Item 1: Description of Business
Smithtown Bancorp, Inc. ("Registrant" or "Company") is a New York State registered bank holding company with one wholly owned subsidiary, Bank of Smithtown ("Bank"). The Registrant was organized as a New York business corporation and was incorporated under the laws of New York State in 1984. At the direction of the Board of Directors, pursuant to a plan of reorganization, the former shareholders of the Bank became the shareholders of the Company. Since commencing business in 1984, the Company has functioned primarily as holder of all of the Bank's common stock. In October 1999, the Bank and Seigerman-Mulvey Co., Inc. entered into a joint venture, SMTB Financial Group, LLC, for the purpose of selling insurance products and services and offering financial investment services to employees and customers of the Bank. In April 2001, the Bank established a new corporation, Bank of Smithtown Insurance Agency, for the purpose of accepting commission payments from Essex National Securities and Essex National Insurance Agency. These commissions were generated through a program called "Investors Marketplace." The program, which was designed by a large group of community bankers, offers tax deferred annuities and mutual funds. During 2005, the Bank filed for a change of name for this subsidiary to Bank of Smithtown Financial Services, Inc.. Effective February, 2006, the source of the agency's commissions will be Great American Advisors. In August 2004, the Bank purchased all of the stock of Seigerman-Mulvey Co., Inc. As a wholly-owned subsidiary of the Bank, conducting business in East Setauket, NY, Seigerman-Mulvey Co., Inc., provides business and personal insurance products as well as financial products and services. Following the Bank's acquisition of Seigerman-Mulvey Co., Inc., SMTB Financial Group, LLC, ceased operation. During 2005, the Bank also filed for a change of name for Seigerman-Mulvey Co., Inc., which is now known as Bank of Smithtown Insurance Agents and Brokers, Inc. ("Agency"). During the fourth quarter of 2005, the Bank began efforts toward the formation of an additional subsidiary, BOS Preferred Funding Corporation. This subsidiary is a real estate investment trust, and is being formed as a vehicle for capital enhancement for the Bank. Upon its formation, which occurred during the first quarter of 2006, the corporation will hold a majority of the consumer and commercial real estate loans of the Bank.
At present, the Registrant does not own or lease any property and has no paid employees. The Registrant uses the Bank's office space and employees without separate payment. Corporate headquarters are located at 100 Motor Parkway, Hauppauge, New York 11788.
The Bank engages in a complete range of commercial and consumer banking services as well as trust services, including demand, savings and time deposits accepted from consumers, businesses and municipalities located primarily within Suffolk and Nassau Counties, Long Island, NY. These deposits, along with funds generated from operations and other borrowings are invested in 1.) residential and commercial mortgages, 2.) construction and land loans, 3.) secured and unsecured commercial loans, 4.) secured and unsecured consumer loans, 5.) U.S. government treasury and agency securities, obligations of state and political subdivisions and FNMA, FHLMC, FHLB, and GNMA mortgage-backed securities. The Bank also offers merchant credit and debit card processing, safe deposit boxes, online banking including bill pay, telephone banking, automated teller machines, and individual retirement accounts. Through its financial services subsidiary, Bank of Smithtown Financial Services Inc., the Bank offers tax deferred annuities and mutual funds. Through its insurance subsidiary, Bank of Smithtown Insurance Agents and Brokers, Inc., the Bank offers a full line of commercial and personal insurance products, as well as financial services. For the years ended December 31, 2005, 2004 and 2003, the Bank's primary source of income has been interest income received on loans, and it represents 77.50%, 81.32% and 79.96% of total revenue. As the Bank services a wide range of customers, there is no dependence upon any single customer, the loss of which would have a material adverse effect on its business.
The Bank employs a total of 179 full-time equivalent individuals on a full and part time basis, including the employees of its subsidiaries.
The Bank's primary market area extends along the north shore of Long Island, now including both Nassau and Suffolk Counties, principally from Port Washington to Wading River. All of the Bank's current thirteen branch offices are located within this region, as are the majority of the consumers and businesses whom it serves. As part of the Bank's continued growth plans to serve a wider geographical customer base, five additional leases have been signed for branch locations in Nesconset, Deer Park, East Setauket, Bohemia and Coram. The first three mentioned leases are slated for opening during 2007. Two new branch offices are currently scheduled for opening during 2006; the first during the third quarter in Bohemia and the second during the fourth quarter in Coram. Within the Bank's primary market area, the majority of businesses are considered small businesses, and lending tends to be concentrated within health services, technology, insurance, real estate, and construction industries as well as small professional businesses.
Loans are extended for purposes such as medical offices, golf courses, storage facilities and residential housing developments. During the past four years, the Bank has also provided commercial and residential real estate lending services within the five boroughs of New York City. These loans have been extended for various purposes including multi family housing, parking garages, and mixed use office and retail space. Of the total real estate loan portfolio of $656,640, mortgage and construction loans to businesses within New York City total $261,510. Bank of Smithtown Insurance Agents and Brokers, Inc. provides insurance and financial services to a wide range of consumer and business customers, who reside primarily on Long Island and the metropolitan area, thus adding a synergy between the two businesses. Insurance products are also provided nationally by the Agency, but to a much lesser degree. Bank of Smithtown Financial Services, Inc. serves consumers located primarily within the Bank's market area.
All of the business lines engaged in by the Bank and its subsidiaries are of a highly competitive nature. The Bank faces competitive pressures from community banks located within its market area, as well as regional and super-regional banks in the same area. These competitive pressures can affect the pricing of bank deposit and loan products, as well as the costs of providing bank services. Competition results from other commercial banks, savings banks, credit unions and financial service providers such as investment and insurance companies.
The Registrant, the Bank and its subsidiaries report their income on a consolidated basis using the accrual method of accounting and are subject to federal and state income taxes. In general, banks are subject to federal income tax in the same manner as other corporations. However, gains and losses from the sale of available for sale securities are treated as ordinary income rather than capital gains or losses. Additionally, the Company can exclude 100% of the dividend income it receives from its subsidiary as they are all members of the same affiliated group. The Bank is subject to New York State Franchise Tax on Banking Corporations based on certain criteria. The taxation of income is similar to federal taxable income subject to certain modifications.
Regulation and Supervision
The Bank maintains a New York State charter and as such is subject to supervision, examination and regulation by the New York State Banking Department. The Bank is also a member of the Federal Reserve System and therefore is also subject to regulation, examination and supervision by the Federal Reserve Bank of New York. Smithtown Bancorp, Inc. is subject to the Bank Holding Company Act of 1956, as amended ("BHCA"), and as such is subject to the rules and regulations under the BHCA. The statutory rules and regulations enforced by the Bank's regulatory agencies relate to deposit insurance, minimum capital requirements, allowable investments, lending limits, payments of dividends, and various consumer protection laws. Any change in such laws and regulations, whether by the New York State Banking Department, the Federal Reserve Bank, the FDIC or through legislation, could have a material adverse impact on the Bank and the Company and their operations and shareholders. The Registrant is additionally under the supervision and regulation of the Securities and Exchange Commission ("SEC"). Access to any materials filed with the Securities and Exchange Commission is available at the SEC Public Reference Room, 450 Fifth Street, NW, Washington, DC 20549. Information on the operation of the Public Reference Room is available by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet site, http://www.sec.gov, that contains reports, proxy and information statements filed by the Registrant.
Other Information
The Bank's internet address is www.bankofsmithtown.com. The Annual Report on Form 10-K, quarterly reports on Form 10-Q and amendments to those reports filed or furnished pursuant to Section 13 or 15(d) of the Exchange Act are made available free of charge at the Bank's website as soon as reasonably practicable after electronic filing has been completed. Requests for these documents may also be directed to Smithtown Bancorp, Inc., 100 Motor Parkway, Suite 160, Hauppauge, NY 11788, (631) 360-9300.
The Company has adopted a Code of Ethics, which applies to all directors, officers and employees. This Code is distributed to and signed by all directors and staff members annually, and is maintained in the Bank's Human Resource Department. The Code contains Whistleblower provisions adopted by the Registrant and its subsidiary. Stockholders may request a copy of the Code of Ethics by contacting Smithtown Bancorp, Inc., 100 Motor Parkway, Suite 160, Hauppauge NY 11788 (631) 360-9398, Deborah McElroy, Director of Human Resources.
Item 1A:
Item 1A: Risk Factors
Concentration of loan portfolio
The Bank generally invests a large proportion of its assets in loans secured by commercial and residential real estate properties. A downturn in real estate values and economic conditions on Long Island and New York City could have a significant impact on the value of collateral securing the loans as well as the ability for the repayment of loans. See a further discussion in "Item 7: Management's Discussion and Analysis of Financial Condition and Results of Operations" under "Loans".
Changes in Interest Rates Could Affect Profitability
The ability to earn a profit, as is the case for most financial institutions, depends in large part on net interest income, which is the difference between interest income that the Bank earns on its interest-bearing assets, such as loans and investments, and the interest expense that the Bank incurs on its interest-bearing liabilities, such as deposits and borrowings. The Bank's profitability depends on its ability to manage its assets and liabilities during periods of changing market interest rates. A sustained decrease in market interest rates could adversely affect earnings. When interest rates decline, borrowers may refinance existing loans. Funds received by the Bank as a result of these refinancings would be reinvested at lower rates. Additionally, funds received on matured investment securities may be reinvested in lower yielding instruments. In a period of rising interest rates, the rates paid on interest bearing deposits could rise more rapidly than the rates earned on interest earning assets.
Geographic Location
The Bank's market area is located along the north shore of Long Island, from Port Washington to Wading River. Its customer base also includes the five boroughs of New York City. Competition in the banking and financial services industry is intense. The profitability of the Bank depends on its continued ability to successfully compete. The Bank competes with commercial banks, credit unions, savings banks, insurance companies and brokerage and investment banking firms. Many of the Bank's competitors have substantially greater resources and lending limits than the Bank and may offer certain services that the Bank does not provide.
The Loss of Key Personnel Could Impair the Bank's Future Success
The Bank's future success depends in part on the continued service of its executive officers, other members of key management, and its staff, as well as its ability to continue to attract, motivate and retain additional highly qualified employees. The loss of services of key personnel could have an adverse effect on the Bank's business.
Highly Regulated Environment
The Bank is subject to extensive regulation, supervision and examination by the New York State Banking Department, the Federal Reserve Bank and the SEC. Such regulation and supervision govern the activities in which a financial institution and its holding company may engage and are intended primarily for the protection of the consumer. Recently regulators have intensified their focus on the USA PATRIOT Act's anti-money laundering and Bank Secrecy Act compliance requirements. In order to comply with regulations, guidelines and examination procedures in this area as well as other areas, the Bank has been required to adopt new policies and procedures and to install new systems. The Bank cannot be certain that the policies, procedures and systems in place are flawless and there is no assurance that in every instance the Bank is in full compliance with these requirements. Regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the imposition of restrictions on the operation of an institution. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, or legislation, may have a material impact on operations.
Item 1B:
Item 1B: Unresolved Staff Comments
None
Item 2:
Item 2: Description of Properties
Corporate headquarters of the Registrant are located at 100 Motor Parkway, Suite 160, Hauppauge, NY 11788. At present, the Registrant itself owns no physical properties. The Bank owns in fee the following locations:
Smithtown Office Hauppauge Office 1 East Main Street 548 Route 111 Smithtown, New York 11787 Hauppauge, New York 11788
Trust Building East Setauket Office
17 Bank Avenue 184 North Belle Mead Road Smithtown, New York 11787 East Setauket, New York 11733
The Bank occupies the following locations under lease agreements:
Commack Office Kings Park Office 2020 Jericho Turnpike 14 Park Drive Commack, New York 11725 Kings Park, New York 11754
Centereach Office Lake Grove Office 1919 Middle Country Road 2921 Middle Country Road Centereach, New York 11720 Lake Grove, New York 11755
Northport Office Rocky Point Office 836 Fort Salonga Road 293 Route 25A Northport, New York 11768 Rocky Point, New York 11778
Wading River Office Miller Place Office 6241 Route 25A 347 Route 25A Wading River, New York 11792 Miller Place, New York 11764
Corporate Headquarters Office and Branch Port Washington Office 100 Motor Parkway, Suites 160 and 118 61 Old Shore Road Hauppauge, New York 11788 Port Washington, New York 11050
The Bank has signed leases at 3460 Veterans Highway, Bohemia, New York 11716, 1830 Route 112, Coram, New York 11727, Commack Road, Deer Park, New York 11729, 4032 Nesconset Highway, East Setauket, New York 11733 and 465 Smithtown Blvd., Nesconset, New York 11767 for branch office space. The first two branches are expected to open during the third quarter and fourth quarter of 2006, and the last three during 2007.
Item 3:
Item 3: Legal Proceedings
In the opinion of the Registrant and its counsel, there are no material proceedings pending in which the Registrant, Bank or any of its subsidiaries is a party, or of which its property is the subject, or any which depart from the ordinary routine litigation incident to the kind of business conducted by the Registrant, the Bank and its subsidiaries. No proceedings are known to be contemplated by government authorities or others.
Item 4:
Item 4: Submission of Matters to a Vote of Security Holders
No matter was submitted during the quarter ended December 31, 2005 to a vote of the Registrant's stockholders through the solicitation of proxies or otherwise.
Part II
Item 5:
Item 5: Market for Common Equity and Related Stockholder Matters
Management is not necessarily aware of the price for every transaction of Company stock. The following charts show the prices for the transactions of which management is aware. All per share data have been adjusted to reflect the May 2004 two-for-one stock split.
------------Per Share---------- ------------------------------- Cash Dividend High Low Declared ---- --- -------- First quarter $ 28.32 $ 27.48 $ 0.06 Second quarter 24.61 23.70 0.06 Third quarter 26.89 26.30 0.06 Fourth quarter 29.79 28.93 0.06 ------ Total cash dividends declared $ 0.24 ======
------------Per Share---------- ------------------------------- Cash Dividend High Low Declared ---- --- -------- First quarter $ 33.84 $ 20.47 $ 0.05 Second quarter 40.54 30.90 0.05 Third quarter 40.60 24.86 0.05 Fourth quarter 34.75 24.96 0.05 ------
Total cash dividends declared $ 0.20 ======
At December 31, 2005, the Company had approximately 637 stockholders of record, not including the number of persons or entities holding stock in nominee or street name through various banks and brokers and its stock is traded on NASDAQ under the symbol "SMTB."
Item 6:
Item 6: Selected Financial Data
Consolidated Balance Sheets
Consolidated Statements of Income
Supplementary Information
Item 7:
Item 7: Management's Discussion and Analysis of Financial Condition and Results of Operations
Private Securities Litigation Reform Act Safe Harbor Statement
This report may contain certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations, but actual results may differ materially from anticipated future results. Forward-looking statements may be identified by use of the words "believe," "anticipate," "project," "estimate," "expect," "will be," "will continue," "will likely result," or similar expressions. The Company's ability to predict results or the actual effect of future strategic plans is inherently uncertain. Factors that could have a material adverse effect on the operations of the Company and its subsidiary are discussed under the heading "Risk Factors" in Item 1A herein. Other factors that could have a material adverse effect on the operation of the Company and its subsidiary include, but are not limited to, changes in: general economic conditions, deposit flows, loan demand,
competition, accounting principles and guidelines, and governmental, regulatory and technological factors affecting the Company's operations, pricing, products, and services. The factors included under Item 1A and here are not exhaustive. Other sections of this report may include additional factors that could adversely impact the Company's performance.
Investors are cautioned not to place undue reliance on forward-looking statements as a prediction of actual results. Except as required by applicable law or regulation, the Company undertakes no obligation to republish or revise forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrences of unanticipated results. Investors are advised, however, to consult any further disclosures the Company makes on related subjects in our reports to the Securities and Exchange Commission.
Summary
Smithtown Bancorp, Inc., is a holding company formed in 1984, engaged primarily in commercial banking through its wholly owned subsidiary, Bank of Smithtown. The Bank offers a full array of consumer and commercial deposit and lending products and services through its thirteen branch offices and its online banking site. The Bank also provides insurance and financial products through its two wholly owned subsidiaries, Bank of Smithtown Insurance Agents and Brokers, Inc. and Bank of Smithtown Financial Services, Inc. For the following discussion, the consolidated entity is referred to as the Company and the Bank and its subsidiaries are referred to as the Bank. There were several significant factors that affected the Company's financial condition and results of operations during 2005. The discussion of these factors should be read in conjunction with the accompanying financial statements.
The Company's earnings per share for 2005 was $1.88 as compared to $1.69 for 2004, an increase of 11.24%. As the weighted average number of outstanding shares only decreased by 11,484 shares from 2004 to 2005, this increase in earnings per share is almost exclusively the result of increased earnings. The growth in earnings was primarily the result of an increased loan volume of $128,328 or 22.51%. Loan growth was typically slower during the first quarter of the year, characteristic of one of the primary types of lending engaged in by the Bank. As inclement winter weather tends to slow the construction industry, net loan growth was only $5,843 for the first three months of the year. Customer refinancings with other banks also remained at a high level during the first quarter of 2005 which contributed to the slower growth in the portfolio. During the second quarter of the year, construction returned to its prior high level, and the Bank's net loan growth significantly increased by $42,277. This level of growth was maintained during the remainder of the year with an additional increase of $80,238. Due to the short term nature of construction loans, originations required to sustain this high growth are nearly triple the net growth. Construction projects are typically completed in a nine to twelve month period, at which point the loan is paid and permanent financing is required. The Company's results of operations can be significantly affected by general economic conditions, particularly its ability to increase loan volume through construction lending if market interest rates continue to rise. As this segment of the Bank's loan portfolio must be replaced every nine to twelve months, if the construction industry were to slow due to rising interest rates, Bank originations could be significantly reduced. In order to mitigate this risk, the Bank has begun increasing its volume of longer term, permanent real estate financing. The highly competitive nature of this business is another significant factor that could potentially affect the Company's results of operations. As a lower rate of interest may need to be accepted for this type of credit due to strong competitive bidding, the Bank's net interest margin could be further reduced. During 2005, the Bank's margin decreased from 4.47% to 4.39%. As compared to its peers, this decrease was small, and in fact was entirely sustained during the first quarter of the year. Each quarter thereafter, net interest margin actually increased from 4.29% at March 31 to 4.39% at December 31, 2005. Overall, the increasing rate environment of 2005 was beneficial to the Bank's increasing loan volume, as the average monthly yield on the portfolio increased from 6.82% for January to 7.71% for December. Average yield on loans for the year was 7.22% during 2005 as compared to 6.54% during 2004.
Significant loan growth was achieved during 2005 with no compromise to strict underwriting standards or high asset quality. These achievements were witnessed by the continued low level of nonperforming loans and minimal net charge-offs. Nonperforming loans at year end 2005 and 2004 were $47 and $0. One loan which was internally classified by management during 2004 is now in the 30 through 89 day past due category. This $7,293 loan consists of a leasehold mortgage on property on Madison Avenue in New York City that is appraised at $11,800. Although the loan remains a concern to management, improvements in cash flow, delinquency and technical issues are expected during 2006.
During 2005, the positive impact on earnings from the growth in the loan portfolio was partially due to the Bank's ability to provide most of the lower cost funding for these loans through internally generated deposits. Wholesale borrowings were required only at year end. As loan growth was very strong during the fourth quarter and deposit runoff typical at year end was repeated, the Bank turned to the wholesale market to fund the new loan originations. During 2005 deposits grew by $182,611 or 35.51%. The Bank was able to achieve this record growth through various channels, one of which was through its three newest branch offices. $61,306 of this total growth was originated at the Miller Place, Motor Parkway and Port Washington branches. Deposit growth, similar to loan growth, is also affected by external interest rate movements and strong competitive pressures. Both of these factors played an important role in the Company's results of operations during 2005. Of the total deposit growth of $182,611, demand deposits grew by only $5,362 or 5.93%, money
market accounts by $52,508 or 31.85% and time deposits by $135,525 or 79.13%. NOW accounts and savings accounts decreased in volume by $10,784 or 12.30%. The Bank ran several time deposit promotions during the year in an effort to provide some of the additional funding for the projected loan growth. The timing of the acquisition of these deposits was primarily during the first quarter. It was this $61,062 increase in time deposits that was largely responsible for the 18 basis point decline in net interest margin during the first quarter. Although these time deposits resulted in compression of the Bank's interest margin, management was still able to provide this funding at rates lower than Federal Home Loan Bank advance rates. Due to increasing market rates, the margin compression that could have negatively impacted the Bank's net income for the remainder of the year was actually mitigated by maturing long term certificates of deposit that were renewed and repriced at lower rates. The record growth in deposits during 2005 was also achieved through the introduction of the Elite money market account in February. This account provides high rates of interest for balances over $25 thousand. As liquidity is demanded by consumers during a rising rate environment, this product was very successful in attracting new deposits, and also served as a source of funding that was at a lower cost than the rate offered for comparable borrowings. Growth in demand deposits was small by comparison to time deposits and money markets and was the only deposit goal set by management that was not achieved. Competitive pressures for a "commodity" product have been and remain extremely strong. Free checking is commonplace to all banks, and the "driver" for consumer movement of a checking account from one institution to another is often beyond the control of the acquiring bank. Demand deposit growth remains one of the Bank's largest challenges for 2006. With economic conditions remaining positive in both the Long Island and the metropolitan area marketplace, and the building industry continuing to prosper, the Company's outlook for continued asset growth is positive. The liability side of the balance sheet, particularly the sources for funding this asset growth, remains the Company's greatest challenge.
Growth in the Bank's investment portfolio also tempered margin compression during 2005. As the timing of growth in the loan portfolio and deposit portfolio were not always perfectly matched, deposited funds were invested in short term US government agency securities and municipal securities, offering a higher than federal funds rate of interest. A total of $90,866 in new securities were purchased during 2005, comprised of $78,796 of US government agency securities, $6,821 of mortgage-backed securities and $5,249 of municipal securities. The weighted average maturity of these purchased securities was 6.5 years. These securities also provided the Bank with the collateral necessary for acceptance of local municipal deposits.
2005 was another successful year for the Company, with record earnings for the eleventh consecutive year. Return on equity was 21.48%, the ninth consecutive year for a return to shareholders over 20%. However, significant challenges lie ahead for the Company. Growth in deposits, particularly demand deposits, will remain difficult. With slower demand deposit growth, and free checking accounts as the most popular demand vehicle, maintaining fee income from service charges becomes difficult. Interest bearing deposit acquisition, while not as difficult to achieve as demand deposit acquisition, can place extreme pressure on net interest margin. Based on the uncertainty of actions to be taken by the new Federal Reserve Chairman during 2006, any further rate increases could have a material impact on the cost for these deposits. As longer term borrowings mature during the coming years, the rates at which they are renewed could be significantly higher than the current rates paid. The current weighted average rate on all long term borrowings from the Federal Home Loan Bank is 3.58% with a weighted average term of twenty seven months. The average rate offered by the Federal Home Loan Bank in January 2006 for twenty four month borrowings is 4.86%. This uncertainty in forward interest rates, as well as the unusual yield curve, places additional pressures on net income. The Company continues to meet these challenges in various ways, one of which is by expanding its franchise. Two new branch offices were opened during 2005. Plans for the opening of two additional branch offices in 2006 plus three new offices in 2007 continue to increase the geographical footprint of the Company. Development of new products to increase fee income also assists in maintaining strong earnings despite the preponderance of free checking. The Overdraft Honor program was very successful toward this effort during 2005. This product provides the consumer with coverage of overdrafts up to a predetermined level, yet provides the Bank with significant dollars of new fee income. The third way of meeting these challenges has been and will continue to be through strong asset liability management, with interest rate modeling and other analytical tools to ensure profit maximization within acceptable limits of risk.
Application of Critical Accounting Policies
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported asset and liability balances and revenue and expense amounts. Our determination of the allowance for loan losses is a critical accounting estimate because it is based on our subjective evaluation of a variety of factors at a specific point in time and involves difficult and complex judgments about matters that are inherently uncertain. In the event that management's estimate needs to be adjusted based on, among other things, additional information that comes to light after the estimate is made or changes in circumstances, such adjustment could result in the need for a significantly different allowance for loan losses and thereby materially impact, either positively or negatively, the Bank's results of operations.
The allowance for loan losses is established and maintained through a provision for loan losses based on probable incurred losses inherent in the Bank's loan portfolio. Management, through its Asset Quality Committee, comprised of several members of executive management as well as the chief collection officer, evaluates the adequacy of the allowance on a quarterly basis. Adjustments are made at this time to a level deemed adequate by the Committee, based on its risk evaluation of the portfolio in its entirety as well as in specific loan details. The allowance is comprised of both individual valuation allowances and loan pool valuation allowances.
The Bank monitors its entire loan portfolio on a regular basis, with consideration given to detailed analysis of classified loans, repayment patterns, probable incurred losses, past loss experience, current economic conditions, and various types of concentrations of credit. Additions to the allowance are charged to expense and realized losses, net of recoveries, are charged to the allowance.
Individual valuation allowances are established in connection with specific loan reviews and the asset classification process including the procedures for impairment testing under Statement of Financial Accounting Standard ("SFAS") No. 114, "Accounting by Creditors for Impairment of a Loan", an Amendment of SFAS Statements No. 5 and 15, and SFAS No. 118, "Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures", an Amendment of SFAS Statement No. 114. Such valuation, which includes a review of loans for which full collectibility in accordance with contractual terms is not reasonably assured, considers the estimated fair value of the underlying collateral less the costs to sell, if any, or the present value of expected future cash flows, or the loan's observable market value. Any shortfall that exists from this analysis results in a specific allowance for the loan. Pursuant to our policy, loan losses must be charged-off in the period the loans, or portions thereof, are deemed uncollectible. Assumptions and judgments by management, in conjunction with outside sources, are used to determine whether full collectibility of a loan is not reasonably assured. Assumptions and judgments also are used to determine the estimates of the fair value of the underlying collateral or the present value of expected future cash flows or the loan's observable market value. Individual valuation allowances could differ materially as a result of changes in these assumptions and judgments. Individual loan analyses are periodically performed on specific loans considered impaired. The results of the individual valuation allowances are aggregated and included in the overall allowance for loan losses.
In addition to estimating losses for loans individually deemed to be impaired, management also estimates collective impairment losses for pools of loans that are not specifically reviewed. Statistical information regarding the Bank's historical loss experience over a period of time believed to be relevant is weighted very heavily in management's estimate of such losses. However, future losses could vary significantly from those experienced in the past. In addition, management also considers a variety of general qualitative factors and then subjectively determines the amount of weight to assign to each in estimating losses. The factors include, among others, national and local economic conditions, environmental risks, trends in volume and terms of loans, concentrations of credit, changes in lending policies and procedures, and experience, ability, and depth of the Bank's lending staff. Because of the nature of the factors and the difficulty in assessing their impact, management's resulting estimate of losses may not accurately reflect actual losses in the portfolio.
Although the allowance for loan losses has two separate components, one for impairment losses on individual loans and one for collective impairment losses on pools of loans, the entire allowance for loan losses is available to absorb realized losses as they occur whether they relate to individual loans or pools of loans. At December 31, 2005, management believes the allowance for loan losses has been established and maintained at a level adequate to reflect the probable incurred losses in the Bank's loan portfolio.
Liquidity
The objective of liquidity management is to ensure the sufficiency of funds available to respond to the needs of depositors and borrowers, and to access unanticipated earnings enhancement opportunities for Company growth. Liquidity management addresses the ability to meet deposit withdrawals either on demand or contractual maturity, to repay other borrowings as they mature and to make new loans and investments as opportunities arise.
The Company's principal source of liquidity is dividends from the Bank. Due to regulatory restrictions, dividends from the Bank to the Company at December 31, 2005 were limited to $27,904 which represented the Bank's 2005 retained net income and the net undivided profits from the previous two years. The dividends received from the Bank are used primarily for dividends to the shareholders, and also for interest payments on the subordinated debt. In the event that the Company subsequently expands its current operations, in addition to dividends from the Bank, it will need to rely on its own earnings, additional capital raised and other borrowings to meet liquidity needs.
The Bank's most liquid assets are cash and cash equivalents, securities available for sale and securities held to maturity due within one year. The levels of these assets are dependent upon the Bank's operating, financing, lending and investing activities during any given period. Other sources of liquidity include loan and security principal
repayments and maturities, lines of credit with other financial institutions including the Federal Home Loan Bank, and growth in core deposits. While scheduled loan amortization, maturing securities and short-term investments are relatively predictable sources of funds, deposit flows and loan and mortgage-backed securities prepayments are greatly influenced by general interest rates, economic conditions and competition. The Bank adjusts its liquidity levels as appropriate to meet funding needs such as seasonal deposit outflows, loans, and asset and liability management objectives. The goal of asset liability management is the combination of maintaining adequate liquidity levels without sacrificing earnings. The Bank's objective in asset liability management is to match the maturity of its assets and liabilities in a way that takes advantage of the current and anticipated rate environment. Asset liability management is a primary function of management and is reviewed on an ongoing basis. The Chief Executive Officer, all Executive Vice Presidents, the Vice President of Retail and the Comptroller serve on the Asset Liability Management Committee. Historically, the Bank has relied on its deposit base as its principal source of funding. However, in recent years, various sources of funding have become available to the Bank, in increasing magnitudes. These additional sources may be more attractive to the Bank at different times based on market interest rates and other competitive factors. During the fourth quarter of 2004 competitive pricing of deposits was often "irrational" and actually higher than the rates available through wholesale funding. At that point, management made the decision to use this wholesale funding to temporarily fund new loan originations. Management views all sources of funding as acceptable, and makes decisions as to which sources are more advantageous at the time of need. The discriminate use of different sources of funding at different points in time has contributed to higher interest margins and overall net income for the Bank during 2004 and 2005. At December 31, 2005 the Bank had the ability to borrow on aggregate, unsecured lines of credit of $23,000 with unaffiliated correspondent banks. None of this credit was outstanding at year end, and therefore all $23,000 was available for use. The Bank has the ability, as a member of the Federal Home Loan Bank ("FHLB") system, to borrow against unencumbered residential and commercial mortgages owned by the Bank. At December 31, 2005, $54,614 of these funds was available yet for borrowing. At yearend 2005, due to the combination of strong loan growth and deposit runoff typical for the Bank at this time of the year, borrowings reached their highest point for the entire year and amounted to $107,949. This level was completely within the guidelines of safety and soundness. As has also been typical for the Company in prior years, the level of deposits from December 31, 2005 to January 31, 2006 increased by $47,999, and the level of borrowings decreased significantly.
The following table represents management's expectations regarding the estimated cash flow of interest bearing assets and liabilities as of December 31, 2005. This table has been derived based on internal data and management's assumptions, and not necessarily the contractual terms for repayment or redemption. The amounts shown below could also be significantly affected by external factors such as changes in prepayment assumptions, changes in market interest rates that are not matched by the Company, early withdrawals of deposits and competition. Therefore, this information does not reflect the effect of repricing rights or the impact of repricing on interest income or expense. The following significant assumptions were used in developing the following tables: a.) time deposits reflect contractual maturities, b.) money market accounts are rate sensitive and accordingly, all accounts have been included as withdrawable within the first two years and c.) savings and NOW accounts are not as rate sensitive to withdrawal as money market accounts so a significant percentage of these accounts are reflected in the more than 1 to 5 years category. These assumptions are based on management's historical analysis of market interest rates and levels of the Company's deposits over the past ten years.
Analysis of Net Interest Income 2005 vs. 2004
Net interest income, the primary contributor to earnings, represents the difference between income on interest earning assets and expense on interest bearing liabilities. Net interest income depends upon the volume of interest earning assets and interest bearing liabilities and the interest rates earned or paid on them.
As has been discussed in prior sections, the Bank's net interest margin decreased by eight basis points during 2005, resulting primarily from the increased cost of time deposits and money market accounts, as well as borrowings. The Bank has been able to take advantage of the increasing interest rate environment by repricing its loan portfolio to higher rates. 32.84% of the Bank's loan portfolio is immediately repriceable and tied to the prime rate. 89.80% of the real estate portfolio is adjustable and tied to various US treasury rates. The upward repricing of these loans has mitigated the pressure placed on margin by the higher cost of interest bearing deposits.
The following table sets forth certain information relating to the Company's average consolidated statements of financial condition and its consolidated statements of income for the years indicated and reflects the average yield on assets and average cost of liabilities for the years indicated. Interest income on investment securities is shown on a tax-equivalent basis. Yields and costs are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the years shown. Average balances are derived from daily average balances and include non-performing loans, if any. The yields and costs include fees, which are considered adjustments to yields.
Rate/Volume Analysis
Net interest income can be analyzed in terms of the impact of changes in rates and volumes. The following table illustrates the extent to which changes in interest rates and in volume of average interest earning assets and interest bearing liabilities have affected the Bank's interest income and interest expense during the periods indicated. Information is provided in each category with respect to 1.) changes attributable to changes in volume (changes in volume multiplied by prior rate); 2.) changes attributable to changes in rate (changes in rates multiplied by prior volume); and 3.) the net changes. For purposes of this table, changes, which are not due solely to volume or rate changes, have been allocated to these categories based on the respective percentage changes in average volume and rate. Due to the numerous simultaneous volume and rate changes during the period analyzed, it is not possible to precisely allocate changes between volume and rates. In addition, average earning assets include non-accrual loans (if any).
Rate Volume Relationships of Interest Margin on Interest Earning Assets and Interest Bearing Liabilities
For 2005 vs. 2004
Net interest income, on a tax equivalent basis, increased by $5,683 or 21.41% from 2004 to 2005. As can be seen from the above table, this was due to a combination of an increased volume variance of $3,712 and increased interest rate variance of $1,971.
Variances in Volume
During 2005, the average volume of investment securities increased by $45,240, as excess funds collected early in the year were employed in securities yielding a higher rate of interest than federal funds. A majority of these new securities were US government agency securities with maturities of less than five years. The largest increase in the Company's balance sheet was in the loan portfolio. This average balance increased from 2004 to 2005 by $88,061. Within the loan portfolio, the greatest increase was in real estate loans, which grew by over $50,000 in average balances. Within the real estate portfolio, loans to finance land acquisition and construction loans increased by the greatest percentages. Commercial mortgages decreased slightly in volume due to refinancing activity, to limitations placed upon the Bank relative to legal lending limits, and to intense competitive pricing pressures. On the liability side of the balance sheet, average interest earning deposit volume increased by $113,748 or 26.13%. The greatest increase within deposit balances was in time deposits. The Bank ran several certificate of deposit promotions throughout the year, at rates lower than comparable Federal Home Loan Bank advance rates, and was very successful in attracting new customers. These accounts as well as Elite money market accounts were the primary drivers of deposit acquisition during 2005. The addition of the three newest branch offices also significantly increased the breadth of the Bank's customer base. The average balance increase in demand deposits for 2005 was $8,565 or 9.24%. While not as strong an increase as management would like to have seen this year, demand deposit acquisition and retention will become a priority goal during 2006. The Bank's use of borrowed funds, primarily in the form of term advances from the Federal Home Loan Bank, increased during 2005 by $19,290. Twenty million dollars of borrowings were originated during the last two months of 2004, as the pricing of interest bearing deposits was very high. At that point in time, management made the decision to turn to the wholesale markets for loan funding rather than pay the higher rates on deposit accounts. These additional borrowings at yearend 2004 were responsible for the increased average balances of 2005. Throughout the majority of 2005 the Bank relied on its own internal deposit generation to fund new loan originations. Stockholder's equity increased during 2005 as a result of strong earnings, and this growth resulted in a very strong return on average equity of 21.48%.
Variances in Rate
The increase in short term interest rates resulting from eight Federal Reserve Bank rate increases during 2005 was responsible for the upward movement in rate variance. A majority of the Bank's loan portfolio is adjustable with 32.84% indexed to the prime rate. These immediately repriceable loans were in large part responsible for the increase in yield of 68 basis points on the portfolio during 2005. Investment yields did not fare as well, as new purchases added to the portfolio carried lower yields than currently held securities. These new purchases were predominantly short term issues, as term extension carried no benefit in the flat yield curve environment of 2005. The average yield on federal funds sold increased by 180 basis points over the corresponding yield in 2004. This large increase in average yield in combination with a smaller increase in average balances produced a 262.14% increase in income. Overall, the yield on interest earning assets increased by 7.41% during 2005. Costs for deposits also increased, with the largest increase in interest on money market accounts. This was due to the Elite money market account which bears a high rate of interest for balances of $10,000 or more. The product was very successful in attracting additional deposits. Although there was some cannibalization from lower paying money market accounts and savings accounts, overall the balances raised from the product were new funds to the Bank, and were lower cost than overnight borrowings and short term advances. The increase in average cost of deposit accounts was 56 basis points from 2004 to 2005. The average rate on borrowings also increased during 2005 by 35 basis points. The addition of four advances from the Federal Home Loan Bank totaling twenty million dollars at year end 2004 was responsible for this increase. The total increase in interest expense for the Company's subordinated debt was due to the increase in average rate. This increase amounted to 201 basis points for the year 2005 over 2004. The total effect of the increases in average rates and volumes during 2005 was increased net interest income and slightly decreased net interest margin, due primarily to the significant growth in the Bank's loan portfolio.
For 2004 vs. 2003
Net interest income, on a tax equivalent basis, increased by $3,614 or 15.77% from 2003 to 2004. As can be seen from the above table, this is due to a combination of an increased volume variance of $5,172 and decreased interest rate variance of $1,558.
Variances in Volume
Average balances of investment securities decreased in volume from 2003 to 2004 as $19,000 in securities with call features were redeemed by the issuers, and $13,093 of available for sale securities were sold in order to re-invest these funds into higher yielding loans. The average balance of loans increased by $124,696 or 31.41% from year end 2003 to year end 2004. The increase in the portfolio was predominantly in real estate loans, which increased in average balance by 18.72%. Commercial and industrial loans increased by a lesser amount in average balance of 12.33%. Federal funds sold increased significantly in average balance from 2003 to 2004. This was the result of the mismatch in timing of new deposit acquisition and new loan originations. A large volume of new deposits were collected during the first half of 2004, but new loan originations were much stronger during the last half of the year. Average deposit balances grew significantly during 2004, with the greatest increase in time deposits. The average balance of time deposits represented 31.64% of the total deposit portfolio at December 31, 2004, as compared to 27.01% at December 31, 2003. Money market accounts also grew from 2003 to 2004. The average balance of these deposits increased by 23.63% from yearend 2003 to yearend 2004. Other borrowings increased in average balance from $38,039 to $49,794 from December 31, 2003 to the same date in 2004.
Variances in Rate
Net interest margin decreased from 4.90% in 2003 to 4.47% in 2004, due to a combination of factors. On the asset side of the balance sheet, loan yields decreased from 6.90% to 6.54%, due to a high level of refinancings, which were replaced by loans carrying lower rates of interest. The yield on investment securities decreased from 5.15% to 4.55% resulting from the sale of higher yielding securities also replaced with lower yielding instruments. The total yield on interest earning assets declined from 6.54% to 6.21%. Interest expense on deposit accounts increased by 33.73% from 2003 to 2004, due to the slight increase in rate from 1.83% to 1.90% and the large increase in volume of time deposits and money market accounts. The rate paid for wholesale borrowings decreased by forty basis points during 2004. The rate paid for the subordinated debt also decreased by twenty three basis points in 2004. The increased expense for this debt during 2004 was due to the full year of outstanding balance as compared to three months of balance in 2003.
Loans
The Bank's loan portfolio consists primarily of real estate loans secured by residential and commercial properties located within the Bank's market area as well as within the five boroughs of New York City. Loan growth remained strong during 2005. The portfolio grew by $129,291 over the 2004 level, representing an increase of 22.65%. The largest area of growth during 2005 was in land and construction loans. These loans typically provide the interim financing needs of builders during the construction stage of their project. The second largest area of growth in the portfolio was in the commercial real estate sector. These loans are of a longer term nature, and represent the permanent financing needs after construction is complete. These two segments of the Bank's loan portfolio grew in total by $113,077 or 66.63%. Real estate lending continued to be the Bank's primary focus and strength for 2005 and will be for the coming year. The Bank's experience as to strong performance, low delinquencies, and minimal charge-offs provide the basis for continuation in real estate lending. This can be seen from the segmentation of the portfolio which remained stable from 2004 to 2005, with real estate loans comprising 93.79% and 92.46%, respectively. Concentration risk is mitigated by geographical and industry diversification, as well as sound, conservative underwriting standards and periodic credit review performed by a prior regulatory examiner.
The following table sets forth the major classifications of loans:
Total non-performing loans at December 31, 2005 and 2004 were $47 and $0. Loans past due 30-89 days at these same points in time were $7,490 and $61, respectively. The $7,490 of past due loans this yearend is comprised of two loans, one of which although not past due last year end, was internally classified by management. This $7,293 loan has been in delinquent status since the end of the first quarter of 2005. This property is two adjacent six story office buildings located on Madison Avenue in New York City, and was last appraised at $11,800. The Bank holds a collateral interest in a leasehold mortgage on these buildings. The landlord remains in technical default under his lease. Currently, the Bank has begun efforts to cure the defaults using funds that are in escrow in the Bank. The borrower has been cooperative with the Bank with respect to loan payments, and although in the short term payment difficulties may continue, management fully expects the loan to be substantially improved during 2006. Last year end this same borrower was the principal in two additional New York City properties for which the Bank held mortgages. Both of these properties were sold during 2005 with no loss to the Bank. The second loan included in the $7,490 of past due loans is a commercial loan for $195 and as of the date of this report has become current. The remaining $2 in this category represents checking account overdrafts past due more than 30 days. Total internally classified loans, made up of non-performing and past due loans as well as loans which management deems to be potentially troublesome at December 31, 2005 and 2004 amounted to $8,055 and $8,689, respectively, the majority of which has been the $7,293 loan discussed above. Management expects satisfactory resolution of all of these classified loans.
The following table shows the maturities of loans (excluding real estate mortgages and installment loans) outstanding as of December 31, 2005:
Analysis of the Allowance for Loan Losses
The allowance for loan losses at December 31, 2005 and 2004 was $5,964 and $4,912. The change in the allowance account is comprised of net charge-offs of $148 and a provision for loan losses of $1,200. Based on specific reserves for internally classified loans and multiple factors including historical experience and current economic conditions, management feels the level of the allowance for the loan losses provides adequate coverage.
Currently, the Bank's reserve ratio (the allowance for loan losses as a percentage of end of period loans) is .85%. At December 31, 2004 this same ratio stood at .86%. This level of reserves is adequate due to the quality of the portfolio, and is within the range of peer group banks.
The allowance for loan losses is an amount that management currently believes will be adequate to absorb probable incurred losses inherent in the Bank's loan portfolio. In determining the allowance for loan losses, there is not an exact amount but rather a range for what constitutes an appropriate allowance. As more fully discussed in the "Application of Critical Accounting Policies" section of this discussion and analysis of financial condition and results of operations, the process for estimating credit losses and determining the allowance for loan losses as of any balance sheet date is subjective in nature and requires material estimates. Actual results could differ significantly from these estimates.
The following tables describe the activity in the allowance for loan losses account for the following years ended:
Allocation of Allowance for Loan Losses
The following table sets forth the allocation of the Bank's allowance for loan losses by loan category and the percent of loans in each category to total loans receivable, net, at the dates indicated. The portion of the loan loss allowance allocated to each loan category does not represent the total available for future losses which may occur within the loan category since the total loan loss allowance is a valuation allocation applicable to the entire loan portfolio. The level of unallocated reserves was arrived at after an in depth analysis of the unique characteristics of the Company's portfolio. Factors such as the the high growth rate of the portfolio over the past several years, the historical performance of the portfolio including delinquencies, net charge-off ratios, and the level of nonperforming loans have been considered in determining the level of unallocated reserves. Additional factors including local economic conditions, loan concentrations, and experience level of lending staff all contribute to the final determination of the unallocated portion of the allowance.
The following table shows the Bank's nonaccrual and contractually past due loans:
For 2005 and 2004, the difference between interest income on nonaccrual loans and income that would have been recognized at original contractual rates and terms was $4 and $2.
Securities
During 2005, total securities increased by $62,850. Purchases included the obligations of U.S. Treasury and Agency securities, mortgage backed securities and municipal securities. All purchases were added to the available for sale portfolio. The Bank also invested $1,000 in the Senior Housing Crime Prevention Foundation, Inc. as part of its ongoing community reinvestment commitment. The investment was used to improve the security and well-being of the residents of a rehabilitation and nursing home located in Smithtown, NY.
The following schedule presents the estimated fair value for securities available for sale and the amortized cost for investment securities held to maturity as detailed in the Company's balance sheets as of December 31, 2005, 2004, and 2003.
The following table presents the amortized costs and estimated fair values of securities by contractual maturity at December 31, 2005:
Obligations of U.S. government agencies, mortgage-backed securities, and obligations of state and political subdivisions having an amortized cost of $42,172 and an estimated fair value of $42,298 were pledged to secure public deposits, treasury tax and loan deposits, and advances.
Deposits & Other Borrowings
Total deposits increased by $182,611 or 35.51% from yearend 2004 to yearend 2005. The largest segment of the portfolio remains time deposits and represents 44.02% and 33.30% of total deposits as of December 31, 2005 and 2004, respectively. The large increase in this segment resulted from various certificate of deposit promotions run during the year. The next largest segment of the deposit portfolio is money market accounts. These accounts comprise 31.19% and 32.06% of total deposits. Due to the introduction of the Elite money market account during 2005, this segment of the portfolio increased by 31.85%. Money market accounts proved to be a less costly alternative for funding asset growth during 2005 than certificates of deposit. Demand deposits represent 13.75% and 17.59% of total deposits at yearend 2005 and 2004, respectively. Growth in demand deposits was 5.93% for the year. In conjunction with expanding the Company's franchise with two new branch openings, management has begun exploring additional avenues for demand acquisition during 2006.
At December 31, 2005, the remaining maturities of the Bank's time deposits in amounts of $100,000 or greater were as follows:
3 months or less $ 28,832 Over 3 through 6 months 5,550 Over 6 through 12 months 22,521 Over 12 months 61,879 --------- Total $ 118,782 =========
During 2005, borrowings increased from $99,500 to $107,949. These borrowings are in the form of 12 advances and an overnight line of credit drawdown of $43,949 from the Federal Home Loan Bank of New York.
A description of the borrowings is detailed below:
Description Rate Type Maturity Amount - ----------- ---- ---- -------- ------ Overnight Line of Credit 4.300% Fixed 01/03/2006 $ 43,949 Advance 4.360 Fixed 01/06/2006 2,000 Advance 2.040 Fixed 01/17/2006 10,000 Advance 2.950 Fixed 09/18/2006 2,000 Advance 2.690 Fixed 01/09/2007 10,000 Advance 3.670 Fixed 09/17/2007 5,000 Advance 3.630 Fixed 12/10/2007 5,000 Advance 4.080 Fixed 12/01/2007 5,000 Advance 4.060 Fixed 12/30/2008 5,000 Advance 4.935 Fixed 01/15/2009 5,000 Advance 4.290 Fixed 11/30/2009 5,000 Advance 4.050 Fixed 12/09/2009 5,000 Advance 4.690 Fixed 03/14/2011 5,000 --------- Total $ 107,949 =========
The weighted average interest rate for the advances was 3.55% during 2005 as compared to 3.11% in 2004. The average maturity for these borrowings was 2.25 years. The underlying collateral for Federal Home Loan Bank borrowings is comprised of U.S. government agency securities, mortgage-backed securities and residential and commercial real estate loans. At December 31, 2005, available collateral at Federal Home Loan Bank was $52,614. The Bank also has unsecured lines of credit with its correspondent banks. These unused lines of credit totaled $23,000 at year end 2005.
The following table details the Bank's borrowed funds at December 31.
2005 2004 2003 ---- ---- ----
Advances from FHLBNY Maximum month-end balance during the year $107,949 $ 98,000 $ 44,300 Average balance during the year 69,076 48,720 38,169 Weighted average interest rate during the year 3.55% 3.11% 3.49% Weighted average interest rate at yearend 3.87 3.50 3.84
Federal Funds Purchased Maximum month-end balance during the year $ * $ 7,200 $ * Average balance during the year 8 28 22 Weighted average interest rate during the year *% 2.50% % Weighted average interest rate at yearend * 2.50 *
* not meaningful
A trust formed by the Company issued $11,000 of floating rate trust preferred securities in 2003 as part of a pooled offering of such securities due October 8, 2033. The securities bear interest at 3-month LIBOR plus 2.99%. The Company issued subordinated debentures to the trust in exchange for the proceeds of the offering. The debentures and related debt issuance costs represent the sole assets of the trust. The Company may redeem the subordinated debentures, in whole or in part, at a premium declining ratably to par on October 8, 2008.
Stockholders' Equity
Stockholders' equity increased by 18.97% from yearend 2004 to yearend 2005. This was primarily the result of net income of $11,066, dividends declared of $1,422, a reduction in other comprehensive income of $646 and unearned stock awards of $91. During 2005, the Company approved a restricted stock plan for certain directors and executive officers. Under the provisions of the Plan, stock awards are made to the recipients based on an amount determined by the Compensation Committee each year. The awards vest to the participants over a five year period, with 20% of the award becoming vested each year. As the stock awards are earned each year, stockholders' equity is increased by the value of these vested shares. During 2004, the Company declared a two-for-one stock split; the fourth split in six years. The book value of the Company's shares at December 31, 2005 and 2004 was $9.43 and $7.92, respectively. Basic and diluted earnings per share for the same two periods was $1.88 and $1.69, respectively.
The Company's capital management plan is to maintain capital levels that meet regulatory standards. The Company has exceeded these levels for 2005. If the current level of capital along with future retained earnings does not adequately allow the Company to meet its growth plans for 2006, it has the ability to issue additional common stock and/or trust preferred securities.
The Company had returns on average equity of 21.48%, 23.37%, and 24.74%, and returns on average assets of 1.41%, 1.58%, and 1.80% for the years ended December 31, 2005, 2004, and 2003, respectively.
Off-Balance Sheet Items and Contractual Obligations
The following tables disclose contractual obligations and commercial commitments of the Company as of December 31, 2005.
The Bank had the ability to borrow on unsecured lines of credit up to $23,000 at December 31, 2005. Unused lines at year end totaled $23,000.
Impact of Inflation and Changing Prices
The consolidated financial statements and notes thereto presented herein have been prepared in accordance with accounting principles generally accepted in the United States, which require the measurement of financial position and operating results in terms of historical dollars without considering changes in the relative purchasing power of money over time due to inflation. The primary effect of inflation on the operations of the Company is reflected in increased operating costs. Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, changes in interest rates have a more significant effect on the performance of a financial institution than do the effects of changes in the general rate of inflation and changes in prices. Interest rates do not necessarily move in the same direction or in the same magnitude as the prices of goods and services. Interest rates are highly sensitive to many factors, which are beyond the control of the Company, including the influence of domestic and foreign economic conditions and the monetary and fiscal policies of the United States government and federal agencies, particularly the Federal Reserve Bank.
Recent Accounting Pronouncements
For discussion regarding the impact of new accounting standards, refer to Note A of Notes to Consolidated Financial Statements.
Non-Interest Income, Non-Interest Expense and Income Taxes For 2005 vs. 2004
Noninterest income is comprised of income from operations of the Company, excluding interest income. The two largest contributors to noninterest income during 2005 and 2004 were service charge income from depositors, and revenues from the Agency. The Agency was acquired by the Bank as of August 31, 2004. During 2005, the revenues from the insurance agency became the largest source of the Bank's noninterest income. 2005 was the first full year of operation for the Bank's newly acquired subsidiary, and the results were very positive. Gross revenues from the Agency during 2005 and for the four months of 2004 were $3,458 and $1,155, respectively. Net income from the Agency was $669 and $258 for the same two period ends. As the Agency has become more fully integrated into the Bank, the two entities have served as sources of referrals for each other, and additional synergies between the two have been identified. Providing various types of insurance to many of our loan customers, particularly those in the construction industry, has allowed the Bank to offer them a complete package of products. As the integration between the two affiliates continues, it is expected that additional cost savings to both companies will also be recognized. Service charge income on deposit accounts increased by $293 during 2005, despite the continued growth of free checking products. This increase was due to the Platinum Overdraft product that was added in February 2005. This new product increased the Bank's overdraft fee income by approximately 35% over 2004 income. An additional source of noninterest income for the Bank was the gain on cash value of bank owned life insurance policies. The total cash value of these insurance policies at December 31, 2005 was $17,575 as compared to $16,942 at December 31, 2004. The insurance polices were purchased to provide for tax-free income to fund the accrual of various benefit plans for certain officers and directors. This gain of $633 has offset the majority of the cost for these benefits. Income from operations of the Bank's trust department remained stable from 2004 to 2005, and represented 5.42% of total non-interest income for 2005. Assets under management for the trust department at year end 2005 and 2004 were $92,054 and $89,724. Miscellaneous other noninterest income totaled $1,574 and $911 for 2005 and 2004, respectively. The largest component of this category represented loan fee income, and it increased from $386 in 2004 to $914 in 2005. This increase was due to the fee income generated from short term loans originated during the year.
Total noninterest expense for 2005 and 2004 was $21,140 and $15,418, an increase of 37.11% during 2005. These expenses represent operating expenses of the Company, and the largest components of these expenses are salary and benefit expense and occupancy expense. During 2005, salary and benefit expenses, in total, increased by 30.16%. One full year of the expenses of the Agency is partially responsible for the increase. The Company's contribution to its pension plan remained stable at $180 for both 2004 and 2005. The cost of medical insurance for the Bank's employees increased by 10.3% during 2005. Although the staff contributes 30% of the cost for this insurance, the additional 70% paid for by the Bank contributed to the increase in operating expenses. Salary expense also increased from 2004 to 2005, partially due to the increased number of employees needed to staff the additional branches, to provide quality service to an increasing number of customers, and to manage the additional assets
acquired during the year. Net occupancy expense increased from 2004 to 2005 by 85.61%, due in large part to the additional rental expenses of the new corporate headquarters and new branch offices. Furniture and equipment expense increases were also a result of the new buildings. Despite these increasing operating expenses, efficiency improved from March 31, 2005 to December 31, 2005 by 8.58% from 57.79% to 52.83%. Other miscellaneous operating expenses comprised 18.61% and 20.02% of total noninterest expense. The largest categories of these expenses were business development and auditing and accounting expense. Marketing and advertising costs increased during 2005 as the Bank incurred expenses in promoting various deposit products and rates. Auditing and accounting expenses also increased during 2005 by 16.24%, primarily the result of increased fees required for compliance and audit work related to the Sarbanes Oxley Act of 2002, Section 404.
As a result of the Company's acquisition of the Seigerman-Mulvey Insurance Agency intangible assets were acquired. These intangible assets consist primarily of customer relationship intangibles which are required to be amortized on a declining balance in accordance with FASB 142. The application of the declining balance method over the estimated life of seven years from acquisition date, will result in greatly increased amortization expense for the Company during 2006, with decreasing amortization expense during the following five years. A schedule detailing these future amortization expenses can be found in Note E. to the Company's financial statements.
Income tax expense as a percentage of book income ("effective tax rate") for 2005 and 2004 was 37.90% and 37.38%, respectively. Despite state income taxes, holdings of municipal securities provide a source of tax-free income which reduces the Bank's overall federal income tax rate. Bank owned life insurance policies also reduced the Company's tax liability.
For 2004 vs. 2003
Noninterest income for 2004 increased by 10.82% over 2003 levels, primarily due to the net gain on sales of available for sale securities. Securities were sold during the year in order to provide funds to meet strong loan demand. Income from trust operations decreased during 2004 due to the settlement of several trusts during 2003. This business was not replaced and therefore the fee income generated from these trusts was not earned during 2004. Service charge income on deposit accounts also declined during 2004 as a result of an increased number of "free checking" accounts.
Total other noninterest expenses increased by 28.29% from 2003 to 2004. The expansion into new corporate headquarters as well as new branch facilities were responsible for the additional costs. Salary and benefit expenses increased by 46.94% from 2003 to 2004. Net occupancy and furniture and equipment expenses also increased over 2003 levels by 12.77%. Noteworthy within the category of noninterest expenses were the increased costs incurred by the Company for auditing and accounting services. Compliance with the Sarbanes-Oxley Act of 2002, Section 404, required a very large use of resources within the Bank as well as the assistance of an internal audit firm to assist management in setting up and testing the internal control framework of the Bank. These costs were in excess of $100,000. The effective tax rate of the Company for 2004 was 38.38% as compared to 36.64% for 2003, partially resulting from the lower income received from holdings of municipal securities in 2003.
Item 7A:
Item 7A: Quantitative and Qualitative Disclosures About Market Risk
Significant increases in the level of market interest rates may adversely affect the fair value of securities and other interest earning assets. At December 31, 2005 and 2004, the following levels of securities and loans carried fixed interest rates:
Generally, the value of fixed rate investments varies inversely to changes in interest rates. As a result, increases in interest rates could result in decreases in the market value of interest earning assets. This decrease in market value could adversely affect the Company's results of operations if the loans or securities were sold or, in the case of interest earning assets classified as available for sale, could reduce the Company's stockholders' equity if they were to be retained.
A significant increase in the level of market interest rates could also adversely affect the Bank's net interest income and net interest margin. NOW accounts, money market accounts and savings accounts all can be repriced on a daily
basis. If they were all to be repriced upward due to the competitive pressures of a general increase in market rates, net interest income could be reduced. Based on historical experience, increases in deposit rates typically lag increases in loan rates, in which case, the increase in interest expense on these deposits would be offset by the increase in interest income on the loans.
The Bank monitors and controls interest rate risk through a variety of techniques including the use of interest rate sensitivity models and interest rate gap analysis. Both of these techniques project future net interest income based on changes in interest rates. Gap analysis requires estimates of when all categories of interest rate sensitive assets and liabilities will reprice. Gap analysis looks at stated maturities and assumes all assets and liabilities within the same maturity time frame will reprice. It does not look at the probability of repricing, which in the case of nonmaturity deposits, is up to the discretion of management. Interest rate sensitivity models also rely on various estimates and assumptions, and although a great deal of time and effort is devoted to arriving at these assumptions, any change in the assumptions input into the model can produce very different results. Therefore, both of these techniques may not accurately reflect the actual impact of changes in the interest rate environment on the Bank's net interest income.
In spite of these shortcomings, the Bank utilizes the results of the dynamic simulation model to quantify the estimated exposure to net interest income fluctuations resulting from sustained interest rate changes. Management monitors simulated net interest income sensitivity over a rolling two year horizon. The results of the sensitivity analysis are compared to policy limits set internally by the Asset Liability Committee that specify a maximum tolerance level for net interest income exposure over a one year horizon given both an upward and downward shift in interest rates. The last simulation analysis was modeled on a one-hundred and two-hundred basis point upward and one hundred basis point downward shift in interest rates. A parallel and pro rata shift in rates over a twelve month period is assumed.
The following reflects the Company's most recent income sensitivity analysis:
Change In Interest Rates As of November 30, 2005 In Basis Points Potential Change In (Rate Shock) Net Interest Income -------------------------------------------------------- -------------------------- $ Change % Change --------------------------
Up 200 Basis Points 8,386 19.60 Up 100 Basis Points 4,868 11.38 Static Down 100 Basis Points 2,333 5.45
Item 8:
Item 8: Financial Statements
Report of Independent Registered Public Accounting Firm
To the Audit Committee, Board of Directors and Stockholders of Smithtown Bancorp, Inc.
We have audited the accompanying consolidated balance sheets of Smithtown Bancorp, Inc. as of December 31, 2005 and 2004, and the related consolidated statements of income, comprehensive income, stockholders' equity, and cash flows for each of the years in the three year period ended December 31, 2005. We have also audited management's assessment, included in the accompanying Report by Management On Internal Control Over Financial Reporting, that Smithtown Bancorp, Inc. maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Smithtown Bancorp, Inc.'s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements, an opinion on management's assessment, and an opinion on the effectiveness of the company's internal control over financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Smithtown Bancorp, Inc. at December 31, 2005 and 2004, and the results of its operations and its cash flows for each of the years in the three year period ended December 31, 2005 in conformity with U.S. generally accepted accounting principles. Also in our opinion, management's assessment that Smithtown Bancorp, Inc. maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Furthermore, in our opinion, Smithtown Bancorp, Inc. maintained, in all material respects, effective control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Crowe Chizek and Company LLC
Livingston, New Jersey February 28, 2006
Consolidated Balance Sheets
See notes to consolidated financial statements.
Consolidated Statements of Income
See notes to consolidated financial statements.
Consolidated Statements of Comprehensive Income
See notes to consolidated financial statements.
Consolidated Statements of Changes in Stockholders' Equity
Cash dividends declared per share were $.24 in 2005, $.20 in 2004, and $.18 in 2003.
(1) As a result of the May 7, 2004 two-for-one stock split and the April 20, 2004 reduction in par value from $1.25 to $0.01 per share, a transfer of $4,444 was made from the common stock account into additional paid in capital.
See notes to consolidated financial statements.
Consolidated Statements of Cash Flows
See notes to consolidated financial statements.
Notes to Consolidated Financial Statements
Note A. Summary of Significant Accounting Policies
The accounting and reporting policies of Smithtown Bancorp, Inc. and its subsidiary, Bank of Smithtown, reflect banking industry practices and conform to U.S. generally accepted accounting principles. A summary of the significant accounting policies followed by the Company in the preparation of the accompanying consolidated financial statements is set forth below.
Nature of Operations and Principles of Consolidation
The accompanying consolidated financial statements are prepared on the accrual basis of accounting and include the accounts of Smithtown Bancorp, its wholly owned subsidiary, Bank of Smithtown, and Bank of Smithtown's wholly owned subsidiaries, Bank of Smithtown Financial Services, Inc. and Bank of Smithtown Insurance Agents and Brokers, Inc. All material inter-company transactions and balances have been eliminated.
During May 2004 and April 2003, the Company effected a two-for-one split of common stock. All references in the accompanying consolidated financial statements and notes thereto relating to earnings per share and share data have been retroactively adjusted to reflect the two-for-one stock splits.
Smithtown Bancorp operates under a state bank charter and provides full banking services, including trust, investment management and insurance services. As a state bank, the Bank is subject to regulation by the New York State Banking Department and the Federal Reserve Board. The area served by Smithtown Bancorp is the north shore of Long Island, New York, principally from Port Washington to Wading River, and services are provided at thirteen branch offices.
Use of Estimates
The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions based on available information that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The allowance for loan losses, fair values of financial instruments, deferred taxes and post retirement benefit obligations are particularly subject to change.
Cash Flows
For the purposes of the statements of cash flows, the Company considers cash and due from banks, including deposits with other financial institutions under 90 days and federal funds sold, as cash and cash equivalents. Net cash flows are reported for loan and deposit transactions, interest bearing deposits in other financial institutions, federal funds purchased and other borrowings.
New Accounting Standards Issued But Not Yet Adopted
In June 2005, the FASB decided not to provide additional guidance on the meaning of other-than-temporary impairment, and issued FSP 115-1 with references to existing other-than-temporary impairment guidance, such as SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," SEC Staff Accounting Bulletin No. 59, "Accounting for Noncurrent Marketable Equity Securities," and APB Opinion No. 18, "The Equity Method of Accounting for Investments in Common Stock." FSP FAS 115-1 will codify the guidance set forth in EITF Topic D-44 and clarify that an investor should recognize an impairment loss no later than when the impairment is deemed other than temporary, even if a decision to sell has not been made. FSP FAS 115-1 will be effective for other-than-temporary impairment analysis conducted in periods beginning after December 15, 2005.
SFAS 123R, "Accounting for Stock-Based Compensation, Revised," requires all public companies to record compensation cost for stock options provided to employees in return for employee service. The cost is measured at the fair value of the options granted, and this cost is expensed over the employee service period, which is normally the vesting period of the options. The Securities and Exchange Commission in April 2005 amended the compliance dates for SFAS 123R from periods beginning September 15, 2005 to the beginning of the next fiscal year. Historically substantially all of the options granted by the Company have vested immediately; compensation expense would be recorded on the date of grant. The effect on results of operations will depend on the level of future option grants and the calculation of fair value of the options granted at such future date and so cannot currently be predicted. The effect of other new standards on the Company's financial position and results of operations is not expected to be material upon and after adoption.
Segment Reporting
While management monitors the revenue streams of the various products and services, the identifiable segments are not material and operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the financial service operations are considered by management to be aggregated in one reportable operating segment. The Company's insurance operations do not meet the quantitative criteria for reporting as a segment.
Restrictions on Cash
Cash on hand or on deposit with the Federal Reserve Bank of $765 was required to meet regulatory reserve and clearing balance requirements at December 31, 2005 and 2004. These balances do not earn interest. The average amount of these reserve balances for the years ended December 31, 2005 and 2004 were $895 and $836, respectively.
Securities
The Bank evaluates its security policies consistent with Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"). Accordingly, the Company's investments in securities are classified in two categories and accounted for as follows:
o Securities Held to Maturity: Bonds and notes for which the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for amortization of premiums and accretion of discounts, which are recognized in interest income using the interest method over the period to maturity.
o Securities Available for Sale: Bonds, notes and certain equity securities are carried at estimated fair value.
Restricted securities, as reported on the balance sheet, including Federal Home Loan Bank stock and Federal Reserve Bank stock, are carried at cost. Unrealized holding gains and losses, net of tax, arising on securities available for sale, are reported as a component of accumulated other comprehensive income. Comprehensive income generally represents all changes in stockholders' equity except those resulting from investments by and distributions to stockholders.
Interest income includes amortization of purchase premium or accretion of discount. Premiums and discounts on securities are amortized on the level-yield method without anticipating prepayments. Gains and losses on sales are based on the amortized cost of the security sold and are recorded on trade date.
Declines in the fair value of securities below their cost that are other than temporary are reflected as realized losses. In estimating other-than-temporary losses, management considers: 1) the length of time and extent that fair value has been less than cost, 2) the financial condition and near term prospects of the issuer, and 3) the Company's ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value.
Federal Home Loan Bank (FHLB) stock
The Bank is a member of the FHLB system. Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. FHLB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment. Because this stock is viewed as a long term investment, impairment is based on ultimate recovery of par value. Both cash and stock dividends are reported as income.
Loans
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of unearned interest, deferred loan fees and costs, and allowance for loan losses. Unearned discounts are generally amortized over the term of the loan using the interest method. Interest income is reported on the interest method and includes amortization of net deferred loan fees and costs over the loan term. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the level-yield method without anticipating prepayments.
Interest income on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the loan is well secured and in process of collection. Consumer and credit card loans are typically charged off no later than 180 days past due. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful. Generally, interest received on impaired loans continues either to be applied by the Bank against principal or to be realized as interest income, according to management's judgment as to the collectibility of principal. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Allowance for Loan Losses
The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged off.
The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful. The general component covers non-classified loans and is based on historical loss experience adjusted for current factors.
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures.
Premises and Equipment
Land is carried at cost. Leasehold improvements are amortized over the lives of the respective leases or the service lives of the improvements, whichever is shorter. Premises and equipment are stated at cost less accumulated depreciation and amortization. The depreciation and amortization are computed on the straight-line method over the estimated useful lives of the related assets as follows:
Premises 25 to 30 years Leasehold improvements 5 to 15 years Furniture and equipment 3 to 10 years
Bank-Owned Life Insurance
The Company has purchased life insurance policies on certain key executives and certain eligible directors. Bank-owned life insurance is recorded at its cash surrender value, or the amount that can be realized.
Goodwill and Other Intangible Assets
Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually for impairment and such impairment will be recognized in the period identified. Other intangible assets consist of customer relationships, and covenants not to compete, each of which relate to the acquisition of Bank of Smithtown Insurance Agents and Brokers Inc., as well as trademark, which relates to Bank of Smithtown's proposition statement. They are initially measured at fair value and then are amortized over their estimated useful lives using a declining balance method.
Other Real Estate Owned
Other real estate owned ("OREO") property, acquired principally through foreclosure or a similar conveyance of title is carried at the lower of cost or fair value less estimated costs to sell the property. Any write-downs at the dates of acquisition are charged to the allowance for loan losses. Revenues and expenses associated with holding such assets are recorded through operations when realized.
The valuation reserve account is established through a loss on other real estate owned charged to expense. Properties held in OREO are periodically valued through appraisals and are written down to estimated fair value based on management's evaluation of these appraisals. Specific reserves are allocated to the properties as necessary, and these reserves may be
adjusted based on changes in economic conditions. At December 31, 2005 and 2004, the Company carried no other real estate owned.
Loss Contingencies
Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there now are such matters that will have a material effect on the financial statements.
Treasury Stock
Repurchases of common stock are recorded as treasury stock at cost. Treasury stock is reissued using the first in, first out method. Under the new restricted stock plan, as further discussed in Note F, the Company repurchases, on an annual basis, a selected number of shares of common stock for distribution to directors and certain officers. These shares are initially held as treasury shares and are ratably vested over a five year period.
Comprehensive Income
Comprehensive income includes net income and all other changes in equity during a period, except those resulting from investments by owners and distributions to owners. Other comprehensive income includes revenues, expenses, gains and losses that under generally accepted accounting principles are included in comprehensive income but excluded from net income. Comprehensive income and accumulated other comprehensive income are reported net of related income taxes. Accumulated other comprehensive income for the Company includes unrealized holding gains or losses on available for sale securities. Such gains or losses are net of reclassification adjustments for realized gains (losses) on sales of available for sale securities.
Dividends
Cash available for dividend distribution to shareholders of the Company must initially come from dividends paid by the Bank to the Company. The approval of the Regional Administrator of National Banks is required if the total of all dividends declared by the Bank in any calendar year exceeds the total of the Bank's net income of that year combined with its retained net income of the preceding two years. The Bank had approximately $27,904 available as of December 31, 2005, which may be paid to the Company as a dividend without prior approval.
Loan Commitments and Related Financial Instruments
Financial instruments include off-balance-sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded. Instruments such as standby letters of credit that are considered financial guarantees in accordance with FASB Interpretation No. 45 are recorded at fair value.
Trust Assets
Assets belonging to trust customers that are held in fiduciary or agency capacity by the Company are not included in the financial statements since they are not assets of the Company. Deposits held in fiduciary or agency capacity in the normal course of business are reported in the applicable deposit categories of the consolidated balance sheets.
Employee Stock Ownership Plan
The cost of shares issued to the ESOP, but not yet allocated to participants, is recognized as pension expense and is based on the market price of the shares at the time the Company contributes such shares to the Plan.
Retirement Benefits
The Company accounts for post-retirement benefits other than pensions in accordance with Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106"). This statement requires that the estimated costs of postretirement benefits other than pensions be accrued over the period earned rather than expensed as incurred.
In addition, the Company adopted the provisions of SFAS No. 132, "Employers' Disclosures About Pensions and Other Postretirement Benefits", ("SFAS 132") in 1998. This Statement supersedes the disclosure requirements in
SFAS No. 106. It does not address the measurement or recognition issues as prescribed by SFAS 106. The Company adopted SFAS 132 as amended in 2003 for additional disclosures about the assets, obligations, cash flows of defined benefit pension and postretirement plans, as well as the expense recorded for such plans.
Income Taxes
The tax provision as shown in the consolidated statements of income relates to items of income and expense reflected in the statements after appropriate deduction of tax-free income, principally, nontaxable interest from obligations of state and political subdivisions. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. Deferred taxes are provided for temporary differences related to depreciation, loan loss provisions, postretirement benefits, and investment securities, which are recognized for financial accounting purposes in one period and for tax purposes in another period.
Earnings Per Common Share
Basic earnings per common share is net income divided by the weighted average number of common shares outstanding during the period. Employee Stock Ownership Plan ("ESOP") shares are considered outstanding for this calculation unless unearned. Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable under stock awards. Earnings and dividends per share are restated for all stock splits and stock dividends through the date of issue of the financial statements.
Note B. Securities
The fair value of available for sale securities and the related gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) were as follows:
The carrying amount, gross unrealized gains and losses, and fair value of securities held to maturity were as follows:
The following table presents the amortized costs of and estimated fair values of securities by contractual maturity at December 31, 2005:
Mortgage-backed securities are classified in the above schedule by their contractual maturity. Actual maturities can be expected to differ from scheduled maturities due to prepayment or early call privileges of the issuer.
Obligations of U.S. government agencies, mortgage-backed securities, and obligations of state and political subdivisions having an amortized cost of $66,242 and an estimated fair value of $65,977 were pledged to secure public deposits, treasury tax and loan deposits and advances.
As a member of the Federal Reserve Bank of New York, the Bank owns Federal Reserve Bank stock with a book value of $397. The stock has no maturity and has paid dividends at the rate of 6.00% for 2005 and 2004. The Bank is also a member of the Federal Home Loan Bank of New York and now holds $5,683 of its stock. This stock also has no maturity and has paid average dividends of approximately 5.00% and 1.80% for 2005 and 2004. Stock of both the Federal Reserve Bank and the Federal Home Loan Bank is restricted.
The following table presents the sales of available for sale securities:
2005 2004 2003 ---- ---- ----
Proceeds $ 13,821 $ 12,562 $ 33,341 Gross gains 54 437 109 Gross losses 41 -- --
The Bank has invested $100 in the Nassau-Suffolk Business Development Fund. This consortium of banks provides loans to low-income homeowners.
Securities with unrealized losses at yearend 2005 and 2004, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows:
Unrealized losses on securities held to maturity were $0 at December 31, 2005 and 2004. The unrealized losses on all securities have not been recognized into income because the bonds are of high credit quality, management has the intent and ability to hold for the foreseeable future and the decline in fair value is largely due to increases in market interest rates. The fair value is expected to recover as the securities approach their maturity date and/or market rates decline.
Note C. Loans
Loans as of December 31 consisted of the following:
Activity in the allowance for loan losses was as follows:
All loans considered impaired under SFAS 114 were included in the Bank's 90-day or more past-due or nonaccrual categories. At December 31, 2005 and 2004, loans considered impaired under SFAS were $47 and $0. The average recorded investment in impaired loans during the twelve months ended December 31, 2005 and 2004 was $70 and $66, respectively. The allowance on impaired loans at December 31, 2005 and 2004 was $17 and $0.
Recognition of interest income on impaired loans, as for all other loans, is discontinued when reasonable doubt exists as to the full collectibility of principal or interest. The Bank recognized $1, $0, and $0 in interest revenue in 2005, 2004, and 2003. Any cash receipts received on impaired loans would first be applied to principal outstanding and then to accrued interest.
At December, 2005 and 2004, loans with unpaid principal balances on which the Bank is no longer accruing interest income totaled $47 and $0. At December 31, 2005 and 2004, there were no loans past due ninety days or more and still accruing interest.
A summary of information concerning interest income on nonaccrual loans at December 31 follows:
Note D. Premises and Equipment
Premises and equipment as of December 31, 2005 and 2004 were as follows:
As of December 31, 2005, the minimum rental commitments under non-cancelable operating leases for premises and equipment with initial terms in excess of one year are as follows:
2006 $ 1,392 2007 1,482 2008 1,473 2009 1,509 2010 1,546 Years after 2010 7,384 ------------
Total $ 14,786 ============
A number of leases include escalation provisions relating to real estate taxes and expenses. Individual office rental expenses range from $1.5 to $55.3 per month with escalation provisions tied to the consumer price index or in some offices with a straight line annual increase averaging 2%. Rental expenses for all leases on premises and equipment amounted to $1,303 in 2005, $473 in 2004, and $386 in 2003. The above table includes rental commitments for two new branch locations. The branches are expected to be opened in 2006.
Note E. Goodwill and Intangible Assets
On August 31, 2004, Bank of Smithtown acquired 100% of the outstanding shares of Seigerman-Mulvey Co., Inc. Operating results of Seigerman-Mulvey Co., Inc. are included in the consolidated financial statements since the date of acquisition. As a result of this acquisition, the Bank expects to further solidify its market share in the insurance and financial services business, expand its customer base to enhance fee income and provide an opportunity to market additional products and services to new customers.
The purchase price paid by the Bank is comprised of two components. At closing, $1 million was paid to the stockholders of Seigerman Mulvey Co., Inc. On each of the next three anniversary dates of the acquisition, the prior stockholders will be paid an amount equal to one hundred twenty percent of the income before taxes generated by the acquired company. These amounts will be recorded as an increase to the purchase price when paid. The Company also incurred $53 in costs associated with the acquisition.
The change in balance for goodwill during 2005 and 2004 was as follows:
Acquired intangible assets were as follows at Dec. 31:
Aggregate amortization expense was $73 and $24 for 2005 and 2004.
The amortization of intangibles should result in the following estimated expense for each of the next five years:
2006 $ 842 2007 602 2008 425 2009 336 2010 257
The large increase in amortization expense for years after 2005 is due to the increase in intangible assets as a result of a contingent payment made in 2005 and the application of a declining balance method of amortizing customer relationship intangibles related to the acquisition of the Seigerman-Mulvey Insurance Agency.
Note F. Deposits
At December 31, 2005 and 2004, time deposits in principal amounts of $100,000 or more were $118,782 and $66,597. Interest expense on such deposits for the years ended December 31, 2005, 2004, and 2003 was $3,290, $2,187 and $1,508.
The following table sets forth the remaining maturities of the Bank's time deposits at December 31, 2005.
2006 $ 138,267 2007 97,100 2008 12,660 2009 23,551 2010 35,225 ------------- Total $ 306,803 =============
Note G. Other Borrowings
Federal Home Loan Bank of New York
The Bank has available to it various lines of credit from the Federal Home Loan Bank of New York ("FHLBNY"). The borrowing limit at FHLBNY is calculated at 25% of the Bank's total average assets and is subject to specific collateral requirements.
Each advance is payable at its maturity date, with the exception of two $5 million advances with coupon rates of 4.69% and 4.935% maturing in 2011 and 2009, respectively, both of which are callable each year until maturity. The remaining advances are not callable. Each of the advances carries a prepayment penalty.
Scheduled repayments and maturities of advances from FHLBNY were as follows at December 31,
2005 2004 Weighted Weighted Average Rate Amount Average Rate Amount ------------ ------ ------------ -----
Maturing in 2005 --% $ -- 2.38% $ 36,000 Maturing in 2006 3.87 57,949 3.85 12,000 Maturing in 2007 3.17 20,000 3.63 20,000 Maturing in 2008 4.07 10,000 4.38 10,000 Maturing in 2009 4.43 15,000 3.96 15,000 Maturing in 2011 4.69 5,000 2.95 5,000 ----------- ----------
3.87% $ 107,949 3.28% $ 98,000 =========== ==========
These borrowings are collateralized by residential and commercial mortgages under a specific lien arrangement at December 31, 2005 and 2004. Other collateral includes securities issued by the Federal Home Loan Bank, Federal Home Loan Mortgage Corporation ("FHLMC") and the Government National Mortgage Association ("GNMA"). Based on this collateral and the Company's holdings of FHLB stock, the Company is eligible to borrow up to $162,563. Unused borrowing capacity at FHLBNY at December 31, 2005 and 2004 was $54,614 and $35,768. Unused lines of credit from correspondent banks at December 31, 2005 and 2004 were $23,000 and $5,500.
Note H. Employee Stock Ownership Plan and Postretirement Benefits
The Company has established an Employee Stock Ownership Plan for substantially all of its employees. The ESOP serves as the Bank's pension plan. Eligibility requirements for the ESOP include one year of continuous service, 1,000 hours and attaining an age of 21. Eligible compensation is defined as gross wages less any costs for group term life insurance applicable to the employee. Contributions to the ESOP are in the form of cash and are made at the discretion of the Board of Directors. The ESOP uses this contribution to purchase shares of Smithtown Bancorp stock, which are then allocated to eligible participants. ESOP benefits are 100% vested after five years of service with the Bank. Forfeitures are reallocated among participating employees in the same proportion as contributions. Benefits are payable upon death, retirement, early retirement, disability, or separation from service and may be payable in cash or stock. The Bank reported a net expense of $180, $180, and $160 related to the ESOP for the years ended December 31, 2005, 2004, and 2003. During 2005, 2004, and 2003, the ESOP used the Bank's contribution to purchase 6,945, 7,200 and 5,828 shares of common stock at an average cost of $26.00, $25.00 and $27.00 per share. The 2005 contribution represents 3.0% of eligible compensation. As of December 31, 2005 and 2004, the ESOP held 262,942 and 272,120 allocated shares. There were no unallocated shares in the ESOP effective December 31, 2005 and 2004. ESOP shares are included in weighted average shares outstanding in the calculation of earnings per share.
The Bank sponsors a post-retirement medical and life insurance plan for a closed group of prior employees. The following tables provide a reconciliation of the changes in the plan's benefit obligations and fair value of assets over the two-year period ending December 31, 2005 and a statement of the funded status as of December 31 of both years:
Projected Benefit Obligation
The following table provides the components of net periodic benefit cost for the plans for the years 2005, 2004 and 2003:
The assumptions used in the measurement of the Bank's benefit obligation are shown in the following table:
Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A 1% change in assumed health care cost trend rates would have the following effects:
Contributions
Since the plan holds no assets, the Bank does not expect to contribute to its plan in 2006 other than to fund the payments for the benefits described in the table below.
Expected Future Benefit Payments
The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid:
Benefits --------
2006 $37 2007 34 2008 34 2009 30 2010 30 Years 2011-2015 123
Note I. Other Benefit Plans
The Bank established a 401(k) Defined Contribution Plan (the "Plan"). All employees who have attained age 21 with one continuous year of service may participate in the Plan through voluntary contributions of their compensation up to a maximum of $15 thousand for 2005. The Plan requires that the Bank match 50% of an employee's contribution up to a maximum of 3%. The Bank's 401(k) contribution for 2005, 2004, and 2003 amounted to $137, $155 and $101.
The Bank has adopted a nontax-qualified Executive and Director Incentive Retirement Plan. While this plan is to be funded from the general assets of the Bank, life insurance policies were acquired for the purpose of serving as the primary income source for the accruals during the service period. Benefits under the Incentive Retirement Plan are based solely on the amount contributed by the Bank to the plan, which for executive officers is 10% of the officer's salary for the prior fiscal year and for directors, is 25% of the director's fees for the prior fiscal year. The award will be deferred into an account and will be credited with interest at a rate based upon the growth rate of the stock for the plan year. The benefit may be paid in 180 equal monthly installments or a lump sum at normal retirement. If the participant attains the age of 55 and has completed 20 years of service, he may elect early retirement and may receive the balance in the deferral account on the early retirement date. In case of the participant's early termination prior to early retirement, the executive is entitled to receive a benefit equal to his or her vested portion of the deferral account balance on the termination date. In the event of the participant's termination of employment due to disability, the participant may request to receive a disability benefit equal to the deferral account balance at the date of termination. The incentive retirement plan has five executives and five director participants. Total contributions accrued under this plan for the years 2005 and 2004 were $122 and $113. The Bank has a similar group term replacement life insurance plan for all members of management, funded with similar life insurance policies. The benefit provides post retirement life insurance up to a maximum of two and one half times annual salary. At December 31, 2005 and 2004, the combined value of these insurance policies was $13,834 and $13,308.
The Bank has established a non-qualified Deferred Compensation Plan in 2004. All directors and executive officers of the Company are eligible to participate in this plan. Under this plan, directors may elect to defer a portion of their fees and executive officers may elect to defer a portion of their compensation. A liability is accrued for the obligation under this plan. Interest is accrued based on the prime rate as published in the Wall Street Journal on the 1st day of January of each plan year.
During 2004 the Bank adopted a non-qualified Supplemental Executive Retirement Plan ("SERP") for the Chief Executive Officer. The benefit provided to him by the SERP is calculated at seventy percent of his final three year average compensation reduced by various employer offsets including contributions under the 401k Plan, the Deferred Compensation Plan and the Executive Incentive Retirement Plan as well as by a percentage of his Social Security benefit. The SERP is partially funded by a life insurance policy with a cash value at yearend 2005 and 2004 of $3,741 and $3,635. The Bank's expense for the SERP for 2005 and 2004 was $275 and $43.
The Company established a Restricted Stock Plan for all directors, executive vice presidents and certain other officers of the Bank in 2005. The Board elected to purchase 4,600 shares of stock for the first year of the Plan to be allocated to participants according to the Board's determination. These 4,600 shares were purchased during 2005 at an average price of $24.67 per share. The total cost in 2005 for the purchase of the shares was $113. Vesting occurs over a five year period. Nine hundred and twenty shares became vested at December 31, 2005.
Note J. Subordinated Debentures
A trust formed by the Company issued $11,000 of floating rate trust preferred securities in 2003 as part of a pooled offering of such securities due October 8, 2033. The securities bear interest at 3-month LIBOR plus 2.99%. The Company issued subordinated debentures to the trust in exchange for the proceeds of the offering; the debentures and related debt issuance costs represent the sole assets of the trust. The Company may redeem the subordinated debentures, in whole or in part, at a premium declining ratably to par on October 8, 2008.
In accordance with FASB Interpretation No. 46, as revised in December 2003, the trust is not consolidated with the Company. Accordingly, the Company does not report the securities issued by the trust as liabilities, and instead reports as liabilities the subordinated debentures issued by the Company and held by the trust, as these are no longer eliminated in consolidation.
Note K. Related Party Transactions
Loans to principal officers, directors and their affiliates in 2005 were as follows:
Beginning balance $5,392 New loans 2,576 Repayments 742 ------ Ending balance $7,226
Deposits from principal officers, directors and their affiliates at yearend 2005 and 2004 were $10,456 and $8,975.
Note L. Capital Requirements and Restrictions on Retained Earnings
Banks and bank holding companies are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations involve quantitative measures of assets, liabilities and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action.
Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, under capitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required. At year end 2005 and 2004, the most recent regulatory notifications categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the institution's category.
Actual and required capital amounts and ratios are presented below as of December 31, 2005 and 2004:
The Banking Law of the State of New York and the Federal Reserve Board regulates the amount of cash dividends that may be paid without prior approval. Retained earnings available for cash dividends were $27,904 and $25,146 at December 31, 2005 and 2004.
During 2005, the Board of Directors re-approved a stock repurchase plan authorizing the repurchase of Company stock at market prices. Pursuant to the plan, the Company has repurchased an adjusted equivalent of 0 and 24,748 shares during 2005 and 2004 at a cost of $0 and $685.
Note M. Income Taxes
Income tax expense for the years ended December 31 was as follows:
A reconciliation of the federal statutory tax rate to the required tax rate based on income before income taxes is as follows:
Deferred income tax assets and liabilities are calculated based on their estimated effect on future cash flows. The calculations under this method resulted in a net deferred tax asset of $3,085 and $1,555 as of the end of 2005 and 2004.
Yearend deferred tax assets and liabilities were due to the following:
Note N. Smithtown Bancorp (parent company only)
Smithtown Bancorp has one wholly owned subsidiary, Bank of Smithtown.
Balance Sheets
Note O. Loan Commitments and Contingent Liabilities
The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Material losses are not anticipated. Such financial instruments are recorded on the balance sheet when they are funded. Instruments such as standby letters of credit that are considered financial guarantees in accordance with FASB Interpretation No. 45 are recorded at fair value. The Bank uses the same credit policies in making these commitments as it does for on-balance sheet instruments.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments may have fixed expiration dates or other termination clauses. The following represents commitments outstanding as of December 31,
2005 2004 ---- ----
Standby letters of credit $ 8,508 $ 8,502 Loan commitments outstanding 83,227 49,626 Unused equity lines 16,871 13,761 Unused construction lines 78,026 36,291 Unused lines of credit 25,809 20,495 Unused overdraft lines 737 691 ----------- ----------- Total commitments outstanding $ 213,178 $ 129,366
At December 31, 2005, the Bank's total commitments to extend credit, excluding standby letters of credit, were $5,058 at fixed rates and $199,612 at variable rates. Fixed rate commitments have rates ranging from 5.625% to 18%. Standby letters of credit are written conditional instruments issued by the Bank to guarantee the financial performance of a customer to a third party. There were 63 and 44 performance standby letters of credit as of December 31, 2005 and 2004. The Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained by the Bank upon extension of credit is based on management's credit evaluation of the customer. Collateral held varies but generally includes residential and income-producing properties.
The Bank has agreements (the "Agreements") with Bradley E. Rock, Anita M. Florek, Robert J. Anrig, John A. Romano, Thomas J. Stevens and certain other employees (collectively, the "Executives") which would become effective in the event of a change in control of the Company's stock. The Agreements provide that if the Executives' employment were terminated by the Bank subsequent to a change in control of the Company for any reason other than cause, disability or death, or if the Executive elects to terminate his or her employment following a change in control of the Company because of a diminution of the Executive's compensation or responsibilities or following a breach by the Bank of the Agreement, the Executive would be entitled (a) to receive an amount equal to three times the sum of the Executive's highest salary and incentive compensation paid in the three most recent years preceding the change in control, (b) to receive an amount equal to the contributions and benefits that the Executive would have received for a three year period based on the benefits and contributions paid on the Executive's behalf in the year preceding the Executive's termination, and (c) to continue to participate in the health benefit plans of the Bank for a period of three years following the termination. The Agreement between the Bank and Mr. Rock also provides that if at any time within one year after a change in control of the Company Mr. Rock elects to terminate his employment with the Bank for any reason, he will receive the amounts and the benefits referred to in the previous sentence.
Note P. Estimated Fair Value of Financial Instruments
Fair value estimates are made at a specific point in time and are based on existing on and off balance sheet financial instruments. Such estimates are generally subjective in nature and dependent upon a number of significant assumptions associated with each financial instrument or group of financial instruments, including estimates of discount rates, risks associated with specific financial instruments, estimates of future cash flows and relevant available market information. Changes in assumptions could significantly affect the estimates. In addition, fair value estimates do not reflect the value of anticipated future business, premiums or discounts that could result from offering for sale at one time the Bank's entire holdings of a particular financial instrument, or the tax consequences of realizing gains or losses on the sale of financial instruments.
The Company used the following methods and assumptions in estimating the fair value of its financial instruments:
Cash and due from banks and federal funds sold: Carrying amounts approximate fair value, since these instruments are either payable on demand or have short-term maturities.
Securities available for sale and held to maturity: The estimated fair values are based on independent dealer quotations and quoted market prices.
Loans: The estimated fair values of real estate mortgage loans and other loans receivable are based on discounted cash flow calculations that apply available market benchmarks when establishing discount factors for the types of loans. All nonaccrual loans are carried at their current fair value.
Deposits: The estimated fair value of time deposits are based on discounted cash flow calculations that apply interest rates currently being offered by the Bank for deposits with similar remaining maturities to a schedule of aggregated expected monthly maturities. Stated value is fair value for all other deposits.
Borrowings: The estimated fair value of borrowed funds is based on the discounted value of contractual cash flows using interest rates currently in effect for borrowings with similar maturities and collateral requirements.
Accrued interest receivable and payable: For these short-term instruments, the carrying amount is a reasonable estimate of the fair value.
The estimated fair values and recorded carrying values of the Bank's financial instruments are as follows:
Note Q. Quarterly Results of Operations (Unaudited)
Item 9:
Item 9: Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
None
Item 9a:
Item 9a: Controls and Procedures
Disclosure Controls and Procedures
An evaluation was performed under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities and Exchange Act of 1934, as amended) as of December 31, 2005. Based on that evaluation, the Company's management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company's disclosure controls and procedures were effective.
Report by Management On Internal Control Over Financial Reporting
Management of Smithtown Bancorp, Inc. is responsible for establishing and maintaining an effective system of internal control over financial reporting. The Company's system of internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. There are inherent limitations in the effectiveness of any system of internal control over financial reporting, including the possibility of human error and circumvention or overriding of controls. Accordingly, even an effective system of internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the Company's system of internal control over financial reporting as of December 31, 2005. This assessment was based on criteria for effective internal control over financial reporting described in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management believes that, as of December 31, 2005, the Company maintained effective internal control over financial reporting based on those criteria.
The Company's independent registered public accounting firm that audited the financial statements that are included in this annual report on Form 10-K, has issued an attestation report on management's assessment of the Company's internal control over financial reporting. The attestation report of Crowe Chizek and Company LLC appears on page 25.
Changes in Internal Control Over Financial Reporting
There has been no change in the Company's internal control over financial reporting during the quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.
Part III
Item 10:
Item 10: Directors and Executive Officers
Page 2, page 8 and page 10 of the Registrant's Proxy Statement dated March 16, 2006 are incorporated herein by reference.
Item 11:
Item 11: Executive Compensation
Page 3, page 11 and page 12 of the Registrant's Proxy Statement dated March 16, 2006 are incorporated herein by reference.
Item 12:
Item 12: Security Ownership of Certain Beneficial Owners and Management
Pages 7 through 8 of the Registrant's Proxy Statement dated March 16, 2006 are incorporated herein by reference.
Item 13:
Item 13: Certain Relationships and Related Transactions
Page 13 of the Registrant's Proxy Statement dated March 16, 2006 is incorporated herein by reference.
Page 44 of the Registrant's Annual Report to Stockholders for the year ended December 31, 2005.
Item 14:
Item 14: Principal Accounting Fees and Services
Pages 6 through 7 of the Registrant's Proxy Statement dated March 16, 2006 are incorporated herein by reference.
Part IV
Item 15:
Item 15: Exhibits, Financial Statement Schedules and Reports on Form 8-K
INDEX OF EXHIBITS
Exhibit No. Description ----------- -----------
3a Articles of Incorporation*
3b By-Laws amended as of December 27, 2005
4 By-Laws Page Nos. 2, 11, 12, 13, 14 Articles of Incorporation Page No. 2*
9 No voting trust agreements
10 No material contracts
13 Annual Report to Stockholders for the year ended December 31, 2005
18 No change in accounting principles
19 Reference to Page 1 in Form 10-K
21 Bank of Smithtown Hauppauge, New York 11788
23 Accountant's Consent
24 None
99 Independent Auditor's Report filed on Form 10-K for the year ended December 31, 2005
* Incorporated by reference and filed as a part of the Registrant's Form S-14 Registration Statement under the Securities Act of 1933, Reg #2-91511, filed on June 6, 1984.
Reports on Form 8-K.
(i) Current report on Form 8-K (item 9) filed on October 21, 2005.
(ii) Current report on Form 8-K (item 8) filed on November 12, 2005.
(iii) Current report on Form 8-K (item 8) filed on November 19, 2005.
(iv) Current report on Form 8-K (item 8) filed on November 29, 2005.
(v) Current report on Form 8-K (item 5) filed on December 29, 2005
(vi) Current report on Form 8-K (item 9) filed on January 27, 2006
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, hereunto duly authorized.
SMITHTOWN BANCORP, INC. ------------------------------------------ Registrant
Date: 2/28/06 /s/ BRADLEY E. ROCK ------------------------------------------ Bradley E. Rock, Chairman, President and Chief Executive Officer
Date: 2/28/06 /s/ ANITA M. FLOREK ------------------------------------------ Anita M. Florek, Executive Vice President and Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below, by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
/s/ BRADLEY E. ROCK Date 2/28/06 ---------------------------------------- Bradley E. Rock, Chairman, President and Chief Executive Officer
/s/ AUGUSTA KEMPER Date 2/28/06 ---------------------------------------- Augusta Kemper, Director
/s/ PATRICK A. GIVEN Date 2/28/06 ---------------------------------------- Patrick A. Given, Director
/S/ MANNY SCHWARTZ Date 2/28/06 ---------------------------------------- Manny Schwartz, Director
/s/ BARRY M. SEIGERMAN Date 2/28/06 ---------------------------------------- Barry M. Seigerman, Director
/s/ ROBERT W. SCHERDEL Date 2/28/06 ---------------------------------------- Robert W. Scherdel, Director
/s/ PATRICIA C. DELANEY Date 2/28/06 ---------------------------------------- Patricia C. Delaney, Director
/s/ SANFORD C. SCHEMAN Date 2/28/06 ---------------------------------------- Sanford C. Scheman, Director
/s/ HYUKMUN KWON Date 2/28/06 ---------------------------------------- Hyukmun Kwon, Director