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Item
2.
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Management’s
Discussion and Analysis of Financial Condition and Results
of
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Operations.
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Management's
Discussion and Analysis of Financial Condition and Results of Operations
analyzes the major elements of the Company’s balance sheets and statements of
income. This section should be read in conjunction with the Company's financial
statements and accompanying notes.
Forward-Looking
Statements
The
Company may, from time to time, make written or oral “forward-looking
statements”, including statements contained in the Company’s filings with the
Securities and Exchange Commission (including this Form 10-Q and the exhibits
thereto), in its reports to stockholders, and in other communications by the
Company, which are made in good faith by the Company pursuant to the “safe
harbor” provisions of the Private Securities Litigation Reform Act of
1995.
These
forward-looking statements include statements with respect to the Company’s
beliefs, plans, objectives, goals, expectations, anticipations, estimates,
and
intentions that are subject to significant risks and uncertainties and are
subject to change based on various factors (some of which are beyond the
Company’s control). The words “may”, “could”, “should”, “would”, “believe”,
“anticipate”, “estimate”, “expect”, “intend”, “plan” and similar expressions are
intended to identify forward-looking statements. The following factors, among
others discussed in this Form 10-Q and in the Company’s Form 10-K, could cause
the Company’s financial performance to differ materially from that expressed or
implied in such forward-looking statements:
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the
strength of the United States economy in general and the strength
of the
local economies in which the Company conducts
operations;
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the
effects of, and changes in, trade, monetary and fiscal policies,
including
interest rate policies of the Board of Governors of the Federal Reserve
System;
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interest
rate, market, and monetary
fluctuations;
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·
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the
timely development of competitive new products and services by the
Company
and the acceptance of such products and services by
customers;
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·
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the
willingness of customers to substitute competitors’ products and services
for the Company’s products and services, and vice
versa;
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·
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the
impact of changes in financial services’ laws and regulations (including
laws concerning taxes, banking, securities and
insurance);
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·
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the
impact of the rapid growth of the
Company;
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the
Company’s dependence on Commerce Bancorp, Inc. (and its successor) to
provide various services to the Company and the costs associated with
securing alternate providers of such
services;
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changes
in the Company’s allowance for loan
losses;
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the
effect of terrorists attacks and threats of actual
war;
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unanticipated
regulatory or judicial proceedings;
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changes
in consumer spending and saving habits;
and
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the
success of the Company at managing the risks involved in the
foregoing.
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The
Company cautions that the foregoing list of important factors is not exclusive.
The Company cautions that any such forward-looking statements are not guarantees
of future performance and involve known and unknown risks, uncertainties, and
other factors which may cause the Company’s actual results, performance, or
achievements to differ materially from the future results, performance, or
achievements the Company has anticipated in such forward-looking
statements. You should note that many factors, some of which are
discussed in this Form 10-Q, could affect the Company’s future financial results
and could cause those results to differ materially from those expressed or
implied in the Company’s forward-looking statements contained or incorporated by
reference in this document. The Company does not undertake to update any
forward-looking statements, whether written or oral, that may be made from
time
to time by or on behalf of the Company. For information on subsequent events,
refer to the Company’s filings with the SEC.
EXECUTIVE
SUMMARY
During
the third quarter of 2007, our total assets grew by $100.0 million, from $1.92
billion at June 30, 2007 to $2.02 billion at September 30, 2007. During this
same period, our total net loans (including loans held for sale) increased
by
$36.4 million from $1.08 billion to $1.12 billion while our total deposits
increased by $109 million from $1.53 billion to $1.64 billion. The
large increase in deposits was primarily the result of seasonal increases in
core public fund deposit balances which historically show strong growth during
the third quarter. Also, contributing to the deposit growth was the
opening of three new stores during the third quarter at the following
locations: Shillington Road in Berks County, Manheim Pike in
Lancaster County and Linglestown Road in Dauphin County.
Total
revenues for the three months ended September 30, 2007 were $21.0 million,
up
$3.2 million, or 18% over the same period in 2006. Net income for the third
quarter was $1.9 million, a 13% increase over the third quarter in 2006 and
net
income per share for the quarter totaled $0.28, an 8% increase over the $0.26
per share recorded during the third quarter of 2006.
During
the first nine months of 2007, our total assets grew by $149.0 million, from
$1.87 billion at December 31, 2006 to $2.02 billion at September 30, 2007.
During this same period, interest-earning assets (primarily loans and
investments) increased by $143.0 million, from $1.73 billion to $1.87
billion. The
growth in interest-earning assets was funded by an increase in deposits as
well
as short-term and long-term borrowings.
During
the first nine months of 2007, our total net loans (including loans held for
sale) increased by $128.3 million, from $988.4 million at December 31, 2006
to
$1.12 billion at September 30, 2007. This growth was represented across most
loan categories, reflecting a continuing commitment to the credit needs of
our
market areas. Our loan to deposit ratio, which includes loans held for sale,
was
69% at September 30, 2007, compared to 62% at December 31, 2006.
Total
deposits increased $25.1 million, from $1.62 billion at December 31, 2006 to
$1.64 billion at September 30, 2007. Core deposits increased $43.1 million,
from
$1.58 billion at December 31, 2006 to $1.62 billion at September 30, 2007.
The
increase was largely the result of seasonal increases in core public fund
deposits balances of $60.1 million during the first nine months. Our core
deposits include all deposits except for primarily our public fund time
deposits.
Total
borrowings increased by $115.4 million from $112.8 million at December 31,
2006
to $228.2 million at September 30, 2007, primarily to fund the increase in
loan
balances mentioned above. Of the total borrowings at September 30, 2007, $178.2
million were short-term and $50.0 million were considered
long-term.
The
first
two quarters of 2007 were marked by the difficult yield curve environment that
was present during the third and fourth quarters of 2006. This added
pressure to our net interest margin and constrained our historical net interest
income growth. However, during the third quarter of 2007, the yield curve
environment began to slowly move from one of inversion to one of a more of
a
traditional slope. As a result, the Company experienced marked improvement
in
its level of net interest income and in its net interest margin statistic over
both the amount recognized in the
second quarter
of 2007 as well as during the
third quarter
of 2006. Net interest income for the first nine months of 2007 grew by $2.9
million, or 7%, over the first nine months of 2006. Interest income
was up 11%, due primarily to the increased volume in interest-earning assets
and
was partially offset by a higher level of interest expense. Total revenues
(net
interest income plus noninterest income) increased by $6.0 million, or
11%, for the first nine months of 2007 compared to the first nine months of
2006. Net income decreased by 21%, from $5.7 million for the first nine months
of 2006 to $4.5 million for the first nine months of 2007. Diluted net income
per common share was $0.69 for the first nine months of 2007 compared to $0.89
for the same period in 2006.
The
decrease in net income and related net income per share were due to a higher
level of noninterest expenses. Net income results for the first nine months
of
2007 included the expense impact of our two new stores opened during the fourth
quarter of 2006, the costs associated with the three new stores opened during
the most recent quarter, as well as a full three quarter impact of expenses
associated with Commerce Center, our Headquarters, Operations and Training
Center which we moved into on March 31, 2006. Another contributing factor was
the deposit insurance assessment which was reinstated by the FDIC during the
first quarter of 2007 for all banks whose deposits are federally
insured.
The
financial highlights for 2007 compared to 2006 are summarized
below.
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(dollars
in millions, except per share amounts)
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September
30,
2007
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September
30,
2006
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%
Change
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Total
Assets
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$
2,015.5
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$
1,838.2
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10
%
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Total
Loans (net)
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1,104.3
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928.0
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19
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Total
Deposits
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1,641.9
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1,606.3
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2
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Total
Revenues
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$ 59.4
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$ 53.4
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11
%
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Net
Income
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4.5
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5.7
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(21)
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Diluted
Net Income Per Share
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$ 0.69
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$ 0.89
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(22)
%
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APPLICATION
OF CRITICAL ACCOUNTING POLICIES
Our
accounting policies are fundamental to understanding Management’s Discussion and
Analysis of Financial Condition and Results of Operations. Our accounting
policies are more fully described in Note 1 of the
Notes
to Consolidated
Financial Statements
described
in
the Company’s annual report on Form 10-K for the year ended December 31, 2006.
Our consolidated financial statements are prepared in conformity with accounting
principles generally accepted in the United States of America. These principles
require our management to make estimates and assumptions about future events
that affect the amounts reported in our consolidated financial statements and
accompanying notes. Since future events and their effects cannot be determined
with absolute certainty, actual results may differ from those estimates.
Management makes adjustments to its assumptions and estimates when facts and
circumstances dictate. We evaluate our estimates and assumptions on an ongoing
basis and predicate those estimates and assumptions on historical experience
and
on various other factors that are believed to be reasonable under the
circumstances. Management believes the following critical accounting policies
encompass the more significant assumptions and estimates used in preparation
of
our consolidated financial statements.
Allowance
for Loan
Losses.
The
allowance
for loan losses represents the amount available for estimated probable losses
existing in our loan portfolio. While the allowance for loan losses is
maintained at a level believed to be adequate by management for estimated losses
in the loan portfolio, the determination of the allowance is inherently
subjective, as it involves significant estimates by management, all of which
may
be susceptible to significant change.
While
management uses available information to make such evaluations, future
adjustments to the allowance and the provision for loan losses may be necessary
if economic conditions or loan credit quality differ substantially from the
estimates and assumptions used in making the evaluations. The use of different
assumptions could materially impact the level of the allowance for loan losses
and, therefore, the provision for loan losses to be charged against earnings.
Such changes could impact future financial results.
We
perform periodic, systematic reviews of our loan portfolios to identify
potential losses and assess the overall probability of collection. These reviews
include an analysis of historical default and loss experience, which results
in
the identification and quantification of loss factors. These loss factors are
used in determining the appropriate level of allowance to cover the estimated
probable losses in various loan categories. Management judgment involving the
estimates of loss factors can be impacted by many variables, such as the number
of years of actual default and loss history included in the
evaluation.
The
methodology used to determine the appropriate level of the allowance for loan
losses and related provisions differs for commercial and consumer loans, and
involves other overall evaluations. In addition, significant estimates are
involved in the determination of the appropriate level of allowance related
to
impaired loans. The portion of the allowance related to impaired loans is based
on either (1) discounted cash flows using the loan’s effective interest rate,
(2) the fair value of the collateral for collateral-dependent loans, or (3)
the
observable market price of the impaired loan. Each of these variables involves
judgment and the use of estimates. For instance, discounted cash flows are
based
on estimates of the amount and timing of expected future cash
flows.
In
addition to periodic estimation and testing of loss factors, we periodically
evaluate qualitative factors which include:
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changes
in lending policies and procedures, including changes in underwriting
standards and collection, charge-off, and recovery practices not
considered elsewhere in estimating credit
losses;
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changes
in international, national, regional, and local economic and business
conditions and developments that affect the collectibility of the
portfolio, including the condition of various market
segments;
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changes
in the nature and volume of the portfolio and in the terms of
loans;
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changes
in the experience, ability, and depth of lending management and other
relevant staff;
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changes
in the volume and severity of past due loans, the volume of nonaccrual
loans, and the volume and severity of adversely classified or graded
loans;
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changes
in the quality of the institution’s loan review
system;
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changes
in the value of underlying collateral for collateral-dependent
loans;
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the
existence and effect of any concentrations of credit, and changes
in the
level of such concentrations; and
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the
effect of other external factors such as competition and legal and
regulatory requirements on the level of estimated credit losses in
the
institution’s existing portfolio.
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Management
judgment is involved at many levels of these evaluations.
An
integral aspect of our risk management process is allocating the allowance
for
loan losses to various components of the loan portfolio based upon an analysis
of risk characteristics, demonstrated losses, industry and other segmentations,
and other more judgmental factors.
RESULTS
OF OPERATIONS
Average
Balances and Average Interest Rates
Interest-earning
assets averaged $1.78 billion for the third quarter of 2007, compared to $1.66
billion for the same period in 2006. For the quarter ended September 30, total
loans receivable including loans held for sale, averaged $1.10 billion in 2007
and $917.0 million in 2006, respectively. For the same two quarters, total
securities averaged $684.0 million and $739.7 million.
The
growth in interest-earning assets was funded by an increase in the average
balance of interest-bearing liabilities, which increased from $1.43 billion
for
the third quarter of 2006 to $1.54 billion for the third quarter of 2007. Total
interest-bearing deposits averaged $1.27 billion for the third quarter of 2007,
compared to $1.19 billion for the third quarter of 2006 and average short-term
borrowings were $217.1 million and $219.1 million for the third quarter of
2007
and 2006, respectively. Other borrowed money, which includes $50.0 million
in
Federal Home Loan Bank (“FHLB”) advances known as convertible select
borrowings, and junior subordinated debt averaged $55.2 million in the third
quarter of 2007 compared to $13.9 million in the third quarter of
2006.
The
fully-taxable equivalent yield on interest-earning assets for the third quarter
of 2007 was 6.59%, an increase of 14 basis points (“bps”) over the
comparable period in 2006. This increase resulted from higher yields on our
floating rate loans and securities during the third quarter of 2007 as compared
to the same period in 2006. Approximately 10% of our investment securities
have
a floating interest rate and provide a yield that consists of a fixed spread
tied to the one month LIBOR interest rate. Our floating rate loans represent
approximately 35% of our total loans receivable portfolio. The majority of
these
loans are tied to the New York prime lending rate which increased 50 bps during
the second quarter of 2006 and remained at that level until September 18, 2007
when the prime rate decreased by 50 bps. Subsequently, the New York prime
lending rate decreased another 25 bps on October 31, 2007 following a similar
decrease in the overnight federal funds rate by the Federal Open Market
Committee. Going forward, we expect these two decreases in the prime lending
rate will somewhat decrease our interest income received from our floating
rate
loan portfolio.
The
average rate paid on total interest-bearing liabilities for the third quarter
of
2007 was 3.66%, compared to 3.79% for the third quarter of 2006. Our deposit
cost of funds decreased from 2.47% in the third quarter of 2006 to 2.31% for
the
third quarter of 2007. The aggregate average cost of all funding sources for
the
Company was 3.16% for the third quarter of 2007, compared to 3.27% for the
same
quarter of the prior year. The average cost of short-term borrowings decreased
from 5.36% in the third quarter of 2006 to 5.24% in the third quarter of 2007.
The reason for the decrease in the Company’s deposit cost of funds and borrowing
cost of funds is primarily related to the decrease in the average interest
yield
tied to the United States 91-day Treasury bill. The average interest rate of
the
91-day Treasury bill decreased from 4.77% in the third quarter of 2006 to 3.72%
in the third quarter of 2007, thereby significantly reducing the average
interest rate paid on our indexed deposits. At September 30, 2007, approximately
$748 million, or 46%, of our total deposits are those of local municipalities,
school districts, not-for-profit organizations or corporate cash management
customers, which are indexed to the 91-day Treasury bill. Also included in
interest expense for the third quarter of 2007 is the full quarter impact of
$15.0 million of Trust Preferred Securities that were issued on September 29,
2006 at an interest rate of 7.75%.
Interest-earning
assets averaged $1.76 billion for the first nine months of 2007, compared to
$1.63 billion for the same period in 2006. For the same two periods, total
loans
receivable including loans held for sale, averaged $1.07 billion in 2007 and
$887.0 million in 2006. Total securities averaged $692.8 million and $739.2
million for the first nine months of 2007 and 2006, respectively.
The
growth in interest-earning assets was funded by an increase in the average
balance of interest-bearing liabilities, which increased from $1.40 billion
for
the first nine months of 2006 to $1.52 billion for the first nine months of
2007. Total interest-bearing deposits averaged $1.28 billion for the first
nine
months of 2007, compared to $1.15 billion for the first nine months of 2006
and
short-term borrowings averaged $207.2 million and $229.0 million in the first
nine months of 2007 and 2006, respectively. Long-term debt, which includes
long-term FHLB borrowings as well as the junior subordinated debt associated
with the Trust Preferred securities, averaged $38.1 million for the first nine
months of 2007 as compared to $13.7 million for the same period in
2006.
The
fully-taxable equivalent yield on interest-earning assets for the first nine
months of 2007 was 6.55%, an increase of 21 bps over the comparable period
in 2006. This increase resulted primarily from increased yields on our loans
receivable as a result of the increases in the level of short-term market
interest rates that occurred during the first half of 2006.
The
average rate paid on interest-bearing liabilities for the first nine months
of
2007 was 3.81%, compared to 3.57% for the first nine months of 2006. Our deposit
cost of funds increased from 2.27% in the first nine months of 2006 to 2.49%
for
the same period in 2007. The aggregate cost of all funding sources was 3.29%
for
the first nine months of 2007, compared to 3.07% as reported for the prior
year.
This increase was the result of a higher level of short-term interest rates
present during the first three quarters of 2007 compared to the first three
quarters of 2006.
Net
Interest Income and Net Interest Margin
Net
interest income is the difference between interest income and interest expense.
Interest income is generated from interest earned on loans, investment
securities, and other interest-earning assets. Interest expense is paid on
deposits and borrowed funds. Changes in net interest income and net interest
margin result from the interaction between the volume and composition of
interest-earning assets, related yields, and associated funding costs. Net
interest income is our primary source of earnings. There are several factors
that affect net interest income, including:
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the
volume, pricing mix, and maturity of earning assets and interest-bearing
liabilities;
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market
interest rate fluctuations; and
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Net
interest income for the third quarter of 2007 increased by $2.0 million, or
15%
over the same period in 2006. Interest income on interest-earning assets totaled
$29.5 million for the third quarter of 2007, an increase of $2.6 million, or
10%, over 2006. Interest income on loans receivable increased by $3.3 million,
or 20%, over the third quarter of 2006. The majority of this increase was
related to a 20% increase in the balance of average loans receivable portfolio.
Interest income on the investment securities portfolio decreased by $723,000,
or
8%, for the third quarter of 2007 as compared to the same period last year.
This
was primarily a result of a decrease in the average balance of investment
securities of $55.7 million, or 8%, from the third quarter one year ago. Due
to
the yield curve environment that was present throughout the majority of the
past
twelve months, the cash flows from principal repayments on the investment
securities portfolio were used to fund the continued strong loan growth and
were
not redeployed back into the securities portfolio. Interest expense for the
third quarter increased $572,000, or 4%, from $13.7 million in 2006 to $14.3
million in 2007. Interest expense on deposits increased by $80,000, or 1%,
over
the third quarter of 2006 while interest expense on short-term borrowings
decreased by $97,000 for the same period. Interest expense on long-term debt
totaled $950,000 for the third quarter of 2007 compared to $361,000 for the
same
period in 2006. This was the direct result of the Company’s issuance of $15
million of 7.75% Trust Capital Securities on September 29, 2006 and the result
of adding two convertible select borrowing products during the third quarter
of
2007. See the Long-Term Debt section later in this Form 10-Q for further
discussion on the convertible select borrowings. See Note 10 in the Notes to
Consolidated Financial Statements included in our Annual Report on Form 10-K
for
the year ended December 31, 2006 for further discussion of our Trust Capital
securities.
During
the first half of 2006, the Federal Reserve Board (“FRB”) continued to increase
short-term interest rates by increasing the targeted federal funds rate four
times for a total of 100 bps from January 1, 2006 through June 30, 2006. These
increases followed a total increase of 200 bps in short-term interest rates
throughout 2005. As a result, our cost of funds increased significantly in
2006
and the first half of 2007 over levels experienced in recent years. The
increase in short-term rates, while significant in direction, had little impact
on long-term interest rates, and as a result, we did not experience a similar
increase in the yields on our interest-earning assets. This served to
constrain our historical net interest income growth and also materially reduced
our net interest margin. During the third quarter of 2007, however, the United
States Treasury yield curve began to move from flat (and sometimes inverted)
to
a more traditional slope with short-term rates lower than long-term rates.
As a
result, the Company began to experience a lower cost of deposits and lower
cost
of borrowings, thereby improving our net interest margin. Also, on September
18,
2007 the FRB decreased the overnight federal funds rate by 50 basis points
(bps). Subsequent to the end of the third quarter of 2007, the FRB lowered
the
overnight federal funds interest rate by an additional 25 bps from 4.75% to
4.50%. The decreases in the federal funds rate has led to a lower level of
interest rates associated with our overnight short-term borrowings as well
as a
lower yield on the 91-day Treasury bill to which approximately 46% of our
deposits are priced. Therefore, for the remainder of 2007, we expect some level
of continued growth in our overall level of net interest income as a result
of
an anticipated lower level of interest expense associated with a decrease in
our
overall total cost of funding sources.
Changes
in net interest income are frequently measured by two statistics: net interest
rate spread and net interest margin. Net interest rate spread is the difference
between the average rate earned on interest-earning assets and the average
rate
incurred on interest-bearing liabilities. Our net interest rate spread on a
fully taxable-equivalent basis was 2.93% during the third quarter of 2007
compared to 2.66% during the same period in the previous year. Net interest
margin represents the difference between interest income, including net loan
fees earned, and interest expense, reflected as a percentage of average
interest-earning assets. The fully tax-equivalent net interest margin increased
25 bps, from 3.18% for the third quarter of 2006 to 3.43% for the third quarter
of 2007, as a result of the decreased cost of funding sources as previously
discussed. For the first nine months of 2007 and 2006, the fully
taxable-equivalent net interest margin was 3.26% and 3.27%,
respectively.
Provision
for Loan Losses
We
recorded provisions of $537,000 to the allowance for loan losses for the third
quarter of 2007 as compared to $428,000 for the third quarter of 2006. The
loan
loss provisions for the first nine months were $1.5 million and $1.4 million
for
2007 and 2006, respectively. Management undertakes a rigorous and consistently
applied process in order to evaluate the allowance for loan losses and to
determine the level of provision for loan losses, as previously stated in the
Application of Critical Accounting Policies. Net loan charge-offs for the third
quarter of 2007 were $222,000, or 0.02%, of average loans outstanding, compared
to net charge-offs of $470,000, or 0.05%, for the same period in
2006. Net charge-offs for the first nine months of 2007 were $529,000, or 0.05%,
of average loans outstanding, compared to net charge-offs of $1.0 million,
or
0.11%, of average loans outstanding for the same period in 2006. Approximately
$165,000, or 31%, of the total net charge-offs for the first nine months of
2007
was related to one loan. The allowance for loan losses as a percentage of
period-end loans was 0.96% at September 30, 2007, as compared to 0.99% at
December 31, 2006, and 1.03% at September 30, 2006.
From
December 31, 2006 to September 30, 2007, the level of total non-performing
loans
remained the same at $3.4 million. Non-performing assets as a percentage of
total assets remained the same as well at 0.19% for both December 31, 2006
and September 30, 2007. See the section in this Management’s Discussion and
Analysis on the allowance for loan losses for further discussion regarding
our
methodology for determining the provision for loan losses.
Noninterest
Income
Noninterest
income for the third quarter of 2007 increased by $1.1 million, or 24%, over
the
same period in 2006. Deposit service charges and fees increased by 25%, from
$4.3 million for the third quarter of 2006 to $5.4 million in the third quarter
of 2007. The increase is mainly attributable to additional income associated
with servicing a higher volume of deposit and loan accounts. The largest
increase in noninterest income was revenue relating to Visa® check card
transactions, which increased by $362,000 in the third quarter of 2007 compared
to the same period in 2006. Noninterest income for the third quarter of 2007
included $238,000 of gains on the sale of residential loans compared to $209,000
gains on the sale of residential loans during the third quarter 2006. There
were
no sales of SBA loans during the third quarter of 2006 or 2007.
Noninterest
income for the first nine months in 2007 increased by $3.1 million, or 23%,
over
the same period in 2006. Deposit service charges and fees increased by 22%,
from
$12.2 million for the first nine months of 2006 to $15.0 million in the first
nine months of 2007. The increase is primarily attributable to additional income
associated with servicing a higher volume of deposit accounts and transactions.
Again, the largest increase in noninterest income was revenue related to Visa®
check card transactions, which increased by $1.1 million in the first nine
months of 2007 over the same period in 2006. Included in noninterest income
for
the first nine months of 2007 were gains on the sale of student loans totaling
$130,000, gains on the sale of SBA loans totaling $162,000, gains on the sale
of
residential loans totaling $719,000 and $171,000 of gains on the call of
investment securities. Noninterest income for the first nine months of 2006
included gains on the sale of student loans totaling $123,000, gains on the
sale
of SBA loans totaling $110,000 and gains on the sale of residential loans of
$603,000.
Noninterest
Expenses
For
the
third quarter of 2007, noninterest expenses increased by $3.0 million, or 20%,
over the same period in 2006. The increase in noninterest expenses for the
quarter was widespread across all categories, reflecting the Company’s continued
growth. This increase includes the impact of opening two new stores during
the
fourth quarter of 2006 and the expenses associated with the new stores we opened
recently in mid-July, mid-August and mid-September of 2007. Also, noninterest
expenses for the third quarter of 2007 include a significant impact for premiums
related to Federal Deposit Insurance Corporation, (“FDIC”) deposit insurance
coverage which were not incurred during the third quarter of 2006. Beginning
January 1, 2007, the FDIC began charging insured Banks for such coverage for
the
first time since 1997. Banks which were in operation and paying deposit
insurance premiums during 1997 and prior received a one time credit in 2007
based upon premiums paid during those previous years. Commerce utilized 100%
of
this credit during the first quarter of 2007 to partially reduce its expense
costs and therefore incurred a full quarter’s worth of FDIC premiums during both
the second and third quarters of 2007 and will continue to do so for the fourth
quarter of 2007 as well. Also, staffing levels, data processing costs, and
related expenses increased as a result of servicing more deposit and loan
customers and processing a higher volume of transactions. A comparison of
noninterest expenses for certain categories for the three months ended September
30, 2007 and September 30, 2006 is presented in the following
paragraphs.
Salary
and employee benefits expenses, which represent the largest component of
noninterest expenses, increased by $894,000, or 12%, for the third quarter
of
2007 over the third quarter of 2006. The increased level of these expenses
included the impact associated with the additional staff for the new stores
opened in October 2006 and November 2006 as well as additional staff hired
throughout 2006 to support compliance, audit and loan operation functions.
Also
included were salary and benefit costs for additional employees hired during
the
first nine months of 2007 for the new stores we opened recently in mid-July
2007, mid-August 2007 and mid-September 2007. The increase in total salary
and
benefit expenses were somewhat offset by a reduction of such costs directly
related to call center processing. On October 1, 2006, the Company outsourced
call center functions to a third party and as a result the expenses associated
with salary and benefits for call center employees were not included in this
line item for 2007. Rather those costs are now reflected on the income statement
in a line titled Telephone expenses which are discussed further
below.
Occupancy
expenses totaled $1.9 million for the third quarter of 2007, an increase of
$201,000, or 12%, over the third quarter of 2006, while furniture and equipment
expenses increased 19%, or $163,000, over the third quarter of 2006. The five
stores opened in the past twelve months contributed to the increases in
occupancy, furniture, and equipment expenses.
Advertising
and marketing expenses totaled $946,000 for the three months ending September
30, 2007, an increase of $304,000, or 47%, over the same period in 2006. This
is
a direct result of holding three grand opening celebrations for the new stores
opened during the third quarter of 2007.
Data
processing expenses increased by $258,000, or 18%, in the third quarter of
2007
over the three months ended September 30, 2006. The primary increases were
due
to costs associated with processing additional transactions as a result of
growth in the number of accounts serviced, the costs associated with processing
for five additional stores and enhancements to existing systems.
Postage
and supplies expenses of $496,000 were $70,000, or 16%, higher for the third
quarter of 2007 than for the third quarter of 2006. The increase was attributed
to the additional supplies needed to process higher volumes of transactions
as
well as additional supplies needed for the new stores. Also included is the
impact of the increase in U.S. Postal rates which occurred earlier in 2007.
This
will increase our cost to mail account statements and notices to customers
going
forward.
Regulatory
assessments of $607,000 were $475,000 higher for the third quarter of 2007
than
for the third quarter of 2006. This increase is primarily due to the
reinstatement of FDIC charges as previously discussed.
Telephone
expenses of $635,000 were $402,000 higher for the third quarter of 2007 compared
to the third quarter of 2006. This increase is primarily due to our outsourcing
of the call center services to a third party in October 2006 as mentioned
previously. Rather than booking salary and benefit costs directly to those
line
items for call center staff as was done in prior years, now the Company receives
a bill for total call center expenses based on a per call charge and those
expenses are reflected in this line item going forward.
Other
noninterest expenses increased by $210,000, or 12%, for the three-month period
ended September 30, 2007, compared to the same period in 2006. Components of
the
increase included expenses related to consulting services, coin shipment
expenses due to our popular and convenient Penny Arcade Machines located in
all
of our stores and other miscellaneous expenses.
For
the
first nine months of 2007, noninterest expenses increased by $8.4 million,
or
19%, over the same period in 2006. A comparison of noninterest expenses for
certain categories for the nine months ending September 30, 2007 and September
30, 2006 is presented in the following paragraphs.
Salary
expenses and employee benefits, increased by $2.9 million, or 13%, for the
first
nine months of 2007 over the first nine months of 2006. The increased level
of
these expenses included the impact associated with the additional staff for
the
new stores opened in October 2006 and November 2006 as well as additional staff
hired throughout 2006 to support compliance, audit and loan operation functions.
Also included were salary and benefit costs for additional employees hired
during the first nine months of 2007 for the new stores we opened recently
in
mid-July 2007, mid-August 2007 and mid-September 2007. Also included are
additional employee medical and prescription plan costs of $665,000 year over
year. Again, the level of total salary and benefit expenses were somewhat offset
by the previously discussed call center outsourcing.
Occupancy
expenses totaled $5.5 million for the first nine months of 2007, an increase
of
$576,000, or 12%, over the first nine months of 2006, while furniture and
equipment expenses increased 16%, or $407,000, over the first nine months of
2006. In late March 2006, we discontinued leasing two facilities that housed
the
majority of our executive, lending, financial and operational staff departments
and relocated approximately 300 employees to Commerce Center, our newly
constructed Headquarters, Operations and Training Center. The discontinued
occupancy and furniture expenses associated with the discontinued leases on
the
two facilities partially offset higher levels of expense associated with the
new
building and its furniture and equipment. The additional expenses associated
with Commerce Center, in addition to the two new stores opened in late 2006
and
three new stores opened in the third quarter of 2007, contributed to the
increases in occupancy, furniture, and equipment expenses.
Advertising
and marketing expenses totaled $2.5 million for the nine months ending September
30, 2007, an increase of $486,000, or 25%, over the same period in 2006. The
increase is primarily related to grand opening expenses associated with three
new stores opened during the third quarter of 2007 whereas no new stores were
opened during the first three quarters of 2006.
Data
processing expenses increased by $857,000, or 22%, for the first nine months
of
2007 over the nine months ended September 30, 2006. The primary increases were
due to costs associated with processing additional transactions as a result
of
growth in the number of accounts serviced, the costs associated with processing
for five additional stores, adding electronic products and services for customer
use, and enhancements to existing services.
Postage
and supplies expenses of $1.5 million were $311,000, or 26%, higher for the
first nine months of 2007 than for the comparable period in 2006. The increase
was attributed to the increase in supplies needed to process higher volumes
of
transactions and the additional supplies needed for the new stores. Also
included is the impact of the increase in U.S. Postal rates which occurred
earlier in 2007. This will increase our cost to mail account statements and
notices to customers going forward.
Regulatory
assessments of $1.5 million were $1.1 million higher for the first nine months
of 2007 compared to the nine months ended September 30, 2006. This increase
is
primarily due to the reinstatement of FDIC charges as previously
discussed.
Telephone
expenses of $1.8 million were $1.1 million higher for the first nine months
of
2007 compared to the first nine months of 2006. This increase is primarily
due
to the previously discussed outsourcing of the call center services to a third
party in October 2006.
Other
noninterest expenses increased by $645,000, or 13%, for the nine month period
ending September 30, 2007, compared to the same period in 2006. Components
of
the increase included expenses related to consulting fees, other non-credit
related losses, and coin shipment expenses due to our popular and convenient
Penny Arcade Machines located in all of our stores.
One
key
measure that management utilizes to monitor progress in controlling overhead
expenses is the ratio of net noninterest expenses to average assets. For
purposes of this calculation, net noninterest expenses equal noninterest
expenses less noninterest income. In 2007, this ratio equaled 2.5% for both
the
third quarter and the first nine months. In 2006, this ratio equaled 2.3% for
both the third quarter and the first nine months.
Another
productivity measure utilized by management is the operating efficiency ratio.
This ratio expresses the relationship of noninterest expenses to net interest
income plus noninterest income. For the quarter ending September 30, 2007,
the
operating efficiency ratio was 84.9%, compared to 83.3% for the similar period
in 2006. The increase in the operating efficiency ratio is primarily due to
the
current interest rate environment and the resulting impact on our net interest
income. This ratio equaled 87.0% for the first nine months of 2007, compared
to
81.1% for the first nine months of 2006. Our operating efficiency ratio remains
above our peer group primarily due to our strong growth and aggressive expansion
activities, and our strong customer service focused model.
Provision
for Federal Income Taxes
The
provision for federal income taxes was $780,000 for the third quarter of 2007,
compared to $902,000 for the same period in 2006. For the nine months ending
September 30, the provision was $1.7 million and $2.9 million for 2007 and
2006,
respectively. The effective tax rate, which is the ratio of income tax expense
to income before income taxes, was 27.0% for the first nine months of 2007
and
33.8% for the same period in 2006. This decrease in effective tax rate and
the
corresponding provision during 2007 was primarily due to the greater proportion
of tax exempt interest income on investments and loans to total pretax
income.
Net
Income and Net Income Per Share
Net
income for the third quarter of 2007 was $1.9 million, an increase of $206,000,
or 13%, from the $1.6 million recorded in the third quarter of 2006. The
increase was due to a $2.0 million increase in net interest income, a $1.1
million increase in noninterest income and a $122,000 decrease in income taxes,
partially offset by a $3.0 million increase in noninterest expenses and a
$109,000 increase in the provision for loan losses.
Net
income for the first nine months of 2007 was $4.5 million, a decrease of $1.2
million, or 21%, from the $5.7 million recorded in the first nine months of
2006. The decrease was due to an $8.4
million increase
in noninterest expenses and a $108,000 increase in the provision for loan
losses, partially offset by a $2.9 million increase in net interest income,
a
$3.1 million increase in noninterest income, and a $1.3 million decrease in
income taxes.
Basic
earnings per common share were $0.29 for the third quarter of 2007, compared
to
$0.27 for the third quarter of 2006. For the first nine months of 2007 and
2006,
basic earnings per share were $0.72 and $0.93, respectively. Diluted earnings
per common share increased 8%, to $0.28, for the third quarter of 2007, compared
to $0.26 for the third quarter of 2006. For the first nine months in 2007 and
2006, diluted earnings per common share were $0.69 and $0.89,
respectively.
Return
on Average Assets and Average Equity
Return
on
average assets (“ROA”) measures our net income in relation to our total average
assets. Our annualized ROA for the third quarter of 2007 was 0.38%, compared
to
0.36% for the third quarter of 2006. The ROA for the first nine months in 2007
and 2006 was 0.32% and 0.44%, respectively. Return on average equity (“ROE”)
indicates how effectively we can generate net income on the capital invested
by
our shareholders. ROE is calculated by dividing net income by average
stockholders' equity. The annualized ROE was 6.91% for the third quarter of
2007, compared to 6.77% for the third quarter of 2006. The ROE for the first
nine months of 2007 was 5.79%, compared to 8.15% for the first nine months
of
2006. Both ROA and ROE for the third quarter and first nine months of 2007
were
impacted by the current interest rate environment and the resulting impact
on
our net interest income.
FINANCIAL
CONDITION
Securities
During
the first nine months of 2007, the total investment securities portfolio
increased by $9.4 million from $711.7 million to $721.0 million. Purchases
of new securities during the first nine months of 2007 were $116.2 million
as
compared to $116.1 million during the first nine months of 2006. Due to the
unfavorable yield curve environment that was present throughout the majority
of
the past twelve months, the cash flows from principal repayments on the
investment securities portfolio were used to fund the continued strong loan
growth and to reduce the level of average short-term borrowings rather than
redeploy these cash flows back into investment securities at a minimal net
interest spread.
During
the first nine months of 2007, securities available for sale increased by $4.3
million, from $392.1 million at December 31, 2006 to $396.4 million at September
30, 2007 as a result of $49.9 million in purchases offset by principal
repayments of $45.3 million. The securities available for sale portfolio is
comprised of U.S. Government agency securities, mortgage-backed securities,
and
collateralized mortgage obligations. The duration of the securities available
for sale portfolio was 3.9 years at September 30, 2007 compared to 3.8 years
at
December 31, 2006. The current weighted average yield was 5.37% at September
30,
2007 compared to 5.35% at December 31, 2006.
During
the first nine months of 2007, securities held to maturity increased by $5.0
million as a result of $66.3 million in purchases, offset by principal
repayments and calls of $61.3 million. The securities held in this portfolio
include U.S. Government agency securities, tax-exempt municipal bonds,
collateralized mortgage obligations, corporate debt securities, and
mortgage-backed securities. The duration of the securities held to maturity
portfolio was 3.6 years at September 30, 2007 and 4.4 years at December 31,
2006. The current weighted average yield was 5.23% at September 30, 2007 and
5.32% at December 31, 2006, respectively.
Total
securities aggregated $721 million, or 36%, of total assets at September 30,
2007 as compared to $712 million, or 38%, of total assets at December 31,
2006.
The
average fully-taxable equivalent yield on the combined securities portfolio
for
the first nine months of 2007 was 5.33% as compared to 5.29% for the similar
period of 2006.
Loans
Held for Sale
Loans
held for sale are comprised of student loans and selected residential loans
the
Company originates with the intention of selling in the future. Occasionally,
loans held for sale also include selected Small Business Administration (“SBA”)
loans and business and industry loans that the Company decides to
sell. These loans are carried at the lower of cost or estimated fair
value, calculated in the aggregate. Depending on market conditions, the Bank
typically sells its student loans during the first quarter of each year. At
the
present time, the Bank’s residential loans are originated with the intent to
sell to the secondary market unless the loan is nonconforming to the secondary
market standards or if we agree not to sell the loan due to a customer’s
request. The residential mortgage loans that are designated as held for sale
are
sold to other financial institutions in correspondent relationships. The sale
of
these loans takes place typically within 30 days of funding. At December 31,
2006 and September 30, 2007, there were no past due or impaired residential
mortgage loans held for sale. SBA loans are held in the Company’s loan
receivable portfolio unless or until the Company’s management determines a sale
of certain loans is appropriate. At the time such a decision is made, the SBA
loans are moved from the loans receivable portfolio to the loans held for sale
portfolio. Total loans held for sale were $12.4 million at September 30, 2007
and $15.3 million at December 31, 2006. At December 31, 2006, loans held for
sale were comprised of $8.7 million of student loans and $6.6 million of
residential mortgages as compared to $9.8 million of student loans and $2.6
million of residential loans of SBA loans at September 30, 2007. The change
was
the result of sales of $8.9 million of student loans and $56.5 million of
residential loans, offset by originations of $62.5 million in new loans held
for
sale. Loans held for sale, as a percent of total assets, represented
approximately 0.6% at September 30, 2007 and 0.8% at December 31,
2006.
Loans
Receivable
During
the first nine months of 2007, total gross loans receivable increased by $132.3
million, from $982.7 million at December 31, 2006, to $1.11 billion at September
30, 2007. The growth was widespread across most loan categories. Gross loans
receivable represented 68% of total deposits and 55% of total assets at
September 30, 2007, as compared to 61% and 53%, respectively, at December 31,
2006.
The
following table reflects the composition of the Company’s loan
portfolio.
|
(dollars
in thousands)
|
As
of
9/30/2007
|
%
of Total
|
As
of
9/30/2006
|
%
of Total
|
$
Increase
|
%
Increase
|
|
Commercial
|
$ 347,238
|
31%
|
$
265,280
|
28%
|
$
81,958
|
31%
|
|
Owner-Occupied
|
132,976
|
12
|
122,982
|
13
|
9,994
|
8
|
|
Total
Commercial
|
480,214
|
43
|
388,262
|
41
|
91,952
|
24
|
|
Consumer
/ Residential
|
298,204
|
27
|
275,473
|
30
|
22,731
|
8
|
|
Commercial
Real Estate
|
336,577
|
30
|
273,850
|
29
|
62,727
|
23
|
|
Gross
Loans
|
1,114,995
|
100%
|
937,585
|
100%
|
$
177,410
|
19%
|
|
Less:
Reserves
|
(10,673)
|
|
(9,635)
|
|
|
|
|
Net
Loans
|
$
1,104,322
|
|
$
927,950
|
|
|
|
Loan
and Asset Quality and Allowance for Loan Losses
Non-performing
assets include non-performing loans and foreclosed real estate. Non-performing
assets at September 30, 2007, were $3.7 million, or 0.19%, of total assets
as
compared to $3.5 million, or 0.19%, of total assets at December 31, 2006. Total
non-performing loans (nonaccrual loans, loans past due 90 days and still
accruing interest and restructured loans) were $3.4 million at September 30,
2007 as well as at December 31, 2006. Foreclosed real estate totaled $390,000
at
September 30, 2007 and $159,000 at December 31, 2006. At September 30, 2007,
seventeen loans were in the nonaccrual commercial categories ranging from $2,000
to $230,000 and no loans were in the nonaccrual commercial real estate
categories. At December 31, 2006, fifteen loans were in the nonaccrual
commercial categories ranging from $2,000 to $285,000 and five loans were in
the
nonaccrual commercial real estate categories ranging from $21,000 to $490,000.
Overall, asset quality, as measured in terms of non-performing assets to total
assets, coverage ratios, and non-performing assets to stockholders’ equity,
remains strong.
The
table
below presents information regarding non-performing loans and assets at
September 30, 2007 and 2006, and at December 31, 2006.
|
|
Non-performing
Loans and Assets
|
|
(dollars
in thousands)
|
September
30,
2007
|
|
December
31,
2006
|
|
September
30,
2006
|
|
|
Nonaccrual
loans:
|
|
|
|
|
|
|
|
Commercial
|
$ 997
|
|
$ 984
|
|
$ 1,275
|
|
|
Consumer
|
57
|
|
19
|
|
139
|
|
|
Mortgage:
|
|
|
|
|
|
|
|
Construction
|
529
|
|
247
|
|
0
|
|
|
Mortgage
|
1,767
|
|
2,129
|
|
2,216
|
|
|
Total
nonaccrual loans
|
3,350
|
|
3,379
|
|
3,630
|
|
|
Loans
past due 90 days or more and still accruing
|
0
|
|
2
|
|
0
|
|
|
Renegotiated
loans
|
0
|
|
0
|
|
0
|
|
|
Total
non-performing loans
|
3,350
|
|
3,381
|
|
3,630
|
|
|
Foreclosed
real estate
|
390
|
|
159
|
|
159
|
|
|
Total
non-performing assets
|
$
3,740
|
|
$
3,540
|
|
$
3,789
|
|
|
Non-performing
loans to total loans
|
0.30
|
%
|
0.34
|
%
|
0.39
|
%
|
|
Non-performing
assets to total assets
|
0.19
|
%
|
0.19
|
%
|
0.21
|
%
|
|
Non-performing
loan coverage
|
319
|
%
|
287
|
%
|
265
|
%
|
|
Non-performing
assets / capital plus reserves
|
3
|
%
|
3
|
%
|
3
|
%
|
Management’s
Allowance for Loan Loss Committee reviewed the composition of the nonaccrual
loans and believes adequate collateralization exists. Additional loans of $5.2
million, considered by our internal loan review department as problem loans
at
September 30, 2007, have been evaluated as to risk exposure in determining
the
adequacy for the allowance for loan losses.
The
following table sets forth information regarding the Company’s provision and
allowance for loan losses.
|
|
Allowance
for Loan Losses
|
|
(dollars
in thousands)
|
Nine
Months Ending
September
30,
2007
|
|
Year
Ending
December
31,
2006
|
|
Nine
Months Ending
September
30,
2006
|
|
|
Balance
at beginning of period
|
$ 9,685
|
|
$ 9,231
|
|
$ 9,231
|
|
|
Provisions
charged to operating expense
|
1,517
|
|
1,634
|
|
1,409
|
|
|
|
11,202
|
|
10,865
|
|
10,640
|
|
|
Recoveries
of loans previously charged-off:
|
|
|
|
|
|
|
|
Commercial
|
4
|
|
34
|
|
62
|
|
|
Consumer
|
23
|
|
71
|
|
40
|
|
|
Real
Estate
|
8
|
|
0
|
|
0
|
|
|
Total
recoveries
|
35
|
|
105
|
|
102
|
|
|
Loans
charged-off:
|
|
|
|
|
|
|
|
Commercial
|
(469)
|
|
(895)
|
|
(750)
|
|
|
Consumer
|
(69)
|
|
(390)
|
|
(357)
|
|
|
Real
Estate
|
(26)
|
|
0
|
|
0
|
|
|
Total
charged-off
|
(564)
|
|
(1,285)
|
|
(1,107)
|
|
|
Net
charge-offs
|
(529)
|
|
(1,180)
|
|
(1,005)
|
|
|
Balance
at end of period
|
$
10,673
|
|
$ 9,685
|
|
$ 9,635
|
|
|
Net
charge-offs as a percentage of average loans outstanding
|
0.05
|
%
|
0.13
|
%
|
0.11
|
%
|
|
Allowance
for loan losses as a percentage of period-end loans
|
0.96
|
%
|
0.99
|
%
|
1.03
|
%
|
Restricted
Investments in Bank Stock
During
the first nine months of 2007, restricted investments in Bank stock increased
by
$3.9 million, or 33%, from $11.7 million at December 31, 2006 to $15.6 million
at September 30, 2007. The primary increase was in the purchase of additional
Federal Home Loan Bank (“FHLB”) stock needed to cover the short-term borrowings
at the FHLB which are discussed elsewhere in this Form 10-Q.
Premises
and Equipment
During
the first nine months of 2007, premises and equipment increased by $5.7 million,
or 7%, from $83.7 million at December 31, 2006 to $89.4 million at September
30,
2007. The increase in premises and equipment was primarily due to three new
stores constructed during the first half of 2007 and opened during the third
quarter of 2007, partially offset by the provision for depreciation and
amortization.
Other
Assets
Other
assets decreased by $2.0 million from December 31, 2006 to September 30, 2007
primarily the result of a security sale with a trade date in late December
for
which we received the cash at settlement in early January.
Deposits
Total
deposits at September 30, 2007 were $1.64 billion, up $25.1 million from total
deposits of $1.62 billion at December 31, 2006. The Company has experienced
lower than normal deposit growth during the first nine months of 2007 as
compared to prior years. During 2007, management has made a conscious decision
not to match certain “high rate” pricing on deposits which has been present in
our marketplace. As a result, we have experienced some runoff of such higher
rate deposit balances although this pricing discipline has served to stabilize
and even lower our deposit cost of funds, thereby helping to increase net
interest income and improve our net interest margin. Core deposits averaged
$1.53 billion for the quarter ended September 30, 2007, up $104
million, or 7%, over average core deposits for the quarter
ended September 30, 2006.
The
average balances and weighted average rates paid on deposits for the first
nine
months of 2007 and 2006 are presented in the table below.
|
|
|
Nine
Months Ending September 30,
|
|
|
2007
|
|
2006
|
|
(dollars
in thousands)
|
Average
Balance
|
Average
Rate
|
|
Average
Balance
|
Average
Rate
|
|
Demand
deposits:
|
|
|
|
|
|
|
Noninterest-bearing
|
$ 270,346
|
|
|
$ 252,919
|
|
|
Interest-bearing
(money market and checking)
|
693,072
|
3.68%
|
|
568,884
|
3.55%
|
|
Savings
|
375,575
|
2.53
|
|
356,746
|
2.23
|
|
Time
deposits
|
206,668
|
4.29
|
|
228,360
|
3.84
|
|
Total
deposits
|
$
1,545,661
|
|
|
$
1,406,909
|
|
Short-Term
Borrowings
Short-term
borrowings used to meet temporary funding needs consist of short-term and
overnight advances from the Federal Home Loan Bank, securities sold under
agreements to repurchase, and overnight federal funds lines of credit. At
September 30, 2007, short-term borrowings totaled $178.2 million as compared
to
$96.3 million at September 30, 2006 and $112.8 million at December 31, 2006.
The
average rate paid on the short-term borrowings was 5.30% during the first nine
months of 2007, compared to an average rate paid of 5.02% during the first
nine
months of 2006. The increased rate paid on the borrowings is a direct result
of
the increases in short-term interest rates by the Federal Reserve Board during
the first half of 2006 as previously discussed in this Form 10-Q. Also, as
previously discussed in this Form 10-Q, we expect this average borrowing rate
to
be significantly lower during the fourth quarter of 2007 as a result of the
recent decreases in the overnight federal funds rate.
Long-Term
Debt
Long-term
debt totaled $79.4 million at September 30, 2007 as compared to $29.4 million
at
December 31, 2006 and September 30, 2006. On September 29, 2006, the Company
issued $15 million of 7.75% Trust Capital Securities to Commerce Bank, N.A.
through Commerce Harrisburg Capital Trust III, a Delaware statutory trust
subsidiary. Our long-term debt consisted of Trust Capital Securities through
Commerce Harrisburg Capital Trust I, Commerce Harrisburg Capital Trust II and
Commerce Harrisburg Capital Trust III, our Delaware business trust subsidiaries.
At September 30, 2007, all of the Capital Trust Securities qualified as Tier
I
capital for regulatory capital purposes. Proceeds of the trust capital
securities were used for general corporate purposes, including additional
capitalization of our wholly-owned banking subsidiary. As part of the Company’s
Asset/Liability management strategy, management utilized the Federal Home Loan
Bank convertible select borrowing product during the third quarter of 2007
with
the purchase of a $25.0 million borrowing with a 5 year maturity and a six
month
conversion term at an initial interest rate of 4.29% and a $25.0 million
borrowing with a 2 year maturity and a three month conversion term at an initial
interest rate of 4.48%. These borrowings positively impacted the Company’s net
interest income by approximately $50,000 and the net interest margin by 2 bps
during the third quarter.
Stockholders’
Equity and Capital Adequacy
At
September 30, 2007, stockholders’ equity totaled $108.3 million, up 7% over
stockholders’ equity of $101.1 million at December 31, 2006. Stockholders’
equity at September 30, 2007 included $4.5 million of unrealized losses,
net of income taxes, on securities available for sale. Excluding these
unrealized losses, gross stockholders’ equity increased by $7.3 million, or 7%,
from $105.6 million at December 31, 2006, to $112.8 million at September 30,
2007 as a result of retained net income and the proceeds from common stock
issued through our stock option and stock purchase plans.
Banks
are
evaluated for capital adequacy based on the ratio of capital to risk-weighted
assets and total assets. The risk-based capital standards require all banks
to
have Tier 1 capital of at least 4% and total capital (including Tier 1 capital)
of at least 8% of risk-weighted assets. Tier 1 capital includes common
stockholders' equity and qualifying perpetual preferred stock together with
related surpluses and retained earnings. Total capital includes total Tier
1
capital, limited life preferred stock, qualifying debt instruments, and the
allowance for loan losses. The capital standard based on total assets, also
known as the “leverage ratio,” requires all, but the most highly-rated, banks to
have Tier 1 capital of at least 4% of total assets. At September 30, 2007,
the
Bank met the definition of a “well-capitalized” institution.
The
following table provides a comparison of the Bank’s risk-based capital ratios
and leverage ratios to the minimum regulatory requirements for the periods
indicated.
|
|
September
30,
2007
|
December
31,
2006
|
Minimum
For
Adequately
Capitalized
Requirements
|
Minimum
For
Well-Capitalized
Requirements
|
|
Capital
Ratios:
|
|
|
|
|
|
Risk-based
Tier 1
|
9.84%
|
9.98%
|
4.00%
|
6.00%
|
|
Risk-based
Total
|
10.59
|
10.71
|
8.00
|
10.00
|
|
Leverage
ratio
(to
average assets)
|
7.28
|
7.30
|
3.00
- 4.00
|
5.00
|
The
consolidated capital ratios of Pennsylvania Commerce Bancorp, Inc. at September
30, 2007 were as follows: leverage ratio of 7.30%, Tier 1 capital to
risk-weighted assets of 9.87%, and total capital to risk-weighted assets of
10.62%.
Interest
Rate Sensitivity
Our
risk
of loss arising from adverse changes in the fair value of financial instruments,
or market risk, is composed primarily of interest rate risk. The primary
objective of our asset/liability management activities is to maximize net
interest income while maintaining acceptable levels of interest rate risk.
Our
Asset/Liability Committee (“ALCO”) is responsible for establishing policies to
limit exposure to interest rate risk and to ensure procedures are established
to
monitor compliance with those policies. Our Board of Directors reviews the
guidelines established by ALCO.
Our
management believes the simulation of net interest income in different interest
rate environments provides a meaningful measure of interest rate risk. Income
simulation analysis captures not only the potential of all assets and
liabilities to mature or reprice, but also the probability that they will do
so.
Income simulation also attends to the relative interest rate sensitivities
of
these items and projects their behavior over an extended period of time.
Finally, income simulation permits management to assess the probable effects
on
the balance sheet not only of changes in interest rates, but also of proposed
strategies for responding to them.
Our
income simulation model analyzes interest rate sensitivity by projecting net
interest income over the next twenty-four months in a flat rate scenario versus
net interest income in alternative interest rate scenarios. Our management
continually reviews and refines its interest rate risk management process in
response to the changing economic climate. Currently, our model projects a
200
basis point (“bp”) increase and a 200 bp decrease during the next year, with
rates remaining constant in the second year.
Our
ALCO
policy has established that income sensitivity will be considered acceptable
if
overall net interest income volatility in a plus 200 or minus 200 bp scenario
is
within 4% of net interest income in a flat rate scenario in the first year
and
5% using a two-year planning window.
The
following table compares the impact on forecasted net interest income at
September 30, 2007 of a plus 200 and minus 200 basis point (bp) change in
interest rates to the impact at September 30, 2006 in the same
scenarios.
|
|
|
|
|
|
September
30, 2007
|
September
30, 2006
|
|
|
12
Months
|
24
Months
|
12
Months
|
24
Months
|
|
Plus
200
|
(3.8)%
|
(3.1)%
|
(3.3)%
|
(2.2)%
|
|
Minus
200
|
5.0
|
4.0
|
2.9
|
0.8
|
The
forecasted net interest income variability in all interest rate scenarios
indicate levels of future interest rate risk within the acceptable parameters
per the policies established by ALCO. Management continues to
evaluate strategies in conjunction with the Company’s ALCO to effectively manage
the interest rate risk position. Such strategies could include
adjusting the investment leverage position funded by short-term borrowings,
altering the mix of deposits by product, adjusting the mismatch between
short-term interest-sensitive assets and liabilities and the potential use
of
risk management instruments such as interest rate swaps and caps.
We
used
many assumptions to calculate the impact of changes in interest rates, including
the proportionate shift in rates. Our actual results may not be similar to
the
projections due to several factors including the timing and frequency of rate
changes, market conditions, and the shape of the interest rate yield curve.
Actual results may also differ due to our actions, if any, in response to the
changing interest rates.
Management
also monitors interest rate risk by utilizing a market value of equity model.
The model assesses the impact of a change in interest rates on the market value
of all our assets and liabilities, as well as any off-balance sheet items.
The
model calculates the market value of our assets and liabilities in excess of
book value in the current rate scenario, and then compares the excess of market
value over book value given an immediate 200 bp increase or 200 bp decrease
in
interest rates. Our ALCO policy indicates that the level of interest rate risk
is unacceptable if the immediate change would result in the loss of 40% or
more
of the excess of market value over book value in the current rate scenario.
Management lowered this percentage from 50% to 40% in the first quarter of
2007
to more prudently limit the market valuation risk exposure of the Company.
The
revised risk parameter reflects management’s historical practice of implementing
strategies that limit the Company’s exposure to market valuation fluctuations.
At September 30, 2007, the market value of equity indicates an acceptable level
of interest rate risk.
The
market value of equity model reflects certain estimates and assumptions
regarding the impact on the market value of our assets and liabilities given
an
immediate plus 200 or minus 200 bp change in interest rates. One of the key
assumptions is the market value assigned to our core deposits, or the core
deposit premiums. Using an independent consultant, we have completed and updated
comprehensive core deposit studies in order to assign core deposit premiums
to
our deposit products as permitted by regulation. The studies have consistently
confirmed management’s assertion that our core deposits have stable balances
over long periods of time, are generally insensitive to changes in interest
rates, and have significantly longer average lives and durations than our loans
and investment securities. Thus, these core deposit balances provide an internal
hedge to market fluctuations in our fixed rate assets. Management believes
the
core deposit premiums produced by its market value of equity model at September
30, 2007 provide an accurate assessment of our interest rate risk. At September
30, 2007, the average life of our core deposit transaction accounts was 16.4
years.
Liquidity
The
objective of liquidity management is to ensure our ability to meet our financial
obligations. These obligations include the payment of deposits on demand at
their contractual maturity, the repayment of borrowings as they mature, the
payment of lease obligations as they become due, the ability to fund new and
existing loans and other funding commitments, and the ability to take advantage
of new business opportunities. Our ALCO is responsible for implementing the
policies and guidelines of our board-governing liquidity.
Liquidity
sources are found on both sides of the balance sheet. Liquidity is provided
on a
continuous basis through scheduled and unscheduled principal reductions and
interest payments on outstanding loans and investments. Liquidity is also
provided through the following sources: the availability and maintenance of
a
strong base of core customer deposits, maturing short-term assets, the ability
to sell investment securities, short-term borrowings, and access to capital
markets.
Liquidity
is measured and monitored daily, allowing management to better understand and
react to balance sheet trends. On a quarterly basis, our board of directors
reviews a comprehensive liquidity analysis. The analysis provides a summary
of
the current liquidity measurements, projections, and future liquidity positions
given various levels of liquidity stress. Management also maintains a detailed
liquidity contingency plan designed to respond to an overall decline in the
condition of the banking industry or a problem specific to the
Company.
The
Company’s investment portfolio consists mainly of mortgage-backed securities and
collateralized mortgage obligations that do not have stated maturities. Cash
flows from such investments are dependent upon the performance of the underlying
mortgage loans, and are generally influenced by the level of interest rates.
As
rates increase, cash flows generally decrease as prepayments on the underlying
mortgage loans slow. As rates decrease, cash flows generally increase as
prepayments increase.
The
Company and the Bank’s liquidity are managed separately. On an unconsolidated
basis, the principal source of our revenue is dividends paid to the Company
by
the Bank. The Bank is subject to regulatory restrictions on its ability to
pay
dividends to the Company. The Company’s net cash outflows consist principally of
interest on the trust-preferred securities, dividends on the preferred stock,
and unallocated corporate expenses.
We
also
maintain secondary sources of liquidity which can be drawn upon if
needed. These secondary sources of liquidity include federal funds
lines of credit, repurchase agreements, and borrowing capacity at the Federal
Home Loan Bank. At September 30, 2007, our total potential liquidity through
these secondary sources was $802.0 million, of which $573.8 million was
currently available, as compared to $485.2 million available out of our total
potential liquidity of $598.0 million at December 31, 2006.