Item 1A. Risk Factors
Like all financial companies, NB&T Financial’s business and results of operations are subject to a number of risks, many of which are outside of our control. In addition to the other information in this report, readers
should carefully consider that the following important factors, among others, could materially impact our business and future results of operations.
Changes in interest rates could adversely affect our financial condition and results of operations.
Our results of operations depend substantially on our net interest income, which is the difference between (i) the interest earned on loans, securities and other interest-earning assets and (ii) the interest paid on deposits and borrowings. These rates are highly sensitive to many factors beyond our control, including general economic conditions, inflation, recession, unemployment, money supply and the policies of various governmental and regulatory authorities. If the interest we pay on deposits and other borrowings increases at a faster rate than the interest we receive on loans and other investments, our net interest income and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest we receive on loans and other investments falls more quickly than the interest we pay on deposits and borrowings. While we have taken measures intended to manage the risks of operating in a changing interest rate environment, there can be no assurance that these measures will be effective in avoiding undue interest rate risk.
Increases in interest rates also can affect the value of loans and other assets, including our ability to realize gains on the sale of assets. We originate loans for sale and for our portfolio. Increasing interest rates may reduce the origination of loans for sale and consequently the fee income we earn on such sales. Further, increasing interest rates may adversely affect the ability of borrowers to pay the principal or interest on loans and leases, resulting in an increase in non-performing assets and a reduction of income recognized.
Changes in national and local economic and political conditions could adversely affect our earnings, as our borrowers’ ability to repay loans and the value of the collateral securing our loans decline and as loans and deposits decline.
There are inherent risks associated with our lending activities, including credit risk, which is the risk that borrowers may not repay outstanding loans or the value of the collateral securing loans will decrease. Conditions such as inflation, recessions unemployment, changes in interest rates and money supply and other factors beyond our control may adversely affect the ability of our borrowers to repay their loans and the value of collateral securing the loans, which could adversely affect our earnings. Because we have a significant amount of real estate loans, a decline in the value of real estate could have a material adverse affect on us. As of December 31, 2005, 64% of our loan portfolio consisted of commercial and industrial, commercial real estate, real estate construction, installment and agricultural loans, all of which are generally viewed as having more risk of default than residential real estate loans and all of which, with the exception of installment loans, are typically larger than residential real estate loans. We attempt to manage credit risk through a program of underwriting standards, the review of certain credit decisions and an on-going process of assessment of the quality of the credit already extended. Economic and political changes could also adversely affect our deposits and loan demand, which could adversely affect our earnings and financial condition. Since substantially all of our loans are to individuals and businesses in Ohio, any decline in the economy of this market area could have a materially adverse effect on our credit risk and on our deposit and loan levels.
We operate in an extremely competitive market, and our business will suffer if we are unable to compete effectively.
In our market area, we encounter significant competition from other banks, savings and loan associations, credit unions, mortgage banking firms, securities brokerage firms, asset management firms and insurance companies. The increasingly competitive environment is a result primarily of changes in regulation and the accelerating pace of consolidation among financial service providers. NB&T Financial is smaller than many of our competitors. Many of our competitors have substantially greater resources and lending limits than we do and may offer services that we do not or cannot provide.
Legislative or regulatory changes or actions could adversely impact the financial services industry.
The financial services industry is extensively regulated. Banking laws and regulations are primarily intended for the protection of consumers, depositors and the deposit insurance funds, not to benefit our shareholders. Changes to laws and regulations or other actions by regulatory agencies may negatively impact us, possibly limiting the services we provide, increasing the ability of non-banks to compete with us or requiring us to change the way we operate. Regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the ability to impose restrictions on the operation of an institution and the ability to determine the adequacy of an institution’s allowance for loan losses. Failure to comply with applicable laws, regulations and policies could result in sanctions being imposed by the regulatory agencies, including the imposition of civil money penalties, which could have a material adverse effect on our operations and financial condition. The significant federal and state banking regulations that affect us are described in this annual report under the heading “Regulation.”
Our ability to pay cash dividends is limited.
We are dependent primarily upon the earnings of our operating subsidiaries for funds to pay dividends on our common shares. The payment of dividends by us and our subsidiaries is subject to certain regulatory restrictions. As a result, any payment of dividends in the future will be dependent, in large part, on our ability to satisfy these regulatory restrictions and our subsidiaries’ earnings, capital requirements, financial condition and other factors. Although our financial earnings and financial condition have allowed us to declare and pay periodic cash dividends to our shareholders, there can be no assurance that our dividend policy or size of dividend distribution will continue in the future.
The preparation of financial statements requires management to make estimates about matters that are inherently uncertain.
Management’s accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. Our management must exercise judgment in selecting and applying many of these accounting policies and methods in order to ensure that they comply with generally accepted accounting principles and reflect management’s judgment as to the most appropriate manner in which to record and report our financial condition and results of operations. Two of the most critical estimates are the level of the allowance of loan losses and the valuation of mortgage servicing rights. Due to the inherent nature of these estimates, we cannot provide absolute assurance that we will not significantly increase the allowance for loan losses or sustain loan losses that are significantly higher than the provided allowance.
Trading in our common shares is very limited, which may adversely affect the time and the price at which you can sell your NB&T Financial common shares.
Although the common shares of NB&T Financial are quoted on The Nasdaq Capital Market, trading in NB&T Financial’s common shares is not active, and the spread between the bid and the asked price is often wide. As a result, you may not be able to sell your shares on short notice, and the sale of a large number of shares at one time could temporarily depress the market price. The price at which you may be able to sell your common shares may be significantly lower than the price at which you could buy NB&T Financial common shares at that time.
Our organizational documents and the large percentage of shares controlled by management and family members of management may have the effect of discouraging a third party from acquiring us.
Our articles of incorporation and code of regulations contain provisions that make it more difficult for a third party to gain control or acquire us without the consent of the board of directors. These provisions could also discourage proxy contests and may make it more difficult for dissident shareholders to elect representatives as
directors and take other corporate actions. Moreover, as of March 1, 2006, directors and executive officers controlled the vote of 18.3% of the outstanding common shares of NB&T Financial in addition to the 5.98% of the outstanding shares with respect to which the Bank controls the vote as trustee and an additional 29.37% owned by relatives of a director. The provisions in our articles and code of regulations and the percentage of voting control by NB&T Financial affiliates and relatives could have the effect of delaying or preventing a transaction or a change in control that a shareholder might deem to be in the best interests of that shareholder.
Item 1B.
Item 1B. Unresolved Staff Comments
Not applicable
REGULATION
General
Because of its ownership of all the outstanding stock of the Bank, NB&T Financial is subject to regulation, examination and oversight by the FRB as a bank holding company under the BHCA. The Bank, as a national bank, is subject to regulation, examination and oversight by the OCC and special examination by the FRB. The Bank is a member of the Federal Reserve Bank of Cleveland and a member of the Federal Home Loan Bank of Cincinnati. In addition, since its deposits are insured by the FDIC, the Bank is also subject to some regulation, oversight and special examination by the FDIC. The Bank must file periodic financial reports with the FDIC, the OCC and the Federal Reserve Bank of Cleveland. Examinations are conducted periodically by these federal regulators to determine whether the Bank and NB&T Financial are in compliance with various regulatory requirements and are operating in a safe and sound manner. In general, the FRB may initiate enforcement actions for violations of law and regulations.
Bank Holding Company Regulation
The FRB has adopted capital adequacy guidelines for bank holding companies, pursuant to which, on a consolidated basis, NB&T Financial must maintain total capital of at least 8% of risk-weighted assets. Risk-weighted assets consist of all assets, plus credit equivalent amounts of certain off- balance sheet items, which are weighted at percentage levels ranging from 0% to 100%, based on the relative credit risk of the asset. At least half of the total capital to meet this risk-based requirement must consist of core or “Tier 1” capital, which includes common stockholders’ equity, qualifying perpetual preferred stock (up to 25% of Tier 1 capital) and minority interests in the equity accounts of consolidated subsidiaries, less goodwill, certain other intangibles, and portions of certain nonfinancial equity investments. The remainder of total capital may consist of supplementary or “Tier 2 capital.” In addition to this risk-based capital requirement, the FRB requires bank holding companies to meet a leverage ratio of a minimum level of Tier 1 capital to average total consolidated assets of 3%, if they have the highest regulatory examination rating, well-diversified risk and minimal anticipated growth or expansion. All other bank holding companies are expected to maintain a leverage ratio of at least 4% of average total consolidated assets. NB&T Financial was in compliance with these capital requirements at December 31, 2005. For NB&T Financial’s capital ratios, see Note 14 to the Consolidated Financial Statements in Item 8.
A bank holding company is required by law to guarantee the compliance of any insured depository institution subsidiary that may become “undercapitalized” (defined in the regulations as not meeting minimum capital requirements) with the terms of the capital restoration plan filed by such subsidiary with its appropriate federal banking agency.
The BHCA restricts NB&T Financial’s ownership or control of the outstanding shares of any class of voting stock of any company engaged in a nonbanking business, other than companies engaged in certain activities determined by the FRB to be closely related to banking. In addition, the FRB has the authority to require a bank
holding company to terminate any activity or relinquish control of any nonbank subsidiary (other than a nonbank subsidiary of a bank) upon the determination by the FRB that such activity or control constitutes a serious risk to the financial soundness and stability of any bank subsidiary of the bank holding company. NB&T Financial currently has no nonbank subsidiaries, except subsidiaries of the Bank. The ownership of subsidiaries of the Bank is regulated by the OCC, rather than the FRB.
The Financial Services Modernization Act of 1999 permits bank holding companies to become financial holding companies and thereby affiliate with securities firms and insurance companies and engage in other activities that are financial in nature. A bank holding company may become a financial holding company if each of its subsidiary banks is well capitalized under the Federal Deposit Insurance Corporation Act of 1991 prompt corrective action provisions, is well managed, and has at least a satisfactory rating under the Community Reinvestment Act, by filing a declaration that the bank holding company wishes to become a financial holding company. No regulatory approval will be required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board.
The Financial Services Modernization Act defines “financial in nature” to include:
•
securities underwriting, dealing and market making;
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sponsoring mutual funds and investment companies;
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insurance underwriting and agency;
•
merchant banking; and
•
activities that the Federal Reserve Board has determined to be closely related to banking.
A national bank also may engage, subject to limitations on investment, in activities that are financial in nature, other than insurance underwriting, insurance company portfolio investment, real estate development and real estate investment, through a financial subsidiary of the bank, if the bank is well capitalized, well managed and has at least a satisfactory Community Reinvestment Act rating. Subsidiary banks of a financial holding company or national banks with financial subsidiaries must continue to be well capitalized and well managed in order to continue to engage in activities that are financial in nature without regulatory actions or restrictions, which could include divestiture of the financial in nature subsidiary or subsidiaries. In addition, a financial holding company or a bank may not acquire a company that is engaged in activities that are financial in nature unless each of the subsidiary banks of the financial holding company or the bank has a Community Reinvestment Act rating of satisfactory or better. NB&T Insurance is a financial subsidiary.
Transactions between NB&T Financial and the Bank are subject to statutory limits in Sections 23A and 23B of the Federal Reserve Act (the “FRA”), which limit the amounts of such transactions and require that the terms of the transactions be at least as favorable to the Bank as the terms would be of a similar transaction between the Bank and an unrelated party. NB&T Financial and the Bank were in compliance with these requirements and restrictions at December 31, 2005.
The FRB must approve the application of a bank holding company to acquire any bank or savings association.
National Bank Regulation
Office of the Comptroller of the Currency. The OCC is an office in the Department of the Treasury and is subject to the general oversight of the Secretary of the Treasury. The OCC is responsible for the regulation and supervision of all national banks, including the Bank. The OCC issues regulations governing the operation of national banks and, in accordance with federal law, prescribes the permissible investments and activities of
national banks. The Bank is authorized to exercise trust powers in accordance with OCC guidelines. National banks are subject to regulatory oversight under various consumer protection and fair lending laws. These laws govern, among other things, truth-in-lending disclosure, equal credit opportunity, fair credit reporting and community reinvestment.
The Bank is required to meet certain minimum capital requirements set by the OCC. These requirements consist of risk-based capital guidelines and a leverage ratio, which are substantially the same as the capital requirements imposed on NB&T Financial. The Bank was in compliance with those capital requirements at December 31, 2005. For the Bank capital ratios, see Note 14 to the Consolidated Financial Statements in Item 8. The OCC may adjust the risk-based capital requirement of a national bank on an individualized basis to take into account risks due to concentrations of credit or nontraditional activities.
The OCC has adopted regulations governing prompt corrective action to resolve the problems of capital deficient and otherwise troubled national banks. At each successively lower defined capital category, a national bank is subject to more restrictive and numerous mandatory or discretionary regulatory actions or limits, and the OCC has less flexibility in determining how to resolve the problems of the institution. In addition, the OCC generally can downgrade a national bank’s capital category, notwithstanding its capital level, if, after notice and opportunity for hearing, the national bank is deemed to be engaging in an unsafe or unsound practice, because it has not corrected deficiencies that resulted in it receiving a less than satisfactory examination rating on matters other than capital or it is deemed to be in an unsafe or unsound condition. The Bank’s capital at December 31, 2005, met the standards for the highest capital category, a well-capitalized bank.
A national bank is subject to restrictions on the payment of dividends, including dividends to a holding company. The Bank may not pay a dividend if it would cause the Bank not to meet its capital requirements. In addition, the dividends that a Bank subsidiary can pay to its holding company without prior approval of regulatory agencies is limited to net income plus its retained net income for the preceding two years. Based on the current financial condition of the Bank, the Bank does not expect these provisions to affect the current ability of the Bank to pay dividends to NB&T Financial in an amount customary for the Bank.
OCC regulations generally limit the aggregate amount that a national bank can lend to one borrower or aggregated groups of related borrowers to an amount equal to 15% of the bank’s unimpaired capital and surplus. A national bank may loan to one borrower an additional amount not to exceed 10% of the association’s unimpaired capital and surplus, if the additional amount is fully secured by certain forms of “readily marketable collateral.” Loans to executive officers, directors and principal shareholders and their related interests must conform to the OCC lending limits. All transactions between national banks and their affiliates, including NB&T Financial, must comply with Sections 23A and 23B of the FRA.
Federal Deposit Insurance Corporation. The FDIC is an independent federal agency that insures the deposits, up to prescribed statutory limits, of federally insured banks and thrifts and safeguards the safety and soundness of the banking and thrift industries. The FDIC is authorized to establish annual assessment rates for deposit insurance. The FDIC has established a risk-based assessment system for members. Under this system, assessments vary based on the risk the institution poses to its deposit insurance fund. The risk level is determined based on the institution’s capital level and the FDIC’s level of supervisory concern about the institution. Insurance of deposits may be terminated by the FDIC if it finds that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition enacted or imposed by the institution’s regulatory agency.
In February of 2006, President Bush signed into law the Deposit Insurance Reform Act of 2005 and its companion bill, the Deposit Insurance Reform Conforming Amendments Act of 2005 (collectively, the “Deposit Insurance Reform Acts”), which provide for the Bank Insurance Fund (BIF) and the Savings Association
Insurance Fund (SAIF) to be merged into a new Deposit Insurance Fund (DIF). The Deposit Insurance Reform Acts provide for several additional changes to the deposit insurance system, including the following:
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Increasing the deposit insurance limit for retirement accounts from $100,000 to $250,000;
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Adjusting the deposit insurance limits (currently $100,000 for most accounts) every five years based on an inflation index, with the first adjustment to be effective on January 1, 2011;
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Providing pass-through deposit insurance for the deposits of employee benefit plans (but prohibiting undercapitalized depository institutions from accepting employee benefit plan deposits);
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Allocating an aggregate of $4.7 billion of one-time credits to offset the premiums of depository institutions based on their assessment bases at the end of 1996;
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Establishing rules for awarding cash dividends to depository institutions, based on their relative contributions to the DIF and its predecessor funds, when the DIF reserve ratio reaches certain levels; and
•
Revising the rules and procedures for risk-based premium assessments.
The FDIC is required to adopt rules implementing the various provisions of the Deposit Insurance Reform Acts. The BIF and the SAIF are required to be merged into the DIF by July 1, 2006, while most of the other provisions are required to be implemented by November 5, 2006. Management is not yet able to determine the effect the Deposit Insurance Reform Acts will have on the Company.
Federal Reserve Board. The FRA requires national banks to maintain reserves against their net transaction accounts (primarily checking and NOW accounts). The amounts are subject to adjustment by the FRB. At December 31, 2005, the Bank was in compliance with its reserve requirements.
Federal Home Loan Banks. The Federal Home Loan Banks (the FHLBs) provide credit to their members in the form of advances. As a member, the Bank must maintain an investment in the capital stock of the FHLB of Cincinnati in an amount equal to the greater of 1% of the aggregate outstanding principal amount of the Bank’s residential real estate loans, home purchase contracts and similar obligations at the beginning of each year, or 5% of its advances from the FHLB. The Bank is in compliance with this requirement with an investment in FHLB of Cincinnati stock having a book value of $7.8 million at December 31, 2005. The FHLB advances are secured by collateral in one or more specified categories. The amount a member may borrow from the FHLB is limited based upon the amounts of various assets held by the member.
Ohio Department of Insurance. The Bank’s insurance agency operating subsidiary is subject to the insurance laws and regulations of the State of Ohio and the Ohio Department of Insurance. The insurance laws and regulations require education and licensing of agencies and individual agents, require reports and impose business conduct rules.
I tem 2. Properties
NB&T Financial and the Bank own and occupy their main offices located at 48 North South Street, Wilmington, Ohio. The National Bank and Trust Company also owns or leases 19 full-service branch offices and one remote drive-through ATM facility, all of which are located in Adams, Brown, Clermont, Clinton, Fayette, Hardin, Highland, and Warren Counties in Ohio. The Bank owns a building at 1600 West Main Street, Wilmington, Ohio, which serves as an operation center for the Bank and houses the Bank’s insurance agency.
I tem 3. Legal Proceedings
Neither NB&T Financial nor the Bank is presently involved in any legal proceedings of a material nature. From time to time, the Bank is a party to legal proceedings incidental to its business to enforce its security interest in collateral pledged to secure loans made by the Bank.
I tem 4. Submission of Matters to a Vote of Security Holders
None
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
There were 3,232,513 common shares of the Company outstanding on December 31, 2005 held of record by approximately 418 shareholders of record other than brokers, banks and depositories, and approximately an additional 423 beneficial owners holding their shares in the names of brokers, banks and depositories. Dividends per share declared were $0.26 per share in each quarter in 2005 and were $0.25 per share in each quarter in 2004.
The Company’s shares trade on the Nasdaq Capital Market (formerly Nasdaq SmallCap Market) under the symbol NBTF. The following table summarizes the quarterly common stock prices and dividends declared for the last two years.
As a national bank, the Bank is subject to restrictions on the payment of dividends to the Company, which could restrict the ability of the Company to pay dividends. The Bank may not pay a dividend if it would cause the Bank not to meet its capital requirements. In addition, without regulatory approval, the Bank is limited to paying dividends equal to net income to date in the fiscal year plus its retained net income for the preceding two years.
The Company has a stock option plan under which the Company may grant options that vest over five years to selected employees for up to 7% of the authorized and issued shares of the Company, currently 3,818,950 shares. The plan will terminate effective upon adoption of a new equity plan being submitted for shareholder approval at the 2006 annual meeting. The following table summarizes the securities authorized for issuance at December 31, 2005 under all equity compensation plans in existence at that date:
I tem 6. Selected Financial Highlights
(Dollars and shares in thousands, except per share data)
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis comparing 2005 to prior years should be read in conjunction with the audited consolidated financial statements at December 31, 2005 and 2004 and for the three years ended December 31, 2005.
FORWARD-LOOKING STATEMENTS
Statements preceded by, followed by or that otherwise include the words “believes,” “expects,” “anticipates,” “intends,” “estimates,” “plans,” “may increase,” “may fluctuate,” “will likely result,” and similar expressions or future or conditional verbs such as “will,” “should,” “would,” and “could” are generally forward-looking in nature and not historical facts. Results could differ materially from those expressed in such forward-looking statements due to a number of factors, including (1) changes in interest rates; (2) changes in national and local economic and political conditions; (3) competitive pressures in the retail banking, financial services, insurance and other industries; (4) changes in laws and regulations, including changes in accounting standards; (5) changes in policy by regulatory agencies; and (6) changes in the securities markets. Any forward-looking statements are not guarantees of future performance. They involve risks, uncertainties and assumptions, and actual results could differ materially from those contemplated by those forward-looking statements. Many of the factors that will determine these results are beyond the Company’s ability to control or predict. The Company disclaims any duty to update any forward-looking statements, all of which are qualified by the statements in this section. See Item 1.A. “Risk Factors” in this annual report for further discussion of the risks affecting the business of the Company and the value of an investment in its shares.
RESULTS OF OPERATIONS
EXECUTIVE SUMMARY
Net income for 2005 was $4.1 million, or $1.30 per diluted share, compared to $4.9 million, or $1.56 per diluted share, for last year. The decrease in net income was primarily due to a declining net interest margin and fewer gains on security sales, partially offset by a decrease in the provision for loan losses due to lower charged-off loans and management’s evaluation of the current portfolio. Net interest income declined $1.1 million from $20.2 million in 2004 to $19.1 million in 2005, and security gains were down $685,000. Net loan charge-offs were $928,000, or 0.23% of average loans in 2005, compared to $2.52 million, or 0.62%, in 2004, contributing to the decline in loan loss provision from $1.9 million in 2004 to $775,000 in 2005. Performance ratios for 2005 included a return on assets of .63% and a return on equity of 6.98%, compared to .75% and 8.57%, respectively, in 2004.
Net income for 2004 was $4.9 million, or $1.57 per share, compared to $4.1 million, or $1.31 per share, for the year of 2003. The increase in net income in 2004 was primarily due to a lower loan loss provision of $2.0 million, as a result of decreasing non-performing loans. Partially offsetting the lower loan loss provision was a decrease in net interest income of $1.3 million from $21.5 million in 2003 to $20.2 million in 2004. Total non-interest income of $8.5 million for 2004, excluding securities gains, was relatively unchanged from 2003. Non-interest expense decreased from $22.5 million in 2003 to $21.6 million in 2004 due to reorganization costs of $709,000 in 2003. Performance ratios for 2004 included a return on assets of 0.75% and a return on equity of 8.57 %, compared to 0.60% and 7.06%, respectively, in 2003.
NET INTEREST INCOME
Net interest income, the difference between interest income earned on interest-earning assets and interest expense incurred on interest-bearing liabilities, is the most significant component of the Company’s earnings. Net interest income is affected by changes in the volumes, rates and composition of interest-earning assets and interest-bearing liabilities. Table 1 reflects the components of the Company’s net interest income for each of the three years ended December 31, 2005, setting forth: (i) average assets, liabilities and shareholders’ equity,
(ii) interest income earned on interest-earning assets and interest expense incurred on interest-bearing liabilities, (iii) average yields earned on interest-earning assets and interest expense incurred on interest-bearing liabilities, and (iv) the net interest margin (i.e., net interest income divided by average interest-earning assets). Non-accrual loans have been included in the average loan balances.
TABLE 1-NET INTEREST INCOME AND NET INTEREST MARGIN
(Dollars in thousands)
(1) Includes nonaccrual loans and loan fees.
Net interest income was $19.1 million in 2005, a decrease of $1.1 million compared to 2004. During 2005, the Federal Reserve increased its targeted federal funds rate 200 basis points from 2.25% to 4.25%. This action increased general market rates for terms of less than two years by a similar amount; however, longer-term rates increased only slightly. The Bank’s deposits and short-term borrowing costs are more closely associated with short-term rates. As a result, total interest expense increased $1.86 million to $13.8 million during 2005 despite a $9.7 million decrease in average outstanding interest-bearing liabilities. A higher percentage of the Bank’s earning assets have yields more closely associated with longer-term rates. Interest income increased $751,000 to $32.9 million in 2005 from $32.1 million in 2004. Unfortunately, this increase was not enough to offset the increase in interest expense, and the Bank’s net interest margin dropped from 3.31% in 2004 to 3.16% in 2005.
Net interest income decreased $1.3 million, or 6.0%, from $21.5 million in 2003 to $20.2 million in 2004. Net interest margin decreased from 3.38% in 2003 to 3.31% in 2004. Interest income on loans decreased $1.6 million, or 6.0%, from 2003, and the yield on average loans decreased from 6.62% in 2003 to 6.09% in 2004,
despite an increase in average loans of $8.8 million. Although the prime rate increased approximately 125 basis points from June 2004 to December 2004, approximately 60% of the Company’s adjustable-rate loan portfolio reprices off the three- and five-year treasury rates. These treasury rates remained lower in 2004 than the previous repricing rates, resulting in a decrease in the yield earned on adjusting loans. In addition, interest income on securities decreased $1.2 million from $8.3 million in 2003 to $7.1 million in 2004. The average securities balance declined $36.3 million in 2004, primarily due to the use of proceeds from the sale and maturity of securities to pay down approximately $21.0 million in FHLB debt. The interest expense on interest-bearing liabilities only decreased $1.5 million from $13.4 million in 2003 to $11.9 million in 2004. The yield on interest-bearing deposits declined 24 basis points from 1.65% in 2003 to 1.41% in 2004 as certificates of deposit matured and repriced at lower rates. Rates on short-term borrowings are directly tied to the prime rate. As a result, short-term borrowing costs increased during the last six months of 2004.
Net interest income may also be analyzed by segregating the volume and rate components of interest income and interest expense. Table 2 presents an analysis of increases and decreases in interest income and expense in terms of changes in volume and interest rates during the three years ended December 31, 2005. Changes attributable to rate and volume are allocated to both rate and volume on an equal basis.
TABLE 2-NET INTEREST INCOME-RATE/VOLUME ANALYSIS
(Dollars in thousands)
NON-INTEREST INCOME
Table 3 details the components of non-interest income, excluding securities gains and losses, and the percentage change from the two previous years. Total non-interest income was $8.3 million in 2005, $ 8.5 million in 2004, and $8.5 million in 2003. Trust income increased 1.8% in 2005 and 14.8 % in 2004, due to an increase in the average market value of funds under management and increased trust account fees. Service charges on deposits decreased 9.2% in 2005 largely due to fees on overdrawn accounts decreasing by approximately $69,000 and lower service charges on business checking accounts resulting from an increase in the average earnings credit. Other service charges and fees increased in 2005 and 2004 due to additional fee income on debit card transactions. ATM network fees have decreased since 2003 as a result of increased
competition in the ATM network business and the Company’s decision to discontinue this line of business due to lower profit margins and higher machine upgrade expenses. Bank owned life insurance (“BOLI”) income decreased to $438,000 in 2005 compared to $520,000 and $531,000 in 2004 and 2003, respectively, due to a decline in the yield on the underlying investments. Other income increased to $848,000 in 2005 from $716,000 in 2004 due to increased gains on loan sales and loan extension fee income.
TABLE 3-NON-INTEREST INCOME
(Dollars in thousands)
Gain on sales of securities totaled $101,000 in 2005, compared to $787,000 in 2004. Proceeds from the sale of securities totaled $7.5 million in 2005, compared to $42.1 million in 2004.
NON-INTEREST EXPENSE
Table 4 details the components of non-interest expense and the percentage change from the two previous years. Total non-interest expense was $21.9 million in 2005, $21.6 million in 2004 and $22.5 million in 2003.
TABLE 4-NON-INTEREST EXPENSE
(Dollars in thousands)
Salaries and benefits expense, which is the largest component of non-interest expense, increased to $11.6 million in 2005 from $11.1 million in 2004. Salaries and benefits expense in 2003 was $11.0 million. Salaries and employee benefits expense increased 4.9% during 2005 due to merit increases and increased health insurance costs. In 2004, salary expense was down approximately $370,000, largely due to a reduction in staffing in the
fourth quarter of 2003 and the closing of three offices in January 2004. This decrease was offset by payment of bonuses in 2004. The average number of full-time equivalent employees was 247 in 2005, 249 in 2004 and 269 in 2003.
Occupancy expense increased $123,000 in 2005 largely due to increased maintenance and repair costs, utility costs and real estate taxes. Equipment expense declined from $2.3 million in 2003 to $2.0 million in 2004 and 2005. Most of this decrease is the result of closing three branches in January 2004 and reduced depreciation and maintenance expenses related to the Company’s ATM network. Data processing expenses were down in 2005 and 2004 due to conversion to a new data processing system in 2004. The maintenance fees on the new data processing system were waived for the first year, resulting in a partial year’s fees in both 2005 and 2004. Professional fees increased $323,000 in 2005 from 2004 due to new corporate branding initiatives and executive search costs. Printing, postage and supplies expenses declined to $702,000 in 2005 from $809,000 and $827,000 in 2004 and 2003, respectively. These expense savings primarily came from decreases in supplies and postage costs related to office closings and lower preprinted form costs. Other non-interest expenses decreased from $2.3 million in 2003 to $1.6 million in 2004 and $1.2 million in 2005. Other expenses were higher in 2003 compared to 2004 due to $704,000 in reorganization expenses related to the closing of three banking offices in January 2004. Other non-interest expenses were down further in 2005 due to lower expenses associated with foreclosed real estate and reduced education expense.
INCOME TAXES
The effective tax rates were 15.2% for 2005, 17.7% for 2004 and 10.0% for 2003. The effective tax rate being lower than the statutory rate was primarily due to tax-exempt municipal bond interest income and BOLI income.
FINANCIAL CONDITION
ASSETS
Average total assets decreased 1.4% during 2005 to $655.0 million. Average interest-earning assets decreased 1.0%, and were 93% of total average assets, equivalent to 2004 and 2003.
SECURITIES
The following table sets forth the composition of the Bank’s securities portfolio, based on amortized cost, at the dates indicated:
TABLE 5-SECURITIES PORTFOLIO
(Dollars in thousands)
In 2005, total securities increased $3.6 million to $173.0 million, compared to $169.4 million at December 31, 2004. Approximately $7.6 million in U.S. agency mortgage-backed securities were sold in 2005 with $16.6 million and $10.9 million reinvested in U.S. Agency notes and collateralized mortgage-backed securities, respectively. Approximately $6.6 million in U.S. agency notes were called or matured in 2005, and $9.7 million in payments were received on mortgage-backed securities.
The majority of the decreases in the securities portfolio from 2003 to 2004 were the result of sales of U.S. agency mortgage-backed securities and other mortgage-backed securities, as well as some out-of-state municipal bonds. Part of the proceeds of these sales, along with the proceeds from matured securities, were used to pay off approximately $21.0 million in Federal Home Loan Bank debt.
Effective July 30, 2004, the Company reclassified its Held-to-Maturity Securities as Available-for-Sale. Historically, the Held-to-Maturity portfolio contained both out-of-state and Ohio municipal securities which were used to meet State of Ohio public fund pledging requirements and provide non-taxable income for the Company. As a result of a change in the Ohio Revised Code, the State of Ohio public fund pledging requirements eliminated out-of-state municipals as eligible collateral. Because of this change, approximately 77% of the Held-to-Maturity portfolio could not be used as originally intended. Management reclassified the portfolio to provide more flexibility for public fund pledging requirements, interest rate risk management and potential tax savings opportunities.
The following table sets forth the amortized cost of the Bank’s securities portfolio at December 31, 2005. Expected maturities of individual securities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Mortgage-backed securities are presented in the table based on current prepayment assumptions. U.S. Treasury and U.S. Agency notes, as well as municipal securities, are categorized based on contractual maturity. Yields do not include the effect of income taxes.
TABLE 6-SECURITIES PORTFOLIO REPRICING
(Dollars in thousands)
LOANS
Table 7 shows loans outstanding at period end by type of loan. Commercial and industrial loans declined from $89.6 million in 2003 and $90.1 million in 2004 to $82.9 million in 2005. The decline in the commercial
and industrial loan portfolio has been largely offset by an increase in commercial real estate loans, which increased from $35.4 million in 2003 to $55.6 million in 2004 and $82.6 million in 2005. The Company has experienced an increase in its commercial real estate lending over the past five years, because of the Company’s sales activities in the higher-growth Clermont and Warren Counties. The Company continues to focus its commercial lending on small- to medium-sized companies with established track records in the Company’s market area.
Residential real estate loans declined $9.8 million in 2004 compared to 2003, and declined $762,000 in 2005 to $148.3 million. Over the past two years, the Company has maintained shorter-term fixed-rate real estate loans for its portfolio and sold the majority of the long-term fixed-rate residential real estate loans originated. Outstanding balances have declined due to payments and refinancings. Currently, the Company has approximately $29.0 million in residential real estate loans with a loan-to-value ratio greater than 80% for which private mortgage insurance has not been required. The Company does not offer residential real estate loan products with negative amortization.
Installment loans outstanding decreased $2.2 million to $70.7 million in 2005 from $72.9 million at December 31, 2004. Installment loans also decreased $15.1 million from 2003 to 2004. This decrease occurred primarily in direct personal loans. Installment loans decreased to 17% of the portfolio at December 31, 2005 from 21% at December 31, 2003.
The Company has avoided concentration of commercial lending in any one industry. As of December 31, 2005, the highest commercial lending concentration was 8% for commercial rental real estate properties.
TABLE 7-LOAN PORTFOLIO
(Dollars in thousands)
At December 31,
Table 8 shows the amount of commercial, construction and agricultural loans outstanding as of December 31, 2005, which, based on contractual maturities, are due in the periods indicated. The table also sets
forth the amounts of loans due after one year from December 31, 2005 which have predetermined rates and which have floating or adjustable rates.
TABLE 8-LOAN MATURITIES AND PRICE SENSITIVITY
(Dollars in thousands)
NON-PERFORMING ASSETS
Table 9 shows the amount of non-performing assets outstanding as of December 31 for each of the last five years:
TABLE 9-NON-PERFORMING ASSETS
(Dollars in thousands)
The Company’s policy is to place a commercial loan on non-accrual status when it reaches 90 days past due and any of the following conditions exist: 1) the borrower cannot meet the payment obligations under the loan; 2) full payment of principal and interest is not expected; 3) the borrower has filed for bankruptcy and a plan of reorganization or liquidation is not imminent; or 4) foreclosure action has been initiated. All other loans are typically placed on non-accrual status once they reach 90 days past due. The amount of non-accrual loans was $8.2 million at year-end 2005, compared to $2.9 million at year-end 2004. The increase in non-accrual loans is due to placing one $5.0 million relationship on non-accrual during September 2005. At the time the relationship was placed on non-accrual status, the loans were less than 60 days past due; however, management was aware of potential cash flow weaknesses. At December 31, 2005, all payments due on this relationship were current.
Interest income recognized in 2005 on non-accrual loans outstanding at December 31, 2005 was $94,000; however, interest income that would have been recognized had the loans been accruing would have been approximately $251,000. The interest income recognized in 2005 relates to the $5.0 million relationship discussed above, which is earning interest income on a cash basis as payments are made.
ALLOWANCE FOR LOAN LOSSES
The provision for loan losses charged to expense was $775,000 in 2005, a decrease of $1.1 million from the provision of $1.9 million recorded in 2004, which was a decrease from $3.9 million in 2003. The lower provision for loan losses in 2005 is a result of lower net charge-offs and management’s evaluation of the current portfolio. Net charge-offs were $928,000, or 0.23% of average loans outstanding, in 2005, compared to $2.52 million, or 0.62%, for the same period in 2004.
Table 10 shows selected information relating to the Company’s allowance for loan losses. The allowance is maintained to absorb potential losses in the portfolio. If, as a result of charge-offs or increases in risk characteristics of the loan portfolio, the reserve is below the level considered by management to be adequate to absorb possible future loan losses, the provision for loan losses is increased. Loans deemed not collectible are charged off and deducted from the reserve. Recoveries on loans previously charged off are added to the reserve.
TABLE 10-ALLOWANCE FOR LOAN LOSSES
(Dollars in thousands)
Net charge-offs were higher in 2003 with increased bankruptcies, foreclosures and changes in economic conditions. During 2003, management reappraised collateral securing loans, updated estimated recovery rates, and used a third-party loan specialist to assist in identifying other potential loan weaknesses. Management then charged-off or charged-down problem loans and increased the loan loss provision in 2003 based upon evaluation of the loan portfolio and potential weaknesses of specific loans incorporating the updated estimates. The allowance for loan losses as a percent of total loans at December 31 was .97% in 2005, 1.05% in 2004, and 1.18% in 2003.
The Company allocates the allowance for loan losses to specifically classified loans and generally based on three-year net charge-off history. In assessing the adequacy of the allowance for loan losses, the Company considers three principal factors: (1) the three-year rolling average charge-off percentage applied to the current outstanding balance by portfolio type; (2) specific percentages applied to individual loans estimated by management to have a potential loss; and (3) estimated losses attributable to economic conditions. Economic conditions considered include unemployment levels, the condition of the agricultural business, and other local economic factors. Table 11 shows the allocation of the allowance for loan losses as of December 31, 2005.
TABLE 11-ALLOCATION OF ALLOWANCE FOR LOAN LOSSES
(Dollars in thousands)
OTHER ASSETS
In September 2000, $10 million was used to purchase Bank Owned Life Insurance with a cash surrender value that increases tax-free during future years at an adjustable rate. At December 31, 2005, the cash surrender value was $12.6 million. The intangible assets consisted of core deposit intangibles of $3.1 million, which is amortized over the expected life of the related core deposits, and goodwill of $3.8 million, which is tested annually for impairment in accordance with SFAS No. 141 . In 2005 and 2004, no goodwill was expensed due to impairment of value.
DEPOSITS
Table 12 presents a summary of period end deposit balances. Total deposits declined to $447.6 million in 2005 from $452.6 million in 2004 and $450.5 million in 2003. Both non-interest bearing and interest-bearing checking accounts have remained relatively stable since 2003. Savings accounts grew from 2003 to 2004 but leveled off at 11% of total deposits at December 31, 2005. The Company introduced a Business Savings account in 2004, which contributed to the savings growth. Money market accounts declined from 13% in 2003 to 10% and 9% in 2004 and 2005, respectively, partially due to the introduction of the Business Savings account but also due to higher rates on certificates of deposit and higher rates offered by competitors. Certificates of deposit less than $100,000 declined $1.3 million in 2005 but continued to represent 32% of deposits at the end of 2005. Certificates of $100,000 and over are primarily short-term public funds and brokered deposits. Balances of such large certificates fluctuate depending on the Company’s pricing strategy and funding needs at any particular time
and were up to 10% of total deposits in 2005. Deposits are attracted principally from within the Company’s market area through the offering of numerous deposit instruments. Interest rates, maturity terms, service fees, and withdrawal penalties for the various types of accounts are established periodically by management based on the Company’s liquidity requirements, growth goals and market trends. The Company issued approximately $6.0 million in certificates of deposit through brokers in 2004 at terms ranging from 15 to 24 months. The amount of deposits currently from outside the Company’s market area is not significant.
TABLE 12-DEPOSITS
(Dollars in thousands)
At December 31,
The following table sets forth the dollar amount of time deposits maturing in the periods indicated:
TABLE 13-MATURITY OF TIME DEPOSITS
(Dollars in thousands)
OTHER BORROWINGS
Periodically during the past five years the Company has purchased investment securities with funds borrowed from the FHLB. At December 31, 2005, the Bank had outstanding $100.8 million of total borrowings from the FHLB, $98.5 million of which consisted of seven fixed-rate notes with a weighted average rate of 5.20% and with maturities in 2008, 2010 and 2011. At the option of the FHLB, all of these notes can be converted once a quarter to instruments that adjust quarterly at the three-month LIBOR rate. These notes are subject to substantial prepayment penalties. If converted by the Federal Home Loan Bank, the notes can be prepaid without penalty. The remaining $2.3 million consists of one fixed-rate monthly amortizing note with a weighted average rate of 4.67% and with final maturity in 2006. The Company completed paying off $47 million in Federal Home Loan Bank advances with a weighted average rate of 5.65% during February 2006. The prepayment of these advances included a penalty of $1.4 million. In addition, investments of approximately $18 million were sold at a loss of $156,000 to help fund repayment of these advances. Of the securities sold, one mortgage-backed security with a par value of approximately $14 million realized a loss of approximately
$160,000. This security was projected to mature over the next ten months. The Company had the ability to hold the security until maturity, but sold it to accelerate cash flow to fund repayment of the fixed-rate advances. The sale of this security and repayment of advances does impact the Company’s ability and intent to hold the remaining available for sale securities until the foreseeable future. This penalty and loss will be recognized during the first quarter of 2006 and will reduce net income for the quarter approximately $1 million.
At December 31, 2005, the Company’s short-term borrowings consisted of $28.5 million in securities sold under repurchase agreements and $1.6 million in treasury demand notes. Table 14 sets forth certain information regarding the Company’s outstanding short-term borrowings at the dates and for the periods indicated:
TABLE 14-SHORT-TERM BORROWINGS
(Dollars in thousands)
During the second quarter of 2002, the Company participated in a securities sale commonly referred to as a “pooled trust preferred securities offering.” In that offering, the Company issued to a trust controlled by the Company $8.2 million in thirty-year debt securities at a rate of interest adjustable quarterly equal to the three-month LIBOR rate plus 3.45% (currently 7.97%), and the trust issued capital securities of $8.0 million to an unrelated party. The securities issued by the Company are classified as Tier 1 capital for regulatory purposes, and the interest is deductible for federal income tax purposes. The Company made a capital contribution of $8 million of these funds to the Bank to improve its regulatory capital ratios.
OFF-BALANCE SHEET ARRANGEMENTS
The Company has not entered into off-balance sheet arrangements that have or are reasonably likely to have a material current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
CONTRACTUAL OBLIGATIONS
The following table summarizes the Company’s contractual obligations at December 31, 2005 and the periods the expected payments are due.
TABLE 15-CONTRACTUAL OBLIGATIONS
(Dollars in thousands)
December 31, 2005
(a) Variable purchase obligation includes service contracts based on variable pricing measures, such as number of accounts or items processed. Future obligations have been estimated based on recent activity and pricing.
CAPITAL
The Federal Reserve Board has adopted risk-based capital guidelines that assign risk weightings to assets and off-balance sheet items and also define and set minimum capital requirements (risk-based capital ratios). Bank holding companies must maintain total risk-based, Tier 1 risk-based and Tier 1 leverage ratios of 8%, 4% and 3%, respectively. At December 31, 2005, NB&T Financial met all of its capital requirements with a total risk-based capital ratio of 14.96%, a Tier 1 risk-based capital ratio of 14.03%, and a Tier 1 leverage ratio of 9.36%. For further information regarding NB&T Financial’s capital, see Note 14 to the Financial Statements in Item 8
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
The Company’s principal executive officer and principal financial officer have concluded, based upon their evaluation of the Company’s disclosure controls and procedures as of December 31, 2005, that the Company’s disclosure controls and procedures were effective. During the quarter ended December 31, 2005, no changes have occurred in the Company’s internal control over financial reporting that have materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The information contained in the Proxy Statement under the captions “BOARD OF DIRECTORS,” “EXECUTIVE OFFICERS” and “SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE” is incorporated herein by reference.
The Board of Directors has determined that it does not have an “audit committee financial expert,” as defined in 17 C.F.R. Section 229.401(h). The Board currently has an individual who recently met the independence requirements to qualify as an “audit committee financial expert”. The Board intends to add this person to the Audit Committee after the 2006 annual meeting and election of Directors.
The NB&T Financial Group, Inc. Code of Ethics is attached to this Form 10-K as Exhibit 14. Amendments to the Code of Ethics and waivers of the provisions of the Code of Ethics will be posted on the registrant’s web site at www.nbtdirect.com.
Item 11.
Item 11. Executive Compensation
The information contained in the Proxy Statement under the caption “COMPENSATION OF EXECUTIVE OFFICERS AND DIRECTORS” is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholders Matters
The information contained in the Proxy Statement under the caption “VOTING SECURITIES AND OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT” is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions
The information contained in the Proxy Statement under the caption “CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS” is incorporated herein by reference.
Item 14.
Item 14. Principal Accountant Fees and Services
The information contained in the Proxy Statement under the caption “AUDITORS” is incorporated herein by reference.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a)
(1) Financial Statements-See Index to Consolidated Financial Statements in Item 8 of this Form 10-K.
(2) Financial Statement Schedules-None
(b) Exhibits
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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.
INDEX TO EXHIBITS