with significant trading activity, must incorporate a measure for market risk in their regulatory capital calculations. As of December 31, 2003, the most recent notification from the FDIC categorized both Banks as well capitalized.
U.S. bank regulatory authorities and international bank supervisory organizations, principally the Basel Committee on Banking Supervision ("Basel Committee"), currently are considering changes to the risk-based capital adequacy framework, which ultimately could affect the appropriate capital guidelines, including changes (such as those relating to lending to registered broker-dealers) that are of particular relevance to banks, such as the Banks, that engage in significant securities activities. Among other things, the Basel Committee rules, which were proposed formally for public comment in May 2003 and are expected to become effective around early 2007, would add operational risk as a third component to the denominator of the risk-capital calculation, which currently includes only credit and market risks.
Limitations on Bank Dividends. The FDIC has the authority to use its enforcement powers to prohibit a bank from paying dividends if, in its opinion, the payment of dividends would constitute an unsafe or unsound practice. Federal law also prohibits the payment of dividends by a bank that will result in the bank failing to meet its applicable capital requirements on a pro forma basis.
The Community Reinvestment Act. The Community Reinvestment Act ("CRA") requires lenders to identify the communities served by the institution's offices and other deposit taking facilities and to make loans and investments and provide services that meet the credit needs of these communities. Regulatory agencies examine each of the banks and rate such institutions' compliance with CRA as "Outstanding", "Satisfactory", "Needs to Improve" or "Substantial Noncompliance". Failure of an institution to receive at least a "Satisfactory" rating could inhibit such institution or its holding company from undertaking certain activities, including engaging in activities newly permitted as a financial holding company under the GLBA and acquisitions of other financial institutions. The FRB must take into account the record of performance of banks in meeting the credit needs of the entire community served, including low-and moderate-income neighborhoods. New Hampshire also has enacted substantially similar community reinvestment requirements. PNB has achieved a rating of outstanding and BCB a rating of satisfactory on their most recent examinations.
Customer Information Security. The FDIC and other bank regulatory agencies have adopted guidelines for establishing standards for safeguarding nonpublic personal information about customers that implement provisions of GLBA, which establishes a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms, and other financial service providers by revising and expanding the BHCA framework. Specifically, the Information Security Guidelines established by the GLBA require each financial institution, under the supervision and ongoing oversight of its board of directors or an appropriate committee thereof, to develop, implement and maintain a comprehensive written information security program designed to ensure the security and confidentiality of customer information, to protect against anticipated threats or hazards to the security or integrity of such information; and to protect against unauthorized access to or use of such information that could result in substantial harm or inconvenience to any customer.
Privacy. The GLBA requires financial institutions to implement policies and procedures regarding the disclosure of nonpublic personal information about consumers to nonaffiliated third parties. In general, the statute requires financial institutions to explain to consumers their policies and procedures regarding the disclosure of such nonpublic personal information, and, unless otherwise required or permitted by law, financial institutions are prohibited from disclosing such information except as provided in their policies and procedures.
USA PATRIOT Act. The USA PATRIOT Act of 2001 (The "USA PATRIOT Act"), designed to deny terrorists and others the ability to obtain anonymous access to the U.S. financial system, has significant implications for depository institutions, broker-dealers and other businesses involved in the transfer of money. The USA PATRIOT Act, together with the implementing regulations of various federal regulatory agencies, have caused financial institutions, including banks, to adopt and implement additional, or amend existing, policies and procedures with respect to, among other things, anti-money laundering compliance, suspicious activity and currency transaction reporting, customer identity verification and customer risk analysis. The statute and its underlying regulations also permit information sharing for counter-terrorist purposes between federal law enforcement agencies and financial institutions, as well as among financial institutions, subject to certain conditions, and require the FRB (and other federal banking agencies) to evaluate the effectiveness of an applicant in combating money laundering activities when considering applications filed under Section 3 of the BHCA or under the Bank Merger Act. Management believes that the Company is in compliance with all the requirements prescribed by the USA PATRIOT Act and all applicable final implementing regulations.
The Sarbanes-Oxley Act. The Sarbanes-Oxley Act of 2002 ("S-O Act") implements a broad range of corporate governance and accounting measures for public companies (including publicly-held bank holding companies such as the Company) designed to promote honesty and transparency in corporate America and better protect investors from corporate wrongdoings. The S-O Act's principal provisions, many of which have been interpreted through regulations released in 2003, provide for and include, among other things:
o the creation of an independent accounting oversight board; o auditor independence provisions which restrict non-audit services that accountants may provide to their audit clients; o additional corporate governance and responsibility measures, including the requirement that the chief executive officer and chief financial officer of a public company certify financial statements; o the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer's securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement; o an increase in the oversight of, and enhancement of certain requirements relating to, audit committees of public companies and how they interact with the company's independent auditors; o requirements that audit committee members must be independent and are barred from accepting consulting, advisory or other compensatory fees from the issuer; o requirements that companies disclose whether at least one member of the audit committee is a `financial expert' (as such term is defined by the SEC) and if not, why not; o expanded disclosure requirements for corporate insiders, including accelerated reporting of stock transactions by insiders and a prohibition on insider trading during pension blackout periods; o a prohibition on personal loans to directors and officers, except certain loans made by insured financial institutions, such as the Banks, on nonpreferential terms and in compliance with other bank regulatory requirements; o disclosure of a code of ethics and filing a Form 8-K for a change or waiver of such code; and o a range of enhanced penalties for fraud and other violations.
The Company has taken steps to comply with and anticipates that it will incur additional expenses in continuing to comply with the provisions of the S-O Act and its underlying regulations. Management believes that such compliance efforts have strengthened the Company's overall corporate governance structure and does not expect that such compliance has to date, or will in the future have a material impact on the Company's results of operations or financial condition.
COMPETITION
The banking industry in the United States, which includes commercial banks, savings and loan associations, mutual savings banks, capital stock savings banks, credit unions, and bank and savings and loan holding companies, is part of the broader financial services industry which includes insurance companies, mutual funds, and the brokerage industry, among others. In recent years, intense market demands and economic pressures have eroded once clearly defined industry classifications and have forced financial services institutions to diversify their services, increase returns on deposits, and become more cost effective as a result of competition with one another and with new types of financial services companies, including non-bank competitors.
The Company's banking subsidiaries face significant competition in their respective markets from commercial banks, savings banks, credit unions, consumer finance companies, insurance companies, "non-bank banks," mutual funds, government agencies, investment management companies, investment advisors, brokers and investment bankers. In addition, increasing consolidation within the banking and financial services industry, as well as increased competition from larger regional and out-of-state banking organizations and non-bank providers of various financial services, may adversely affect the Company's ability to achieve its financial goals. Federal banking laws permit adequately capitalized bank holding companies to venture across state lines to offer banking services through bank subsidiaries to a wider geographic market. Consequently, it is possible for large organizations to enter many new markets including the markets served by the Company. Certain of these competitors, by virtue of their size and resources, may enjoy certain efficiencies and competitive advantages over the Company in pricing, delivery, and marketing of their products and services. The Company's long-term success depends on the ability of the Company's banking subsidiaries to compete successfully with other financial institutions in their service areas. It is not possible to assess what impact these changes in the regulatory environment will have on the Company. Many of these large competitors have significantly more financial resources, larger market share and greater name recognition in the market areas served by the Company and its banking subsidiaries.
BCB and PNB compete in this environment by providing a broad range of financial services, competitive interest rates and a personal level of service that, combined, tend to retain the loyalty of its customers in its market areas against competitors with far larger resources. To a lesser extent, convenience of branch locations and hours of operations are also considered competitive advantages of the Banks.
RISK FACTORS
The discussions set forth below contain certain statements that may be considered "forward-looking statements." Forward-looking statements involve unknown risks, uncertainties and other factors that may cause the Company's actual results to materially differ from those projected in the forward-looking statements. For further information regarding forward-looking statements, you should review the discussion under the caption "FORWARD-LOOKING STATEMENTS" on page 1 of this report.
Recent accounting changes could give rise to adverse changes in the regulatory capital treatment of junior subordinated debentures, including currently outstanding junior subordinated debentures of the Company which, in turn, could adversely affect the Company's regulatory capital position. In January 2003, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46") that addresses the consolidation rules to be applied to "variable interest entities" as defined in FIN 46. FIN 46, which applies to certain variable interest entities as of February 1, 2003 and to all variable interest entities as of December 14, 2003, provides that certain variable interest entities should not be treated as consolidates subsidiaries. Northway Capital Trust I and Northway Capital Trust II, the Company's Delaware statutory business trusts, may constitute variable interest entities. Historically, issuer trusts, such as Northway Capital Trust I and Northway Capital Trust II that issued junior subordinated debentures have been consolidated by their parent companies. In addition, junior subordinated debentures have been treated as eligible for Tier 1 capital treatment by bank holding companies under the FRB's rules and regulations relating to minority interests in equity accounts of consolidated subsidiaries. Accordingly, the Company has consolidated its existing issuer trusts in preparing its consolidated financial statements in the past, and the Company's outstanding junior subordinated debentures have been treated as Tier 1 capital.
On December 24, 2003, FASB issued a revision to FIN 46 ("FIN46R"), to clarify some of the provisions of FIN 46. Based on FIN46R, the Company deconsolidated its existing issuer trusts as of December 31, 2003, and restated their historical financial statements. The adoption of FIN46R results in the reclassification of the redeemable junior subordinated debentures from mezzanine capital to other liabilities as well as the reclassification of interest cost from minority interest to interest expense.
This deconsolidation could result in a change to the regulatory capital treatment of junior subordinated debentures issued by the Company and other U.S. bank holding companies. Specifically, it is possible that since its issuer trust would no longer be consolidated by the Company the junior subordinated debentures issued by such issuer trust would not be considered a minority interest in equity accounts of a consolidated subsidiary and therefore not be accorded Tier 1 capital treatment by the FRB. The FRB has indicated in supervisory letter SR 03-13, dated July 2, 2003 (the "Supervisory Letter"), that junior subordinated debentures will be treated as Tier 1 capital until notice is given to the contrary, but the Supervisory Letter also indicates that the FRB will review the regulatory implications of any accounting treatment changes and will provide further guidance if necessary or warranted.
If Tier 1 capital treatment were disallowed by the FRB, the Company would be able to redeem its owner junior subordinated debentures, thereby causing a mandatory redemption of capital securities pursuant to the terms and conditions of the applicable governing documents. As of December 31, 2003, assuming it were not allowed to include the junior subordinated debentures in Tier 1 Capital, the Company would still exceed the regulatory required minimums for capital adequacy purposes.
The Company could be adversely impacted by changes in applicable regulations. The Company is subject to extensive federal and state laws and regulations and is subject to supervision, regulation and examination by various federal and state bank regulatory agencies. The restrictions imposed by such laws and regulations limit the manner in which the Company and its bank subsidiaries may conduct business and obtain financing. There can be no assurance that any modification of these laws and regulations, or new legislation that may be enacted, in the future will not make compliance more difficult or expensive, restrict the Company's ability to originate, broker or sell loans or otherwise adversely affect the operations of the Company. See "Supervision and Regulation" on page 5 of this report.
The Company's business is largely dependent upon the hospitality industry. A number of the Company's loan customers are in the hospitality industry. The hospitality industry is dependent on personal discretionary spending levels. Consequently, the hospitality industry has been adversely impacted by current negative economic trends, including recession and increased unemployment. Additionally, unforeseen events including acts of terrorism, war, increases in fuel prices, travel-related accidents and unusual weather patterns also may adversely affect the hospitality industry. As a result, the Company's business also is likely to be adversely affected by those events.
Interest rate volatility may adversely impact the Company's results of operations. The principal component of the Company's income stream is net interest and dividend income. Net interest and dividend income is the difference between interest and fee income on earning assets, such as loans and investments, and the interest expense paid on interest bearing liabilities, such as deposits and borrowed funds. The Company's net interest and dividend income may be significantly affected by changes in market interest rates, which are currently at historically low levels. A decrease in interest rates could reduce the Company's net interest and dividend income as the difference between interest and fee income and interest expense decreases. An increase in interest rates could also negatively impact the Company's results of operations by reducing borrowers' ability to repay their current loan obligations, resulting in increased loan defaults, foreclosures and write-offs and could necessitate increases to the Company's allowance for loan losses. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 7 of this report.
The Company's allowance for loan losses may not be adequate to cover actual losses. The Company makes various assumptions and judgments about the collectibility of its loan portfolio and provides an allowance for potential loan losses based on several factors. If the Company's assumptions are incorrect, its allowance for loan losses may be insufficient to cover its actual losses, which would have an adverse effect on the Company's results of operations, and may cause the Company to increase the allowance in the future. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 7 of this report.
Changes in the securities market may adversely impact the Company's results of operations. In recent years the securities market has experienced a significant downturn and will likely continue to experience volatility as a result of, among other things, world economic and political conditions. Continued declines in equity prices, as well as declines in the performance of certain sectors or specific companies, may result in a corresponding decline in the value of Company-held securities. The decline in the value of Company-held securities may decrease the Company's earnings. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 7 of this report.
EMPLOYEES
As of December 31, 2003 the Company has 266 full-time equivalent employees. The Company considers its employee relations to be good.
WEBSITE ACCESS TO COMPANY REPORTS
The Company's annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are available free of charge on the Company's website at www.northwayfinancialinc.com as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission. Also, copies of the Company's annual report will be made available, free of charge, upon written request.
ITEM 2.
ITEM 2. PROPERTIES
The Company operates 21 branch offices and one loan origination facility that are located in the central and northern New Hampshire communities of Berlin, Conway (four offices), Gorham (two offices), Groveton, Littleton, West Ossipee, West Plymouth, Plymouth, Campton, Ashland, North Woodstock, Tilton (two offices), Franklin, Laconia, Belmont, Pittsfield and Concord. Fourteen of these offices, including its main offices in Berlin, New Hampshire and Plymouth, New Hampshire, are located on properties the Company owns. The Company leases seven of its branches and the loan origination facility under five-year leases expiring between April 30, 2004 and December 31, 2008. Seventeen of the Company's branches have drive-up facilities and all are equipped with automated teller machines.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is not a party to, nor are any of its subsidiaries the subject of, any material pending legal proceedings, other than ordinary routine litigation incidental to the business.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the quarter ended December 31, 2003.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The Company's common stock is traded on The Nasdaq Stock Market, Inc.'s National Market under the symbol "NWFI". The following table sets forth, for the periods indicated, the high and low closing sale prices for the common stock, as reported by The Nasdaq National Market, and the dividends paid on the common stock:
Price Per Share Dividends Low High Per Share
2003 4th Quarter $29.99 $35.49 $0.17 3rd Quarter 29.10 30.97 0.17 2nd Quarter 28.01 30.65 0.17 1st Quarter 28.81 31.25 0.17
2002 4th Quarter $26.18 $31.50 $0.17 3rd Quarter 27.75 29.90 0.17 2nd Quarter 28.15 30.00 0.17 1st Quarter 27.50 29.40 0.17
The Company intends to continue to pay dividends on a quarterly basis subject to, among other things, the financial condition and earnings of the Company, capital requirements, and other factors, including applicable governmental regulations. No dividends will be payable unless declared by the Board of Directors and then only to the extent funds are legally available for the payment of such dividends.
On March 2, 2004, the closing sales price of the common stock on the Nasdaq National Market was $35.65 per share. As of such date, there were approximately 1,300 holders of record of the Company common stock.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth the selected consolidated financial information of the Company for the five years in the period ended December 31, 2003. This selected consolidated financial information should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing under Item 7
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The purpose of this discussion is to focus on significant changes in the financial condition and results of operations of the Company. It is intended to supplement and highlight information contained in the accompanying consolidated financial statements and the selected financial data presented elsewhere in this report. The discussion set forth below contains certain statements that may be considered "forward-looking statements." Forward-looking statements involve risks, uncertainties and other factors that may cause the Company's actual results to materially differ from those projected in the forwarding-looking statements. For further information regarding forward-looking statements, you should review the discussion under the caption "FORWARD-LOOKING STATEMENTS" on page 1 of this report.
OVERVIEW OF PERFORMANCE
The Company derives substantially all of its revenue and income from community bank-related activities. The Banks operate as typical community banking institutions and do not engage in any specialized finance or capital markets activities. Northway Financial, Inc. functions primarily as the holder of stock of its subsidiaries and assists in the management of the operations of its subsidiaries as appropriate.
The principal components of the Company's income sources are net interest and dividend income. Net interest and dividend income is the difference between interest and fee income received on income earning assets, such as loans and investments, and the interest expense paid on interest bearing liabilities, such as deposits and borrowed funds. Our other sources of income include revenues from fee-based services, such as debit card and ATM fees and sales of securities.
Economic and industry factors that could cause the Company's financial performance to differ from expected results include changes in applicable federal and state regulations, changes in the hospitality industry on which the Company's business is largely dependent, interest rate volatility, significant changes in loan losses which may affect the Company's allowance for loan losses and the related provision for loan losses, and changes in the securities market that would affect the performance of the Company's investment portfolio. Management evaluates each of these factors on an ongoing basis to determine their impact and to effect any strategies necessary to mitigate these risks.
The Company reported net income of $3,617,000, or $2.40 per common share, in 2003 compared to net income of $2,598,000, or $1.71 per common share, in 2002 and $3,873,000, or $2.55 per common share, in 2001. Return on average equity was 7.82% in 2002, compared to 5.86% in 2002 and 9.14% in 2001. Return on average assets was 0.59% in 2003, compared to 0.49% in 2002 and 0.78% in 2001.
During 2003, the Company took advantage of the improved market conditions for investment securities and realized securities gains totaling $1,522,000 compared to $151,000 for the prior year. The low interest rate environment resulted in significant mortgage refinancing activity. The Company decided to sell a portion of this loan volume in the secondary market based on our underwriting standards. The result of these sales was an increase in gain on sale of loans of $163,000 to $422,000 in 2003. The current low interest rate environment also provided the Company an opportunity to reduce its average cost of interest bearing liabilities by 0.59%. In addition, this rate environment allowed the Company to increase its average outstanding borrowings at very attractive rates and use the proceeds to fund increases in both average loans and investments.
During the year 2002, the Company continued the implementation of its growth initiatives with the purchase of three branches located in Laconia, Belmont and Pittsfield, New Hampshire. Also during 2002 the Company acquired and installed technology the cost of which was approximately $1,700,000 including a wide-area network, a voice over internet protocol telephone system, a new on-line teller system, document imaging and computer upgrades. The Company also made increases to staff during the year, most notably in the lending area. In addition, the sustained weakness of the equity market and the impact it had on certain holdings of the Company's equity securities resulted in net losses on sale of equity securities of $410,000 and write-downs of equity securities of $910,000. Costs associated with the expansion of the Company's branch network, new technology and personnel resulted in increased noninterest expense which, when added to the loss on sale of equity securities and the write-down of equity securities, caused a decline in 2002 earnings as compared to 2001.
NET INTEREST AND DIVIDEND INCOME ANALYSIS
Fluctuations in interest rates as well as changes in volume and mix of income earning assets and interest-bearing liabilities can materially impact net interest and dividend income, the principal source of our income. The discussion of net interest and dividend income is presented on a taxable equivalent basis, unless otherwise noted, to facilitate performance comparisons among various taxable and tax-exempt assets.
The table below under the caption "Consolidated Average Balances, Interest and Dividend Income/Expense and Average Yields/Rates," presents the average balances, income earned or interest paid, and average yields earned or rates paid on our assets and liabilities for the years ended December 31, 2003, 2002, and 2001.
Net interest and dividend income for 2003 increased $1,466,000, or 7%, over 2002. Interest and dividend income increased $85,000 in 2003 compared to 2002. This was due to an increase in average earning assets of $66,200,000 which increase was partially offset by a 0.74% decrease in the yield on average earning assets. Interest and dividend income on securities increased $423,000 as an increase in average securities of $17,360,000 was partially offset by a decrease in the average yield on securities of 0.56%. The increase in interest and dividend income on securities was partially offset by a decrease in interest income and fees on loans of $185,000 which decrease was primarily due to a decrease in the average yield of 0.82% and was partially offset by an increase in the average balance of $52,679,000. In addition, interest income on federal funds sold decreased $153,000 as the average balance decreased $3,818,000 and was accompanied by a decrease in the average yield of 0.65%.
Interest expense decreased $1,381,000, or 14%, in 2003 compared to 2002. The decrease in net interest expense was due primarily to a 0.59% decrease in the average rate paid on interest bearing liabilities partially offset by an increase in average interest bearing liability balances of $65,798,000. The decrease in the rate paid on interest bearing liabilities was a function of both the acquisition of long-term debt at attractive rates as well as a decision by management to lower rates on interest bearing deposits. The increase in the average liability balance is the result of increases in average FHLB advances of $16,570,000 as the Company took advantage of the current low rate environment to borrow $28,000,000 in medium-term advances at an average rate of 2.74%. Further, the average balance in junior subordinated debentures increased $8,971,000 as a result of the inclusion of this debt, which was issued during 2002, for the full 2003 fiscal year as compared to six months in fiscal 2002. . Average interest bearing deposits increased $40,527,000 due primarily to the fact that deposits acquired in October 2002 were recorded for the full 2003 fiscal year. Average securities sold under agreements to repurchase declined $270,000.
Net interest and dividend income for 2002 increased $802,000, or 4%, over 2001. While net interest and dividend increased, interest and dividend income decreased $3,653,000, or 10%, in 2002 compared to 2001. The continued decline in market interest rates during 2002 resulted in a 1.24% decrease in the yield on average earning assets. A 1.19% decrease in the yield on loans was partially offset by an increase in average loan balances of $13,829,000. This resulted in a net decrease of $3,736,000, or 12%, in interest and fees on loans. Federal funds sold income decreased $157,000 as a decrease in average yield of 1.67% was partially offset by a $5,175,000 increase in the average balance. The decrease in interest and fees on loans was partially offset by an increase in interest and dividend income on securities of $241,000, which was the result of an increase in average balances of $13,580,000 partially offset by a decrease in average yield of 0.86%.
Interest expense decreased $4,455,000, or 31%, in 2002 compared to 2001. The decrease in net interest expense was due primarily to a 1.33% decrease in rates paid on interest bearing liabilities partially offset by an increase in average balances of $30,832,000. The increase in average balances is the result of the issuance of junior subordinated debentures by the Company's Delaware statutory business trusts, Northway Capital Trust I and Northway Capital Trust II, with an average balance of $11,649,000 as well as an increase in average interest bearing deposit balances of $19,539,000 associated primarily with the branches acquired in the fourth quarter of 2002.
The trend in net interest and dividend income is commonly evaluated in terms of average rates using net interest margin and interest rate spread. The net interest margin is computed by dividing fully taxable equivalent net interest and dividend income by average total earning assets. This ratio represents the difference between the average yield returned on average earning assets and the average rate paid for all funds used to support those earning assets, including both interest bearing and noninterest bearing sources of funds. The net interest margin decreased 0.26% to 4.16% in 2003 after having decreased 0.14% to 4.42% in 2002. The decrease in the net interest margin for 2003 was a direct result of the decrease in the yield on earning assets, which decrease was only partially offset by the decrease in the cost of funds. The portion of interest earning assets funded by interest bearing liabilities increased to 87% in 2003 compared to 85% in 2002 and 84% in 2001.
The interest rate spread measures the difference between the average yield on earning assets and the average rate paid on interest bearing liabilities. The interest rate spread eliminates the impact of noninterest bearing funds and gives a direct perspective on the effect of interest rate fluctuations. During 2003, the net interest rate spread decreased 0.15% to 3.92% as the yield on earning assets declined 0.74% and was only partially offset by a decrease in the cost of interest bearing liabilities of 0.59%. During 2002, the net interest rate spread increased 0.09% to 4.07% as the cost of interest bearing liabilities decreased 1.33% while the yield on earning assets declined 1.24%.
See the tables below under the captions "Consolidated Average Balances, Interest and Dividend Income/Expense and Average Yields/Rates" and "Consolidated Rate/Volume Variance Analysis" for more information.
PROVISION FOR LOAN LOSSES
The provision for loan losses represents the annual cost of providing an allowance for losses inherent in the loan portfolio. The size of the provision for each year is determined by management based upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management's assessment of loan portfolio quality, the value of collateral and general economic factors.
The provision for loan losses was $805,000 in 2003, a decrease of $95,000 from the provision recorded in 2002. The 2002 provision of $900,000 was unchanged from 2001. The provision for each of the three years was based upon a review of the adequacy of the allowance for loan losses, which review is conducted on a quarterly basis. This review is based upon many factors including the risk characteristics of the portfolio, trends in loan delinquencies, and an assessment of existing economic conditions. In addition, various regulatory agencies, as part of their examination process, review the banks' allowances for loan losses and such review may result in changes to the allowance based on judgments different from those of management.
The decrease in the provision was due in part to the recording of $70,000 to other expense for a provision for losses related to unfunded loan commitments such as unused lines of credit and unused portions of home-equity loans. This provision had previously been calculated as part of the allowance for loan losses.
Although management utilizes its best judgment in providing for losses, there can be no assurance that the Company will not have to change its provision for loan losses in subsequent periods. Management will continue to monitor the allowance for loan losses and modify the provision to the allowance for loan losses as appropriate. For additional information regarding estimates in the assessment of the allowance for loan losses see "Application of Critical Accounting Policies" below.
NONINTEREST INCOME
Noninterest income consists of revenues generated from a broad range of financial services and activities, including fee-based services and income earned through securities sales.
The following table sets forth the components of the Company's noninterest income:
($000 Omitted) Years Ended December 31, --------------------------- 2003 2002 2001 ---- ---- ---- Service charges and fees on deposit accounts $1,673 $1,473 $1,169 Gain on sales of securities available-for-sale, net 1,522 151 128 Gain on sales of loans, net 422 259 438 Other 1,758 1,513 1,174 ------ ------ ------ Total noninterest income $5,375 $3,396 $2,909 ====== ====== ======
Fee income from service charges and fees on deposit accounts increased 14% in 2003, 26% in 2002 and 11% in 2001. The improvement in 2003 is due principally to increases in overdraft fee income and service charge income resulting from the full year impact of the branch acquisitions completed in October 2002. The improvement in 2002 is due principally to the introduction of new overdrawn account procedures and fee schedules introduced in January 2002 as well as the impact of the branch purchases during the fourth quarter 2002. The improvements in 2001 were due to an increased number of deposit accounts as a result of the Littleton branch purchase in October 2001.
Net gains on sales of securities were $1,522,000 in 2003 compared to $151,000 in 2002 and $128,000 in 2001. Securities gains in 2003 were the result of improved market conditions for investment securities. Securities gains, net, in 2003 included $175,000 of net losses on sales of equity securities compared to net losses of $410,000 in 2002 and net gains of $55,000 in 2001. Net gains on the sales of debt securities totaled $1,669,000 in 2003 compared to $561,000 in 2002 and $73,000 in 2001.
The low interest rate environment resulted in significant mortgage refinancing activity. The Company decided to sell a portion of this loan volume in the secondary market based on our underwriting standards. The result of these sales was an increase in gain on sale of loans of $163,000 to $422,000 in 2003. During 2002 and 2001, the Company recorded a gain on sale of loans of $259,000 and $438,000, respectively. The gain on sale of loans in 2002 resulted from the sale of mortgage loans to the secondary market. 2001 gains reflect loans sold to the secondary market as well as a realized gain of approximately $148,000 from the sale of a pool of nonperforming loans.
Other noninterest income (sources of which include debit card interchange fees, credit card merchant and fee income, automated teller machine fees, loan fees and safe deposit fees) increased $245,000, or 16%, to $1,758,000 in 2003 following an increase of $339,000, or 29%, to $1,513,000 in 2002 from $1,174,000 in 2001. The increase in 2003 was due primarily to the recognition of approximately $191,000 in other loan fees resulting from transactions with Federal Home Loan Mortgage Corporation ("FHLMC"). The increase in 2002 compared to 2001 was the result of increases in several categories including official check fees, debit card interchange fees, the sale of bank owned real estate, and the introduction of a loan extension skip-a-payment program for indirect installment loans.
NONINTEREST EXPENSE
Total noninterest expense increased $2,101,000, or 10%, during 2003 following an increase of $2,886,000, or 17%, during 2002 and an increase of $450,000, or 3%, during 2001. The increase in expenses during 2003 is due in large part to the full year impact of the October 2002 branch purchases, which contributed to the overall in increase in salaries and benefits expense, office occupancy and equipment expense and increased expenses associated with the amortization of core deposit intangibles. The increase to expenses during 2002 is due in large part to the $910,000 write-down of equity securities, expenses related to the acquisition of three branches during the fourth quarter, staff additions and technology initiatives. During 2001 expenses increased due to the Company's initiatives to standardize product offerings at the subsidiary banks, to increase market share in existing markets and entry into new markets. In 2001 the Company acquired a branch in Littleton, New Hampshire and completed construction of a new branch location in Tilton, New Hampshire.
The following table sets forth information relating to the Company's noninterest expense during the periods indicated:
($000 Omitted) Years Ended December 31, -------------------------------- 2003 2002 2001 ------- -------- ------ Salaries and employee benefits $11,426 $ 9,758 $9,014 Office occupancy and equipment 3,753 3,298 2,864 Amortization of unidentifiable intangible assets - - 625 Amortization of core deposit intangible 954 476 - Write-down of equity securities available-for-sale 184 910 - Professional fees 1,166 1,096 886 Stationery and supplies 556 596 486 Telephone 571 505 283 Postage and shipping 378 378 323 ATM expense 442 366 352 Other 2,706 2,652 2,316 ------- ------- ------- Total noninterest expense $22,136 $20,035 $17,149 ======= ======= =======
Salaries and employee benefits increased $1,668,000, or 17%, from 2002 to 2003 and $744,000, or 8%, from 2001 to 2002. These increases reflect staff additions in connection with the expansion of the retail franchise, increased lending activities and normal salary and wage increases. Also, during 2003, the Company recorded a liability to deferred compensation related to a Supplemental Employee Retirement Plan ("SERP"). Refer to Note 15 to the Consolidated Financial Statements for a further discussion regarding the SERP.
Office occupancy and equipment expense increased $455,000, or 14%, from 2002 to 2003 and $434,000, or 15%, from 2001 to 2002. These increases were due to increases in depreciation expense associated with technology purchases made in 2002 as well as the expansion of the retail franchise.
The amortization of core deposit intangibles, net, increased $478,000 from 2002 to 2003 due to the full year impact of the October 2002 branch purchases. Amortization of unidentifiable intangible assets and amortization of core deposit intangible, net, decreased $149,000 from 2001 to 2002. On October 1, 2002, the Company adopted SFAS 147 which resulted in a decrease of amortization expense of $281,000 over the prior year which was partially offset by the recording of $132,000 of amortization of core deposit intangible associated with the fourth quarter branch acquisitions.
These increases were offset, in part, by a decrease in the write-down on equity securities of $726,000. During 2003, the Company recorded a write-down of equity securities of $184,000 compared to $910,000 for the prior year. During 2003, five securities were determined to be other than temporarily impaired due to sustained weakness in their sector as well as weaknesses related to the individual companies. During 2002, the sustained overall weakness in the equity market as well as significant declines in certain sectors and specific companies within those sectors, resulted in the Company determining that the market values of certain of its marketable equity securities were other than temporarily impaired. As a result, during 2002 the Company recorded a write-down of equity securities of $910,000.
INCOME TAX EXPENSE
The Company recognized $1,867,000, $1,507,000 and $1,708,000 in income tax expense for the years ended December 31, 2003, 2002 and 2001, respectively. The effective tax rate was 34.1% for 2003, 36.7% for 2002 and 30.6% for 2001. The increase in the effective tax rate in 2002 compared to 2001 is due to the fact that, during 2001, the Company had obtained a number of state tax credits in New Hampshire related to economic development grants. In addition, the 2001 tax rate as compared to 2000 was reduced by the increased level of municipal income. This was partially offset by a 50 basis point increase, or 0.50%, in the State of New Hampshire Business Profits Tax. For additional information relating to income taxes, see Note 14 to the Consolidated Financial Statements.
ASSETS
Total assets increased $10,271,000, or 2%, to $609,216,000 at December 31, 2003 compared to $598,945,000 at December 31, 2002. The following is a summary of significant balance sheet changes.
($000 Omitted) Years Ended December 31, -------------------------------------- 2003 2002 Change % Change ---- ---- ------ -------- Total assets $609,216 $598,945 $ 10,271 1.7% Earning assets 562,311 548,980 13,331 2.4 Federal funds sold 16,470 10,170 6,300 61.9 Securities available-for-sale, at fair value* 78,786 96,109 (17,323) (18.0) Loans, net of unearned income 467,985 442,152 25,833 5.8 Deposits 463,307 476,194 (12,887) (2.7) Borrowings 95,021 74,871 20,150 26.9 Stockholders' equity 47,872 44,266 3,606 8.1
* Includes Federal Home Loan Bank stock and Federal Reserve Bank stock.
The increase in earning assets of $13,331,000 was due primarily to an increase in gross loans partially offset by a decrease in securities available-for-sale. The increase in earning assets was funded by an increase in borrowings, specifically FHLB medium-term advances which were acquired at attractive rates in the current low interest rate environment. This increase in borrowings was partially offset by a decrease in deposits, primarily time accounts.
SECURITIES AVAILABLE-FOR-SALE
The Company's securities are classified into one of two categories based on management's intent to hold the securities: (i) "held-to-maturity" securities, or (ii) securities "available-for-sale." Securities designated to be held-to-maturity are reported at amortized cost. Securities classified as available-for-sale are required to be reported at fair value with unrealized gains and losses, net of taxes, excluded from earnings and shown separately as a component of stockholders' equity. At December 31, 2003 and 2002 the Company had no securities designated as held-to-maturity.
The following table summarizes the Company's securities portfolio at December 31, 2003 and 2002, showing amortized cost and fair value for each category:
($000 Omitted) December 31, --------------------------------------- 2003 2002 ------------------ ---------------- Amortized Fair Amortized Fair Cost Value Cost Value Securities available-for-sale: US Treasury and US government agencies $37,945 $37,840 $36,167 $36,188 Mortgage-backed securities 2,803 2,888 7,286 7,476 Collateralized mortgage obligations 15 15 5,103 5,170 Marketable equity securities 2,589 2,766 3,163 2,377 Corporate bonds 20,857 21,983 33,407 33,848 State and political subdivisions 8,066 8,224 6,154 6,338 ------- ------- ------- ------- Total securities available-for-sale $72,275 $73,716 $91,280 $91,397 ======= ======= ======= =======
Total securities decreased $17,861,000 during 2003 to $73,716,000. One of the primary functions of the investment portfolio is to provide liquidity to the Company. During 2003, the Company had the ability to increase outstanding loans, which are a higher yielding asset. As a result of the low interest rate environment during 2003, the Company sold several corporate bonds at attractive gains and reinvested these proceeds into the loan portfolio.
The net unrealized gain on securities available-for-sale was $1,441,000 at December 31, 2003 compared to $117,000 at December 31, 2002. At December 31, 2003, the net unrealized gain on debt securities was $1,264,000 and the net unrealized gain on marketable equity securities was $177,000. At December 31, 2002, the net unrealized gain on debt securities totaled $903,000, which was partially offset by a net unrealized loss on marketable equity securities of $786,000. The net unrealized gain on debt securities for both years is primarily the result of the low rate environment during 2003 and 2002, which resulted in an appreciation in value of existing debt holdings. The net unrealized loss on marketable equity securities for 2002 is primarily the result of the weak equity market.
Due to the decline in the performance of securities in certain sectors and specific companies within those sectors, the Company determined, through the evaluations described in Note 1 to the Consolidated Financial Statements, that the market values of certain of its marketable equity securities were other than temporarily impaired. As a result, during 2003 net losses on sales of marketable equity securities amounted to $147,000 and write-downs of marketable equity securities amounted to $184,000. During 2002 net losses on sales of marketable equity securities amounted to $410,000 and write-downs of marketable equity securities amounted to $910,000.
At December 31, 2003, the Company's investment in equity securities totaled $2,766,000. This amount is net of a market value adjustment of $177,000, of which the full amount was reflected in accumulated other comprehensive loss in stockholders' equity.
The Company has a general policy of purchasing investment grade securities and U.S. government securities to minimize credit risk. All securities, however, carry interest rate risk, which affect their market values such that as market yields increase, the value of the Company's securities decline and vice versa. Additionally, mortgage-backed securities carry prepayment risk whereby expected yields may not be achieved due to the inability to reinvest proceeds from prepayment at comparable yields. Moreover, such mortgage-backed securities may not benefit from price appreciation in periods of declining rates to the same extent as the remainder of the portfolio.
A portion of the securities portfolio is pledged to secure public deposits, short-term securities sold under agreements to repurchase and treasury, tax and loan accounts. Refer to Note 3 to the Consolidated Financial Statements for a further discussion of pledging of securities.
LOANS
Loans increased 6% in 2003 with the most significant increases occurring in residential real estate, commercial real estate and indirect installment loans. At December 31, 2002 loans increased 10% over the prior year as all categories of loans, with the exception of other loans, recognized increases, with the greatest increases occurring in residential real estate, installment loans and indirect installment loans. The following table presents the composition of the loan portfolio as of December 31, 2003 and 2002:
($000 Omitted) Percent Percent 2003 of Total 2002 of Total -------- -------- -------- -------- Real estate: Residential $129,493 27.7% $114,526 25.9% Commercial 120,366 25.7 111,941 25.3 Construction 3,851 0.8 6,330 1.4 Commercial 24,528 5.2 23,885 5.4 Installment 30,291 6.5 40,169 9.1 Indirect installment 150,807 32.2 139,477 31.5 Other 8,896 1.9 6,031 1.4 -------- ----- -------- ----- $468,232 100.0% $442,359 100.0% ======== ===== ======== =====
The loan portfolio mix shifted slightly during the year. Indirect installment loans, which are fixed-rate loans secured by automobiles originated through automobile dealers with an average term of 60 months, comprised 32.2% of the loan portfolio at December 31, 2003 as compared to 31.5% at the end of 2002. Residential real estate loans increased to account for 27.7% of the portfolio from 25.9% at December 31, 2002 due in part to the decision to retain high credit quality fixed rate mortgages in the portfolio rather than sell in the secondary market. Installment loans, which include consumer loans, fixed rate equity loans, and home equity lines of credit, comprised 6.5% of the portfolio at December 31, 2003 compared to 9.1% a year ago due primarily to a decrease in home equity lines of credit. The Company strives to maintain a balanced portfolio consisting of approximately 30% residential real estate loans, 33-35% commercial loans, and 35-37% installment and other loans.
Commercial real estate loans consist of loans secured by income producing commercial real estate and commercial loans consist of loans that are either unsecured or are secured by inventories, receivables or other corporate assets, and many are additionally secured by a guarantee of the federal Small Business Administration. Commercial real estate and commercial loans increased by $9,068,000 in 2003 as compared to 2002. The Company continues to emphasize commercial real estate and commercial loans in order to enhance earnings and maintain the balance of its portfolio.
Residential real estate loans increased by $14,967,000 in 2003, a 13% increase from 2002, compared to an increase of $5,265,000, or 5%, in 2002 compared to 2001. The Company originates both fixed-rate and adjustable-rate residential loans for its portfolio. Some fixed-rate residential loans are originated for sale to investors in the secondary market. The increase in residential real estate loans in 2003 resulted primarily from the Company's decision to retain a greater percentage of fixed-rate residential mortgage loans.
Installment loans consist primarily of loans originated directly by the Company, however, as part of the Laconia, Belmont and Pittsfield branch acquisitions, the Company purchased installment loans totaling approximately $18,102,000 during 2002. During 2003, installment loan balances decreased $9,878,000 compared to 2002. Indirect installment loans increased by $13,330,000, or 8%, in 2003.
NONPERFORMING ASSETS
Nonperforming assets were $4,180,000, or 0.69% of total assets, at December 31, 2003 compared to $3,892,000, or 0.65% of total assets, at December 31, 2002, an increase of $288,000, or 7%. Nonperforming assets are comprised primarily of nonaccrual loans, other chattels owned and real estate acquired by foreclosure or a similar conveyance of title. The accrual of interest on a loan is discontinued when there is reasonable doubt as to its collectibility or whenever the payment of principal or interest is more than 90 days past due. However, there are loans within this nonaccrual classification that provide periodic payments, but which have a weakness with respect to the collateral securing the loan.
At December 31, 2003, nonaccrual loans totaled $4,089,000, or 0.87% of total loans, compared to $3,619,000, or 0.82% of total loans, in 2002. There was no other real estate owned at December 31, 2003 compared to $175,000 of other real estate owned at December 31, 2002. Other chattels owned decreased $7,000 to $91,000 at December 31, 2003 compared to $98,000 at December 31, 2002.
ALLOWANCE FOR LOAN LOSSES
The Company maintains an allowance for loan losses to absorb losses inherent in the existing loan portfolio. When a loan, or portion thereof, is considered uncollectible, it is charged against the allowance. Recoveries of amounts previously charged-off are added to the allowance when collected. The adequacy of the allowance for loan losses is evaluated on a regular basis by management. Factors considered in evaluating the adequacy of the allowance include previous loss experience, current economic conditions and their effect on borrowers and the market area in general, and the performance of individual credits in relation to the contract terms. In addition various federal and state regulatory agencies, as an integral part of their examination process, periodically review the adequacy of the Company's allowance for loan losses. For additional information regarding estimates in the assessment of the allowance for loan losses see "Application of Critical Accounting Policies-Allowance for Loan Losses" below.
The Company's allowance for loan losses increased $116,000 from December 31, 2002 to $5,036,000, or 1.08% of total loans, at December 31, 2003.
The following table sets forth the composition of the allowance for loan losses for the periods indicated:
($000 Omitted) Years Ended December 31, 2003 2002 2001 ------ ------ ------ Beginning allowance $4,920 $4,642 $4,354 Provision for loan losses 805 900 900 Loans charged-off (870) (824) (734) Recoveries of loans previously charged-off 181 202 122 ------ ------ ------ Net charge-offs (689) (622) (612) ------ ------ ------ Ending allowance $5,036 $4,920 $4,642 ====== ====== ======= Allowance as a percentage of loans outstanding 1.08% 1.11% 1.16% Allowance as a percentage of nonperforming loans 123.2 135.95 333.48 Net charge-offs as a percentage of average loans 0.15 0.15 0.15
DEPOSITS
Total deposits at December 31, 2003 were $463,307,000, a decrease of $12,887,000, or 3%, compared to $476,194,000 at December 31, 2002. The decrease in deposits was due primarily to a decrease in time deposits partially offset by an increase in regular savings, NOW and money market accounts.
The following table sets forth the components of deposits for the periods indicated:
($000 Omitted) December 31, 2003 2002 --------- --------- Demand $ 69,599 $ 71,759 Regular savings, NOW and money market 244,766 232,892 Time 148,942 171,543 -------- -------- Total deposits $463,307 $476,194 ======== ========
At December 31, 2003, time deposits of $100,000 or more are scheduled to mature as follows:
($000 Omitted) 3 months or less $ 6,069 Over 3 to 6 months 4,771 Over 6 to 12 months 7,354 Over 12 months 4,514 ------- $22,708
BORROWINGS
At December 31, 2003 short-term borrowings consisted of securities sold under agreements to repurchase of $7,401,000 compared to $8,251,000 for 2002.
Long-term debt in 2003 consists of FHLB term advances of $67,000,000 as well as $20,620,000 of junior subordinated debentures, compared to $46,000,000 of FHLB term advances and $20,620,000 of junior subordinated debentures in 2002. Many of the long-term term FHLB advances are callable quarterly with call dates in January, February and March 2004. The increase in FHLB advances is the result of twelve new advances, totaling $28,000,000, during the year ranging in term from two years to seven years with an average interest rate of 2.74% which was partially offset by the maturity of $7,000,000 in advances.
Junior subordinated debentures consist of two issues of floating rate trust preferred securities acquired during April and July 2002 in the amount of $7,217,000 and $13,403,000, respectively, due in 2032. These trust preferred securities were offered for the purpose of providing capital to the subsidiary banks to ensure adequate capital following the recent branch acquisitions and for general corporate purposes. As of December 31, 2003, of the $20,620,000 principal amount outstanding, $10,858,000 qualified as Tier 1 capital and $9,142,000 was allocated to Tier 2 capital.
See Notes 9 and 10 to the Consolidated Financial Statements for additional information regarding our borrowings.
The following table sets forth certain information concerning the Company's borrowings at the dates indicated:
($000 Omitted) December 31, 2003 2002 ------- ------- Short-term borrowings $ 7,401 $ 8,251 Long-term debt 87,620 66,620 ------- ------- $95,021 $74,871 ======= =======
At December 31, 2003, long-term debt is scheduled to mature as follows:
($000 Omitted) Less than one year $ 9,000 One to three years 19,000 Three to five years 11,000 Over five years 48,620 ------- $87,620 =======
OFF-BALANCE SHEET ARRANGEMENTS
The Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to originate loans and standby letters of credit. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for loan commitments and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for balance sheet instruments.
Financial instruments with off-balance sheet credit risk at December 31, 2003 and 2002 totaled $45,276,000 and $58,229,000, respectively.
See Note 16 to the Consolidated Financial Statements for additional information regarding off-balance sheet arrangements.
CAPITAL
The Company's stockholders' equity serves to support growth and provide depositors and other creditors protection against loss. Equity capital represents the stockholders' investment in the Company. Management strives to maintain an optimal level of capital on which an attractive return to the stockholders will be realized over both the short-term and long-term, while serving depositors' and creditors' needs.
The Company must also observe the minimum requirements enforced by the federal banking regulators. There are three capital requirements that banks and bank holding companies must meet: Tier 1 capital, total capital (combination of Tier 1 capital and Tier 2 capital), and leverage (Tier 1 capital to average assets) ratios. Tier 1 capital consists of stockholders' equity, net of intangible assets as well as a portion of junior subordinated debentures. Tier 2 capital consists of a limited amount of allowance for loan losses and the portion of junior subordinated debentures not allocated to Tier 1 capital. Tier 1 capital, total capital and leverage ratios do not include any adjustments for unrealized gains and losses relating to securities available-for-sale except net unrealized losses relating to marketable equity securities. The minimum requirements for the leverage ratio, risk-based Tier 1 capital and risk-based total capital are 4%, 4% and 8%, respectively. As of December 31, 2003 and 2002, Banks were "well capitalized" as defined under FDIC regulations.
The following table sets forth the Company's risk-based capital and leverage ratios:
($000 Omitted) December 31, 2003 2002 -------- -------- Risk-adjusted assets $453,272 $445,281 Tier 1 capital (to average assets) 7.22% 6.70% Tier 1 capital (to risk weighted assets) 9.66 8.57 Total capital (to risk weighted assets) 12.81 12.04
Total stockholders' equity includes a $149,000 adjustment for accumulated other comprehensive income, net of tax, at December 31, 2003 and a $1,366,000 negative adjustment for accumulated other comprehensive loss, net of tax, at December 31, 2002. At December 31, 2003, this adjustment was comprised of a net unrealized gain on securities available-for-sale of $870,000, net of taxes, and an unfunded pension accumulated benefit obligation of $721,000, net of taxes. The net unrealized gain on securities available-for-sale is attributable primarily to the low interest rate environment which results in appreciation of securities held at higher than market rates. While the Company continues to contribute the maximum amount permitted by law to its pension plan, the discount rate used to calculate the future value of such contribution and the poor asset performance of investment securities has resulted in the unfunded pension accumulated benefit obligation. For additional information regarding estimates see "Application of Critical Accounting Policies" below.
The Company intends to continue to pay dividends on a quarterly basis subject to the financial condition and earnings of the Company, capital requirements, and other factors, including applicable governmental regulations. No dividends will be payable unless declared by the Board of Directors and then only to the extent funds are legally available for the payment of such dividends.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
The Company's accounting policies are more fully described in Note 1 of the Consolidated Financial Statements. As disclosed in Note 1, the preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. The Company believes that the following discussion addresses the Company's most critical accounting policies, which are those that are most important to the portrayal of the Company's financial condition and results of operations and require management's most difficult, subjective and complex judgments.
Allowance for Loan Losses. Allowance for loan losses are estimated at the individual Banks based on estimates of losses related to customer loan balances. In establishing the appropriate provisions for customer loan balances, the Company makes assumptions with respect to their future collectibility. The Company's assumptions are based on an individual assessment of the customer's credit quality as well as subjective factors and trends, including the credit rating of the loans. Generally, these individual credit assessments occur prior to the inception of the credit exposure and at regular reviews during the life of the exposure and consider (a) the customer's ability to meet and sustain their financial commitments; (b) a customer's current and projected financial condition; (c) the positive or negative effects of the current and projected industry outlook; and (d) the economy in general. Once the Company considers all of these factors, a determination is made as to the probability of default. An appropriate provision is made, which takes into account the severity of the likely loss on the outstanding loan balances based on the Company's experience in collecting these amounts. The Company's level of allowance for loan losses fluctuates depending upon all of the factors mentioned above.
Goodwill and Core Deposit Intangible. Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142 ("SFAS No. 142"), "Goodwill and Other Intangible Assets." Under SFAS No. 142, the Company is required to perform annual impairment tests of its goodwill and intangible assets and more frequently in certain circumstances. The Company has elected to test for goodwill and intangible asset impairment in the fourth quarter of each year. In that goodwill is carried on the books of the Banks and Northway Financial, Inc. owns 100% of their outstanding stock, there is no market value for their common stock. The Company utilizes a multiple of earnings approach in analyzing the valuation of goodwill. Core deposit intangibles are carried on the books of the Banks as well. The valuation of core deposit intangibles incorporate deposits acquired compared with current deposit levels, considers deposit outflow assumptions made at acquisition as well as other factors.
The most recent impairment test of goodwill and core deposit intangible assets indicated that no adjustment was required. The Company cannot predict the occurrence of certain future events that might adversely affect the reported value of goodwill and core deposit intangible that totaled $10,152,000 and $3,903,000, respectively, at December 31 2003. Such events include, but are not limited to, strategic decisions made in response to economic and competitive conditions, the impact of the economic environment on the Company's customer base, or the impact of changes in federal and state laws and regulations.
Pension Benefits. The Company maintains a trusteed non-contributory pension plan (the "Plan") covering substantially all full-time employees. Several statistical and other factors, which attempt to anticipate future events, are used in calculating the expense and liability related to the Plan. Key factors include assumptions about the expected rates of return on plan assets and discount rates. The Company considers market conditions, including changes in investment returns and interest rates, in making these assumptions.
The Company determines the expected long-term rate of return on plan assets based on the building block method, which consists of aggregating the expected rates of return for each component of the plan's asset mix. Plan assets are comprised primarily of mutual funds including bond funds, US equity funds, international equity funds, real estate funds and short-term money market funds. The Company uses historic plan asset returns combined with current market conditions to estimate the rate of return. The expected rate of return on plan assets is a long-term assumption and generally does not change annually. The discount rate reflects the market rate for high-quality fixed income debt instruments on the Company's annual measurement date (December 31) and is subject to change each year.
Unrecognized actuarial gains and losses are being recognized over approximately a 17-year period, which represents the expected remaining service life of the employee group. Unrecognized actuarial gains and losses arise from several factors including experience and assumption changes in the obligations and from the difference between expected returns and actual returns on plan assets. These unrecognized losses will be systematically recognized as an increase in future net periodic pension expense in accordance with FAS 87, "Employers' Accounting for Pensions."
The actuarial assumptions used by the Company in determining its pension benefits may differ materially from actual results due to changing market and economic conditions, higher or lower withdrawal rates or longer or shorter life spans of the participants. While the Company believes that the assumptions used are appropriate, differences in actual experience or changes in assumptions may materially affect the Company's financial position or results of operations.
Mortgage Servicing Rights (MSR or MSRs). Servicing assets are recognized as separate assets when rights are acquired through purchase or through sale of financial assets. Capitalized servicing rights are reported in other assets and are amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights by predominant characteristics, such as interest rates and original loan terms (primarily 15 and 30 year.) Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market-based assumptions. In periods of falling market interest rates, accelerated loan prepayment speeds can adversely impact the fair value of these mortgage-servicing rights relative to their book value. In the event that the fair value of these assets were to increase in the future, the Company can recognize the increased fair value to the extent of the impairment allowance but cannot recognize an asset in excess of its amortized book value. When the book value of an individual stratum exceeds its fair value, an impairment reserve must be recognized. Future changes in management's assessment of the impairment of these servicing assets, as a result of changes in observable market data relating to market interest rates, loan prepayment speeds, and other factors, could impact the Company's financial condition and results of operations either positively or adversely.
MARKET RISK
Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates and prices, such as interest rates, foreign currency exchange rates, commodity prices and equity prices. The Company's primary market risk exposure is interest rate risk. The ongoing monitoring and management of this risk is an important component of the Company's asset/liability management process which is governed by policies established by the Company's Boards of Directors that are reviewed and approved annually. The Board of Directors delegates responsibility for carrying out the asset/liability management policies to the Company's Asset Liability Committee ("ALCO"). In this capacity ALCO develops guidelines and strategies impacting the Company's asset/liability management-related activities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels/trends.
Interest Rate Risk
Interest rate risk represents the sensitivity of earnings to changes in market interest rates. As interest rates change, the interest income and interest expenses associated with the Company's financial instruments also change, thereby impacting net interest income ("NII"), the primary component of the Company's earnings. ALCO utilizes the results of a detailed and dynamic simulation model to quantify the estimated exposure of NII to sustained interest rate changes. While ALCO routinely monitors simulated NII sensitivity over a rolling 2-year horizon, it also utilizes additional tools to monitor potential longer-term interest rate risk.
The simulation model captures the impact of changing interest rates on the interest income received and interest expense paid on all interest-earning assets and interest-bearing liabilities reflected on the Company's balance sheet. The Company uses computer simulations to determine the impact on net interest income of various interest rate scenarios, balance sheet trends and strategies. These simulations incorporate assumptions about balance sheet dynamics such as loan and deposit growth, loan and deposit pricing, changes in funding mix, and asset and liability repricing and maturity characteristics. Simulations based on numerous assumptions are run under various interest rate scenarios to determine the impact on net interest income and capital. From these scenarios, interest rate risk is quantified and appropriate strategies are developed and implemented.
This sensitivity analysis is compared to ALCO policy limits which specify a maximum tolerance level for NII exposure over a 1-year horizon given both an immediate 300 basis point, or 3%, upward and downward shift in interest rates. Given the current level of interest rates, the Company has modeled an upward shift in rates of 300 basis points and a downward shift in rates of 100 basis points. Using an immediate rate shock simulation where interest rates increase 300 basis points, the December 31, 2003 earnings simulation model projects that net interest income for the twelve months ending December 31, 2004 would increase by an amount equal to approximately 1.25%. In addition, utilizing an immediate rate shock simulation where interest rates decrease 100 basis points, the December 31, 2003 earnings simulation model projects that net interest income for the twelve months ending December 31, 2004 would decrease by an amount equal to approximately 2.19%.
Using an immediate rate shock simulation where interest rates increase 300 basis points, the December 31, 2003 earnings simulation model projected that net interest income for the twelve months ending December 31, 2005 would increase by an amount equal to approximately 7.30%. In addition, utilizing an immediate rate shock simulation where interest rates decrease 100 basis points, the December 31, 2003 earnings simulation model projected that net interest income for the twelve months ending December 31, 2005 would decrease by an amount equal to approximately 7.15%. The projected results are within Company policy limits for both years.
The preceding sensitivity analysis does not represent a Company forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions including, among others, the nature and timing of interest rate levels, yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, and reinvestment/replacement of asset and liability cashflows. The assumptions differed in each of the periods included in the sensitivity analysis above. While assumptions are developed based upon current economic and local market conditions, the Company cannot make any assurances as to the predictive nature of these assumptions, including how customer preferences or competitor influences might change.
The most significant factors affecting the changes in market risk exposure during 2003 compared to 2002 were the continuation of the low interest rate environment, changes in the yield curve for investment securities, the increase in the aggregate principal amount in fixed-rate loans extended by the Banks, the aggregate decrease in securities available-for-sale, the decrease in total deposits, as well as the increase in long-term debt.
LIQUIDITY RISK
Liquidity risk management involves the Company's ability to raise funds in order to meet its existing and anticipated financial obligations. These obligations are the withdrawal of deposits on demand or at contractual maturity, the repayment of debt as it matures, the ability to fund new and existing loan commitments and the ability to take advantage of new business opportunities. Liquidity may be provided through amortization, maturity or sale of assets such as loans and securities available-for-sale, liability sources such as increased deposits, utilization of the FHLB credit facility, purchased or other borrowed funds, and access to the capital markets. Liquidity targets are subject to change based on economic and market conditions and are controlled and monitored by the ALCO. At the bank level, liquidity is managed by measuring the net amount of marketable assets after deducting pledged assets, plus lines of credit, primarily with the FHLB, which are available to fund liquidity requirements. Management then measures the adequacy of that aggregate amount relative to the aggregate amount of liabilities deemed to be sensitive or volatile. These include brokered deposits, deposits in excess of $100,000, term deposits with short maturities, and credit commitments outstanding.
Additionally, the parent holding company requires cash for various operating needs including dividends to stockholders, the purchase of treasury stock, capital injections to the subsidiary banks, and the payment of general corporate expenses. The primary sources of liquidity for the parent holding company are dividends from the subsidiary banks and reimbursement for services performed on behalf of the banks. Additionally, the parent holding company may utilize outside sources of funding such as the issuance of the trust preferred securities during 2002.
Cash and cash equivalents increased by $3,659,000 during 2003. Cash used for investing activities totaled $8,664,000 with lending activities utilizing $27,538,000 and investment purchases providing $19,577,000. Cash provided by financing activities totaled $5,737,000. This cash consisted of $28,000,000 from advances from the FHLB partially offset by the repayment of maturing FHLB advances in the amount of $7,000,000 as well as a decrease in deposits of $12,887,000. The net cash provided by operating activities totaled $6,586,000 and consisted primarily of net income of $3,617,000, a decrease in loans held for-sale and a decrease in other assets and other liabilities, net.
CAPITAL EXPENDITURES AND COMMITMENTS
During 2003, the Company incurred approximately $1,806,000 in capital expenditures. The expenditures included approximately $846,000 for the purchase and improvement of a commercial lending and administration facility in North Conway, New Hampshire. Approximately $307,000 was expended for the reengineering of the operations department of the Berlin main office facility, which included both construction and furniture costs. The remaining expenditures were for normal replacement of, or upgrades in, existing property and equipment.
During 2002, the Company incurred approximately $2,628,000 in capital expenditures. These expenditures included approximately $1,700,000 in technology improvements including installation of a wide-area network, a voice over internet protocol telephone system, a new on-line teller system, document imaging and computer upgrades. In addition, $430,000 was recorded for the purchase of real estate in Laconia, New Hampshire as part of the branch acquisition. The remaining expenditures were for normal replacement of, or upgrades in, existing property and equipment.
The Company's estimated capital expenditures for 2004 total $2,067,000. The Company has budgeted approximately $1,150,000 to complete improvements and provide equipment and furniture for the commercial lending and administration facility in North Conway, $276,000 for ATM software and $153,000 for the replacement of the mainframe computer. The remaining expenditures will be incurred for normal replacement of, or upgrades to, existing property and equipment. These expenditures are expected to be funded through normal Company cash flows.
CONTRACTUAL OBLIGATIONS
The table below contains information on the Company's contractual obligations as of the fiscal year ended December 31, 2003:
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Information regarding quantitative and qualitative disclosures about market risk is included in "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing under Item 7 of this report and is hereby incorporated by reference in this Item 7A.
See Notes to Consolidated Financial Statements
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
NATURE OF OPERATIONS
The Company is a bank holding company formed in 1997 under the laws of New Hampshire and is registered under the Bank Holding Company Act of 1956. The Company's only business activity has been to own all of the shares of, and provide management, capital and operational support to, The Berlin City Bank ("BCB") and The Pemigewasset National Bank of Plymouth, New Hampshire ("PNB") and its Delaware statutory business trusts Northway Capital Trust I and Northway Capital Trust II. The Company's headquarters are in Berlin, New Hampshire. The banking subsidiaries are engaged principally in the business of attracting deposits from the general public and investing those deposits in securities, commercial loans, real estate loans, and consumer loans.
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in the consolidation.
The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry.
In preparing the financial statements, management is required to make estimates and judgments that affect the reported amounts of assets and liabilities as of the dates of the statements of financial condition, and income and expense for the periods. Actual results could differ from those estimates. Material estimates that are particularly susceptible to change in the near-term relate to the determination of the allowance for loan losses.
RECLASSIFICATIONS
Certain amounts in the prior years' financial statements have been reclassified to conform with the current year's presentation.
CASH AND CASH EQUIVALENTS
For purposes of the statement of cash flows, cash and cash equivalents include cash and due from banks, federal funds sold and interest bearing deposits.
SECURITIES
Debt securities that the Company has the positive intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost; if debt and equity securities are bought and held principally for the purpose of selling in the near term they would be classified as trading and reported at fair value, with unrealized gains and losses included in earnings; and debt and equity securities not classified as either held-to-maturity or trading are classified as available-for-sale and reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity, net of estimated income taxes. At this time, the Company has not established a trading account.
Premiums and discounts are amortized and accreted primarily on the level yield method over the contractual life of the securities adjusted for expected prepayments.
If a decline in the fair value below the adjusted cost basis of an investment is judged to be other than temporary, the cost basis of the investment is written down to fair value as the new cost basis and the amount of the write-down is included in noninterest expense.
Gains and losses on sales of securities available-for-sale are recognized at the time of the sale on a specific identification basis.
LOANS HELD-FOR-SALE
Loans held-for-sale are generally identified as such at origination and are stated at the lower of aggregate cost or market. Market value is based on outstanding investor commitments. When loans are sold, a gain or loss is recognized to the extent that the sale proceeds exceed or are less than the carrying value of the loans. Gains and losses are determined using the specific identification method. All loans sold are without recourse to the Company.
LOANS
Loans are carried at the principal amounts outstanding, net of any unearned income, premiums on originated loans and discounts on acquired loans. Unearned income includes loan origination fees, net of direct loan origination costs. This income is deferred and recognized as adjustments to loan income over the contractual life of the related notes using a method the result of which approximates that of the interest method.
Loans are placed on nonaccrual when payment of principal or interest is considered to be in doubt or is past due 90 days or more. The Company may choose to place a loan on nonaccrual status due to payment delinquency or uncertain collectibility, while not classifying the loan as impaired, if (i) it is probable that the Company will collect all amounts due in accordance with the contractual terms of the loan or (ii) the loan is not a commercial, commercial real estate or an individually significant mortgage or consumer loan. Previously accrued income on nonaccrual loans that has not been collected is reversed from current income, and subsequent cash receipts are recorded as income. Loans are returned to accrual status when collection of all contractual principal and interest is reasonably assured and there has been sustained repayment performance.
The Company's loans are primarily secured by real estate in New Hampshire. In addition, other real estate owned is located in this market. Accordingly, the ultimate collectibility of a substantial portion of the Company's loan portfolio and the recovery of other real estate owned are susceptible to changing conditions in this market.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is maintained at a level considered adequate by management on the basis of many factors including the risk characteristics of the portfolio, trends in loan delinquencies and an assessment of existing economic conditions. Additions to the allowance are charged to earnings; realized losses, net of recoveries, are charged directly to the allowance.
While management uses available information in establishing the allowance for loan losses, future additions to the allowance may be necessary if economic conditions differ substantially from the estimates used in making the evaluations. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Banks' allowances for loan losses. Such agencies may require the Banks to recognize additions to the allowance based on judgments different from those of management.
Commercial, commercial real estate and individually significant mortgage and consumer loans are considered impaired, and are placed on nonaccrual, when it is probable that the Company will not be able to collect all amounts due according to the contractual terms of the loan agreement. Mortgage and consumer loans, which are not individually significant, are measured for impairment collectively. Loans that experience insignificant payment delays and insignificant shortfalls in payment amounts generally are not classified as impaired. The amount of impairment for all impaired loans is determined by the difference between the present value of the expected cash flows related to the loan, using the original contractual interest rate, and its recorded value, or, as a practical expedient in the case of collateralized loans, the difference between the fair value of the collateral and the recorded amount of the loan.
When foreclosure is probable, impairment is measured based on the fair value of the collateral.
SERVICING ASSETS
Servicing assets are recognized as separate assets when rights are acquired through purchase or through sale of financial assets. Capitalized servicing rights are reported in other assets and are amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights by predominant characteristics, such as interest rates and terms. Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market-based assumptions. Impairment is recognized through a valuation allowance for an individual stratum, to the extent that fair value is less than the capitalized amount for the stratum.
OTHER REAL ESTATE OWNED
Other real estate owned is comprised of properties acquired either through foreclosure proceedings or acceptance of a deed in lieu of foreclosure, and for which the Company has taken physical possession. The Company classifies loans as repossessed or foreclosed if the Company receives physical possession of the debtor's assets, regardless of whether or not foreclosure proceedings take place.
Assets acquired through foreclosure or a similar conveyance of title are initially recorded at the lower of the carrying value of the loan or the fair value, less estimated costs to sell, of the property constructively or actually received. Gains and losses upon disposition are reflected in the statement of income as realized.
PREMISES AND EQUIPMENT
Premises and equipment are carried at cost less accumulated depreciation. Depreciation is computed on the straight-line method over the estimated useful lives of the respective assets. Estimated lives are 39 years for buildings, ten to fifteen years for building improvements and three to seven years for furniture and equipment.
Amortization of leasehold improvements is accumulated on a straight-line basis over the lesser of the term of the respective lease or the asset's useful life, not to exceed ten years.
ADVERTISING
The Company directly expenses costs associated with advertising as they are incurred.
INCOME TAXES
The Company uses the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and the respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
STOCK-BASED COMPENSATION
At December 31, 2003, the Company has a stock-based employee compensation plan which is described more fully in Note 15. The Company accounts for this plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under this plan had an exercise price equal to the market value of the underlying common stock on the date of the grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.
EARNINGS PER SHARE
Basic earnings per share ("EPS") excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS, if applicable, reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity.
Earnings per common share have been computed based on the following:
($000 Omitted) Years Ended December 31, ----------------------------- 2003 2002 2001 ------- ------- -------
Net income $3,617 $2,598 $3,873 Less: Preferred stock dividends - - - ------- ------- -------
Net income applicable to common stock $3,617 $2,598 $3,873 ======= ======= =======
Average number of common shares outstanding 1,504.4 1,515.1 1,521.6 Effect of dilutive options(1) 7.8 6.0 4.3 ------- ------- ------- Average number of common shares outstanding used to calculate diluted earnings per common share 1,512.2 1,521.1 1,525.9 ======= ======= =======
(1) Approximately 21,000 of the Company's outstanding stock options were not included in the diluted net earnings per share calculation for 2001 because to do so would have been antidilutive.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 2002, the FASB issued SFAS No. 146 "Accounting for Costs Associated with Exit or Disposal Activities" ("SFAS No. 146"). This Statement requires that a liability for a cost associated with an exit or disposal activity be recognized and measured initially at fair value only when the liability is incurred. SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002. This Statement did not have a material impact on the Company's consolidated financial statements.
In October 2002, the FASB issued SFAS No. 147 "Acquisitions of Certain Financial Institutions" ("SFAS No. 147") an Amendment of SFAS Nos. 72 and 144 and FASB Interpretation No. 9. SFAS No. 72 "Accounting for Certain Acquisitions of Banking or Thrift Institutions" and FASB Interpretation No. 9 "Applying APB Opinions No. 16 and 17" When a Savings and Loan Association or a Similar Institution Is Acquired in a Business Combination Accounted for by the Purchase Method" provided interpretive guidance on the application of the purchase method to acquisitions of financial institutions. Except for transactions between two or more mutual enterprises, SFAS No. 147 removes acquisitions of financial institutions from the scope of both Statement 72 and Interpretation 9 and requires that those transactions be accounted for in accordance with SFAS No. 141 "Business Combinations" and SFAS No. 142 "Goodwill and Other Intangible Assets." Thus, the requirement in paragraph 5 of Statement 72 to recognize (and subsequently amortize) any excess of the fair value of liabilities assumed over the fair value of tangible and identifiable intangible assets acquired as an unidentifiable intangible asset no longer applies to acquisitions within the scope of SFAS No. 147. In addition, SFAS No. 147 amends SFAS No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets" to include in its scope long-term customer-relationship intangible assets of financial institutions such as depositor- and borrower-relationship intangible assets and credit cardholder intangible assets. Consequently, those intangible assets are subject to the same undiscounted cash flow recoverability test and impairment loss recognition and measurement provisions that SFAS No. 144 requires for other long-lived assets that are held and used.
Paragraph 5 of SFAS No. 147, which relates to the application of the purchase method of accounting, was effective for acquisitions for which the date of acquisition is on or after October 1, 2002. The provisions in paragraph 6 related to accounting for the impairment or disposal of certain long-term customer-relationship intangible assets were effective on October 1, 2002. Transition provisions for previously recognized unidentifiable intangible assets in paragraphs 8-14 were effective on October 1, 2002, with earlier application permitted. There was no substantial impact on the Company's consolidated financial statements on adoption of this Statement.
In November 2002, the FASB issued FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 elaborates on the disclosure to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. FIN 45 clarifies that a guarantor is required to disclose (a) the nature of the guarantee; (b) the maximum potential amount of future payments under the guarantee; (c) the carrying amount of the liability; (d) the nature and extent of any recourse provisions or available collateral that would enable the guarantor to recover the amounts paid under the guarantee.
The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements in FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. The Company adopted the initial recognition and initial measurement provisions of FIN 45 effective as of January 1, 2003 and adopted the disclosure requirements effective as of December 31, 2002. The adoption of this interpretation did not have a material effect on the Company's financial position or results of operations.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure, an amendment of SFAS Statement No. 123" ("SFAS No. 148"). SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The transition provisions and disclosure provisions are required for financial statements for fiscal years ending after December 15, 2002. The Company adopted the disclosure provisions of SFAS No. 148 as of December 31, 2002 and currently uses the intrinsic value method of accounting for stock options.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement No. 133 on Derivative Instruments and Hedging Activities" ("SFAS No. 149"), which amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This Statement (a) clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative, (b) clarifies when a derivative contains a financing component, (c) amends the definition of an underlying to conform to language used in FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others," and (d) amends certain other existing pronouncements. The provisions of SFAS No. 149 are effective for contracts entered into or modified after June 30, 2003. There was no substantial impact on the Company's consolidated financial statements on adoption of this Statement.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity" ("SFAS No. 150"). This Statement establishes standards for the classification and measurement of certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that certain financial instruments that were previously classified as equity must be classified as a liability. Most of the guidance in SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. This Statement did not have any material effect on the Company's consolidated financial statements.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"), in an effort to expand upon and strengthen existing accounting guidance that addresses when a company should include in its financial statements the assets, liabilities and activities of another entity. In December 2003, the FASB revised Interpretation No. 46, also referred to as Interpretation 46 (R) ("FIN 46(R)"). The objective of this interpretation is not to restrict the use of variable interest entities but to improve financial reporting by companies involved with variable interest entities. Until now, one company generally has included another entity in its consolidated financial statements only if it controlled the entity through voting interests. This interpretation changes that, by requiring a variable interest entity to be consolidated by a company only if that company is subject to a majority of the risk of loss from the variable interest entity's activities or entitled to receive a majority of the entity's residual returns or both. The Company is required to apply FIN 46, as revised, to all entities subject to it no later than the end of the first fiscal year or interim period ending after March 15, 2004. However, prior to the required application of FIN 46, as revised, the Company shall apply FIN 46 or FIN 46 (R) to those entities that are considered to be special-purpose entities as of the end of the first reporting period ending after December 15, 2003. The adoption of this interpretation has not and is not expected to have a material effect on the Company's consolidated financial statements.
In December 2003, the FASB issued SFAS No. 132 (revised 2003), "Employers' Disclosures about Pensions and Other Postretirement Benefits - an amendment of SFAS No. 87, SFAS No. 88 and SFAS No. 106" ("SFAS No. 132 (revised 2003)"). This Statement revises employers' disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans required by SFAS No. 87, "Employers' Accounting for Pensions," SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits," and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." This Statement retains the disclosure requirements contained in SFAS No. 132, "Employers' Disclosures About Pensions and Other Postretirement Benefits," which it replaces. It requires additional disclosures to those in the original Statement 132 about assets, obligations, cash flows and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. This Statement is effective for financial statements with fiscal years ending after December 15, 2003 and interim periods beginning after December 15, 2003. Adoption of this Statement did not have a material impact on the Company's consolidated financial statements.
NOTE 2 CASH AND DUE FROM BANKS
Cash and due from banks at December 31, 2003 and 2002 includes $3,588,000 and $2,911,000, respectively, which is subject to withdrawals and usage restrictions to satisfy the reserve requirements of the Federal Reserve Bank.
NOTE 3 SECURITIES AVAILABLE-FOR-SALE
The amortized cost, gains in accumulated other comprehensive income, losses in accumulated other comprehensive income and fair value of securities at December 31, 2003 and 2002 follows:
Actual maturities of state and political subdivision bonds and notes, mortgage-backed securities and collateralized mortgage obligations will differ from the maturities presented because borrowers have the right to prepay obligations without prepayment penalties.
An analysis of gross realized gains and losses on securities available-for-sale which have been sold or called during the years ended December 31, follows:
The tax provision applicable to these net realized gains amounted to $603,000, $60,000 and $50,000 for 2003, 2002, and 2001, respectively.
Securities with a carrying amount totaling $39,789,000 and $48,433,000 were pledged to secure public deposits, securities sold under agreements to repurchase and treasury, tax and loan accounts at December 31, 2003 and 2002, respectively.
The aggregate fair value and unrealized losses of securities that have been in a continuous unrealized loss position for less than twelve months and for twelve months or more, and are not other than temporarily impaired, are as follows as of December 31, 2003:
At December 31, 2003, securities with a total fair value of $17,620,000 were in a loss position. These securities were comprised primarily of five US government agency securities with a fair value of $16,813,000 and an unrealized loss of $179,000. These securities had an unrealized loss due to the current interest rate environment. As these securities are guaranteed by US government agencies such as FHLB or FNMA there is no credit risk associated with them. These securities are not other-than-temporarily impaired as the Company has the ability and the intent to hold these securities until maturity.
Mortgage-backed securities with a fair value of $353,000 had an unrealized loss of $5,000 at December 31, 2003. This total consists of eleven positions with an average balance of $32,000. As with the US government agency securities, these securities have an unrealized loss due to the current interest rate environment. As all of these mortgage-backed securities are guaranteed by US government agencies such as FHLMC, GNMA or FNMA there is no credit risk associated with them. These securities have not been classified as other-than-temporarily impaired as the Company has the ability and intent to hold these securities until they are paid in full.
Eight marketable equity securities with a fair value of $454,000 had an unrealized loss of $74,000 at December 31, 2003. Marketable equity securities are subject to internal testing on a quarterly basis to determine impairment. Testing includes review of industry analyst reports, credit ratings, sector analysis and earnings projections. Based upon the December 31, 2003 review, these securities were not determined to be other-than-temporarily impaired.
NOTE 4 LOANS
Loan balances were comprised of the following:
($000 Omitted) December 31, 2003 2002 - ------------------------------ -------- -------- Real estate: Residential $129,493 $114,526 Commercial 120,366 111,941 Construction 3,851 6,330 Commercial 24,528 23,885 Installment 30,291 40,169 Indirect installment 150,807 139,477 Other 8,896 6,031 -------- -------- Total loans 468,232 442,359 Less: Unearned income 247 207 Allowance for loan losses 5,036 4,920 -------- -------- Total unearned income and allowance for loan losses 5,283 5,127 -------- -------- Net loans $462,949 $437,232 ======== ========
Total loans above are net of unearned discount on loans acquired in the amount of $575,000 and $681,000 at December 31, 2003 and 2002, respectively. In addition, total loans above are net of unamortized premium on indirect installment loans originated in the amount of $3,392,000 and $3,684,000 at December 31, 2003 and 2002, respectively.
Loans are made in the ordinary course of business to directors, executive officers, and their immediate families and to organizations in which such persons have more than a 10% ownership interest. These loans are made on substantially the same terms, including interest rate and collateral, as those prevailing at the same time for comparable transactions with unrelated persons and did not involve more than the normal risk of collectibility or present other unfavorable features. Total loans to such persons and their companies amounted to $364,000 as of December 31, 2003. During 2003, principal payments were $533,000 and principal advances amounted to $58,000.
The Company's lending activities are conducted principally in New Hampshire. Although the loan portfolio is diversified, a portion of its debtors' ability to repay is dependent upon the economic conditions prevailing in New Hampshire. The Company maintains significant credit relationships with borrowers in the hotel and motel industry. The aggregate loan balances to these industries totaled $56,200,000 at December 31, 2003 and $56,470,000 at December 31, 2002.
Loans serviced for others are not included in the accompanying statements of financial condition. The unpaid principal balances of these loans total $45,967,000 and $49,908,000 at December 31, 2003 and 2002, respectively. The Company sold $22,483,000 of mortgage loans and $1,482,000 of indirect installment loans in 2003 and $20,694,000 of mortgage loans and $1,472,000 of indirect installment loans in 2002.
The Company capitalized $187,000 and $177,000 of servicing rights and amortized $137,000 and $97,000 of those rights in 2003 and 2002, respectively. Impairment of mortgage servicing rights of $5,000 and $0 was recognized in 2003 and 2002, respectively. Impairment of mortgage servicing rights is assessed based on the fair value of those rights. Fair values are estimated using discounted cash flows based on a current market interest rate. The amount of the impairment recognized is the amount by which the capitalized mortgage servicing rights exceed their fair value. At December 31, 2003 and 2002, respectively, the carrying amount of servicing rights was $384,000 and $339,000, and is included in other assets.
Restructured, accruing loans entered into prior to the adoption of SFAS No. 114 and 118 are not required to be reported as impaired loans unless such loans are not performing in accordance with the restructured terms at adoption of SFAS No. 114. Restructured, accruing loans entered into subsequent to the adoption of these statements are reported as impaired loans. In the year subsequent to restructure these loans may be removed from the impaired loan disclosure provided that the loan bears a market rate of interest at the time of restructure and is performing under the restructured terms.
At December 31, 2003 and 2002, loans restructured in a troubled debt restructuring before January 1, 1995, the effective date of SFAS No. 114, that are not impaired based on the terms specified by the restructuring agreement totaled $897,000 and $945,000, respectively. The gross interest income that would have been recorded in the years ended December 31, 2003 and 2002 if such restructured loans had been current in accordance with their original terms was $65,000 and $76,000, respectively. The amount of interest income recognized on such restructured loans for the years ended December 31, 2003 and 2002 was $44,000 and $54,000, respectively.
At December 31, 2003 and 2002, nonperforming loans totaled $4,089,000 and $3,619,000, respectively. Of this total, $0 and $3,000, for December 31, 2003 and 2002, respectively, were past due 90 days or more and still accruing interest.
The recorded investment in loans that are considered to be impaired under SFAS No. 114 was $3,014,000 and $2,775,000 at December 31, 2003 and 2002, respectively, for which the related allowance for loan losses is $485,000 and $459,000 as of December 31, 2003 and 2002, respectively. All of the Company's impaired loans are collateralized and therefore all impaired loans are measured by the difference between the fair value of the collateral and the recorded amount of the loan. All of the Company's impaired loans had a related allowance for loan losses at December 31, 2003 and 2002. The average recorded investment in impaired loans during the twelve months ended December 31, 2003 and 2002 was approximately $3,001,000 and $854,000, respectively. For the twelve months ended December 31, 2003 and 2002 the Company recognized interest income on impaired loans of $217,000 and $94,000, respectively, which included $168,000 and $67,000 of interest income recognized using the cash-basis method of income recognition, respectively.
NOTE 5 ALLOWANCE FOR LOAN LOSSES
Changes in the allowance for loan losses for the years ended December 31, follows: ($000 Omitted) 2003 2002 2001 ------- ------- ------- Balance at beginning of year $4,920 $4,642 $4,354 Provision for loan losses 805 900 900 Recoveries on loans previously charged-off 181 202 122 Loans charged-off (870) (824) (734) ------ ------ ------ Balance at end of year $5,036 $4,920 $4,642 ====== ====== ======
NOTE 6 OTHER REAL ESTATE OWNED
Other real estate owned consists of real estate acquired by foreclosure or a similar conveyance of title. At December 31, 2003 the Company had no other real estate owned. At December 31, 2002 other real estate owned was comprised of commercial real estate of $175,000.
Sales of other real estate owned by the Company resulted in gains of $65,000, $13,000 and $17,000 for the years ended December 31, 2003, 2002 and 2001, respectively.
There were no write-downs on other real estate owned for the years ended December 31, 2003 and 2002; and write-downs on other real estate owned totaled $3,000 for the year ended December 31, 2001.
NOTE 7 PREMISES AND EQUIPMENT
A summary of premises and equipment follows: ($000 Omitted) December 31, 2003 2002 ------- ------- Land $ 2,445 $ 2,418 Buildings 9,644 9,437 Leasehold improvements 508 481 Construction in progress 958 228 Equipment 7,855 7,162 ------- ------- 21,410 19,726 Less accumulated depreciation and amortization 8,552 7,223 ------- ------- $12,858 $12,503 ======= =======
Depreciation expense for the years ended December 31, 2003, 2002 and 2001 amounted to $1,427,000, $1,315,000 and $1,079,000, respectively.
The Company leases seven of its locations under non-cancellable operating leases and one location under a tenant at will agreement. In addition, the Company leases a storage facility under a non-cancellable lease. Minimum lease payments in future periods under non-cancellable operating leases at December 31, 2003 are as follows:
($000 Omitted) 2004 $ 338 2005 157 2006 156 2007 123 2008 25 Thereafter - ----- $ 799
The terms of two of the leases provide that the Company can, at the end of the initial five-year term, renew the lease under two five-year options. The terms of two of the leases provided that the Company can, at the end of the current five year term, renew the lease under one five-year option. All leases contain a provision that the Company shall pay its pro-rata share of operating costs. Additionally, two of the leases require that the Company pay all real estate taxes.
Rent expense for the years ended December 31, 2003, 2002, and 2001 amounted to $421,000, $369,000 and $287,000, respectively.
NOTE 8 DEPOSITS
The aggregate amount of maturities for time deposits as of December 31, 2003, for each of the following five years ended December 31 and thereafter, are as follows: ($000 Omitted) 2004 $120,373 2005 21,395 2006 5,968 2007 853 2008 333 Thereafter 20 -------- $148,942
Deposits from related parties held by the Banks at December 31, 2003 and 2002 amounted to $3,081,000 and $2,315,000, respectively.
NOTE 9 SHORT-TERM BORROWINGS
Short-term borrowings consist of securities sold under agreements to repurchase. Amounts outstanding and the related average interest rates for the years ended December 31, 2003, 2002 and 2001 are as follows:
The underlying securities associated with securities sold under agreements to repurchase are under the control of the Company.
NOTE 10 LONG-TERM DEBT
Long-term debt at December 31, 2003 and 2002 consisted of FHLB advances of $67,000,000 and $46,000,000, respectively, as well as $20,620,000 of junior subordinated debentures, for each year.
As of December 31, 2003, contractual principal payments due under long-term debt, which consists of FHLB advances and junior subordinated debentures, are as follows:
($000 Omitted) 2004 $ 9,000 2005 2,000 2006 17,000 2007 7,000 2008 4,000 2009 and years thereafter 48,620 ------- $87,620 =======
The FHLB long-term debt consisted of twenty two separate advances with the following terms:
($000 Omitted) Amount Rate Maturity Date Call Date ------- ----- ------------- --------- $ 1,000 3.49 05/14/04 N/A 3,000 4.78 06/25/04 N/A 5,000 5.79 08/30/04 03/01/04 2,000 2.06 02/07/05 N/A 3,000 2.58 01/24/06 N/A 5,000 2.68 03/20/06 N/A 3,000 2.50 04/03/06 N/A 2,000 2.63 04/24/06 N/A 4,000 2.62 04/24/06 N/A 5,000 6.11 03/28/07 03/29/04 2,000 2.35 06/04/07 N/A 2,000 3.14 05/09/08 N/A 2,000 2.84 05/20/08 N/A 7,000 5.54 11/02/09 02/02/04 7,000 5.57 11/09/09 02/09/04 5,000 5.91 12/17/09 03/17/04 1,000 3.76 04/12/10 N/A 1,000 3.84 04/14/10 N/A 1,000 3.84 04/23/10 N/A 2,000 4.80 12/27/10 03/26/04 3,000 4.50 01/24/11 01/22/04 1,000 4.58 02/07/11 02/05/04 ------- $67,000 =======
The $20,620,000 of junior subordinated debentures consists of the following two issues:
On April 10, 2002, the Company completed the private placement of $7,217,000 aggregate liquidation amount of floating rate trust preferred securities (the "Trust I Capital Securities") issued by its Delaware statutory business trust, Northway Capital Trust I ("Capital Trust I"). The Trust I Capital Securities were sold to a pooled investment vehicle. The proceeds from the sale of the Trust I Capital Securities, which included the proceeds from the sale by Capital Trust I of its common securities to the Company, were invested in Floating Rate Junior Subordinated Debt Securities of the Company due 2032 (the "Trust I Junior Subordinated Debt"), which were issued pursuant to an Indenture, dated April 10, 2002, between the Company and Wilmington Trust Company, as Trustee. Both the Trust I Capital Securities and the Trust I Junior Subordinated Debt have a floating rate, which resets semi-annually, equal to six-month LIBOR plus 3.70%, with a ceiling of 11.00% for the first five years. Currently, the interest rate on these securities is 4.92%. Payments of distributions and other amounts due on the Trust I Capital Securities are irrevocably guaranteed by the Company, to the extent that Capital Trust I has funds available for the payments of such distributions, pursuant to a Guarantee Agreement, dated April 10, 2002, between the Company and Wilmington Trust Company, as Guarantee Trustee. The Trust I Junior Subordinated Debt and the Trust I Capital Securities may be redeemed at the option of the Company on fixed semi-annual dates beginning on April 22, 2007.
On July 11, 2002, the Company completed the private placement of $13,403,000 aggregate liquidation amount of floating rate trust preferred securities (the "Trust II Capital Securities") issued by its Delaware statutory business trust, Northway Capital Trust II (the "Capital Trust II"). The Trust II Capital Securities were sold to a pooled investment vehicle. The proceeds from the sale of the Trust II Capital Securities, which include the proceeds from the sale by Capital Trust II of its common securities to the Company, were invested in Floating Rate Junior Subordinated Debt Securities of the Company due 2032 (the "Trust II Junior Subordinated Debt"), which were issued pursuant to an Indenture, dated July 11, 2002, between the Company and Wilmington Trust Company, as Trustee. Both the Trust II Capital Securities and the Trust II Junior Subordinated Debt have a floating rate, which resets quarterly, equal to three-month LIBOR plus 3.65%, with a ceiling of 12.50% for the first five years. Currently, the interest rate on these securities is 4.80%. Payments of distributions and other amounts due on the Trust II Capital Securities are irrevocably guaranteed by the Company, to the extent that Capital Trust II has funds available for the payments of such distributions, pursuant to a Guarantee Agreement, dated July 11, 2002, between the Company and Wilmington Trust Company, as Guarantee Trustee. The Trust II Junior Subordinated Debt and the Trust II Capital Securities may be redeemed at the option of the Company on fixed quarterly dates beginning on July 7, 2007.
NOTE 11 ACQUISITIONS
On October 18, 2002, the Company acquired certain assets and assumed the deposits of three branches offices of Fleet National Bank located in Laconia, Belmont and Pittsfield, New Hampshire. This acquisition has allowed the Company to expand its market area further into Belknap and Merrimack Counties. Deposits assumed totaled $54,932,000 for which the Company paid a deposit purchase premium of 11.25%. In addition, the Company acquired certain loans associated with the branches totaling $20,192,000. As a result of this purchase the Company made the following entries to record this transaction:
($000 Omitted)
Cash $26,738 Loans 20,192 Goodwill 4,766 Core deposit intangible 2,639 Land and buildings 430 Furniture and fixtures 13 Leasehold improvements 76 Other assets 83 Building lease and equipment expense 12 Salary expense 7 Deposits 54,932 Other liabilities 17 Other income 7
This transaction was accounted for using the purchase method of accounting. The results of operations of the acquired branches are included in the 2002 consolidated statements of income of the Company from the date of the transaction.
The cost of the acquired branch offices exceeded the fair values of the assets acquired and liabilities assumed by $7,405,000. Of this amount, $2,639,000 was assigned to core deposit intangible and $4,766,000 was recorded as goodwill. All of the goodwill was deductible for tax purposes. The core deposit intangible of $2,639,000 is being amortized to noninterest expense over fifty months using the straight line method.
On October 26, 2001, the Company acquired certain assets and assumed the deposits of a branch office of The Bank of New Hampshire located in Littleton, New Hampshire. As a result of this purchase the Company made the following entries to record this transaction: ($000 Omitted)
Cash $22,481 Loans 2,601 Deposit assumption premium 3,607 Equipment 6 Other assets 14 Miscellaneous expense 1 Deposits 28,660 Other liabilities 48 Other income 2
This transaction was accounted for using the purchase method of accounting. The results of operations of the acquired branch are included in the 2001 consolidated statements of income of the Company from the date of the transaction.
The deposit assumption premium of $3,607,000 was amortized, through December 31, 2001, to noninterest expense over fifteen years using the straight line method. For 2002 accounting, see Note 1, Recent Accounting Pronouncements, SFAS No. 147.
On August 25, 2000, the Company acquired certain assets and assumed the deposits of a branch office of The Bank of New Hampshire located in West Ossipee, New Hampshire. As a result of this purchase the Company made the following entries to record this transaction:
($000 Omitted)
Cash $16,952 Loans 6,197 Deposit assumption premium 4,340 Premises and equipment 301 Other assets 38 Miscellaneous expense 8 Deposits 27,782 Other liabilities 50 Other income 4
This transaction was accounted for using the purchase method of accounting. The results of operations of the acquired branch are included in the consolidated statements of income of the Company from the date of the transaction.
The deposit assumption premium of $4,340,000 was amortized, through December 31, 2001, to noninterest expense over fifteen years using the straight line method. For 2002 accounting, see Note 1, Recent Accounting Pronouncements, SFAS No. 147.
On July 9, 1999, the Company acquired certain assets and assumed the deposits from branch offices of Vermont National Bank located in Tilton and Franklin, New Hampshire. As a result of this purchase, the Company made the following entries to record this transaction:
($000 Omitted)
Cash $16,931 Deposit assumption premium 789 Premises and equipment 292 Other assets 5 Interest expense 3 Deposits 18,011 Other liabilities 3 Other income 6
This transaction was accounted for using the purchase method of accounting. The results of operations of the acquired branches are included in the consolidated statements of income of the Company from the date of the transaction.
The deposit assumption premium of $789,000 was amortized, through December 31, 2001, to noninterest expense over seven years using the straight line method. For 2002 accounting, see Note 1, Recent Accounting Pronouncements, SFAS No. 147.
Management reviews the carrying amount of intangible assets resulting from these transactions on an ongoing basis, taking into consideration any events and circumstances that might have diminished such amount. During 2003 and 2002, the Company reviewed the carrying amount of intangible assets and determined that no impairment was required.
NOTE 12 REGULATORY MATTERS
The Company and the Banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Banks' financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Banks must meet specific capital guidelines that involve quantitative measures of the Banks' assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Banks' capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Company and the Banks to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). As of December 31, 2003, the most recent notification from the FDIC categorized both banks as well-capitalized under the regulatory framework for prompt corrective action. To be categorized as well-capitalized the Banks must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios. There are no conditions or events since that notification that management believes have changed the Company's and Banks' categories. Management believes, as of December 31, 2003 and 2002, that the Company and the Banks met all capital adequacy requirements to which they are subject.
These minimum capital amounts and ratios, as well as the Company's and Banks' actual capital amounts and ratios, are presented in the following table:
Federal regulations prohibit banking companies from paying dividends on their stock if the effect would cause stockholders' equity to be reduced below applicable regulatory capital requirements or if such declaration and payment would otherwise violate regulatory requirements.
Under the National Bank Act, the approval of the OCC is required if dividends declared by PNB to the Company in any year exceed the net profits of that year, as defined, combined with the retained net profit for the two preceding years. At December 31, 2003 PNB could, without approval of the OCC, declare dividends aggregating $424,000.
As of December 31, 2003, BCB is restricted from declaring dividends to the Company in an amount greater than approximately $7,651,000, as such declaration would decrease capital below BCB's required minimum level of regulatory capital.
NOTE 13 OTHER NONINTEREST EXPENSE
The major components of other noninterest expense for the years ended December 31, are as follows:
($000 Omitted) 2003 2002 2001 ------- ------- ------- Professional fees $1,166 $1,096 $ 886 Stationery and supplies 556 596 486 Telecommunications 571 505 283 Postage and shipping 378 378 323 ATM expense 442 366 352 Other 2,706 2,652 2,316 ------ ------ ------- $5,819 $5,593 $ 4,646 ====== ====== ========
NOTE 14 FEDERAL AND STATE TAXES
The components of federal and state tax expense (benefit) for the years ended December 31, are as follows:
($000 Omitted) 2003 2002 2001 ------- ------ ------ Current Federal $1,713 $ 985 $1,319 State 403 327 201 ------ ------ 2,116 1,312 1,520 ------ ------ ------ Deferred Federal (181) 176 223 State (37) (12) (35) ------ ------ ------ (218) 164 188 ------ ------ ------
Change in valuation allowance (31) 31 - ------ ------ ------ (249) 195 188 ------ ------ ------
Total $1,867 $1,507 $1,708 ====== ====== ======
The temporary differences (the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases) that give rise to significant portions of the deferred income tax asset and deferred income tax liability at December 31, are as follows:
($000 Omitted) 2003 2002 ------- ------- Deferred income tax asset Allowance for loan losses $ 1,836 $ 1,706 Other 10 8 Interest on nonaccrual loans 27 22 Loan origination costs, net 23 8 Unrealized holding loss on equities available-for-sale - 285 Securities writedown 9 38 Capital loss carryforward 162 - Minimum pension liability adjustment 371 581 Amortization of goodwill and core deposit intangible 257 384 Supplemental pension 136 48 ------- ------- 2,831 3,080 Valuation allowance - (316) ------- ------- 2,831 2,764 ------- -------
Deferred income liabilities Depreciation (751) (728) Unrealized holding gain on securities available-for-sale (571) (357) Prepaid pension (208) (221) Mortgage and consumer servicing rights (152) (134) ------- ------- (1,682) (1,440) ------- ------- Deferred income tax asset, net $ 1,149 $ 1,324 ======= =======
The primary sources of recovery of the deferred income tax asset are taxes paid that are available for carryback and the expectation that the deductible temporary differences will reverse during periods in which the Company generates taxable income.
Total income tax expense for the years ended December 31, 2003, 2002 and 2001 differs from the "expected" federal income tax expense at the 34% statutory rate for the following reasons:
2003 2002 2001 ---- ---- ---- Expected federal income taxes 34.0% 34.0% 34.0% Interest on municipal securities available-for-sale and municipal loans (3.3) (3.8) (4.2) State tax expense, net of federal benefit 4.4 5.1 2.0 Valuation allowance for securities (0.6) - - Other (0.4) 1.4 (1.2) ---- ---- ---- Effective tax rates 34.1% 36.7% 30.6% ==== ==== ====
NOTE 15 EMPLOYEE BENEFITS
Pension Plan
The Company maintains a trusteed non-contributory pension plan (the "Plan") covering substantially all full-time employees. Assuming retirement at age 65 after 30 years or more of service, the benefits are computed as the sum of one percent of final average earnings up to a covered compensation limit, plus 0.65 percent of final average earnings in excess of covered compensation, times years of service, up to 30. Final average earnings are defined as the five consecutive years out of the employee's last ten years of employment during which compensation is highest. The amounts contributed to the Plan are determined annually on the basis of (a) the maximum amount that can be deducted for federal income tax purposes or (b) the amount certified by a consulting actuary as necessary to avoid an accumulated funding deficiency as defined by the Employee Retirement Income Security Act of 1974. Contributions are intended to provide not only benefits attributed to service to date but also for those expected to be earned in the future.
The following table sets forth information about the Plan as of December 31, and for the years then ended:
($000 Omitted) 2003 2002 -------- -------- Change in benefit obligation Benefit obligation at beginning of year $ 4,356 $ 3,305 Service cost 444 356 Interest cost 266 246 Actuarial (gain) loss (46) 747 Benefits paid (119) (298) ------- ------- Benefit obligation at end of year 4,901 4,356 ------- -------
Change in plan assets Fair value of plan assets at beginning of year 2,685 2,918 Actual return on plan assets 540 (248) Employer contributions 546 313 Benefits paid (119) (298) ------- ------- Fair value of plan assets at end of year 3,652 2,685 ------- ------
Funded status at end of year (1,249) (1,671) Unrecognized transition asset (1) (5) Unrecognized net actuarial loss 2,824 3,371 Unrecognized prior service cost (961) (1,046) ------- ------- Net amount recognized $ 613 $ 649 ======= =======
Amounts recognized in the consolidated statements of financial condition consist of: Accrued benefit liability $(1,092) $(1,707) Accumulated other comprehensive loss, before income tax benefit 1,092 1,707 Prepaid benefit cost 613 649 ------- ------- Net amount recognized $ 613 $ 649 ======= =======
The accumulated benefit obligation for the plan was $4,131,000 and $3,743,000 at December 31, 2003 and 2002, respectively.
The expected long-term rate of return for the plan's total assets is based on the expected return of asset categories identified below, weighted based on the target allocations for each class. Equity funds are expected to return 8% to 10% over the long-term and bond funds and short-term money markets are expected to return between 4% and 6%.
($000 omitted) Components of net periodic benefit cost 2003 2002 2001 - --------------------------------------- ----- ----- ----- Service cost $ 444 $ 356 $ 309 Interest cost 266 246 254 Expected return on plan assets (211) (244) (271) Amortization of prior service cost (84) (84) (85) Amortization of net actuarial loss 172 122 85 Recognized transition amount (5) (5) (4) ----- ----- ----- Net periodic benefit cost $ 582 $ 391 $ 288 ===== ===== ====
Assumptions used to determine benefit obligations and benefit cost as of and for the years ending December 31, 2003 2002 - ------------------------------------------- ---- ---- Discount rate 6.25% 6.25% Long-term rate of return on plan assets 8.00 8.50 Rate of compensation increase 4.00 4.00
At December 31, 2003 and 2002, the comprehensive loss for the unfunded pension accumulated benefit obligation was $721,000 and $1,126,000, net of taxes, respectively. While the Company continues to contribute the maximum amount permitted by law to its pension plan, the discount rate used to calculate the future value of such contribution and the poor asset performance of the munutal funds has resulted in the unfunded pension accumulated benefit obligation.
The Company's pension plan actual asset allocations by asset category are as follows:
Plan Assets at December 31, 2003 2002 ------ ------ Asset Category Mutual funds: Bond funds 32.3% 45.1% U. S. common stock funds 36.8 43.6 International equity funds 7.1 7.2 Real estate funds 8.8 - Short-term money market 15.0 4.1 ----- ----- Total 100.0% 100.0% ===== =====
The investment policy, as established by the Company, is to provide for a moderate growth of capital with a moderate level of volatility by investing assets per the target allocations as follows: 2003 2002 ------ ------ Asset Category Mutual funds: Bond funds 40.0% 45.0% U.S. common stock funds 42.0 46.0 International equity funds 8.0 9.0 Real estate funds 10.0 - ----- ----- Total 100.0% 100.0% ===== =====
The assets will be re-allocated quarterly to meet the above target allocations. The investment policy is reviewed on an annual basis, under the advisement of our certified investment advisor, to determine if the policy should be changed.
The plan assets do not include any Company common stock at December 31, 2003 and 2002.
The Company expects to contribute $430,000 to its pension plan in 2004.
401(k) Plan
The Company offers a contributory 401(k) Plan. Under the Northway Financial, Inc. 401(k) and Profit Sharing Plan (the "401K Plan") employees must have attained age 21, completed six months of service and be credited with 1,000 hours of service in order to participate. Employees of the Company, PNB and BCB are eligible to participate. Under the 401K Plan, employers match 50 percent of the first 4 percent of employee contributions. Total 401(k) matching expense in 2003, 2002 and 2001 amounted to $130,000, $120,000 and $113,000, respectively, and there was no Profit Sharing contribution expense for 2003 and 2002, and in 2001 it was $64,000.
Supplemental Executive Retirement Plan
Effective May 29, 2003, the existing Executive Life program sponsored by the Company was terminated and replaced with a SERP. The existing Split Dollar Life Insurance policy designed to support the Executive Life program is now fully owned by Northway. This policy will be maintained by Northway and is used as the benchmark for the newly established SERP.
This SERP is an "account balance" type plan designed to provide retirement income to Mr. Woodward. Pre-retirement, Northway credits the participant's account with a contribution at the end of each calendar year. Contributions to the account are equal to the excess (if any) of the gain in the associated life insurance contract over the cost of the funds expense as defined in the SERP. Contributions are not guaranteed by the Company.
The total retirement SERP benefit is as follows: Upon Mr. Woodward's termination of employment for reasons other than death or for cause, the account balance is paid out to him in ten (10) equal annual installments on the first day of the month following the month in which employment is terminated. Upon death after retirement, the unpaid account balance, if any, is paid out in a lump sum to the named beneficiary. During retirement, an additional retirement payment, based on the policy gains associated with the prior calendar year, will also be paid on an annual basis until the executive's death. In the event of Mr. Woodward's death while employed by the Company, the SERP permits a death benefit of $2,000,000 be paid to his beneficiary.
Stock-Based Compensation
The Board of Directors (the "Committee") administers the 1999 Stock Option and Grant Plan (the "1999 Plan") which is described below.
Under the 1999 Plan, the Committee may select the individuals to whom awards may from time to time be granted; determine the time or times of grant; and determines the extent, if any, of incentive stock options, non-qualified stock options, restricted stock awards, unrestricted stock awards, performance share awards, or any combination of the foregoing.
The 1999 Plan expires in February 2009. The aggregate number of shares of the Company's common stock which may be issued upon the exercise of options granted under the 1999 Plan is 175,000. The option price is fixed by the Committee at the time of the grant and may not be less than 100 percent of the fair market value of the stock, as determined by the Committee, in good faith as of the grant date. Each option may be exercised at such times as shall be determined by the Committee at or after the grant date; provided, however, that no option may be exercised ten years after the date of grant.
The fair value of each option granted is estimated on grant date using the Black-Scholes option pricing model. In 2000 the weighted average dividend yield was 2.5%, the weighted average risk-free interest rate was 6.01%, the expected volatility was 23% and the expected life was 8 years.
A summary of the status of the Company's 1999 Plan as of December 31, 2003, 2002 and 2001 and changes during the years then ended is presented below:
Change in Control
The Company and its subsidiaries have entered into Key Employee agreements with the Named Executive Officers as well as other Senior Officers of the Company. These agreements provide for payments, under certain circumstances, to the officer upon the officer's termination after a change in control. Payments will be made under these agreements upon the officer's termination or resignation in connection with certain specified actions adverse to the officer's employment status after a change in control. The amount of such payments ranges from 1.0 to 1.5 times such officer's annual compensation.
NOTE 16 FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
The Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to originate loans and standby letters of credit. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for loan commitments and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
Financial instruments with off-balance sheet credit risk at December 31, are as follows: ($000 Omitted) 2003 2002 ------- ------- Financial instrument whose contract amounts represent credit risk: Unadvanced portions of home equity loans $13,798 $14,414 Unadvanced portions of lines of credit 10,535 10,761 Unadvanced portions of commercial real estate loans 2,202 2,410 Commitments to originate all other loans 18,391 29,608 Commitments to originate municipal notes - 1,000 Standby letters of credit 350 36
Commitments to originate loans and municipal notes, unadvanced portions of home equity loans, lines of credit and commercial real estate loans are agreements to lend to a customer provided there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without having been drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management's credit evaluation of the borrower.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance by a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers. As of December 31, 2003 and 2002, the maximum potential amount of the Company's obligation was $350,000 and $36,000, respectively, for financial and standby letters of credit. The Company's outstanding letters of credit generally have a term of less than one year. If a letter of credit is drawn upon, the Company may seek recourse through the customer's underlying line of credit. If the customer's line of credit is also in default, the Company may take possession of the collateral, if any, securing the line of credit.
NOTE 17 FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:
Cash and cash equivalents: The carrying amounts reported in the statements of financial condition for cash and cash equivalents approximates the fair value of those assets.
Securities: Fair values for securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.
FHLB and Federal Reserve Bank ("FRB") Stock: The carrying amount reported in the statements of financial condition for FHLB and FRB Stock approximates their fair value. If redeemed, the Company will receive an amount equal to the par value of the stocks.
Loans held-for-sale: Fair values for loans held-for-sale are estimated based on outstanding investor commitments, or in the absence of such commitments, are based on current investor yield requirements.
Loans: For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair value for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. The fair value of nonaccrual loans was estimated using the estimated fair value of the underlying collateral. The fair value of commitments to originate loans and outstanding letters of credit were considered in estimating the fair value of loans. As the undisbursed lines of credit are at floating rates, there is no fair value adjustment.
Accrued interest receivable: The carrying value of accrued interest receivable approximates its fair value because of the short-term nature of this financial instrument.
Deposits: The fair value of demand deposits (e.g. NOW and super NOW checking, noninterest bearing checking, regular savings, money market accounts and mortgagors' escrow accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e. their carrying amounts). Fair values for certificates of deposit are estimated using a discounted cash flow technique that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities of time deposits.
Short-term borrowings: The carrying value of short-term borrowings approximates its fair value because of the short-term nature of these financial instruments.
Long-term debt: The fair values of long-term debt are determined by discounting the anticipated future cash payments by using the rates currently available to the Company for debt with similar terms and remaining maturities.
Junior subordinated debentures: The fair values of junior subordinated debentures are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.
The estimated fair values of the Company's financial instruments are as follows:
The carrying amounts of financial instruments shown in the above table are included in the consolidated statements of financial condition under the indicated captions except that accrued interest receivable is included with other assets in the statements and in junior subordinated debentures is included with long-term debt in the statements.
At December 31, 2003 and 2002, all the Company's financial instruments were held for purposes other than trading.
Limitations
Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. Because no market exists for some of the Company's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, cash flows, current economic conditions, risk characteristics, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions and changes in the loan, debt and interest rate markets could significantly affect the estimates. Further, the income tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on the fair value estimates and have not been considered. The fair value amounts presented do not represent the underlying value of the Company because fair values of certain other financial instruments, assets and liabilities have not been determined.
NOTE 18 CONDENSED PARENT ONLY FINANCIAL STATEMENTS
Condensed financial statements of Northway Financial, Inc. (Parent Company only) as of December 31, 2003 and 2002 and for the three years ended December 31, 2003 follow:
INDEPENDENT AUDITORS' REPORT
Shatswell, MacLeod & Company, P.C. Certified Public Accountants 83 Pine Street West Peabody, Massachusetts 01960
The Board of Directors and Stockholders Northway Financial, Inc. Berlin, New Hampshire
We have audited the accompanying consolidated statements of financial condition of Northway Financial, Inc. and Subsidiaries as of December 31, 2003 and 2002 and the related consolidated statements of income, comprehensive income, changes in stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 2003. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Northway Financial, Inc. and Subsidiaries as of December 31, 2003 and 2002 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.
/s/ SHATSWELL, MacLEOD & COMPANY, P.C.
SHATSWELL, MacLEOD & COMPANY, P.C.
West Peabody, Massachusetts January 16, 2004
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
The Company's management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the company's disclosure controls and procedures as of December 31, 2003. Based on that evaluation, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective as of December 31, 2003. There were no material changes in the Company's internal control over financial reporting during the fourth quarter 2003.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information required by this item is incorporated by reference to the information set forth under the captions "Information Concerning Directors and Nominees," "Executive Officers" and "Audit and Compliance Committee" in the Company's definitive proxy statement to be delivered in connection with its 2004 Annual Meeting of Stockholders.
Further, the Company has adopted a code of ethics that applies to all of its directors, officers and employees. The Company has filed a copy of this Code of Ethics as Exhibit 14 to this Form 10-K. The Company has also made the Code of Ethics available on its website at www.northwayfinancialinc.com.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference to the information set forth under the caption "Executive Compensation" in the Company's definitive proxy statement to be delivered in connection with its 2004 Annual Meeting of Stockholders, provided however, that the "Report of the Human Resources, Compensation and Nominating Committee on Executive Compensation" and the "Stock Price Performance Graph" contained in such proxy statement are not incorporated by reference herein.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this item is incorporated by reference to the information set forth under the caption "Security Ownership of Management" in the Company's definitive proxy statement to be delivered in connection with its 2004 Annual Meeting of Stockholders.
The following table sets forth information regarding securities authorized for issuance under the Company's equity compensation plans as of December 31, 2003:
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated by reference to the information set forth under the caption "Certain Relationships and Related Transactions" in the Company's definitive proxy statement to be delivered in connection with its 2004 Annual Meeting of Stockholders.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item is incorporated by reference to the information set forth under the caption "Fees Paid to Independent Auditors" in the Company's definitive proxy statement to be delivered in connection with its 2004 Annual Meeting of Stockholders.
ITEM 15 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) The following financial statements are incorporated by reference from Item 8
Item 8 hereof: Auditor's Independent Report Consolidated Statements of Financial Condition as of December 31, 2003 and 2002 Consolidated Statements of Income for the years ended December 31, 2003 and 2002 Consolidated Statements of Changes in Stockholders Equity for the years ended December 31, 2003, 2002, 2001 and 2000 Consolidated Statements of Comprehensive Income for the years ended December 31, 2003, 2002 and 2001 Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002 and 2001 Notes to Consolidated Financial Statements
(2) Financial Statement Schedules: None
(3) The Exhibits which are filed with this report or which are incorporated herein by reference are set forth in the Exhibit Index. The Exhibit Index is incorporated herein by reference.
(b) Current Report on Form 8-K filed on October 28, 2003. Item reported: Earnings announcement for third quarter ending September 30, 2003.
(c) See Item 15(a)(3) above
(d) See Item 8 of this Annual Report on Form 10-K
SIGNATURES
Pursuant to requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
NORTHWAY FINANCIAL, INC.
March 23, 2004 BY: /S/ William J. Woodward ------------------------------- William J. Woodward Chairman of the Board, President & Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Title Date
Chairman of the Board, March 23, 2004 President and CEO (Principal /S/ William J. Woodward Executive Officer) - ------------------------------ William J. Woodward
Senior Vice President and March 23, 2004 Chief Financial Officer (Principal Financial /S/ Richard P. Orsillo and Accounting Officer) - ------------------------------ Richard P. Orsillo
/S/ Fletcher W. Adams Vice Chairman of the Board March 26, 2004 - ------------------------------ Fletcher W. Adams
/S/ John D. Morris Director March 26, 2004 - ------------------------------ John D. Morris
/S/ John H. Noyes Director March 24, 2004 - ------------------------------ John H. Noyes
/S/ Barry J. Kelley Director March 23, 2004 - ------------------------------ Barry J. Kelley
/S/ Randall G. Labnon Director March 25, 2004 - ------------------------------ Randall G. Labnon
/S/ Stephen G. Boucher Director March 26, 2004 - ------------------------------ Stephen G. Boucher
/S/ Brien L. Ward Director March 26, 2004 - ----------------------------- Brien L. Ward
/S/ Charles H. Clifford, Jr. Director March 26, 2004 - ----------------------------- Charles H. Clifford, Jr.
/S/ Arnold P. Hanson, Jr. Director March 23, 2004 - ----------------------------- Arnold P. Hanson, Jr.
/S/ Frederick C. Anderson Director March 26, 2004 - ----------------------------- Frederick C. Anderson
INDEX OF EXHIBITS
Exhibit Number Description of Exhibit
2.1 Agreement and Plan of Merger, dated as of March 14, 1997, by and among Northway Financial, Inc., The Berlin City Bank, Pemi Bancorp, Inc. and Pemigewasset National Bank (the "Merger Agreement") (incorporated by reference to Exhibit 2.1 to Registration Statement No. 333-33033).
3.1 Amended and Restated Articles of Incorporation of Northway Financial, Inc. (incorporated by reference to Exhibit 3.1 to Registration Statement No. 333-33033).
3.2 By-laws of Northway Financial, Inc (incorporated by reference to Exhibit 3.2 to the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
4 Form of Certificate representing the Company Common Stock (reference is also made to Exhibits 3.1 and 3.2) (incorporated by reference to Exhibit 4 to Registration Statement No. 333-33033).
10.1 Employment Agreement for William J. Woodward (incorporated by reference to Exhibit 10.1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.2 Employment Agreement for Fletcher W. Adams (incorporated by reference to Exhibit 10.2 to the Company's Annual Report on Form 10-K for the year ended December 31, 1997).
10.3 Amendment to the Employment Agreement for William J. Woodward. (incorporated by reference to Exhibit 10.3 to the Company's Annual Report on Form 10-K for the year ended December 31, 1998).(2)
10.4 Amendment to the Employment Agreement for Fletcher W. Adams. (incorporated by reference to Exhibit 10.4 to the Company's Annual Report on Form 10-K for the year ended December 31, 1998). (2)
10.5 Northway Financial, Inc. 1999 Stock Option and Grant Plan (incorporated by reference to Exhibit 4.1 to Registration Statement No. 333-83571 dated July 23,1999). (2)
10.7 Form of Key Employee Agreement (incorporated by reference to Exhibit 10.8 to the Company's Annual Report on Form 10-K for the year ended 1999). (2)
10.8 Supplemental Executive Retirement Plan.(1)
11 Statement re: Computation of Per Share Earnings(1)
14 Code of Ethics(1)
21 List of Subsidiaries(1)
23 Consent of Shatswell, MacLeod & Company, P.C. (1)
31.1 Certification of President of Northway Financial, Inc., pursuant to rules 13(a)-15(e) and 15d-15(e), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.(1)
31.2 Certification of Chief Financial Officer of Northway Financial, Inc., pursuant to rules 13(a)-15(e) and 5d-15(e), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.(1)
32.1 Certification of President of Northway Financial, Inc., pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.(1)
32.2 Certification of Chief Financial Officer of Northway Financial, Inc., pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.(1)
(1) Filed herewith. (2) Management contract or compensatory plan required to be filed as an exhibit to this form pursuant to Item 14(c) of this report.