ITEM 1.
BUSINESS
General
State Bancorp, Inc. (the “Company”), a one-bank holding company headquartered in Jericho, New York, was formed in 1985. The Company operates as the parent for its wholly owned subsidiary, State Bank of Long Island and subsidiaries (the “Bank”), a New York State chartered commercial bank founded in 1966, and its unconsolidated wholly owned subsidiaries, State Bancorp Capital Trust I and II (collectively called the “Trusts”), entities formed in 2002 and 2003, respectively, to issue trust preferred securities. The Bank, emphasizing high-quality personal service, conducts a general banking business focused on the small to mid-sized businesses and municipal markets in Long Island and New York City. The income of the Company is primarily derived through the operations of the Bank and its subsidiaries, SB Portfolio Management Corp. (“SB Portfolio”), New Hyde Park Leasing Corp. and its subsidiary, P.W.B. Realty, L.L.C, and SB ORE Corp. The Company had 290 employees as of December 31, 2009.
The Bank serves its client base through seventeen branches in Nassau, Suffolk, Queens and Manhattan. The Bank offers a full range of banking services to our diverse client base which includes commercial real estate owners and developers, small to middle market businesses, professional service firms, municipalities and consumers. Retail and commercial products include checking accounts, NOW accounts, money market accounts, savings accounts, certificates of deposit, individual retirement accounts, commercial loans, construction loans, commercial mortgage loans, small business lines of credit, cash management services and telephone and online banking. In addition, the Bank also provides access to annuity products and mutual funds. The Company’s loan portfolio is concentrated in commercial and industrial loans and commercial mortgage loans. The Bank does not engage in subprime lending and does not offer payment option ARMs or negative amortization loan products.
At December 31, 2009, the Company, on a consolidated basis, had total assets of approximately $1.6 billion, total deposits of approximately $1.3 billion, and stockholders’ equity of approximately $149 million. Unless the context otherwise requires, references herein to the Company include the Company and its subsidiaries on a consolidated basis. The Company operates in the banking industry and management considers the Company to be aggregated in one reportable operating segment.
Neither the Company nor any of its direct or indirect subsidiaries is dependent upon a single or very few clients. No material amount of deposits is obtained from a single depositor. The Bank does not rely on foreign sources of funds or income and the Bank does not have any foreign commitments, with the exception of letters of credit issued on behalf of several of its domestic customers.
The Company’s Internet address is www.statebankofli.com. The Company makes available on its website, free of charge, its periodic and current reports, proxy and information statements and other information we file with the SEC and amendments thereto as soon as reasonably practicable after the Company files such material with, or furnishes such material to, the SEC, as applicable. Unless specifically incorporated by reference, the information on our website is not part of this annual report. Such reports are also available on the SEC’s website at www.sec.gov, or at the SEC’s Public Reference Room at 100 F Street, N.E., Room 1580, Washington, DC, 20549. Information may be obtained on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.
Market Area and Competition
The Company considers its business to be highly competitive in its market areas. The Company has numerous competitors for its core niche of small business and middle market customers. The Company competes with local, regional and national depository financial institutions, including commercial banks, savings banks, insurance companies, credit unions and money market funds, and other businesses with respect to its lending services and in attracting deposits. The New York metropolitan area has a high density of financial institutions, a number of
which are significantly larger than the Company. Some competitors have entered the marketplace through de novo banks, acquisitions and strategic alliances. Additionally, over the past several years, various large out-of-state financial institutions have entered the New York metropolitan market. All of these institutions are our competitors to varying degrees.
The Company’s current market area, consisting primarily of Nassau and Suffolk Counties in New York and New York City, provides opportunity for growth in deposits and commercial lending. The Company believes that there is a significant number of small to mid-size businesses in its current market area that seek a locally-based commercial bank that can offer a broad array of financial products and services. Many of these businesses have been displaced as a result of recent bank mergers in the area. Given the variety of financial products and services offered by the Company, its focus on client service, and its local management, the Company believes that it can well serve the growing needs of both new and existing clients in its current market areas.
Commercial and residential real estate values in our market appear to have stabilized at lower levels. Locally, however, properties are burdened by high maintenance costs including an ever increasing state and local tax burden. The national and local economies still remain fragile with low levels of economic activity and high unemployment rates. Business conditions remain subdued and that uncertainty is serving to limit both consumer and corporate spending. Accordingly, 2010 will be approached with a continued significant degree of caution as the Company expects that weakness will continue in the equity, credit and real estate markets. Although we, like many other financial service firms, continue to witness the unfolding of very difficult and challenging market conditions, the Company is diligently managing its business interests, particularly in the area of maintaining strengthened underwriting standards and risk management practices.
Competitive Strengths
The Company believes that the following business strengths differentiate it from its peers:
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Asset Quality. The Company’s successful execution of its decision to liquidate lower quality legacy loans, including a significant portion of its non-accrual loans, represents an important strategic step toward significantly reducing future balance sheet risk. By eliminating the multiple distractions, inherent costs and uncertainties that these lower quality loans were consistently demanding, the Company can effectively deploy the Bank’s ample resources to take advantage of other opportunities ahead, including organic franchise expansion and potential acquisitions. The year-end 2009 allowance for loan losses was at a level in excess of 2.6% of total loans and the amount of non-accrual loans has been significantly reduced. Non-accrual loans and leases declined by 81% to $7 million or 0.6% of loans and leases outstanding at December 31, 2009 versus $16 million or 1.4% of loans and leases outstanding at December 31, 2008 and $35 million or 3.1% of loans and leases outstanding at September 30, 2009. Total watch list loans at December 31, 2009 amounted to $143 million, an increase of $54 million from December 31, 2008. This increase was primarily comprised of $27 million of commercial and industrial loans and $24 million of commercial real estate loans.
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Strong Net Interest Margin. For the years ended December 31, 2009 and December 31, 2008, the Company’s net interest margin was 4.03% and 4.12%, respectively. A 98 basis point reduction in the cost of interest-bearing liabilities was more than offset by the 110 basis point decline in the average rate earned on the Company’s loan portfolio during 2009. Our healthy 2009 fourth quarter net interest margin of 4.15% is a positive and tangible reflection of the Company’s continued ability to produce strong core net interest earnings, even in this very challenging interest rate environment.
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One of the Largest Independent Commercial Banks Headquartered on Long Island. The Bank is one of the largest independent commercial banks headquartered on Long Island, with a network of branches stretching from central Suffolk County to midtown Manhattan. As an entrepreneurial and community-oriented bank, the Bank has the ability to render lending decisions quickly to clients and prospective borrowers.
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Low - Cost Deposit Base. Core deposits, consisting of demand, savings and money market deposits, increased to $995 million at December 31, 2009 versus $964 million at December 31, 2008. Core deposits represented 74% of total deposits at December 31, 2009 and 65% of total deposits at December 31, 2008. Demand deposits increased by 8% to $381 million at December 31, 2009 versus $352 million at the comparable 2008 date.
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Strong Capital Base. In 2009, the Company enhanced its capital position by exchanging its 8.25% subordinated notes (due to mature in 2013) with an outstanding principal balance of $10 million for common equity in a privately negotiated transaction with four major institutional investors. The net effect of this exchange increased the Company’s tangible common
equity by $11 million. The Company’s capital ratios exceeded all regulatory requirements at December 31, 2009. The Bank’s year-end 2009 capital ratios were in excess of the regulatory guidelines, as established by federal banking regulatory agencies, for a “well capitalized” institution, the highest regulatory capital category.
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Strong Corporate Governance and Transparency. The Company is diligent in ensuring its business is conducted with the highest level of integrity and with full transparency. All employees, officers and directors of the Company are governed by a Code of Business Conduct and Ethics that requires them to conduct themselves in a professional, honest, and ethical manner, and to avoid conflicts of interest. Additionally, in 2009 the Company conducted a Special Stockholder Meeting that introduced proposals, ultimately approved by stockholders, which strengthened the Company’s corporate governance practices. These stockholder-friendly initiatives, including the elimination of the Company’s classified board structure to provide for the annual election of directors, increased the Company’s Corporate Governance Quotient (“CGQ”) to 98.1% in relation to other financial institutions as of February 1, 2010. The CGQ is a metric used by RiskMetrics Group (“RiskMetrics”) that rates publicly traded companies in terms of the quality of their corporate governance based upon a number of factors including board structure and composition, charter and bylaw provisions, executive and director compensation, audit issues and progressive practices such as board performance review. The CGQ is reported on a percentile basis ranging from zero to 100%. Starting in early March 2010, RiskMetrics will be replacing CGQ with a new measurement of governance risk - Governance Risk Indicators (“GRId”), which will grade companies in four discrete categories: board structure, compensation, shareholder rights and audit. At this time, we do not know what our GRId rating will be.
Lending
General
The Bank provides loans to small to moderate size and middle market borrowers and business entities diversified across industries. Loan types include business installment loans, commercial lines of credit and commercial mortgage loans. Loans are primarily categorized as commercial real estate (“CRE”), commercial & industrial (“C&I”) and small business loans. CRE loans consist of loans on multifamily, mixed use, retail, office and industrial property or construction loans. C&I loans consist of a broad range of loans to a wide variety of business clients for acquisition of equipment, machinery or leasehold improvements, short term or seasonal working capital needs, and business expansion. Small business loans are a subset of C&I loans where the origination amount is less than $1 million.
Structure
Lending officers are primarily responsible for loan origination, structure, document preparation, obtaining approval, and monitoring the relationship. Each lending officer reports to a team leader. The lenders are supported by a fully staffed, full service credit department of experienced credit analysts who prepare a full credit proposal including research on business and industry and the borrower’s financial condition.
CRE. There are currently four teams in the CRE division each headed by a team leader who reports directly to the Chief Lending Officer (“CLO”). All teams within the CRE department are CRE generalists and can originate any of the loans within the division.
C&I. The C&I division is divided into the middle market team, which originates loans over $1 million, and the small business team, which originates loans under $1 million. The C&I division is headed by the C&I team leader who reports to the CLO.
Small Business. The small business team is divided into two subdivisions headed by the small business manager - one subdivision originates loans from $250,000 to $1 million and the other originates loans under $250,000. The larger small business loans are individually account managed and relationship driven. The smaller loan subdivision has one account manager and utilizes a small business scoring system (“SBSS”) to assist in making decisions on small business loan applications. The small business manager reports to the C&I team leader.
Lending Authority
Authority for extending commercial credit is delegated by the Board of Directors to the President of the Bank, the management credit committee and to certain individuals as applicable. Each loan officer and team leader has lending authority depending on experience and title. Regardless of lending authority, all extensions of commercial credit, except deficit balances/uncollected funds, require the approval of
at least two Bank officers with credit authority, one of whom must have the authority for the aggregate amount being approved All loans above a designated amount must be approved by the management credit committee, which is comprised of the President of the Bank, the Chief Lending Officer (“CLO”), the Chief Credit Officer (“CCO”) and a number of team leaders. Loans above the authority of the management credit committee and up to the Bank’s legal lending limit must be approved by the loan committee of the Board of Directors, which consists of three outside directors and the President of the Bank.
Administration
Loan administration focuses on credit support, control systems and other practices necessary to manage the outstanding credits. Credit administration for C&I loans provides for periodic reviews on all C&I credit facilities depending on length to maturity and aggregate balance. For CRE loans, on an ongoing basis, each loan file must contain current credit and financial information to properly monitor trends as well as the borrower’s ability to service the debt and the capacity to repay the loan. If the loan officer receives information that may negatively affect repayment of the loan, the loan officer must take appropriate measures, including for example, implementing a remedial action plan. Site inspections for CRE mortgages are performed periodically depending on loan balance and delinquency status.
Risk Management
Management’s goal is to have a balanced portfolio of loans. The allowable risk for the portfolio is determined by senior management through credit policies and annual business plans which are approved by the Board of Directors. The Bank will establish limits and monitor concentrations of risk as appropriate. A concentration of credit is the total of funded and unfunded loans, mortgages, lines of credit, etc., issued to borrowers sharing similar characteristics such as industry, collateral/security type, size, pricing, location and other items that might have a bearing on risk management. It is also the Bank’s policy to spread credit risk among a broad range of industries and/or industry sectors, and to monitor concentration on an ongoing basis.
Loan Workouts
The Bank has workout specialists who are directly responsible for managing loans that are unable to meet the required debt service or where borrowers are experiencing other financial difficulties due to issues such as economic conditions resulting in reduced cash flow or vacancies in rental properties. The workout specialists work in an independent environment so that a true evaluation as to the severity of the problem can be assessed. Such specialists will work with the borrower to rectify the problem, monitor the credit as needed and, if necessary, restructure the loan. If there are signs of further deterioration in the credit, the workout specialist will search for additional collateral to improve the Bank’s position while the credit is weak. The workout specialists will also assess the financial situation of the borrower on a long term basis, and when appropriate may market the loan for sale to an investor or commence litigation. All workout loans are approved by the President, CLO, CCO, management credit committee or the loan committee of the Board of Directors.
Deposits
The Bank offers a variety of deposit products ranging in maturity from demand accounts to certificates of deposits of up to five years. Our principal products include checking accounts, money market accounts, savings accounts, escrow services and interest on lawyer (“IOLA”) accounts, time deposit accounts and IRA accounts. The Bank competes for customers by emphasizing personal service and by addressing the needs of small and mid-size businesses, professional associations, municipalities and consumers. Deposits are generally derived from customers within our primary marketplace. To the lesser extent, we also utilize the Certificate of Deposit Account Registry Service and brokered certificates of deposits, pursuant to authorization limits, as a source of funding and to manage interest rate risk. The Bank, currently a well-capitalized depository institution, is allowed to solicit and accept, renew or roll over any brokered deposit without restriction. Should the Bank become adequately capitalized, it may accept, renew or roll over any brokered deposit only after it has applied for and been granted a waiver by the FDIC. Should the Bank become undercapitalized, it may not accept, renew, or roll over any brokered deposit.
Subject to the guidelines of our Asset/Liability Committee of the Board of Directors (“ALCO”) , we set deposit rates to remain generally competitive with other financial institutions in our market, although we do not generally seek to match the highest rates paid by competing institutions. We have established a process to review interest rates on all deposit products and, based upon this process, update our deposit rates weekly.
In addition to its loan and deposit products, the Bank offers other services to its customers including the following:
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Automated Clearing House (ACH) transactions
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Account Reconciliation Services
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ATM Banking
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Municipal Deposits
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Night Depository Services
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Non-Deposit Investment Products
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Bank by Mail
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Cash Management Services
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Collection Services
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Controlled Disbursement Accounts
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Drive-Through Banking
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Gift Checks and Personal Money Orders
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Internet PC Banking and Bill Payment
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Lock Box Services
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Merchant Credit Card Depository Services
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Payroll Services
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Remote Deposit
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Safe Deposit Boxes
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Signature Guarantee Services
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Travelers Checks
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U.S. Savings Bonds
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Wire Transfers
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Withholding Tax Depository Services
The Bank’s branches are open up to 55 hours per week and our online and telephone banking system is available 24 hours a day. We also offer deposit pick up services for certain business customers. We have 14 automated teller machines or ATMs, at various locations, which generate activity fees based on use by other banks’ customers.
Supervision and Regulation
General
The Company is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the “BHCA”), and is therefore subject to supervision and examination by the Board of Governors of the Federal Reserve System (“FRB”). The Bank is a member of the Federal Home Loan Bank of New York (“FHLB-NY”) and its deposit accounts are insured up to the applicable limits by the Federal Deposit Insurance Corporation (the “FDIC”) under the Deposit Insurance Fund (“DIF”). The Bank is subject to the regulation and supervision and examination of the New York State Banking Department (the “Banking Department”) and the FDIC.
The following summary discussion sets forth certain of the material elements of the legal and regulatory framework applicable to banks and bank holding companies and their subsidiaries. The regulation of banks and bank holding companies is extremely complex and this summary is qualified in its entirety by reference to the applicable statutes, regulations and regulatory guidance. Management believes the Company is in compliance in all material respects with these laws and regulations. A change in applicable statutes and regulations or regulatory policy cannot be predicted, but may have a material effect on the business of the Company and/or the Bank.
Bank holding companies and banks are prohibited by law from engaging in unsafe and unsound banking practices. Federal and New York State banking laws, regulations and policies extensively regulate the Company and the Bank including prescribing standards relating to capital, earnings, dividends, the repurchase or redemption of shares, loans or extension of credit to affiliates and insiders, internal controls, information systems, internal audit systems, loan documentation, credit underwriting, asset growth, impaired assets and loan to value ratios. Such laws and regulations are intended primarily for the protection of depositors, other customers and the federal deposit insurance funds and not for the protection of security holders. Bank regulatory agencies have broad examination and enforcement powers over bank holding companies and banks, including the power to impose substantial fines, limit dividends and restrict operations and acquisitions.
A bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit all available resources to support such institutions in circumstances where it might not do so absent such policy. Consistent with this “source of strength” policy, the FRB takes the position that a bank holding company generally should not maintain a rate of cash dividends unless its net income available to common stockholders is sufficient to fully fund the dividends and the prospective rate of earnings retention appears to be consistent with the company’s capital needs, asset quality and overall financial condition. In addition, any loans by the Company to the Bank would be subordinate in right of payment to depositors and to certain other indebtedness of the Bank.
Acquisitions
As a bank holding company, the Company may not acquire direct or indirect ownership or control of more than 5% of the voting shares of any company, including a bank, without the prior approval of the FRB, except as specifically authorized under the BHCA. Under the BHCA, the Company, subject to the approval of or notice to the FRB, may acquire shares of non-banking corporations, the activities of which are deemed by the FRB to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.
The Change in Bank Control Act prohibits a person or group of persons from acquiring “control” of a bank holding company unless the FRB has been notified and has not objected to the transaction. Under a rebuttable presumption established by the FRB, the acquisition of 10% or more of a class of voting stock of a bank holding company with a class of securities registered under Section 12 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), would, under the circumstances set forth in the presumption, constitute acquisition of control of the Company. In addition, any entity is required to obtain the approval of the FRB under the BHCA before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of the Company’s outstanding common stock, or otherwise obtaining control or a “controlling influence” over the Company. The New York Banking Law (the “Banking Law”) similarly regulates a change in control affecting the Bank and requires the approval of the New York State Banking Board.
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, as amended (the “Interstate Banking Act”), generally permits bank holding companies to acquire banks in any state, and preempts all state laws restricting the ownership by a bank holding company of banks in more than one state. The Interstate Banking Act also permits a bank to merge with an out-of-state bank and convert any offices into branches of the resulting bank if both states have not opted out of interstate branching; permits a bank to acquire branches from an out-of-state bank if the law of the state where the branches are located permits the interstate branch acquisition; and permits banks to establish and operate de novo interstate branches whenever the host state opts-in to de novo branching. Bank holding companies and banks seeking to engage in transactions authorized by the Interstate Banking Act must be adequately capitalized and managed. The Banking Law authorizes interstate branching by merger or acquisition on a reciprocal basis, and permits the acquisition of a single branch without restriction, but does not provide for de novo interstate branching.
Capital Adequacy
The federal banking regulators have adopted risk-based capital guidelines for bank holding companies and banks. The minimum ratio of qualifying total capital (“total capital”) to risk-weighted assets (including certain off-balance sheet items) is 8%. At least half of the total capital must consist of common stock, retained earnings, qualifying noncumulative perpetual preferred stock, minority interests in the equity accounts of consolidated subsidiaries and, for bank holding companies, a limited amount of noncumulative perpetual preferred stock, trust preferred securities and certain other so-called “restricted core capital elements” less most intangibles including goodwill (“Tier I capital”). The remainder (“Tier II capital”) may consist of certain other preferred stock, certain other capital instruments, and limited amounts of subordinated debt and the allowance for loan and lease losses. Restricted core capital elements are currently limited to 25% of Tier I capital.
The federal banking regulators have adopted risk-based capital and leverage guidelines that require the Company’s and the Bank’s capital-to-assets ratios meet certain minimum standards. The risk-based capital ratio is determined by allocating assets and specified off-balance sheet financial instruments into four weighted categories, with higher levels of capital being required for the categories perceived as representing greater risk. For a further discussion, see the Notes to the Company’s Consolidated Financial Statements.
In addition, the FRB has established minimum guidelines for the “leverage ratio” of Tier I capital to average total assets for bank holding companies and banks. The FRB’s guidelines provide for a minimum leverage ratio of 3% for bank holding companies and banks that meet certain specified criteria, including those having the highest supervisory rating. All other banking organizations are required to maintain a leverage ratio of at least 4%. At December 31, 2009, the FRB had not advised the Company of any specific minimum leverage ratio applicable to it.
The FRB guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.
At December 31, 2009, the Bank’s Tier I leverage ratio was 8.46% while its risk-based capital ratios were 10.98% for Tier I capital and 12.24% for total capital. These ratios exceed the minimum regulatory guidelines for a well-capitalized institution. At December 31, 2009, the Company’s Tier I leverage ratio was 8.68% and its risk-based capital ratios were 11.26% and 12.52% for Tier I capital and total capital, respectively. The Company’s ratios exceed the minimum regulatory guidelines.
Prompt Corrective Action
The Federal Deposit Insurance Act (“FDIA”) requires, among other things, that federal banking regulators take prompt corrective action in respect of FDIC-insured depository institutions that do not meet minimum capital requirements. The FDIA specifies five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized.” A depository
institution’s capital tier will depend upon how its capital levels compare to various relevant capital measures and certain other factors, as established by regulation.
Under applicable regulations, an FDIC-insured bank is deemed to be: (i) well capitalized if it maintains a leverage ratio of at least 5%, a Tier I capital ratio of at least 6% and a total capital ratio of at least 10% and is not subject to an order, written agreement, capital directive, or prompt corrective action directive to meet and maintain a specific level for any capital measure; (ii) adequately capitalized if it maintains a leverage ratio of at least 4% (or a leverage ratio of at least 3% if it received the highest supervisory rating in its most recent report of examination, subject to appropriate federal banking agency guidelines, and is not experiencing or anticipating significant growth), a Tier I capital ratio of at least 4% and a total capital ratio of at least 8% and is not defined to be well capitalized; (iii) undercapitalized if it has a leverage ratio of less than 4% (or a leverage ratio that is less than 3% if it received the highest supervisory rating in its most recent report of examination, subject to appropriate federal banking agency guidelines, and is not experiencing or anticipating significant growth), a Tier I capital ratio less than 4% or a total capital ratio of less than 8% and it does not meet the definition of a significantly undercapitalized or critically undercapitalized institution; (iv) significantly undercapitalized if it has a leverage ratio of less than 3%, a Tier I capital ratio of less than 3% or a total capital ratio of less than 6% and it does not meet the definition of critically undercapitalized; and (v) critically undercapitalized if it maintains a level of tangible equity capital of less than 2% of total assets. A bank may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position if it receives an unsatisfactory examination rating. The FDIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the capital category in which an institution is classified. A depository institution that is not well capitalized is also subject to certain limitations on brokered deposits and Certificate of Deposit Account Registry Service (“CDARS”) deposits.
The FDIA generally prohibits an FDIC-insured depository institution from making any capital distribution (including payment of dividends) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to restrictions on borrowing from the Federal Reserve and to growth limitations, and are required to submit a capital restoration plan. For a capital restoration plan to be acceptable, any holding company must guarantee the capital plan up to an amount equal to the lesser of 5% of the depository institution’s assets at the time it became undercapitalized and the amount of the capital deficiency at the time it fails to comply with the plan. In the event of the holding company’s bankruptcy, such guarantee would take priority over claims of its general unsecured creditors. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized.
Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cessation of receipt of deposits from correspondent banks. Critically undercapitalized depository institutions are subject to appointment of a receiver or conservator.
Deposit Insurance
The FDIC merged the Savings Association Insurance Fund and the Bank Insurance Fund to create the DIF on March 31, 2006. The Bank is a member of the DIF and pays its deposit insurance assessments to the DIF. Effective January 1, 2007, the FDIC established a new risk-based assessment system for determining the deposit insurance assessments to be paid by insured depository institutions. Under this new assessment system, the FDIC assigns an institution to one of four risk categories, with the first category having two sub-categories, based on the institution’s most recent supervisory ratings and capital ratios. Base assessment rates range from two to four basis points for Risk Category I institutions and are seven basis points for Risk Category II institutions, twenty-five basis points for Risk Category III institutions and forty basis points for Risk Category IV institutions. For institutions within Risk Category I, assessment rates generally depend upon Capital adequacy, Asset quality, Management, Earnings, Liquidity, Sensitivity to market risk, or CAMELS component ratings, and financial ratios, or for large institutions with long-term debt issuer ratings, assessment rates will depend on a combination of long-term debt issuer ratings and CAMELS component ratings. The FDIC has the flexibility to adjust rates, without further notice-and-comment rulemaking, provided that no such adjustment can be greater than three basis points from one quarter to the next, that adjustments cannot result in rates more than three basis points above or below the base rates and that rates cannot be negative. Effective January 1, 2007, the FDIC set the assessment rates at three basis points above the base rates. Assessment rates, therefore, currently range from five to forty-three basis points of deposits. The deposit insurance assessment rates are in addition to the assessments for payments on the bonds issued in the late 1980’s by the Financing Corporation (“FICO”) to recapitalize the now defunct Federal Savings and Loan Insurance Corporation. For 2009, the Bank had an assessment rate of 12.54 basis points and a total expense of $3.5 million, which includes $730 thousand for the special assessment discussed below, for the assessment for deposit insurance and the FICO payments. The FDIC also established 1.25% of estimated insured deposits as the designated reserve ratio of the DIF. The FDIC is authorized to change the assessment rates as necessary, subject to the previously discussed limitations, to maintain the required reserve ratio of 1.25%.
The FDIC also approved a one-time assessment credit to institutions that were in existence on December 31, 1996, and paid deposit insurance assessments prior to that date, or are a successor to such an institution. The Bank received a $649 thousand one-time assessment credit, of which $547 thousand was used to offset 100% of the 2007 deposit insurance assessment, excluding the FICO payments, and $102 thousand was used to offset a portion of the 2008 deposit insurance assessment.
Interim assessment rates ranging from 12 to 50 basis points took effect January 1, 2009. For the first quarter of 2009 only, the FDIC raised the prior rates uniformly by seven basis points. On February 27, 2009, the FDIC adopted a final rule which took effect on April 1, 2009. Under the final rule, the initial base assessment rates will range from 12 to 45 basis points and the total base assessment rates will range from seven to 77.5 basis points. To determine initial base assessment rates, the FDIC will: (1) introduce a new financial ratio into the financial ratios method applicable to most Risk Category I institutions to include brokered deposits above a threshold that are used to fund rapid asset growth; (2) for a large Risk Category I institution with long-term debt issuer ratings, combine weighted average CAMELS component ratings, the debt issuer ratings, and the financial ratios method assessment rate; and (3) use a new uniform amount and pricing multipliers for each method. The final rule also provides for three adjustments that could be made to an institution’s initial base assessment rate: (1) a potential decrease for long-term unsecured debt, including senior and subordinated debt and, for small institutions, a portion of Tier 1 capital; (2) a potential increase for secured liabilities above a threshold amount; and (3) for non-Risk Category I institutions, a potential increase for brokered deposits above a threshold amount.
On May 22, 2009, the FDIC adopted the final rule imposing a 5 basis point special assessment on each insured depository institution’s assets minus Tier 1 capital as of June 30, 2009. The assessment, collected on September 30, 2009, totaled $730 thousand for the Bank. The final rule also permits the FDIC to impose an emergency special assessment after June 30, 2009, of up to 10 basis points if necessary, to maintain public confidence in federal deposit insurance. The FDIC did not impose another special assessment in the fourth quarter of 2009.
On November 12, 2009, the FDIC adopted the final rule regarding prepaid assessments. The final rule requires insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011 and 2012. The prepaid assessments for these periods were collected on December 30, 2009, along with the Bank’s regular quarterly insurance assessment for the third quarter of 2009. For purposes of estimating an institution’s assessments for the fourth quarter of 2009 and all of 2010, 2011 and 2012, and calculating the amount the Bank prepaid on December 20, 2009, the Bank’s assessment rate was its total base assessment rate in effect on September 30, 2009. On September 29, 2009, the FDIC increased annual assessment rates by 3 basis points beginning in 2011. The Bank’s quarterly risk-based insurance assessments will be paid from the amount the Bank has prepaid until that amount is exhausted or until the prepayment is returned, whichever comes first. Prepaid assessments may only be used to offset regular quarterly risk-based deposit insurance assessments.
The FDIC will begin to offset prepaid assessments on March 30, 2010, representing payment of the regular quarterly risk-based deposit insurance assessment for the fourth quarter of 2009. The FDIC will refund any unused assessments after collection of the amount due on June 30, 2013. Requiring prepaid assessments does not preclude the FDIC from changing assessment rates or from further revising the risk-based assessment system during 2009, 2010, 2011, 2012, or thereafter.
The prepayment of FDIC assessments primarily impacts the Bank’s liquidity. As the prepaid assessments merely represent the prepayment of future expense, they do not affect a Bank’s capital (the prepaid asset will have a risk-weighting of 0%) or tax obligations.
Under the FDIA, the FDIC may terminate the insurance of an institution’s deposits upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. The management of the Company does not know of any practice, condition or violation that might lead to termination of its deposit insurance.
Transactions with Affiliates and the Bank
The Bank is subject to the affiliate and insider transaction rules set forth in Sections 23A, 23B, 22(g) and 22(h) of the Federal Reserve Act (“FRA”), and Regulation W issued by the FRB. These provisions, among other things, prohibit or limit an insured bank from extending credit to, or entering into certain transactions with, its affiliates (which for the Bank would include the Company) and principal stockholders, directors and executive officers. The FRB requires depository institutions that are subject to Sections 23A and 23B to implement policies and procedures to ensure compliance with Regulation W regarding transactions with affiliates.
Section 402 of the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) prohibits the extension of personal loans to directors and executive officers of issuers (as defined in Sarbanes-Oxley). The prohibition, however, does not apply to mortgages advanced by an insured depository institution, such as the Bank, that are subject to the insider lending restrictions of Section 22(h) of the FRA.
Privacy Standards
The Bank is subject to the FDIC’s regulations implementing the privacy protection provisions of the Gramm-Leach-Bliley Act (“Gramm-Leach”). These regulations require the Bank to disclose its privacy policy, including identifying with whom it shares “non-public personal information,” to customers at the time of establishing the customer relationship and annually thereafter.
The regulations also require the Bank to provide its customers with initial and annual notices that accurately reflect its privacy policies and practices. In addition, the Bank is required to provide its customers with the ability to “opt-out” of having the Bank share their non-public personal information with unaffiliated third parties before they can disclose such information, subject to certain exceptions.
The Bank is subject to regulatory guidelines establishing standards for safeguarding customer information. These regulations implement certain provisions of Gramm-Leach. The guidelines describe the agencies’ expectations for the creation, implementation and maintenance of an information security program, which would include administrative, technical and physical safeguards appropriate to the size and complexity of the institution and the nature and scope of its activities. The standards set forth in the guidelines are intended to ensure the security and confidentiality of customer records and information, protect against any anticipated threats or hazards to the security or integrity of such records and protect against unauthorized access to or use of such records or information that could result in substantial harm or inconvenience to any customer.
Community Reinvestment Act
Bank holding companies and their subsidiary banks are also subject to the provisions of the Community Reinvestment Act (“CRA”). Under the terms of the CRA, the FDIC (or other appropriate bank regulatory agency) is required, in connection with its examination of a bank, to assess such bank’s record in meeting the credit needs of the communities served by that bank, including low- and moderate-income neighborhoods. Furthermore, such assessment is also required of any bank that has applied, among other things, to merge or consolidate with or acquire the assets or assume the liabilities of a federally regulated financial institution or to open or relocate a branch office. In the case of a bank holding company applying for approval to acquire a bank or bank holding company, the FRB will assess the record of each subsidiary bank of the applicant bank holding company in considering the application. The Banking Law contains provisions similar to the CRA which are applicable to New York State chartered banks. The Bank has consistently received “satisfactory” ratings from its regulatory CRA exams.
Dividend Limitations
The Company has two primary sources of funds: proceeds from its Dividend Reinvestment and Stock Purchase Plan (the “DRP”) and dividends from the Bank. Certain regulatory agencies impose limitations on the declaration of dividends by the Bank. As the Company issued preferred stock and a warrant to purchase common stock to the Treasury under the CPP, the Treasury’s consent is required for any increase in common stock dividends that is greater than the amount of the last quarterly cash dividend declared prior to October 14, 2008, until the earlier of a redemption of the Series A Preferred Stock or December 5, 2011. The Company’s last quarterly cash dividend declared prior to October 14, 2008, was the $0.10 per common share declared on July 29, 2008.
Anti-Money Laundering and the USA PATRIOT Act
The Company is subject to federal regulations implementing the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA PATRIOT Act”). The USA PATRIOT Act amended the Bank Secrecy Act and gave the federal government powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing and other anti-money laundering and anti-terrorist financing requirements. The USA PATRIOT Act and the Bank Secrecy Act and implementing regulations impose affirmative obligations on a broad range of financial institutions, including banks, thrifts, brokers, dealers, credit unions, money service businesses and others.
Among other requirements, the USA PATRIOT Act and the Bank Secrecy Act and implementing regulations impose the following requirements with respect to financial institutions:
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Establishment of anti-money laundering programs.
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Establishment of a program specifying procedures for obtaining identifying information from customers seeking to open new accounts (“Customer Identification Programs”).
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Establishment of enhanced due diligence policies, procedures and controls designed to detect and report money laundering.
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Prohibition on correspondent accounts for foreign shell banks and compliance with recordkeeping obligations with respect to correspondent accounts of foreign banks.
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Establishment of policies and procedures relating to foreign private banking customers and politically exposed persons.
Substantial civil and criminal penalties may be imposed for violations of the USA PATRIOT Act and the Bank Secrecy Act and implementing regulations. Bank regulators may also require banks to take costly corrective action. Further, bank regulators are directed to consider a financial institution’s effectiveness in combating money laundering and terrorist financing when ruling on applications for approval of proposed corporate transactions.
Legislative and Regulatory Initiatives
Concern for the stability of the banking and financial systems reached a magnitude which has resulted in unprecedented government intervention on a global scale. At a domestic level, on October 3, 2008, the Emergency Economic Stabilization Act of 2008 (the “EESA”) was signed into law providing for, among other things, $700 billion in funding to the Treasury to purchase troubled assets from financial institutions. Then, on October 14, 2008, the Treasury, FRB and the FDIC issued a joint statement announcing additional steps aimed at stabilizing the financial markets. First, the Treasury announced a $250 billion voluntary CPP that allows qualifying financial institutions to sell preferred shares to the Treasury. Second, the FDIC announced the Temporary Liquidity Guarantee Program (the “TLGP”), enabling the FDIC to temporarily guarantee the senior debt of all FDIC-insured institutions and certain holding companies (“Debt Guarantee Program”), as well as fully insure all deposits in non-interest bearing transaction accounts (“Transaction Account Guarantee Program”). The FDIC adopted such program on November 21, 2008 pursuant to its authority to prevent “systemic risk to the U.S. banking system.” Third, to further increase access to funding for businesses in all sectors of the economy, the FRB announced further details of its Commercial Paper Funding Facility program (the “CPFF”), which provides a broad backstop for the commercial paper market. These actions were intended to restore confidence in the banking system, ease liquidity concerns and stabilize the rapidly deteriorating economy.
The Treasury announced the CPP to strengthen the capital and liquidity positions of healthy institutions and to encourage banks and thrifts to increase lending to creditworthy borrowers. Under the CPP, qualifying financial institutions are able to sell senior preferred shares to the Treasury, which will qualify as Tier 1 capital for regulatory capital purposes. The minimum amount of preferred shares that may be issued is equal to 1% of the institution’s risk-weighted assets, and the maximum amount that may be issued is the lesser of $25 billion and 3% of the institution’s risk-weighted assets. If an institution participates in the program, the Treasury would also receive a warrant to purchase the institution’s common stock with an aggregate market value equal to 15% of the senior preferred investment. The staffs of both the SEC and the Financial Accounting Standards Board (“FASB”) have indicated that they would not object if such warrants were to be classified as permanent equity under applicable GAAP, provided that certain conditions are met. In addition, an institution would be required to adopt the Treasury’s standards for executive compensation and corporate governance for the period during which the Treasury holds equity issued under this program. After carefully examining this program, including whether there are appropriate lending opportunities for the deployment of this additional capital, management of the Company chose to participate in the program and subsequently received a capital infusion of $37 million under the terms of this program.
The Company is participating in the Transaction Account Guarantee Program of the FDIC’s TLGP which provides non-interest bearing transaction accounts and interest bearing transaction accounts with interest rates no higher than 0.50% at the Bank with unlimited FDIC insurance coverage beyond the current limit of $250,000. The unlimited coverage was to be in effect through December 31, 2009. Effective October 1, 2009, a final rule adopted by the FDIC extends the TLGP for six months to June 30, 2010. In announcing the extension, the FDIC indicated that it will charge a higher guarantee fee to banks that elect to participate in the extension to reflect each bank’s risk. We have elected to participate in the extension. Management anticipates that the cost of continuing to participate in the TLGP will be immaterial to the Company’s financial statements. The Company participated in the Debt Guarantee Program of the TLGP in March 2009 allowing the Bank to issue $29 million in FDIC-guaranteed senior unsecured debt at a fixed interest rate of 2.625% per annum and a maturity of March 30, 2012. The FDIC guarantee will be in effect through the March 2012 maturity date.
The TLGP was due to expire in June of 2009, however, in an effort to further strengthen the financial system and U.S. economy, the FDIC announced on January 16, 2009, that it would propose rule changes to the TLGP to extend the maturity of the guarantee under the Debt Guarantee Program from three to up to 10 years where the debt is supported by collateral and the issuance supports new consumer lending. On February 10, 2009 the FDIC announced its intention to extend the TLGP through October 2009 for an additional premium. On February
27, 2009, the Board of the FDIC voted to modify the debt guarantee component of the TLGP to allow participating entities, with the FDIC’s permission, to issue mandatory convertible debt. Such change provides institutions with additional options for raising capital and reducing the concentration of FDIC-guaranteed debt maturing in mid-2012.
Pursuant to the EESA, on October 9, 2008, the Federal Reserve Banks began to pay interest on depository institutions’ required and excess reserve balances. The interest rate paid on required and excess reserve balances is currently 0.25%. Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector. The payment of interest on excess reserves will permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity needed to support financial stability.
The U.S. Government is currently reviewing a plan for regulatory reform that would consolidate bank regulators, create new government agencies and give new powers to the Federal Reserve. Specific proposals include, among other things, the creation of a new national bank supervisor to regulate all federally chartered depository institutions, giving the Federal Reserve the power to regulate systemic risk to the nation’s financial stability and the creation of a Consumer Financial Protection Agency to regulate consumer financial products. The Company will continue to monitor the progress of these proposals and their possible effect on the Company. The exact requirements and timing of any final legislation cannot be determined at this time. Therefore, we cannot assure you that any final legislation will not have a material effect on our operations.
Various other legislative initiatives are from time to time introduced in Congress, and various regulatory initiatives are from time to time introduced, that would apply to the Company. The Company cannot determine the ultimate effect that any such potential legislation or regulations, if adopted, would have upon its financial condition or operations.
Interagency Guidance on Concentrations in Commercial Real Estate Lending
In December 2006, the FRB, the Office of the Comptroller of the Currency (“OCC”) and the FDIC adopted guidance entitled “Concentrations in Commercial Real Estate (“CRE”) Lending, Sound Risk Management Practices” (“CRE Guidance”) to address concentrations of commercial real estate loans in financial institutions. Although the CRE Guidance does not establish specific commercial real estate lending limits, the FRB, OCC and FDIC use the following criteria to evaluate whether an institution has a commercial real estate concentration risk. An institution may be identified for further supervisory analysis if it has experienced rapid growth in commercial real estate lending or has notable exposure to a specific type of commercial real estate. An institution may also be subject to further supervisory analysis if its total reported loans for construction, land development and other land represent 100 percent or more of that institution’s total capital, or if the institution’s total commercial real estate loans represent 300 percent or more of its total capital and the outstanding balance of its commercial real estate portfolio has increased by 50 percent or more during the prior 36 months. The CRE Guidance applies to financial institutions with an accumulation of credit concentration exposures and asks that the associations quantify the additional risk such exposures may pose. Such quantification should include the stratification of the commercial real estate portfolio by, among other things, property type, geographic market, tenant concentrations, tenant industries, developer concentrations and risk rating. In addition, an institution should perform periodic market analyses for the various property types and geographic markets represented in its portfolio. Further, an institution with commercial real estate concentration risk should also perform portfolio level stress tests or sensitivity analysis to quantify the impact of changing economic conditions on asset quality, earnings and capital.
Statement of Subprime Mortgage Lending
In June 2007, the FRB and other federal bank regulatory agencies issued a final Statement on Subprime Mortgage Lending (the “Statement”) to address the growing concerns facing the subprime mortgage market, particularly with respect to rapidly rising subprime default rates that may indicate borrowers do not have the ability to repay adjustable-rate subprime loans originated by financial institutions. In particular, the agencies express concern in the Statement that current underwriting practices do not take into account that many subprime borrowers are not prepared for “payment shock” and that the current subprime lending practices compound risk for financial institutions. The Statement describes the prudent safety and soundness and consumer protection standards that financial institutions should follow to ensure borrowers obtain loans that they can afford to repay. These standards include a fully indexed, fully amortized qualification for borrowers and cautions on risk-layering features, including an expectation that stated income and reduced documentation should be accepted only if there are documented mitigating factors that clearly minimize the need for verification of a borrower’s repayment capacity. Consumer protection standards include clear and balanced product disclosures to customers and limits on prepayment penalties that allow for a reasonable period of time, typically at least 60 days, for borrowers to refinance prior to the expiration of the initial fixed interest rate period without penalty. The Statement also reinforces the April 2007 Interagency Statement on Working with Mortgage Borrowers, in
which the federal bank regulatory agencies encouraged institutions to work constructively with residential borrowers who are financially unable or reasonably expected to be unable to meet their contractual payment obligations on their home loans. We have evaluated the Statement to determine our compliance and, as necessary, modified our risk management practices, underwriting guidelines and consumer protection standards.
Interagency Policy Statement Regarding Commercial Real Estate Loan Workouts
On October 30, 2009, the FRB and other federal bank regulatory agencies adopted a policy statement supporting prudent CRE loan workouts (the “Policy Statement”). The Policy Statement provides guidance for examiners, and for financial institutions that are working with CRE borrowers who are experiencing diminished operating cash flows, depreciated collateral values, or prolonged delays in selling or renting commercial properties. The Policy Statement details risk-management practices for loan workouts that support prudent and pragmatic credit and business decision-making within the framework of financial accuracy, transparency, and timely loss recognition. Financial institutions that implement prudent loan workout arrangements after performing comprehensive reviews of borrowers’ financial conditions will not be subject to criticism for engaging in these efforts, even if the restructured loans have weaknesses that result in adverse credit classifications. In addition, performing loans, including those renewed or restructured on reasonable modified terms, made to creditworthy borrowers, will not be subject to adverse classification solely because the value of the underlying collateral declined. The Policy Statement reiterates existing guidance that examiners are expected to take a balanced approach in assessing institutions’ risk-management practices for loan workout activities.
Interest Rate Risk Management Advisory
In January 2010, the FRB and other federal bank regulatory agencies released an Advisory on Interest Rate Risk Management (the “IRR Advisory”) to remind institutions of the supervisory expectations regarding sound practices for managing IRR. While some degree of IRR is inherent in the business of banking, the agencies expect institutions to have sound risk management practices in place to measure, monitor and control IRR exposures, and IRR management should be an integral component of an institution’s risk management infrastructure. The agencies expect all institutions to manage their IRR exposures using processes and systems commensurate with their earnings and capital levels, complexity, business model, risk profile and scope of operations, and the IRR Advisory reiterates the importance of effective corporate governance, policies and procedures, risk measuring and monitoring systems, stress testing, and internal controls related to the IRR exposures of institutions.
The IRR Advisory encourages institutions to use a variety of techniques to measure IRR exposure which includes simple maturity gap analysis, income measurement and valuation measurement for assessing the impact of changes in market rates as well as simulation modeling to measure IRR exposure. Institutions are encouraged to use the full complement of analytical capabilities of their IRR simulation models. The IRR Advisory also reminds institutions that stress testing, which includes both scenario and sensitivity analysis, is an integral component of IRR management. The IRR Advisory indicates that institutions should regularly assess IRR exposures beyond typical industry conventions, including changes in rates of greater magnitude (e.g., up and down 300 and 400 basis points as compared to up and down 200 basis points which is the general practice) across different tenors to reflect changing slopes and twists of the yield curve.
The IRR Advisory emphasizes that effective IRR management not only involves the identification and measurement of IRR, but also provides for appropriate actions to control this risk. The adequacy and effectiveness of an institution’s IRR management process and the level of its IRR exposure are critical factors in the agencies’ evaluation of an institution’s sensitivity to changes in interest rates and capital adequacy.
Federal Securities Laws
The Company’s securities are registered with the SEC under the Exchange Act. As such, the Company is subject to the information, proxy solicitation, insider trading, and other requirements and restrictions of the Exchange Act.
New York Business Corporation Law
The Company is incorporated under the laws of the State of New York, and is therefore subject to regulation by the State of New York. In addition, the rights of the Company’s stockholders are governed by the New York Business Corporation Law.
Government Monetary Policies and Economic Control
The earnings of the Company and the Bank are affected by the policies of regulatory authorities including the FRB and the FDIC. An important function of the Federal Reserve System is to regulate the money supply and interest rates. Among the instruments used to implement these objectives are open market operations in U.S. Government securities, changes in reserve requirements against member bank deposits, purchases of U.S. Government and agency securities, purchases of mortgage-backed securities and changes in the federal funds and discount rates. These instruments are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits and their use may also affect interest rates charged on loans or paid for deposits. Changes in government monetary policies and economic controls could have a material effect on the business of the Bank.
Statistical Information
Statistical information is furnished pursuant to the requirements of Guide 3 (Statistical Disclosure by Bank Holding Companies) promulgated under the Exchange Act.
Investment Portfolio
The following table presents the amortized cost and estimated fair value of available for sale securities held by the Company for each period (in thousands):
The following table presents the expected maturity distribution and the weighted-average yield of the Company’s investment portfolio (all of which are available for sale) at December 31, 2009 (dollars in thousands). The yield information does not give effect to changes in estimated fair value of investments available for sale that are reflected as a component of stockholders’ equity.
(1) Fully taxable-equivalent basis using a tax rate of 34%.
(2) Assumes maturity dates pursuant to average lives as determined by constant prepayment rates.
(3) Assumes coupon yields for securities past their call dates and not bought at a discount; yields to call for securities not past their call dates and not bought at a discount; and yields to maturity for securities purchased at a discount.
Loan and Lease Portfolio
The following table categorizes the Company’s loan and lease portfolio for each period (in thousands):
The following table presents the contractual maturities of selected loans and the sensitivities of those loans to changes in interest rates at December 31, 2009 (in thousands):
The following table presents the Company’s non-accrual, past due and restructured loans and leases for each period (in thousands):
The Bank generally discontinues the accrual of interest on loans and leases whenever there is reasonable doubt that interest and/or principal will be collected, or when either principal or interest is 90 days or more past due. At December 31, 2009, there was $3.8 million in loans and leases 90 days or more past due and still accruing interest comprised of a non-criticized real estate credit that was past due as to principal but not interest and was due to close with an improved collateral position on this credit before December 31, 2009. Due to unforeseen circumstances, the closing did not occur until January 5, 2010. All interest was current at December 31, 2009. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations, Summary of Loan and Lease Loss Experience and Allowance for Loan and Lease Losses.”
Summary of Loan and Lease Loss Experience
The determination of the balance of the allowance for loan and lease losses is based upon a review and analysis of the Company’s loan and lease portfolio. Management’s review includes monthly analyses of past due and non-accrual loans and leases and detailed, periodic loan-by-loan or lease-by-lease analyses.
Based on current economic conditions, management has determined that the current level of the allowance for loan and lease losses appears to be adequate at December 31, 2009 in relation to the probable inherent losses present in the portfolio. Management considers many factors in this analysis, among them credit risk grades assigned to commercial loans, delinquency trends, concentrations within segments of the loan and lease portfolio, recent charge-off experience and local economic conditions.
The following table presents an analysis of the Company’s allowance for loan and lease losses for each period (dollars in thousands):
The following table presents the allocation of the Company’s allowance for loan and lease losses at December 31 for each period (dollars in thousands):
(1) Prior to 2007, no breakdown between commercial and residential mortgage was available. Thus, all such real estate - mortgage amounts are included in real estate - commercial mortgage.
(2) Prior to 2007, no breakdown between commercial and residential construction was available. Thus, all such real estate - construction amounts are included in real estate - commercial construction.
Deposits
The following table presents the average balance and the average rate paid on the Company’s deposits for each period (dollars in thousands):
The following table sets forth, by time remaining to maturity, the Company’s certificates of deposit of $100,000 or more at December 31, 2009 (in thousands):
Short-Term Borrowings
The following information is provided on the Bank’s short-term borrowings for each period (dollars in thousands):
ITEM 1A.
ITEM 1A.
RISK FACTORS
The following is a summary of risk factors relevant to our operations which should be carefully reviewed. These risk factors do not necessarily appear in the order of importance.
Banking laws and regulations could limit our access to funds from the Bank, one of our primary sources of liquidity.
As a bank holding company, one of our principal sources of funds is dividends from our subsidiaries. These funds are used to service our debt as well as to pay expenses and dividends on our common and preferred stock. Our non-consolidated interest expense on our debt obligations was $1.7 million and $2.2 million for the years ended December 31, 2009 and 2008, respectively. Our non-consolidated operating expenses were $915 thousand and $31 thousand for the years ended December 31, 2009 and 2008, respectively. Our cash dividends paid on common stock were $2.9 million and $7.1 million for the years ended December 31, 2009 and 2008, respectively. Our cash dividends paid on preferred stock were $1.7 million for the year ended December 31, 2009. No cash dividends on preferred stock were paid in 2008. State banking regulations limit, absent regulatory approval, the Bank’s dividends to us to the lesser of the Bank’s undivided profits and the Bank’s retained net income for the current year plus its retained net income for the preceding two years (less any required transfers to capital surplus) up to the date of any dividend declaration in the current calendar year. As of December 31, 2009, no dividends were available to the Company from the Bank according to these limitations without seeking regulatory approval.
Federal bank regulatory agencies have the authority to prohibit the Bank from engaging in unsafe or unsound practices in conducting its business. The payment of dividends or other transfers of funds to us, depending on the financial condition of the Bank, could be deemed an unsafe or unsound practice.
Dividend payments from the Bank would also be prohibited under the “prompt corrective action” regulations of the federal bank regulators if the Bank is, or after payment of such dividends would be, undercapitalized under such regulations. In addition, the Bank is subject to restrictions under federal law that limit its ability to transfer funds or other items of value to us and our nonbanking subsidiaries, including affiliates, whether in the form of loans and other extensions of credit, investments and asset purchases, or other transactions involving the transfer of value. Unless an exemption applies, these transactions by the Bank with us are limited to 10% of the Bank’s capital and surplus and, with respect to all such transactions with affiliates in the aggregate, to 20% of the Bank’s capital and surplus. As of December 31, 2009, a maximum of approximately $33 million was available to us from the Bank according to these limitations. Moreover, loans and extensions of credit to affiliates generally are required to be secured by specified amounts of collateral. A bank’s transactions with its non-bank affiliates also are required generally to be on arm’s-length terms. We do not have any borrowings from the Bank and do not anticipate borrowing from the Bank in the future.
Accordingly, we can provide no assurance that we will receive dividends or other distributions from the Bank and our other subsidiaries.
Our other primary source of funding is our DRP, which allows existing stockholders to reinvest cash dividends in our common stock and/or to purchase additional shares through optional cash investments on a quarterly basis. Shares are purchased at up to a 15% discount from the current market price under both the dividend reinvestment option and with optional cash payments. No assurance can be given that we will continue the DRP or that stockholders will make purchases in the future.
Commercial real estate and commercial business loans expose us to increased lending risks.
CRE and C&I loans comprise the majority of our loan portfolio. At December 31, 2009, our portfolio of CRE loans totaled approximately $563 million and our commercial and industrial loans amounted to approximately $349 million of total loans of $1.1 billion. At December 31, 2009 CRE and commercial and industrial loans on our watch list increased $24 million and $27 million, respectively, from the December 31, 2008 amounts. Commercial loans generally expose a lender to greater risk of non-payment and loss than non-commercial loans because repayment of commercial loans often depends on the successful operation and cash flow of the borrowers. Such loans also typically involve larger loan balances to single borrowers or groups of related borrowers compared to non-commercial loans. Consequently, an adverse development with respect to a CRE loan or commercial business loan can expose us to a significantly greater risk of loss compared to an adverse development with respect to a non-commercial loan. CRE loans may present special lending risks and may expose lenders to unanticipated earnings and capital volatility due to adverse changes in the general commercial real estate market.
Our results of operations are affected by economic conditions in the New York metropolitan area and nationally.
As a result of our geographic concentration in the New York metropolitan area, our results of operations largely depend upon economic conditions in this region.
We are operating in a challenging and uncertain economic environment, globally, nationally and locally. Financial institutions continue to be affected by declines in the real estate and financial markets. Decreases in real estate values have negatively affected the value of property used as collateral for our loans. Adverse changes in the economy have affected and may continue to affect the ability of our borrowers to make timely repayments of their loans, which would have a negative impact on our earnings. If poor economic conditions result in decreased demand for real estate loans, our earnings capacity may decline because our investment alternatives may earn less income for us than real estate loans.
The Company’s non-performing loans totaled $7 million (which includes $1 million in loans held for sale which have been previously written down to their estimated fair value) at December 31, 2009. If the sale of lower quality loans in the fourth quarter of 2009 had not occurred, our non-performing loans at December 31, 2009 would have been at a level similar to our non-performing loans of $35 million at September 30, 2009. Net loan charge-offs recorded in 2009 were $29.5 million and our provision for loan and lease losses for 2009 was $39.5 million. The impact of the national and local economic recession along with any further economic deterioration could drive losses beyond that which is provided for in our allowance for loan losses and result in additional consequences, such as loan delinquencies, increased problem assets and foreclosures, declining demand for our products and services, decreased deposits and declining collateral value for our loans.
Changes in economic conditions or interest rates may negatively affect our earnings, capital and liquidity.
The results of operations for financial institutions, including the Bank, may be materially adversely affected by changes in prevailing local and national economic conditions, including declines in real estate market values, rapid increases or decreases in interest rates and changes in the monetary and fiscal policies of the federal government. Our profitability is heavily influenced by the spread between the interest rates earned on investments and loans and the interest rates paid on deposits and other interest-bearing liabilities. Like most banking institutions, our net interest spread and margin will be affected by market interest rates and our ability to respond to changes in such rates. At any given time, our assets and liabilities may be affected differently by a change in interest rates.
Funding costs may rise due to competitive pricing pressures and volatility in the credit and money markets. Rates are at historic lows at this time and it would appear from their comments that Federal Reserve policy makers are prepared to keep the fed funds rate low until well past such time as the economy shows evidence of sustainable recovery. In the near term the risks from inflationary pressure due to an increase in economic activity appear limited. Consequently, while inflation remains a matter of concern, those risks appear to be more visible in the intermediate 3-5 year timeframe. As the Federal Reserve begins to remove many of the extraordinary measures put in place during the last year, credit spreads may begin to widen, which may affect the cost that the Bank must bear to borrow funds.
Strong competition within our market areas could hurt our profits and slow growth.
The New York metropolitan area has a high density of financial institutions, a number of which are significantly larger and have greater financial resources than we have, and as such, may have higher lending limits and may offer other services not offered by us. Additionally over the past several years, various large out-of-state financial institutions have entered the New York metropolitan area market. All are our competitors to varying degrees.
We face intense competition in making loans and attracting deposits. Our competition for loans comes principally from commercial banks, savings banks, insurance companies, credit unions and money market funds. Also, as a result of the deregulation of the financial industry, we also face competition from other providers of financial services such as corporate and government securities funds as well as from other financial intermediaries such as brokerage firms and insurance companies.
We operate in a highly regulated industry, which limits the manner and scope of our business activities.
We are subject to extensive supervision, regulation and examination by the FRB, the FDIC and the Banking Department. As a result, we are limited in the manner in which we conduct our business, undertake new investments and activities and obtain financing. This regulatory structure is designed primarily for the protection of the deposit insurance funds and our depositors, and not to benefit our stockholders. This regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to capital levels, the timing and amount of dividend payments, the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. In addition, we must comply with significant anti-money laundering and anti-terrorism laws. Government agencies have substantial discretion to impose significant monetary penalties on institutions which fail to comply with these laws.
We expect to face increased regulation and supervision of our industry as a result of the financial crisis, and there will be additional requirements and conditions imposed on us to the extent that we participate in any of the programs established or to be established by the Treasury under the EESA or by the federal bank regulatory agencies. Such additional regulation and supervision may increase our costs and limit our ability to pursue business opportunities.
Changes in banking laws could have a material adverse effect on us.
We are extensively regulated under federal and state banking laws and regulations that are intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole. In addition, we are subject to changes in federal and state tax laws as well as changes in banking and credit regulations, accounting principles and governmental economic and monetary policies. We cannot predict whether any of these changes may materially adversely affect us. Federal and state banking regulators also possess broad powers to take enforcement actions as they deem appropriate. These enforcement actions may result in higher capital requirements, higher insurance premiums, limitations on our activities, the timing and amount of dividend payments, the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes, that could have a material adverse effect on our business and profitability. In addition, we must comply with significant anti-money laundering and anti-terrorism laws. Government agencies have substantial discretion to impose significant monetary penalties on institutions which fail to comply with these laws.
There can be no assurance that recently enacted legislation and related regulatory actions will stabilize the U.S. financial system.
There can be no assurance as to the actual impact that the EESA, CPP, TLGP, or CPFF or any other governmental program will have on the financial markets. The failure of any such program or the U.S. government to stabilize the financial markets and a continuation or worsening of current financial market conditions and the national and regional economy is expected to materially and adversely affect our business, financial condition, results of operations, access to credit or the trading price of our common stock.
Higher FDIC deposit insurance premiums and assessments could adversely affect our financial condition.
FDIC insurance premiums increased substantially in 2009 including the prepayment of the Bank’s FDIC premium through the fourth quarter of 2012. The amount of this prepayment was $8.0 million, which was recorded as a prepaid expense (asset) as of December 30, 2009. As of December 31, 2009 and each quarter thereafter, we are recording an expense for our regular deposit assessment for the quarter and an offsetting credit to the prepaid assessment until the asset is exhausted. Market developments have significantly depleted the insurance fund of the FDIC and reduced the ratio of reserves to insured deposits. The FDIC adopted a revised risk-based deposit insurance assessment schedule on February 27, 2009, which raised regular deposit insurance premiums. On May 22, 2009, the FDIC also implemented a five basis point special assessment of each insured depository institution’s total assets minus Tier 1 capital as of June 30, 2009, but no more than 10 basis points times the institution’s assessment base for the second quarter of 2009, collected by the FDIC on September 30, 2009. The amount of this special assessment was $730 thousand. Additional special assessments may be imposed by the FDIC in the future at the same or higher levels. We may also have to pay significantly higher FDIC premiums and prepay additional insurance premiums in the future.
We participate in the TLGP for noninterest-bearing transaction deposit accounts. Banks that participate in the TLGP noninterest-bearing transaction account guarantee program will pay the FDIC an annual assessment of 10 basis points on the amounts in such accounts above the amounts covered by FDIC deposit insurance. To the extent that these TLGP assessments are insufficient to cover any loss or expenses arising from the TLGP program, the FDIC is authorized to impose an emergency special assessment on all FDIC-insured depository institutions. The FDIC has authority to impose charges for the TLG program upon the holding companies of such depository institutions as well. The TLGP was scheduled to end December 31, 2009, but the FDIC extended the program to June 30, 2010. In announcing the extension, the FDIC indicated that it will charge a higher guarantee fee to banks that elect to participate in the extension to reflect each bank’s risk. Specifically, beginning on January 1, 2010, a participating entity that does not opt out of the program must pay quarterly an annualized fee in accordance with the respective risk category rating. This fee is either 15 basis points, 20 basis points or 25 basis points for balances that exceed the deposit insurance limit of $250,000. We have elected to participate in the extension.
These changes may cause the premiums and TLGP assessments charged by the FDIC to increase. These actions could significantly increase our non-interest expense in future periods. The prepayment of our FDIC assessments may also temporarily reduce our liquidity.
As a participant in the Treasury’s Capital Purchase Program, we are subject to several restrictions including restrictions on our ability to declare or pay dividends and repurchase our shares as well as restrictions on our executive compensation.
As a participant in the CPP, our ability to declare or pay dividends on any of our shares will be limited. Specifically, we will not be able to declare dividend payments on common, junior preferred or pari passu preferred shares if we are in arrears on the dividends on the senior preferred shares issued to the Treasury. Further, we will not be permitted to increase dividends on our common stock to a level that is greater than the amount of the last quarterly cash dividend declared prior to October 14, 2008, without the Treasury’s approval until the third anniversary of the investment unless the senior preferred stock issued to the Treasury has been redeemed or transferred. In addition, our ability to repurchase our shares will be restricted. Treasury consent generally will be required for us to make any stock repurchase until the third anniversary of the investment by the Treasury unless the senior preferred issued to the Treasury has been redeemed or transferred. Further, common, junior preferred or pari passu preferred shares may not be repurchased if we are in arrears on the senior preferred dividends to the Treasury.
As a participant in the program, we must also adopt the Treasury’s standards for executive compensation and corporate governance for the period during which the Treasury holds equity issued under this program. For this purpose, a warrant to purchase common stock is not considered equity. These standards would generally apply to our Chief Executive Officer, Chief Financial Officer and the three next most highly compensated officers. The standards include (1) ensuring that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution; (2) required clawback of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate; (3) prohibition on making golden parachute payments to senior executives; and (4) agreement not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive. In particular, the change to the deductibility limit on executive
compensation would likely increase the overall cost of our compensation programs in future periods. In conjunction with the purchase of our senior preferred shares, the Treasury received a warrant to purchase our common stock with an aggregate market value equal to 15% of the senior preferred investment, or $5,526,300. The warrant was immediately exercisable and has a term of 10 years.
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 key members of 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 because of their skills, knowledge of the Company’s market, years of industry experience and the difficulty of promptly finding qualified replacement personnel. The Company currently has an employment agreement in place with its Chief Executive Officer. Change in control agreements are in place for selected key officers. The American Recovery and Reinvestment Act of 2009 (“ARRA”) was signed by the President on February 17, 2009 and imposed strict new limits on executive compensation for all CPP participants, including a prohibition on the payment or accrual of any bonus, retention award or incentive compensation to the Company’s five most highly compensated employees. These prohibitions may negatively impact the Company’s ability to retain existing key staff members and/or to attract additional qualified personnel to join the Company in key positions.
If our investment in the Federal Home Loan Bank of New York is classified as other-than-temporarily impaired or as permanently impaired, our earnings and stockholders’ equity could decrease.
We own common stock of the FHLB-NY to qualify for membership in the Federal Home Loan Bank System and to be eligible to borrow funds under the FHLB-NY’s advance program. The aggregate cost and fair value of our FHLB-NY common stock as of December 31, 2009 was $4 million based on its par value. This amount fluctuates as a function of our FHLB-NY borrowings. There is no public market for our FHLB-NY common stock.
Certain member banks of the Federal Home Loan Bank System, including the FHLB-NY, may be subject to accounting rules and asset quality risks that could result in materially lower regulatory capital levels. In an extreme situation, it is possible that the capitalization of a Federal Home Loan Bank, including the FHLB-NY, could be substantially diminished or reduced to zero. Consequently, we believe that there is a risk that our investment in FHLB-NY common stock could be deemed other-than-temporarily impaired at some time in the future, and if this occurs, it would cause our earnings and stockholders’ equity to decrease by the after-tax amount of an impairment charge.
Alternatives to deposits as a funding source may become more expensive.
The Company’s primary sources of funds are cash provided by deposits, proceeds from maturities and sales of securities available for sale and cash provided by operating activities. If deposits become less attractive to customers due to customer preference, competition, or rates, we may have to rely on alternative sources of funding such as Federal Home Loan Bank (“FHLB”) advances, which we have used from time to time. However, there is no assurance that such alternative funding sources will be available or, if available, at rates that allow us to maintain a reasonable net interest margin.
We continually encounter technological change, and may have fewer resources than our competitors to continue to invest in technological improvements.
The banking industry continues to undergo rapid technological change with frequent introductions of new technology-driven products and services. In addition to better serving customers, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Our future success will depend, in part, on our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as create additional efficiencies in our operations. Many competitors have substantially greater resources to invest in technological improvements. There can be no assurance that we will be able to effectively implement new technology-driven products and services or be successful in marketing such products and services to our customers.
We experienced a net loss for the fourth quarter of 2009, resulting in a net loss for the year ended December 31, 2009, and we can provide no assurance that additional losses will not be realized in future periods.
We recorded a net loss of $12.7 million in the fourth quarter of 2009 versus a net loss of $4.1 million in the comparable 2008 period, which resulted in a net loss of $14.8 million for the year ended December 31, 2009. The 2009 net loss resulted from several factors, most notably increases in the total operating expenses and the provision for loan and lease losses, which resulted from the sale of non-performing and
classified credits coupled with internal risk rating downgrades of several large commercial loan relationships. Please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations, Results of Operations and Financial Condition.”
Although we believe we have identified and reduced future balance sheet risk by liquidating lower quality legacy loans, there can be no assurance that there are no additional weaknesses in our loan portfolio, which could result in further losses.
If the actual amount of future taxable income is less than what we are currently projecting, it may be necessary to record a valuation allowance for our deferred tax asset in a future period.
On a quarterly basis, management determines whether a valuation allowance is necessary for our deferred tax asset. In performing this analysis, management considers all evidence currently available, both positive and negative, in determining whether, based on the weight of that evidence, the deferred tax asset will be realized. A valuation allowance is established when it is more likely than not that a recorded tax benefit is not expected to be realized. The expense to create the tax valuation allowance is recorded as additional income tax expense in the period the tax valuation allowance is established. In arriving at the conclusion that a valuation allowance was not necessary at December 31, 2009 management considered the Company’s three year cumulative earnings history for 2007 through 2009 on both an unadjusted basis and after adjustment for unusual items of income or expense that are not expected to recur. Management also considered projections of future levels of taxable income. The valuation allowance estimate is highly dependent on projections of future levels of taxable income. Should the actual amount of taxable income be less than what has been projected, it may be necessary to record a valuation allowance in a future period.
The Company’s future growth and liquidity needs may require the Company to raise additional capital in the future, but that capital may not be available when it is needed or may be available at an excessive cost.
The Company is required by regulatory authorities to maintain adequate levels of capital to support its operations. The Company anticipates that current capital levels will satisfy regulatory requirements for the foreseeable future. However, we cannot assure you that regulatory reform will not result in higher capital requirements across the banking industry.
On December 5, 2008, the Company issued $36.8 million of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A, par value $0.01 per share and liquidation preference $1,000 per share (the “Series A Preferred Stock”) and a warrant (“Warrant”) to purchase 465,569 million shares of the Company’s common stock to the Treasury. The Company may at some point choose to raise additional capital to support its continued growth or to redeem the preferred stock issued under the Treasury’s CPP. In addition, there may be increasing market, regulatory or political pressure on the Company to raise capital to redeem the preferred stock issued under the CPP.
The Company’s ability to raise additional capital will depend, in part, on conditions in the capital markets at that time, which are outside of the Company’s control. Accordingly, the Company may be unable to raise additional capital, if and when needed, on terms acceptable to the Company, or at all. If the Company cannot raise additional capital when needed, its ability to further expand operations through internal growth and acquisitions could be materially impacted. In addition, if the Company is unable to raise additional capital to redeem the Series A Preferred Stock, the Company will continue to be subject to certain restrictions described in the risk factor “As a participant in the Treasury’s Capital Purchase Program, we are subject to several restrictions including restrictions on our ability to declare or pay dividends and repurchase our shares as well as restrictions on our executive compensation.”
In addition, any future issuances of equity securities could dilute the interests of existing shareholders and could cause a decline in the Company’s stock price.
The adoption of proposed regulatory reform legislation may have a material effect on our operations.
On December 11, 2009, the House of Representatives passed the Reform Bill. The Reform Bill is intended to address perceived weaknesses in the U.S. financial regulatory system and prevent future economic and financial crises. The Reform Bill, among other things, would create three new governmental agencies: the Financial Services Oversight Council, the Federal Insurance Office and the Consumer Financial Protection Agency (“CFPA”). The CFPA will have the authority to implement and enforce a variety of existing consumer protection statutes and to issue new regulations. Similar legislation is being currently considered by the Senate’s Banking Committee. The exact requirements and timing of any final legislation cannot be determined at this time. Therefore, we cannot assure you that any final legislation will not have a material effect on our operations.
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2.
PROPERTIES
The following table sets forth certain information relating to properties owned or used in the Company’s banking activities at December 31, 2009:
The fixtures and equipment contained in these operating facilities are owned or leased by the Bank. The Company considers that all of its premises, fixtures and equipment are adequate for the conduct of its business.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
The Company and the Bank are subject to legal proceedings and claims that arise in the ordinary course of business. In the opinion of management, the amount of ultimate liability, if any, with respect to such matters will not materially affect future operations and will not have a material impact on the Company’s financial statements.
ITEM 4.
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
For information on the results of the Special Meeting of Stockholders held on November 17, 2009 and adjourned to December 1, 2009, please see our current report on Form 8-K dated December 1, 2009, which is incorporated by reference herein.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
At December 31, 2009, the approximate number of common equity stockholders was as follows:
Title of Class: Common Stock
Number of Record Holders: 1,416
The Company’s common stock trades on the NASDAQ Global Market under the symbol STBC. The approximate high and low closing prices for the Company’s common stock for the years ended December 31, 2009 and 2008, were as follows:
The Company’s primary funding sources are dividends from the Bank and proceeds from the DRP. Both the Company and the Bank are subject to certain restrictions on the payment of dividends. Please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations, Capital Resources.” The Company’s Board declared a cash dividend of $0.05 per share at its January 26, 2010 meeting. The following schedule summarizes the Company’s dividends paid for the years ended December 31, 2009 and 2008:
For information about the Company’s equity compensation plans, please see “Part III, Item 12, Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”
The Company did not repurchase any of its common stock during 2009 under the existing stock repurchase plan. Under the Board’s current stock repurchase authorization, management may repurchase up to 512,348 additional shares if market conditions warrant. This action will only occur if management believes that the purchase will be at prices that are accretive to earnings per share and is the most efficient use of Company capital. The Company does not presently anticipate repurchasing any of its shares in the immediate future.
As the Company issued preferred stock and a common stock warrant to the Treasury under the CPP, the Treasury’s consent is required for any increase in common dividends per share that is greater than the amount of the last quarterly cash dividend declared prior to October 14, 2008 and any repurchases of common stock until the earlier of a redemption of the Series A Preferred Stock or December 5, 2011.
The following Performance Graph compares the yearly percentage change in the Company’s cumulative total stockholder return on its common stock with the cumulative total return of the NASDAQ Market Index and the cumulative total returns of ninety-one (91) Northeast NASDAQ Banks.
COMPARE 5-YEAR CUMULATIVE TOTAL RETURN
AMONG STATE BANCORP, INC.,
NASDAQ MARKET INDEX AND PEER GROUP INDEX
(assumes $100 invested on Dec. 31, 2004, dividends reinvested
and fiscal year ending Dec. 31, 2009)
On November 25, 2009 we entered into an Exchange Agreement (the “Exchange Agreement”) with the investors named therein to exchange our unsecured 8.25% Subordinated Notes due June 15, 2013 with an outstanding principal balance of $10 million plus accrued interest for an aggregate of 1,656,600 shares of our common stock. For purposes of the exchange, each share of our common stock was valued at $6.50
per share. The issuance of the common stock was not registered under the Securities Act but was made in reliance upon the exemption from registration available under Section 3(a)(9) of the Securities Act. Section 3(a)(9) exempts any security exchanged by the issuer with its existing security holders from registration under the Securities Act, provided no commission or other remuneration has been paid or given for soliciting the exchange, which is the case in connection with the Exchange Agreement.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
The Company’s selected financial data for the last five years follows:
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward Looking Statements
Certain statements contained in this report are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan,” “project,” “is confident that,” and similar expressions are intended to identify these forward looking-statements. These forward-looking statements involve risk and uncertainty and a variety of factors that could cause the Company’s actual results and experience to differ materially from the anticipated results or other expectations expressed in these forward-looking statements. The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors that could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to, changes in: market interest rates, general economic conditions, legislative/regulatory changes, monetary and fiscal policies of the U.S. Government, the quality and composition of the loan and lease or investment portfolios, demand for loan and lease products, demand for financial services in the Company’s primary trade area, litigation, tax and other regulatory matters, accounting principles and guidelines, other economic, competitive, governmental, regulatory and technological factors affecting the Company’s operations, pricing and services and those risks detailed in item 1A of this report and in the Company’s periodic reports filed with the SEC.
Executive Summary
The Company is a one-bank holding company, which was formed in 1985. The Company operates as the parent for its wholly owned subsidiary, the Bank, a New York State chartered commercial bank founded in 1966. The Company also has two unconsolidated subsidiaries, the Trusts, entities formed in 2002 and 2003, respectively, to issue trust preferred securities. The income of the Company is principally derived through the operation of the Bank.
The Bank maintains its corporate headquarters in Jericho, New York and serves its customer base through seventeen branches in Nassau, Suffolk, Queens and Manhattan. The Bank offers a full range of banking services to our diverse customer base which includes commercial real estate owners and developers, small to middle market businesses, professional service firms, municipalities and consumers. Retail and commercial products include checking accounts, NOW accounts, money market accounts, savings accounts, certificates of deposit, individual retirement accounts, commercial loans, commercial mortgage loans, small business lines of credit, cash management services and telephone and online banking. In addition, the Bank also provides access to annuity products and mutual funds. The Company’s loan portfolio is concentrated in commercial and industrial loans and commercial mortgage loans. The Bank does not engage in subprime lending and does not offer payment option ARMs or negative amortization loan products.
bp - denotes basis points; 100 bp equals 1%.
(1) Represents net interest income plus total other income.
(2) N/M - denotes % variance not meaningful for statistical purposes.
As of December 31, 2009, the Company, on a consolidated basis, had total assets of $1.6 billion, total deposits of $1.3 billion and stockholders’ equity of $149 million. Unless the context otherwise requires, references herein to the Company include the Company and its subsidiaries on a consolidated basis.
In December 2009, the Company enhanced its capital position by exchanging its 8.25% subordinated notes (due to mature in 2013) with an outstanding principal balance of $10 million for common equity in a privately negotiated transaction with four major institutional investors. The net effect of this exchange increased the Company’s tangible common equity by $11 million.
The Company continues to emphasize loan growth and with strong credit oversight, deposit generation, increased market share, improved operational efficiency and ongoing Company-wide expense management, product development, IT infrastructure improvements and enhanced brand building. However, the Company continues to experience credit quality pressure as well as deposit and loan pricing pressures. The Company has numerous competitors for its very attractive core niche of small business and middle market commercial customers. Some of these competitors have entered the marketplace through de novo branching, acquisitions and strategic alliances. The Company remains focused on expanding its core commercial business relationships, expense reduction initiatives, capital management and strategies to improve non-interest income generation.
The Company recorded a net loss of $14.8 million in 2009 and net income of $1.8 million in 2008. The net loss resulted from several factors, most notably increases in the provision for loan and lease losses and total operating expenses of $22.3 million and $4.8 million, respectively. In addition, net interest income declined by $790 thousand in 2009 versus 2008. Partially offsetting these declines was a $1.1 million increase in non-interest income in 2009.
The increased provision for loan and lease losses in 2009 was due to several factors, including an $18 million increase in net charge-offs in 2009 driven largely by the sale of non-performing loans in the fourth quarter, growth in watch list assets and internal risk rating downgrades of several large commercial loan relationships. Total operating expenses increased by $4.8 million or 10.9% to $48.5 million in 2009, primarily due to an increase in credit and collection expenses due to $4.0 million in write-downs of loans held for sale to their estimated fair value in 2009 versus $250 thousand in such charges recorded in 2008 and a $2.8 million increase in FDIC and NYS assessment expenses in 2009 resulting from higher FDIC insurance premiums, additional deposit insurance programs and the FDIC special assessment of $730 thousand recorded in the second quarter of 2009. Partially offsetting these increases was a reduction in legal expenses of $2.3 million. The decrease in net interest income was due to a nine basis point narrowing of the Company’s net interest margin to 4.03% for 2009 versus 4.12% for 2008. A 98 basis point reduction in the cost of interest-bearing liabilities was more than offset by the 110 basis point decline in the average rate earned on the Company’s loan portfolio during 2009. Average interest-earning assets grew by $12 million or 1% in 2009 versus 2008.
The increase in non-interest income in 2009 as compared to 2008 resulted principally from a $2.2 million reduction in non-cash other than temporary impairment (“OTTI”) charges coupled with a $947 thousand increase in net gains on the sale of securities in 2009. These improvements were partially offset by a decrease in other operating income of $1.8 million, due to reductions in sweep program fees in 2009 coupled with income recorded on certain customer interest rate swaps in 2008 versus losses recorded in 2009.
Total assets of the Company were $1.6 billion at December 31, 2009 compared to $1.7 billion at December 31, 2008. At December 31, 2009, total deposits were $1.3 billion compared to $1.5 billion at December 31, 2008.
While the recession may have technically ended, meaningful growth will only return when renewed economic activity drives corporate hiring and investment. Commercial and residential real estate values in our market appear to have stabilized at lower levels but, locally, properties are burdened by high maintenance costs including an ever increasing state and local tax burden. When appropriate, we pursued opportunities to proactively liquidate and dispose of certain problem loans by selling such loans in the market on a discounted basis. Net loan and lease charge-offs of $23.7 million were recorded in the fourth quarter of 2009 in part to account for the liquidity discount required to sell distressed loans. The Company liquidated certain non-performing and higher risk legacy loans, including a $20 million bulk loan sale that closed in November 2009. Using that same strategy in 2008, we wrote-down certain problem loans totaling $15.7 million to estimated fair market value of $9.8 million and transferred the net balance to loans held for sale after determining that such action represented the most cost-effective solution. Approximately $4.5 million of loans held for sale were sold in the fourth quarter 2008 at a loss of $250 thousand. Loans held for sale amounted to less than $1 million and $5.3 million at year-end 2009 and 2008, respectively. As a result of the foregoing actions, non-accrual and higher risk loans were significantly reduced in 2009, with total non-performing loans of $10.5 million at December 31, 2009 compared to $16.1 million at December 31, 2008. While none of the Company’s actions are necessarily cure-alls and additional credit costs are inevitable, the Company has taken a major step forward by removing these toxic assets from the balance sheet, thereby positioning the Company to begin approaching normal earnings power in 2010 and beyond.
Net charge-offs in 2009 amounted to $29.5 million. Included in this total was a loss of approximately $17.4 million on the aforementioned write-down of loans transferred to held for sale and sold. Net charge-offs in 2008 amounted to $11.3 million. Included in this total was a loss of approximately $5.9 million on the write-down of loans transferred to held for sale
Total watch list loans at December 31, 2009 amounted to $143 million, an increase of $54 million from December 31, 2008. This increase was primarily comprised of $27 million of commercial and industrial loans and $24 million of commercial real estate loans. The criticized/classified commercial and industrial loans were affected by the downgrade of several loans to a meat processor totaling $8 million and two related loans to commercial business investors totaling $20 million. The criticized/classified commercial real estate loans were primarily affected by the downgrades of a $9 million mortgage loan to the owners of an industrial/office property and mortgage loans to two non-related golf course operators totaling $18 million.
The primary focus of the Company’s loan portfolio is commercial real estate and commercial and industrial loans. Residential lending constitutes less than 10% of our total portfolio at December 31, 2009. We expect to achieve modest loan growth in our core competencies of commercial and industrial credits and commercial mortgage loans in 2010. Funding costs may rise in 2010 due to competitive pricing pressures and volatility in the credit and money markets. Rates are at historic lows at this time and it would appear from their comments that Federal Reserve policy makers are prepared to keep the fed funds rate low until well past such time as the economy shows evidence of sustainable recovery. In the near term the risks from inflationary pressure due to an increase in economic activity appear limited. Consequently, while inflation remains a matter of concern, those risks appear to be more visible in the intermediate 3-5 year timeframe. As the Federal Reserve begins to remove many of the extraordinary measures put in place during the last year, credit spreads may begin to widen, which may affect the cost that the Bank must bear to borrow funds.
The Company’s securities portfolio contains no sub-prime, structured debt or exotic structures. At December 31, 2009, the market value of the securities portfolio represented 103% of book value which resulted in an unrealized gain of $10 million.
It is management’s intent for the Company’s branch network to provide funding to support anticipated asset growth, supplemented with short-term borrowings as needed. The Company will continue to pursue product delivery and back office expense reductions and operating efficiencies.
The Company has participated in the CPP through its December 2008 issuance of Series A Preferred Stock and a warrant to the Treasury to purchase common stock. The Company is participating in the Transaction Account Guarantee Program of the FDIC’s TLGP which provides non-interest bearing transaction accounts and interest bearing transaction accounts with interest rates no higher than 0.50% at the Bank with unlimited FDIC insurance coverage beyond the current limit of $250,000. The unlimited coverage was to be in effect through December 31, 2009. Effective October 1, 2009, a final rule adopted by the FDIC extended the TLGP for six months to June 30, 2010. Management anticipates that the cost of continuing to participate in the TLGP will be immaterial to the Company’s financial statements. The Company participated in the Debt Guarantee Program of the TLGP in March 2009 allowing the Bank to issue $29 million in FDIC-guaranteed senior
unsecured debt at a fixed interest rate of 2.625% per annum and a maturity of March 30, 2012. The FDIC guarantee will be in effect through the March 2012 maturity date.
The U.S. Government is currently reviewing a plan for regulatory reform that would consolidate bank regulators, create new government agencies and give new powers to the Federal Reserve. Specific proposals include, among other things, the creation of a new national bank supervisor to regulate all federally chartered depository institutions, giving the Federal Reserve the power to regulate systemic risk to the nation’s financial stability and the creation of a Consumer Financial Protection Agency to regulate consumer financial products. The Company will continue to monitor the progress of these proposals and their possible effect on the Company. The exact requirements and timing of any final legislation cannot be determined at this time. Therefore, we cannot assure you that any final legislation will not have a material effect on our operations.
Critical Accounting Policies, Judgments and Estimates
The discussion and analysis of the financial condition and results of operations of the Company are based on the Consolidated Financial Statements, which are prepared in conformity with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions affecting the reported amounts of assets, liabilities, revenues and expenses. Management evaluates those estimates and assumptions on an ongoing basis, including those related to the allowance for loan and lease losses, income taxes, other-than-temporary impairment of investment securities and recognition of contingent liabilities. Management bases its estimates on historical experience and various other factors and assumptions that are believed to be reasonable under the circumstances. These form the basis for making judgments on the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from those estimates under different assumptions or conditions.
Allowance for Loan and Lease Losses
In management’s opinion, one of the most critical accounting policies impacting the Company’s financial statements is the evaluation of the allowance for loan and lease losses. Management carefully monitors the credit quality of the portfolio and charges off the amounts of those loans and leases deemed uncollectible. Management evaluates the fair value of collateral supporting any impaired loans and leases using independent appraisals and other measures of fair value. This process involves subjective judgments and assumptions that are always subject to substantial change based on factors outside the control of the Company.
LOAN AND LEASE PORTFOLIO (1) AND THE ALLOWANCE
FOR LOAN AND LEASE LOSSES
(1) Excluding loans held for sale.
Management of the Company recognizes that, despite its best efforts to minimize risk through its credit review process, losses will inevitably occur. In times of economic slowdown, regional or national, the credit risk inherent in the Company’s loan and lease portfolio may increase. The timing and amount of loan and lease losses that occur are dependent upon several factors, most notably qualitative and quantitative factors about both the micro and macro economic conditions as reflected in the loan and lease portfolio and the economy as a whole. Factors considered in the evaluation of the allowance for loan and lease losses include, but are not limited to, estimated probable inherent losses from loan and lease and other credit arrangements, general economic conditions, credit risk grades assigned to commercial and industrial and commercial real estate loans, changes in credit concentrations or pledged collateral, historical loan and lease loss experience and trends in portfolio volume, maturity, composition, delinquencies and non-accruals. The allowance for loan and lease losses is established to absorb probable inherent loan and lease charge-offs. Additions to the allowance are made through the provision for loan and lease losses, which is a charge to current operating earnings. The adequacy of the provision and the resulting allowance for loan and lease losses is determined by management’s continuing review of the loan and lease portfolio, including identification and review of individual problem situations that may affect a borrower’s ability to repay, delinquency and non-performing loan data, collateral values, regulatory examination results and changes in the size and character of the loan and lease portfolio. Despite such a review, the level of the allowance for loan and lease losses remains an estimate, cannot be precisely determined and may be subject to significant changes from quarter to quarter. Based on current economic conditions, management believes that the current level of the allowance for loan and lease losses is adequate in relation to the probable inherent losses present in the portfolio.
Commercial loans are assigned credit risk grades using a scale of one to ten with allocations for probable inherent losses made for pools of similar risk-graded loans. Loans with signs of credit deterioration, generally in grades eight through ten, are termed “classified” loans in accordance with guidelines established by the Company’s regulators. When management analyzes the allowance for loan and lease losses, classified loans are assigned allocation factors ranging from 24% to 100% of the outstanding loan balance and are based on the Company’s historic loss experience. Loans that have potential weaknesses, generally in grade seven, that require close monitoring by senior management, are termed “criticized” loans in accordance with regulatory guidelines. Criticized loans are assigned an allocation factor of 4% based on historic loss experience. Non-accrual loans and leases in excess of $250 thousand are individually evaluated for impairment and are not included in these risk grade pools. A loan is considered “impaired” when, based on current information and events, it is probable that both the principal and interest due under the original contractual terms will not be collected in full. The Company measures impairment of
collateralized loans based on the fair value of the collateral, less estimated costs to sell. For loans that are not collateral-dependent, impairment is measured by using the present value of expected cash flows, discounted at the loan’s effective interest rate. Allocations for loans which are performing satisfactorily, generally in grades one through six, are based on historic experience for other performing loans and leases and are assigned an allocation factor of 0.55% of the loan balance. Based upon our annual migration analysis that tracks the progression of loans through our various asset quality categories and reflects charge-off history, the internal watch list and non-criticized allocations increased slightly in 2009 as compared to 2008. An allowance allocation factor for portfolio macro factors currently ranging from 1- 40 basis points is calculated to cover potential losses from a number of variables, not the least of which is the current economic uncertainty.
It is the present intent of management to continue to monitor the level of the allowance for loan and lease losses in order to properly reflect its estimate of the exposure, if any, represented by fluctuations in the local real estate market and the underlying value that market provides as collateral to certain segments of the loan and lease portfolio. The provision is continually evaluated relative to portfolio risk and regulatory guidelines and will continue to be closely reviewed. In addition, various bank regulatory agencies, as an integral part of their examination process, closely review the allowance for loan and lease losses. Such agencies may require the Company to recognize additions to the allowance based on their independent judgment of information available to them at the time of their examinations. Frequently, such additional information generally becomes available only after management has conducted its quarterly calculation of the provision.
Accounting for Income Taxes
Deferred tax assets and liabilities are recognized to reflect the temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating loss carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. Management exercises significant judgment in the evaluation of the amount and timing of the recognition of the resulting tax assets and liabilities. The judgments and estimates required for this evaluation are periodically updated based upon changes in business factors and the tax laws and regulations.
On a quarterly basis, management determines whether a valuation allowance is necessary for our deferred tax asset. In performing this analysis, management considers all evidence currently available, both positive and negative, in determining whether, based on the weight of that evidence, the deferred tax asset will be realized. A valuation allowance is established when it is more likely than not that a recorded tax benefit is not expected to be realized. The expense to create the tax valuation allowance is recorded as additional income tax expense in the period the tax valuation allowance is established. In arriving at the conclusion that a valuation allowance was not necessary at December 31, 2009 management considered the Company’s three year cumulative earnings history for 2007 through 2009 on both an unadjusted basis and after adjustment for unusual items of income or expense that are not expected to recur. Management also considered projections of future levels of taxable income. The valuation allowance estimate is highly dependent on projections of future levels of taxable income. Should the actual amount of taxable income be less than what has been projected, it may be necessary to record a valuation allowance in a future period.
OTTI of Investment Securities
In April 2009, the FASB amended existing guidance for determining whether impairment is other-than-temporary for debt securities. The guidance requires an entity to assess whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of these criteria is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to other factors, which is recognized in other comprehensive income and 2) OTTI related to credit loss, which must be recognized in the statement of operations. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. (See also Note 2 to the Consolidated Financial Statements - Investment Securities.)
In the first quarter of 2009, a $4.0 million OTTI charge was recorded on one $10 million par value trust preferred collateralized debt obligation (“CDO”) that had previously incurred a non-cash OTTI write down of $5.2 million in the fourth quarter of 2008. Management determined that it intended to sell this bond and continued to review developments and other considerations with respect to this trust preferred CDO, including the limited prospects for its ultimate price recovery, the expected time involved and the downside risks involved in continuing to hold this investment. As a result of this review and with some limited liquidity appearing in the trust preferred CDO market, management determined that an immediate liquidation was appropriate. As a result, the bond was liquidated in July 2009 at a price of 13.45% of par representing a gain of 5.2% of par or $520 thousand which was recognized in the Company’s third quarter 2009 financial statements.
Recognition of Contingent Liabilities
The Company and the Bank are subject to proceedings and claims that arise in the normal course of business. Management assesses the likelihood of any adverse outcomes to these matters as well as potential ranges of probable losses. There can be no assurance that actual outcomes will not differ from those assessments. A liability is recognized in the Company’s consolidated balance sheets if such liability is both probable and estimable.
Results of Operations and Financial Condition
Net Interest Income
Distribution of Assets, Liabilities and Stockholders’ Equity: Net Interest Income and Rates
The following table presents the average daily balances of the Company’s assets, liabilities and stockholders’ equity, together with an analysis of net interest earnings and average rates, for each major category of interest-earning assets and interest-bearing liabilities. Interest and average rates are computed on a fully taxable-equivalent basis, adjusted for certain disallowed interest expense deductions, using a tax rate of 34%. Non-accrual loans and leases are included in the average balances (dollars in thousands):
Analysis of Changes in Net Interest Income
The following table presents a comparative analysis of the changes in the Company’s interest income and interest expense due to the changes in the average volume and the average rates earned on interest-earning assets and due to the changes in the average volume and the
average rates paid on interest-bearing liabilities. Interest and average rates are computed on a fully taxable-equivalent basis, adjusted for certain disallowed interest expense deductions, using a tax rate of 34%. Variances in rate/volume relationships have been allocated proportionately to the amount of change in average volume and average rate (in thousands):
2009 versus 2008
Net interest income, the difference between interest earned on loans and investments, and interest paid on deposits and borrowed funds, is the Company’s primary source of operating earnings. Net interest income is influenced by the average balance and mix of the Company’s interest-earning assets, the yield on those assets and the current level of market interest rates. Additionally, the term structure of interest rates, or yield curve, also impacts the Company’s ability to generate net interest income. These rates are significantly influenced by the actions of the FOMC, which periodically adjusts the federal funds rate, the rate at which banks borrow from one another on an overnight basis. During 2009 the FOMC kept the federal funds target rate at historically low levels.
During 2009, interest income declined by $13.5 million, or 13%. This was almost entirely due to a reduction in the yield on average interest-earning assets from 5.99% in 2008 to 5.07% during 2009. The decline in the average yield reflects the continued repricing of our loan portfolio, which primarily has variable rates that adjust with changes in the market rates. Offsetting this decline was a shift in our balance sheet composition to reduce our average balance of lower yielding money market investments (average yield 0.15%) and increase our average balance of higher yielding loans (average yield 5.40%). The average money market investment balance decreased by $22 million while average loans increased by $33 million.
Interest expense decreased by $12.6 million or 44% due to a decrease in the cost of interest-bearing liabilities from 2.42% in 2008 to 1.44% in 2009, a decline of 98 basis points, reflecting the historically low interest rate environment and a reduction of higher cost borrowings. Also contributing to the reduction in interest expense was a $30 million increase in average non-interest-bearing demand deposits in 2009.
Average core deposit balances, consisting of demand, savings and money market deposits, increased by $70 million in 2009 to $951 million as compared to 2008, and provided funding at an average cost of 0.49% in 2009 versus 0.90% in 2008. These core deposit balances funded 62% and 58% of the Company’s average interest-earning assets during 2009 and 2008, respectively, and represented 68% of total average deposits in 2009 compared to 65% in 2008. Core deposit balances provide lower-cost funding that allows the Company to reduce its dependence on higher cost time deposits and borrowings.
2008 versus 2007
Net interest income during 2008 benefited from the FOMC lowering the targeted federal funds rate six times from 4.25% to an unprecedented 0.00% - 0.25%. The Company was able to lower the cost of its interest-bearing liabilities faster than the yield on its interest-earning assets declined. During 2008, interest income declined by $19.6 million, or 18%. This was almost entirely due to a reduction in the yield on average interest-earning assets from 7.01% in 2007 to 5.99% during 2008. Offsetting this decline was a shift in our balance sheet composition to reduce our average balance of lower yielding investment securities (average yield 4.99%) and increase our average balance of higher yielding loans (average yield 6.50%). The average investment portfolio decreased in size by $107 million while average loans increased by $79 million.
Interest expense decreased by $22.1 million or 44% due to a decrease in the cost of interest-bearing liabilities from 4.07% in 2007 to 2.42% in 2008, a decline of 165 basis points. To a lesser extent, the $64 million decline in total interest-bearing liabilities in 2008 as compared to 2007 also contributed to the lower interest expense.
Average core deposit balances declined by $58 million in 2008 to $881 million as compared to 2007, and provided funding at an average cost of 0.90% in 2008 versus 1.97% in 2007. These core deposit balances funded 58% and 59% of the Company’s average interest-earning assets during 2008 and 2007, respectively, and represented 65% of total average deposits in 2008 compared to 66% in 2007.
Investment Securities
SFAS No. 115 requires the Company, at the time of purchase, to designate each investment security as either “available for sale” (“AFS”), “held to maturity” or “trading,” depending upon investment objectives, liquidity needs and ultimate intent. AFS securities are stated at market value, with unrealized gains or losses reported as a separate component of stockholders’ equity, net of taxes, until realized. Securities held to maturity are stated at cost, adjusted for amortization of premium or accretion of discount, if any. Trading securities are generally purchased with the intent of capitalizing on perceived short-term price inefficiencies by selling them in the near term. The Company did not hold any held-to-maturity or trading securities at December 31, 2009 and 2008.
At December 31, 2009, the Company’s $416 million investment portfolio consisted only of AFS securities which had an unrealized positive pre-tax mark to fair value of $10.5 million versus an unrealized net gain of $7.5 million at year-end 2008. At year-end 2009, the AFS portfolio was divided into the following categories: 90% mortgage-backed securities (“MBS”) (FNMA, FHLMC, and GNMA obligations); 5% U.S. Government Agency securities; 3% tax-exempt municipal paper; and 2% corporate and other securities.
Continued turbulence in the capital markets, resulting from the ongoing financial crisis, perpetuated a challenging investment climate during 2009. A continued slowdown in macroeconomic conditions made those challenges even greater. The overall level of interest rates remained low as recessionary expectations were present during the year. Presented with difficult bond market conditions throughout most of the year, our portfolio was maintained with the objective of generating cash flow to be redeployed opportunistically in a rising rate environment.
The Company’s investment policy is conservative in nature and identifies liquidity and safety as being of paramount importance among its objectives and, as such, the portfolio is largely comprised of MBS issues of Government-sponsored enterprises, U.S. Government Agency securities, and local municipal notes. In addition to the creation of liquidity, risk management is another important aspect of the Company’s investment strategy. The Company’s portfolio composition is designed to provide liquidity while managing market risk and avoiding credit risk. Market risk can be defined as the sensitivity of the portfolio’s market value to changes in the level of interest rates, and is managed, primarily, by investing in securities with shorter durations. A security with a shorter duration is preferred to one with a longer duration in a rising rate environment because the market value of a security with a longer duration has a greater sensitivity to changes in interest rates.
Security selection is governed by the Company’s investment policy, and serves to supplement the Company’s asset/liability position. Securities such as premium fixed rate MBS and hybrid adjustable rate MBS with an anticipated short average life were purchased during the past year with the intention of producing cash flow, as well as limiting the sensitivity of the portfolio’s market value. In addition to targeting a short average life, the securities purchased provide incremental yield due to the prepayment activity inherent in MBS and the tendency for yields on callable bonds to be higher than those on non-callable securities because the investor must be rewarded for taking the risk the issuer will call the bond. Cash flow from the portfolio increases in a lower interest rate environment and moderately extends in a higher interest rate environment. Our strategy for this portfolio, with a continuing emphasis on liquidity and risk management, is expected to continue for the foreseeable future.
The Company’s investment portfolio has relatively low credit risk due to its concentration of MBS issued by U.S. Government-sponsored enterprises. The Company’s investment portfolio increased by $4 million at year-end 2009 versus the comparable 2008 date primarily as the result of net increases of $3 million and $1 million in MBS and other securities, respectively.
As of December 31, 2009, the MBS portfolio had an estimated weighted average life of approximately 3.4 years after adjusting for historical prepayment patterns. Approximately 91% of the MBS portfolio, including collateralized mortgage obligations (“CMOs”), had final maturities in excess of ten years. In general, principal prepayments on these securities will slow as interest rates rise and, conversely, prepayments will increase as interest rates fall. However, the turmoil being experienced in the mortgage industry has interrupted the historical relationship between low rates and prepayments. The recent comparative lack of liquidity in the market has constrained the amount of funds available to fund new mortgages. The Company received MBS principal paydowns of $96 million and $65 million in 2009 and 2008, respectively.
The U.S. Government Agency portfolio has remaining final maturities ranging from ten months to fifteen years. The notes are AAA - rated credits that provide a competitive yield. The U.S. Government Agency issues that are callable have call periods within one year and final maturities of less than fifteen years. As a natural outgrowth of its municipal business, the Company purchases local, short-term municipal paper that is also sold throughout the year as part of the Company’s asset/liability management strategy.
MBS, U.S. Government Agency, and local municipal securities portfolios are eligible to pledge to secure municipal deposits and other borrowings and, therefore, are an integral part of the Company’s funding strategy.
There is no subprime exposure in the Company’s securities portfolio. All of the mortgage-backed securities and collateralized mortgage obligations held in the Company’s portfolio are issued by U.S. Government agency and sponsored enterprises.
In the first quarter of 2009, a $4.0 million OTTI charge was recorded on one $10 million par value trust preferred CDO that had previously incurred a non-cash OTTI write down of $5.2 million in the fourth quarter of 2008. Management determined that it intended to sell this bond and continued to review developments and other considerations with respect to this trust preferred CDO, including the limited prospects for its ultimate price recovery, the expected time involved and the downside risks involved in continuing to hold this investment. As a result of this review and with some limited liquidity appearing in the trust preferred CDO market, management determined that an immediate liquidation was appropriate. As a result, the bond was liquidated in July 2009 at a price of 13.45% of par representing a gain of 5.2% of par or $520,000 which was recognized in the Company’s third quarter 2009 financial statements.
Summary of Loan and Lease Loss Experience and Allowance for Loan and Lease Losses
One of management’s primary objectives is to maintain a high-quality loan and lease portfolio in all economic climates. We maintain high underwriting standards coupled with a regular evaluation of each borrower’s creditworthiness and risk exposure. Management seeks to avoid concentrations within industries and customer segments in order to minimize credit exposure. The Company’s senior lending personnel work in conjunction with loan officers to determine the level of risk in the Company’s loan and lease-related assets and establish an adequate level for the allowance for loan and lease losses. The Company utilizes an outside loan review organization to independently verify the loan classifications and the adequacy of the allowance for loan and lease losses. Management actively seeks to reduce the level of non-performing assets, defined as non-accrual loans and leases, loans and leases 90 days or more past due and still accruing interest and other real estate owned (“OREO”), through aggressive sale, collection and workout efforts and, where necessary, litigation and charge-off.
As illustrated in Table I below, the Company’s non-accrual loans and leases totaled $7 million (which includes less than $1 million in loans held for sale which have been previously written down to their estimated fair value) at December 31, 2009, $16 million (which includes $2 million in
loans held for sale) at December 31, 2008 and $6 million at December 31, 2007. The reduction in non-accrual loans and leases at December 31, 2009 compared to December 31, 2008 resulted primarily from payments received and charge-offs of $4 million and $8 million, respectively, on four commercial real estate relationships as well as the combined impact of additions to non-accrual loans throughout the year and the disposition of problem loans and other charge-offs and write-downs in the fourth quarter of 2009. If the sale of lower quality loans in the fourth quarter of 2009 had not occurred, our non-accrual loans at December 31, 2009 would have been at a level similar to our non-accrual loans of $35 million at September 30, 2009. At December 31, 2009, December 31, 2008 and December 31, 2007 the Company held no OREO. At December 31, 2009, there was one loan, a residential mortgage with a principal balance of $436 thousand, restructured and still accruing interest. At December 31, 2008 and 2007, there were no restructured loans and leases still accruing interest. At December 31, 2009, 2008 and 2007, loans and leases 90 days or more past due and still accruing interest totaled $4 million, $3 thousand and $28 thousand, respectively. The Company has no foreign loans outstanding.
(1) Excluding loans held for sale.
The provision for loan and lease losses is based on management’s continual assessment of the adequacy of the allowance for loan and lease losses. The provision for loan and lease losses totaled $39.5 million in 2009, $17.2 million in 2008 and $4.5 million in 2007. The allowance for loan and lease losses amounted to $29 million or 2.6% of total loans and leases, excluding loans held for sale, at December 31, 2009, $19 million or 1.7% of total loans and leases, excluding loans held for sale, at December 31, 2008, and $15 million or 1.4% of total loans and leases at December 31, 2007. The increases in the allowance as a percentage of the total loan and lease portfolio at December 31, 2009 compared to December 31, 2008 and at December 31, 2008 compared to December 31, 2007 were due to increases in the provision for loan
losses related to an increase in watch list loans (see “Watch List summary” table contained herein) and charge-offs for the liquidation of problem loans in 2009, and higher non-accrual and impaired loans in 2008, respectively. Loans held for sale have been previously written down to their estimated fair value and any future losses on such loans would not impact the allowance for loan and lease losses. The allowance for loan and lease losses as a percentage of non-accrual loans and leases, excluding loans held for sale, increased to 474% at December 31, 2009 from 134% at December 31, 2008 and 254% at December 31, 2007, caused primarily by the decrease in non-accrual loans and leases at year-end 2009 and the increased provision for loan and lease losses as previously noted. Net loan and lease charge-offs recorded in 2009 were $29.5 million compared to $11.3 million in 2008 and $6.2 million in 2007. Management has determined that the current level of the allowance for loan and lease losses is adequate in relation to the probable inherent losses present in the portfolio. Management considers many factors in this analysis, among them credit risk grades assigned to commercial and industrial and commercial real estate loans, delinquency trends, concentrations within segments of the loan and lease portfolio, recent charge-off experience, local and national economic conditions, current real estate market conditions in geographic areas where the Company’s loans and leases are located, changes in the trend of non-performing loans and leases, changes in interest rates, and loan and lease portfolio growth. Changes in one or a combination of these factors may adversely affect the Company’s loan and lease portfolio resulting in increased delinquencies, loan and lease losses and future levels of loan and lease loss provisions. Due to these uncertainties, management expects to record loan charge-offs in future periods. See also “Critical Accounting Policies, Judgments and Estimates” contained herein.
TOTAL NON-ACCRUAL LOANS (1) AND THE ALLOWANCE
FOR LOAN AND LEASE LOSSES
(1) Excluding loans held for sale.
Loans to borrowers which the Bank has identified as requiring special attention (such as a result of changes affecting the borrower’s industry, management, financial condition or other concerns) will be added to the Company’s watch list as well as loans which are criticized or classified by bank regulators or loan review auditors. The majority of such watch list loans were originated as residential construction, commercial real estate or commercial and industrial loans. In some cases, additional collateral in the form of commercial real estate was taken based on current valuations. Thus, there exists a broad base of collateral with a mix of various types of corporate assets including inventory, receivables and equipment, and commercial real estate, with no particular concentration in any one type of collateral.
(1) Excluding loans held for sale.
As a result of management’s ongoing review and assessment of the Bank’s policies and procedures, the Company has adopted a more aggressive workout and disposition posture for watch list relationships. The Company has workout specialists who are directly responsible for managing this process and exiting such relationships in an expedited and cost effective manner. Line officers generally do not maintain control over classified watch list relationships. It is anticipated that management will use a variety of strategies, depending on individual case circumstances, to exit relationships where the fundamental credit quality shows indications of more than temporary or seasonal deterioration. We cannot give any assurance that such strategies will enable us to exit such relationships especially in light of recent credit market conditions.
The provision for loan and lease losses is continually evaluated relative to portfolio risk and regulatory guidelines considering all economic factors that affect the loan and lease loss allowance, such as fluctuations in the Long Island and New York City real estate markets and interest rates, economic slowdowns in industries and other uncertainties. All of the factors mentioned above will continue to be closely monitored. The concentration of loans exceeding 10% of total loans was the Bank’s loans totaling $387 million to real estate operators, lessors and developers.
Other Income
2009 versus 2008
Other income increased by $1.1 million in 2009 when compared to 2008, largely as a result of a $2.2 million reduction in non-cash OTTI charges coupled with a $947 thousand increase in net gains on the sales of securities in 2009. Partially offsetting these improvements was a decrease in other operating income of $1.8 million, due to income of $1.1 million recorded on certain customer interest rate swaps in 2008 versus losses of $38 thousand recorded in 2009 coupled with reductions in sweep program fees of $634 thousand. In 2008, the Company recorded a gain of $1.1 million related to the change in value of the customer swaps that were formerly offset with Lehman Special
Financing (see “Off-Balance Sheet Arrangements”). Also offsetting the aforementioned improvements, in part, was lower income from bank owned life insurance of $197 thousand in 2009 versus 2008.
2008 versus 2007
Other income decreased by $5.0 million in 2008 when compared to 2007, largely as a result of $6.2 million in OTTI charges on two investment securities in the fourth quarter of 2008 (see “Investment Securities” contained herein). This compares to $219 thousand in net security losses in 2007 primarily due to sales of mortgage-backed securities. Somewhat offsetting the OTTI charges was an improvement in other operating income in 2008.
Other operating income improved by $1.0 million, or 43.3%, in 2008 as compared to 2007. Growth in several categories accounted for the improvement, principally an increase of $1.1 million in financial products (customer swap) gains.
Operating Expenses
2009 versus 2008
Total operating expenses increased by $4.8 million to $48.5 million in 2009 versus 2008. This increase resulted primarily from higher credit and collection expenses of $4.1 million and a $2.8 million increase in FDIC and NYS assessment expenses. Also contributing to the increase was higher expenses for salaries and other employee benefits of $493 thousand. Partially offsetting these increases were declines in legal expenses of $2.3 million, other operating expenses of $145 thousand, equipment expenses of $90 thousand, marketing and advertising expenses of $37 thousand and occupancy expenses of $34 thousand.
The Company’s primary expense control measure is the operating efficiency ratio. The operating efficiency ratios for the Company were 72.4% in 2009 and 62.5% in 2008. The increase in 2009 was due to growth in operating expenses due largely to $4.0 million in write-downs of loans held for sale in 2009 to their estimated fair value coupled with a lower level of operating revenue. Management expects that the operating efficiency ratio will improve in 2010 as a result of projected operating revenue growth, coupled with a projected nominal decrease in the Company’s operating expenses.
As noted in the table above, salaries and other employee benefits increased by $493 thousand or 2.2% to $23.4 million. The increase is due principally to higher expenses for long-term equity and incentive-based compensation offset, in part, by lower ESOP and 401(k) contribution expenses.
Occupancy costs decreased by $34 thousand or 1% to $5.9 million in 2009 as the result of lower expenses for rent and depreciation. These decreases were partially offset by higher maintenance and repair costs.
Equipment expenses decreased by $90 thousand to $1.2 million or 6.8% in 2009 as compared to 2008. The decline in equipment expenses is due primarily to a reduction in Company owned vehicles during 2009 and 2008.
Legal expenses decreased by $2.3 million or 75% to $784 thousand in 2009 due primarily to the settlement of the shareholder derivative lawsuit in 2008.
Marketing and advertising costs decreased by $37 thousand or 4.6% to $775 thousand in 2009 versus 2008 due mainly to the Company’s media selection efficiencies.
FDIC and NYS assessment expenses increased by $2.8 million to $3.6 million in 2009 versus 2008 as a result of higher FDIC insurance premiums, additional deposit programs and the FDIC special assessment of $730 thousand recorded in the second quarter of 2009.
Credit and collection expenses increased by $4.1 million to $5.2 million during 2009. The increase is due primarily from $4.0 million in write-downs of loans held for sale in 2009 to their estimated fair value.
Other operating expenses decreased by $145 thousand or 1.9% to $7.6 million in 2009 versus 2008. This decline resulted primarily from decreases in several expense categories, most notably a reduction in operating expenses associated with the Company’s former leasing subsidiary and director compensation costs. Somewhat offsetting these expense reductions were increases in computer maintenance and software fees.
2008 versus 2007
Total operating expenses decreased by $8.2 million to $43.8 million in 2008 versus 2007. A $7.5 million reduction in salaries and benefits expense accounted for a substantial portion of the decrease in operating expenses. Also contributing to the decline in operating expenses was a goodwill impairment charge of $2.4 million taken in 2007 and a $445 thousand reduction in marketing and advertising expenses. Somewhat offsetting these reductions in total operating expenses were increases in occupancy expenses of $535 thousand, audit and assessment fees of $425 thousand, legal expenses of $377 thousand, credit and collection fees of $156 thousand and other operating expenses of $736 thousand.
Salaries and other employee benefits decreased by $7.5 million or 24.7% during 2008. The decrease resulted primarily from a reduction in staff and a significant decline in compensation expense, coupled with the impact of the $3.1 million charge recorded in 2007 for the Voluntary Exit Window program. Also contributing to the decrease in salaries and other employee benefits were lower expenses incurred for FICA and employee health insurance in 2008.
Occupancy costs increased to $5.9 million or 9.9% in 2008 versus 2007 as the result of higher costs recorded for depreciation, rent, real estate taxes, and utilities. Equipment expenses decreased by 2.3% or $31 thousand in 2008 as compared to 2007.
Legal expenses were higher by $377 thousand or 13.8% due principally to outside counsel fees incurred related to the purported shareholder derivative lawsuit which was settled in 2008.
Marketing and advertising costs decreased by 35.4% to $812 thousand in 2008 versus 2007 due principally to reductions in print, broadcast and other media advertising.
Credit and collection costs increased by 17.3% to $1.1 million in 2008. This increase is due primarily to higher loan collection and related legal costs in 2008 resulting from an increase in non-performing loans. Offsetting some of these increased costs was a decline in credit-related expenses due to a continued reduction in lending activity during 2008 in the Company’s residential mortgage and home equity line of credit products.
Audit and assessment fees increased by $425 thousand to $1.7 million in 2008 versus 2007 as a result of higher FDIC deposit insurance costs. The additional cost for FDIC insurance incurred by the Company is due to higher premiums in 2008 combined with the impact of a higher assessment credit recorded in 2007.
Other operating expenses increased by 11.8% to $7.0 million in 2008. This increase is due principally to a non-recurring charge of $584 thousand recorded in 2008 related to the Bank’s interest rate swap transactions.
Effective Income Tax Rate
2009 versus 2008 and 2007
An income tax benefit of ($9.6 million) was recorded in 2009 as compared to an income tax provision of $451 thousand in 2008 and an income tax provision of $2.9 million in 2007. The Company’s overall effective tax rate was (39.3%), 20.0% and 32.0% in 2009, 2008 and 2007, respectively. The change in the 2009 effective tax rate was primary due to the pretax loss of $24 million compared to 2008 pretax income of $2 million. In addition, both the 2009 pretax loss and the 2008 pretax income were adjusted for permanent items such as BOLI, tax-exempt interest and ESOP dividends.
The Company is currently subject to a statutory incremental Federal tax rate of 35% (34% for the first $10 million of taxable income). The Company pays taxes to the New York State Department of Taxation and Finance (NYS) on the highest of four bases: a tax of .01% on allocated combined taxable assets. The Company also pays taxes to the New York City Department of Finance of 9.0% on allocated entire net income. In addition, the Company paid taxes to various other states which are not material to its consolidated financial condition or results of operations.
In December 2007, the Company executed tax closing agreements with NYS and local taxation authorities which constituted a final and conclusive settlement of the previously reported audit covering the 1999-2006 period. The final settlement was for an amount less than the reserve previously accrued in the fourth quarter of 2006 and resulted in a reduction of the Company’s 2007 provision for income taxes and the resulting effective tax rate. The effective tax rate in 2007 was impacted negatively by the non-deductible $2.4 million non-cash goodwill impairment accounting charge.
Off-Balance Sheet Arrangements
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. These financial instruments include commitments to extend credit and standby and documentary letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated financial statements. The Bank uses the same credit policies in making commitments and conditional obligations 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 generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the customer. Collateral required varies, but may include accounts receivable, inventory, equipment, real estate and income-producing commercial properties. At December 31, 2009 and 2008, commitments to originate loans and leases and commitments under unused lines of credit for which the Bank is obligated amounted to $232 million and $263 million, respectively. Of these commitments, $195 million and $213 million were at variable rates and $37 million and $50 million were at fixed rates, including LIBOR-based loans, at December 31, 2009 and 2008, respectively. At December 31, 2009 and 2008, the fixed rate commitments had interest rates ranging from 2.30% to 7.23% and 2.40% to 8.92%, respectively.
Letters of credit are conditional commitments guaranteeing payments of drafts in accordance with the terms of the letter of credit agreements. Commercial letters of credit are used primarily to facilitate trade or commerce and are also issued to support public and private borrowing arrangements, bond financing and similar transactions. Collateral may be required to support letters of credit based upon management’s evaluation of the creditworthiness of each customer. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan and lease facilities to customers. Most letters of credit expire within one year. At December 31, 2009 and 2008, the Bank had letters of credit outstanding of approximately $15 million and $17 million, respectively. At December 31, 2009, the uncollateralized portion was approximately $3 million.
The use of derivative financial instruments, i.e. interest rate swaps, is an exposure to credit risk. This credit exposure relates to possible losses that would be recognized if the counterparties fail to perform their obligations under the contracts. To mitigate this credit exposure, only counterparties of good credit standing are utilized and the exchange of collateral over a certain credit threshold is required. From time to time, customer interest rate swap transactions together with offsetting interest rate swap transactions with institutional dealers may be executed. At December 31, 2009 and 2008, the total gross notional amount of swap transactions outstanding was $37 million and $28 million, respectively.
In 2008 Lehman and Lehman Special Financing filed Voluntary Petitions under Chapter 11 of the U.S. Bankruptcy Code, each of which constituted an event of default under the swap agreements the Bank had with Lehman Special Financing. As a result of the events of default, the Bank terminated the interest rate swap agreements with Lehman Special Financing. The terminations resulted in several customer interest rate swap transactions no longer being offset by that institutional dealer and a loss to the Company on those swap agreements of approximately $584 thousand was recorded in the third quarter of 2008. During the third quarter of 2009, the Company recorded a gain of $221 thousand on the sale of its claims against Lehman and Lehman Special Financing.
In addition, during the second and third quarters of 2009, the unhedged customer interest rate swap transactions were once again offset by an institutional dealer. As all customer interest rate swap transactions are now hedged, we expect that their future impact on the Company’s financial statements will be immaterial. For the year ended December 31, 2009, a net loss of $38 thousand was recognized. The 2009 amount includes the gain of $221 thousand on the sale of the Bank’s claims against Lehman and Lehman Special Financing. For the year ended December 31, 2008, a net gain of $1.1 million related to the change in value of the customer swaps that were formerly offset with Lehman Special Financing was recognized. For the year ended December 31, 2007, neither income nor losses associated with interest rate swap transactions were material to the financial statements.
In 2005, the Bank terminated two interest rate swap agreements that hedged a portion of the interest rate variability in its portfolio of prime rate loans in support of enhancing its interest rate sensitivity position. The entire cost to unwind the swap agreements was fully amortized at December 31, 2007, and thus no expenses were recognized during the year ended December 31, 2008. For the year ended December 31, 2007, the Company recognized $300 thousand of such expenses.
The Company is also obligated under various leases covering certain equipment, branches, office space and the land on which its head office is built. The minimum payments under these leases, certain of which contain escalation clauses, are as follows: in 2010, $3.2 million; in 2011, $2.9 million; in 2012, $1.7 million; in 2013, $1.3 million; in 2014, $1.3 million; and the remainder to 2020, $5.0 million.
Capital Resources
The Company strives to maintain an efficient level of capital, commensurate with its risk profile, on which a competitive rate of return to stockholders will be realized over both the short and long term. Capital is managed to enhance stockholder value while providing flexibility for management to act opportunistically in a changing marketplace. In determining an optimal capital level the Company also considers the capital levels of its peers and the evaluations of its primary regulators. Management continually evaluates the Company’s capital position in light of current and future growth objectives and regulatory guidelines.
On December 5, 2008, the Company issued to the Treasury for aggregate consideration of $36,842,000 (i) 36,842 shares of Series A Preferred Stock and (ii) Warrant to purchase 465,569 shares of the Company’s common stock at $11.87 per share. Such securities were issued pursuant to a letter agreement dated December 5, 2008 and the Securities Purchase Agreement - Standard Terms (“Securities Purchase Agreement”) attached thereto between the Company and the Treasury. This increase in capital has allowed the Company to reinforce its commitment to serve the credit needs of our clients and the communities in which we operate. The Company contributed $34 million of this capital to its Bank subsidiary in December 2008.
Total stockholders’ equity amounted to $149 million at December 31, 2009 and $154 million at December 31, 2008, largely reflecting the net loss recorded for the year ended December 31, 2009. Substantially offsetting the 2009 net loss was an increase in equity recorded as a result of the December 2009 exchange of the Company’s $10 million, 8.25% subordinated notes for an aggregate of 1,656,600 shares of common stock. Each share of common stock in the exchange was valued at $6.50. The balance of the change in stockholders’ equity in 2009 can be attributed to an increase in other comprehensive income and stockholder dividend reinvestment. Internal capital generation, defined as earnings less cash dividends paid on common and preferred stock, is the primary catalyst expected to support the Company’s future growth of assets and stockholder value. Management continually evaluates the Company’s capital position in light of current and future growth objectives and regulatory guidelines.
As a participant in the Treasury CPP, the Company is subject to certain restrictions regarding dividend payments, stock repurchases and executive compensation. The Treasury’s consent is required for any increase in common dividends per share that is greater than the amount of the last quarterly cash dividend declared prior to October 14, 2008, and any repurchases of common stock until the earlier of a redemption or December 5, 2011. Furthermore, the ARRA prohibits the payment or accrual of any bonus, retention award or incentive compensation to, in the Company’s case, the five (5) most highly-compensated employees. This prohibition does not apply to the granting of restricted stock, provided that the stock does not fully vest during the time the Treasury owns any debt or equity acquired under the CPP (unless the only securities outstanding are warrants acquired under the CPP) and the amount of restricted stock granted does not have a value greater than one-third of the total annual compensation of the recipient. The ARRA also prohibits the payment of any severance or payment to any named executive officer (“NEO”) or any of the next five (5) most highly-compensated employees for departure from the Company for any reason except for payments relating to services already performed or benefits previously accrued. In addition, under ARRA, any bonus payment made to the twenty (20) most highly compensated employees of the Company is subject to recovery by the Company if the bonus payment was based on materially inaccurate financial statements or any other materially inaccurate performance metric criteria. On June 15, 2009, the Treasury issued an Interim Final Rule to provide guidance on the executive compensation provisions under ARRA. The Interim Final Rule clarified that any payments made in connection with a change in control of the Company will be prohibited golden parachute payments. Under the Interim Final Rule, a golden parachute payment is treated as paid at the time of departure or change in control and may include a right to amounts actually payable after the TARP period. In addition, the Interim Final Rule clarifies that in addition to payments for services performed or benefits accrued, (i) payments under tax-qualified retirement plans, (ii) payments made due to the employee’s death or disability and (iii) severance or similar payments required to be made pursuant to a state statute or foreign law are excluded from prohibited payments. The Treasury has the ability to make unilateral, retroactive changes to the Securities Purchase Agreement which governs the sale of the Series A Preferred Stock to the Treasury.
The Series A Preferred Stock qualifies as Tier 1 capital for bank regulatory purposes and pays cumulative dividends at a rate of 5% per annum for the first five years, and 9% per annum thereafter. When originally issued, the Series A Preferred Stock could be redeemed by the Company after three years or, prior to the end of three years, only with the proceeds from a qualified equity offering. After three years, the Company could, at its option, redeem the Series A Preferred Stock at par value plus accrued and unpaid dividends. However, pursuant to the ARRA, which was signed into law on February 17, 2009, subject to the approval by the Treasury and the Company’s federal regulator, the Company may repay any assistance provided under TARP without regard to whether the Company has replaced such funds from any other source or to any waiting period. The Series A Preferred Stock is generally non-voting.
The Warrant has a 10-year term and is immediately exercisable at an exercise price equal to $11.87 per share of the common stock. The Warrant provides for the adjustment of the exercise price and the number of shares of the Company’s common stock issuable upon exercise pursuant to customary anti-dilution provisions, such as upon stock splits or distributions of securities or other assets to holders of the Company’s common stock, and upon certain issuances of the Company’s common stock at or below a specified price relative to the initial exercise price.
The Company’s tangible common equity to tangible assets ratio was 6.93% at December 31, 2009 compared to 6.91% at December 31, 2008. The ratio of tangible common equity to tangible assets, or TCE ratio, is calculated by dividing total common stockholders’ equity by total assets, after reducing both amounts by intangible assets. The TCE ratio is not required by GAAP or by applicable bank regulatory
requirements, but is a metric used by management to evaluate the adequacy of our capital levels. Since there is no authoritative requirement to calculate the TCE ratio, our TCE ratio is not necessarily comparable to similar capital measures disclosed or used by other companies in the financial services industry. Tangible common equity and tangible assets are non-GAAP financial measures and should be considered in addition to, not as a substitute for or superior to, financial measures determined in accordance with GAAP. Set forth below is the calculation of the actual unaudited TCE ratio as of December 31, 2009, reconciliations of tangible common equity to GAAP total common stockholders’ equity and tangible assets to GAAP total assets (in thousands):
The Company and the Bank are subject to various regulatory capital requirements administered by the FRB and the FDIC. Table II summarizes the Company’s and the Bank’s capital ratios as of December 31, 2009 and compares them to minimum regulatory guidelines and December 31, 2008 and December 31, 2007 actual results. The Company’s ratios exceed the minimum regulatory guidelines, and the Bank’s ratios exceed both the minimum regulatory guidelines for a well-capitalized institution and the minimum requirements under FDICIA. Failure to meet minimum capital requirements can initiate certain actions by regulators that could have a direct effect on the Company’s and the Bank’s operations and financial statements. See “Supervision and Regulation.”
Under New York Business corporation law, the Company can only pay dividends out of surplus or in case there is no surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. The dividends may be declared and paid by the Company at any time except when the Company is then insolvent or would thereby be made insolvent.
The Company’s (parent only) primary funding sources are dividends from the Bank and proceeds from the DRP. State banking regulations limit, absent regulatory approval, the Bank’s dividends to the Company to the lesser of the Bank’s undivided profits and the Bank’s retained net income for the current year plus its retained net income for the preceding two years (less any required transfers to capital surplus) up to the date of any dividend declaration in the current calendar year. As of December 31, 2009, no dividends were available to the Company from the Bank according to these limitations without seeking regulatory approval. Additionally, under the CPP the Company must receive consent from the Treasury in order to increase its dividend on common stock to an amount that is greater than the amount of the last quarterly cash dividend declared prior to October 14, 2008. The Company’s Board declared a cash dividend of $0.05 per share at its January 26, 2010 meeting. The cash dividend will be paid on March 17, 2010 to stockholders of record on February 17, 2010. During 2009, the Company declared $2.9 million in dividends and received $381 thousand from the reinvestment of dividends by stockholders participating in the Company’s DRP.
The Company did not repurchase any shares of its common stock during 2009 under the existing stock repurchase plan. Under the Company’s current stock repurchase authorization, management may repurchase up to 512,348 additional shares if market conditions warrant. This action will only occur if management believes that the purchase will be at prices that are accretive to earnings per share and is the most efficient use of Company capital. The Treasury’s consent is also required for any repurchases of common stock until the earlier of a redemption of the Series A Preferred Stock or December 5, 2011.
At the Company’s 2009 annual meeting of stockholders, the Company’s stockholders approved an amendment to the Company’s certificate of incorporation to change the par value of the common stock to $0.01 per share from $5.00 per share. If such amendment had not been approved, and if the Company had determined that it was in the best interests of the Company to raise capital through an offering of common stock, the Company’s capital raising options may have been limited to issuance of treasury stock or preferred stock unless the sale price of the common stock was at least $5.00 per share. The par value of the Company’s common stock was changed to $0.01 per share from $5.00 per share in the second quarter of 2009, resulting in both a decrease in common stock and an increase in surplus of $77,299,566.
The Company’s two unconsolidated Delaware trust subsidiaries currently have outstanding a total of $20 million in trust preferred securities which presently qualify as Tier I capital of the Company for regulatory capital purposes. The securities each bear an interest rate tied to three-month LIBOR and are each redeemable by the Company in whole or in part after five years. The Company has the right to optionally redeem the debentures of Trust I, which bear a coupon rate of three-month LIBOR plus 345 basis points, prior to the maturity date of November 7, 2032 at par. The Company has the right to optionally redeem the debentures of Trust II, which bear a coupon rate of three-month LIBOR plus 285 basis points, prior to the maturity date of January 23, 2034 at par. The weighted average cost of all trust preferred securities outstanding was 4.12% during 2009 and 6.35% during 2008. Under the CPP, the Company must get approval from the Treasury before it can redeem any capital securities. This requirement will remain in place as long as the Series A Preferred Stock is outstanding.
The Company’s DRP allows existing stockholders to reinvest cash dividends in Company stock and/or to purchase additional shares through optional cash investments on a quarterly basis at up to a 15% discount from the current market price. During 2009 and 2008, $381 thousand and $3.0 million, respectively, were added to stockholders’ equity through plan participation in each year. Approximately 11% of the Company’s cash dividends were reinvested in 2009 under this plan, and since inception, approximately $26 million in additional equity has been added through plan participation. Management anticipates continued future growth in equity through the DRP although the rate will be slower due to the reduced cash dividend rate.
Liquidity
Liquidity management is defined as both the Company’s and the Bank’s ability to meet their financial obligations on a continuous basis without material loss or disruption of normal operations. These obligations include the withdrawal of deposits on demand or at their contractual maturity, the repayment of borrowings as they mature, funding new and existing loan commitments and the ability to take advantage of business opportunities as they arise. Asset liquidity is provided by short-term investments and the marketability of securities available for sale. The Company may also leave excess reserve balances at the FRB if the rate being paid is higher than would be available from other short-term investments. The FRB increased this rate in February 2010 and intends to use this rate as a monetary policy tool in the coming year. Liquid assets declined to $419 million at December 31, 2009 from $457 million at December 31, 2008, resulting largely from a reduction in interest earning balances at the FRB. Liquidity is also provided by the maintenance of a strong base of core deposits, maturing short-term assets including cash and due from banks, the ability to sell or pledge marketable assets and access to lines of credit and the capital markets.
Liquidity is measured and monitored daily, thereby allowing management to better understand and react to emerging balance sheet trends, including temporary mismatches with regard to sources and uses of funds. After assessing actual and projected cash flow needs,
management seeks to obtain funding at the most economical cost. These funds can be obtained by converting liquid assets to cash or by attracting new deposits or other sources of funding. Many factors affect the Company’s ability to meet liquidity needs, including variations in the markets served, loan demand, its asset/liability mix, its reputation and credit standing in its markets and general economic conditions. Borrowings and the scheduled amortization of investment securities and loans are more predictable funding sources, while non-maturity deposit flows and securities prepayments are somewhat less predictable in nature, as they are often subject to external factors beyond the control of management. Among these are changes in the local and national economies, competition from other financial institutions and changes in market interest rates.
The Company’s primary sources of funds are cash provided by deposits, proceeds from maturities and sales of securities available for sale, and cash provided by operating activities. At December 31, 2009, total deposits were $1.3 billion, a decrease of $131 million from December 31, 2008. Of the Company’s total time deposits at December 31, 2009, $276 million are scheduled to mature within the next twelve months. Based on historical experience, the Company expects to be able to replace a substantial portion of those maturing deposits. During 2009 and 2008, proceeds from sales and maturities of securities available for sale totaled $238 million and $258 million, respectively. Additionally, in March 2009 the Bank issued $29 million in senior unsecured debt guaranteed by the FDIC under the TLGP. These funds mature in March 2012.
The Company’s primary uses of funds are for the origination of loans and the purchase of investment securities. For the years ended December 31, 2009 and 2008, the Company had an increase in loans (net of unearned income, principal paydowns and other dispositions, and before allowance for loan and lease losses) totaling $25 million and $103 million, respectively. The Company did not purchase any loans in 2009 or 2008. The Company purchased securities available for sale totaling $244 million and $259 million in 2009 and 2008, respectively. To support the Company’s municipal banking business, certain short-term tax-exempt securities are purchased and often sold prior to maturity. In 2009 these purchases, and subsequent sales, amounted to $16 million.
In 2004, the Bank purchased $25 million in Bank Owned Life Insurance (BOLI). The Bank is the beneficiary of this policy that insures the lives of certain current and former senior officers of the Bank and its subsidiaries. Distributions are made to the Bank only upon the death of an insured officer in accordance with the underlying policy. Accordingly, the BOLI held by the Bank does not generate regular cash flows for reinvestment.
The Asset/Liability Committee of the Board of Directors (the “ALCO”) is responsible for oversight of the liquidity position and the asset/liability structure. The Board has delegated authority to management to establish specific policies and operating procedures governing liquidity levels and develop plans to address future and current liquidity needs. Management monitors the rates and cash flows from the loan and investment portfolios while also examining the maturity structure and volatility characteristics of liabilities to develop an optimum asset/liability mix. Available funding sources include retail, commercial and municipal deposits, purchased liabilities and stockholders’ equity. At December 31, 2009, access to approximately $148 million in FHLB lines of credit for overnight or term borrowings with maturities of up to thirty years was available. At December 31, 2009, approximately $81 million and $5 million in unsecured and secured lines of credit, respectively, extended by correspondent banks were also available to be utilized, if needed, for short-term funding purposes. At December 31, 2009, $45 million in advances were outstanding under lines of credit with the FHLB. At December 31, 2009, no funds were drawn on correspondent bank lines of credit.
To supplement its short-term borrowed funds, the Company also utilized CDARS for $53 million in short-term certificates of deposit outstanding at December 31, 2009. CDARS deposits are considered, for regulatory purposes, to be brokered deposits. These deposits were generally available at rates lower than the competitive market rates on local certificates of deposit, offered us greater flexibility and were more efficient to obtain. Notwithstanding the CDARS deposits, and pursuant to authorization limits, management may also access the traditional brokered deposit market for funding. As of December 31, 2009, $30 million in such brokered deposits were outstanding, none of which is maturing in 2010. The Bank, currently a well-capitalized depository institution, is allowed to solicit and accept, renew or roll over any brokered deposit without restriction. Should the Bank become adequately capitalized, it may accept, renew or roll over any brokered deposit only after it has applied for and been granted a waiver by the FDIC. Should the Bank become undercapitalized, it may not accept, renew, or roll over any brokered deposit. As the Company’s liquidity remains satisfactory due to its deposit base, borrowing capacity secured by liquid assets and other funding sources, management believes that existing funding sources will be adequate to meet future liquidity requirements.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Asset/Liability Management and Market Risk
The process by which financial institutions manage interest-earning assets and funding sources under different interest rate environments is called asset/liability management. The primary goal of asset/liability management is to increase net interest income within an acceptable range of overall risk tolerance. Management must ensure that liquidity, capital, interest rate and market risk are prudently managed. Asset/liability and interest rate risk management are governed by policies reviewed and approved annually by the Company’s Board of Directors. The Board has delegated responsibility for asset/liability and interest rate risk management to the ALCO. The ALCO meets quarterly and sets strategic directives that guide the day to day asset/liability management activities of the Company as well as reviewing and approving all major funding, capital and market risk management programs. The ALCO also focuses on current market conditions, balance sheet management strategies, deposit and loan pricing issues and interest rate risk measurement and mitigation.
Interest Rate Risk
Interest rate risk is the potential adverse change to earnings or capital arising from movements in interest rates. This risk can be quantified by measuring the change in net interest margin relative to changes in market rates. Reviewing repricing characteristics of interest-earning assets and interest-bearing liabilities identifies risk. The Company’s ALCO sets forth policy guidelines that limit the level of interest rate risk within specified tolerance ranges. Management must determine the appropriate level of risk, under policy guidelines, which will enable the Company to achieve its performance objectives within the confines imposed by its business objectives and the external environment within which it operates.
Interest rate risk arises from repricing risk, basis risk, yield curve risk and option risk, and is measured using financial modeling techniques including interest rate ramp and shock simulations to measure the impact of changes in interest rates on earnings for periods of up to two years. These simulations are used to determine whether corrective action may be warranted or required in order to adjust the overall interest rate risk profile of the Company. Asset and liability management strategies may also involve the use of instruments such as interest rate swaps to hedge interest rate risk. Management performs simulation analysis to assess the Company’s asset/liability position on a dynamic repricing basis using software developed by a well known industry vendor. Simulation modeling applies alternative interest rate scenarios to the Company’s balance sheet to estimate the related impact on net interest income. The use of simulation modeling assists management in its continuing efforts to achieve earnings stability in a variety of interest rate environments.
The Company’s asset/liability and interest rate risk management policy limits interest rate risk exposure to -12% and -15% of the base case net interest income for net earnings at risk at the 12-month and 24-month time horizons, respectively. Net earnings at risk is the potential adverse change in net interest income arising from up to +200 and -100 basis point changes in interest rates over a 12 month period, and measured over a 24 month time horizon. The Company’s balance sheet is held flat over the 24 month time horizon with all principal cash flows assumed to be reinvested in similar products and term points at the simulated market interest rates. In prior periods the earnings at risk was measured under a -200bp scenario. Due to the historically low interest rates at December 31, 2009, it was decided that a -200bp scenario would not be relevant. At December 31, 2009, a +300 basis point scenario was also measured.
The Company may be considered “asset sensitive” when net interest income increases in a rising interest rate environment or decreases in a falling interest rate environment. Similarly, the Company may be considered “liability sensitive” when net interest income increases in a falling interest rate environment or decreases in a rising interest rate environment.
As of December 31, 2009 and 2008, the Company’s balance sheet was considered slightly asset sensitive as a hypothetical decrease in interest rates would have minimal negative impact on the percentage change in the Company’s net interest income; whereas, a hypothetical increase in interest rates would have relatively no impact on the Company’s net interest income.
% Change in Net Interest Income
12 Month Interest Rate Changes
Basis Points
For a discussion about a recent interagency advisory regarding sound practices for managing interest rate risk, please see “Supervision and Regulation, Interest Rate Risk Management Advisory.”
Management also monitors equity value at risk as a percentage of market value of portfolio equity (“MVPE”). The Company’s MVPE is the difference between the market value of its interest-sensitive assets and the market value of its interest-sensitive liabilities. MVPE at risk is the potential adverse change in the present value (market value) of total equity arising from an immediate hypothetical shock in interest rates. Management uses scenario analysis on a static basis to assess its equity value at risk by modeling MVPE under various interest rate shock scenarios.
When modeling MVPE at risk, management recognizes the high degree of subjectivity when projecting long-term cash flows and reinvestment rates, and therefore uses MVPE at risk as a relative indicator of interest rate risk. Accordingly, the Company does not set policy limits over MVPE at risk.
As of December 31, 2009 and 2008, the variability in the Company’s MVPE after an immediate hypothetical shock in interest rates of + 200 and -100 basis points was low. The small changes in the percentage change in MVPE and the MVPE Ratio was attributable to the low interest rate environment at December 31, 2009, and its hypothetical impact on the market value of the Company’s investment assets and lower cost core deposits.
MVPE Variability
Immediate Interest Rate Shocks
Basis Points
Simulation and scenario techniques in asset/liability modeling are influenced by a number of estimates and assumptions with regard to embedded options, prepayment behaviors, pricing strategies and cash flows. Such assumptions and estimates are inherently uncertain and, as a consequence, simulation and scenario output will neither precisely estimate the level of, or the changes in, net interest income and MVPE, respectively.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Independent Registered Public Accounting Firm
Board of Directors and Stockholders
State Bancorp, Inc.
Jericho, New York
We have audited the accompanying consolidated balance sheets of State Bancorp, Inc. as of December 31, 2009 and 2008, and the related consolidated statements of operations, cash flows, and changes in stockholders’ equity and comprehensive income (loss) for each of the three years in the three-year period ended December 31, 2009. We also have audited State Bancorp Inc.’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). State 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, included in the accompanying Management’s Report on Internal Control Over Financial Reporting (Item 9A). Our responsibility is to express an opinion on these financial statements and an opinion on 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 audits 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 audits of the 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, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
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 State Bancorp Inc. as of December 31, 2009 and 2008, and the results of its operations and its cash flows for each of the three years in the three-year period ended December 31, 2009 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, State Bancorp Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Crowe Horwath LLP
Livingston, New Jersey
March 12, 2010
CONSOLIDATED BALANCE SHEETS
See Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF OPERATIONS
See Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS)
For the Years Ended December 31, 2009, 2008 and 2007
(1) Unrealized gains (losses) on securities available for sale, net of taxes of $2,450,248, ($2,594) and ($19,293) in 2007, 2008 and 2009, respectively. In 2009 under adoption of OTTI guidance, there were no changes in unrealized gains (losses) on securities for which a portion of an other-than-temporary impairment has been recognized in earnings.
(2) Adjustment for (gains) losses included in net income, net of taxes of ($83,221), ($2,443,792) and ($1,193,156) in 2007, 2008 and 2009, respectively.
(3) Net of taxes of $119,880.
See Notes to Consolidated Financial Statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Summary of Significant Accounting and Reporting Policies
Organization and Nature of Operations - The consolidated financial statements include the accounts of State Bancorp, Inc. and its wholly owned subsidiary, State Bank of Long Island (the “Bank”). The Bank’s consolidated financial statements include the accounts of its wholly owned subsidiaries, SB Portfolio Management Corp. (“SB Portfolio”), SB Financial Services Corp. (“SB Financial”), SB ORE Corp., SB Equipment Leasing Corp., formerly known as Studebaker-Worthington Leasing Corp., (“SB Equipment”) and New Hyde Park Leasing Corporation and its subsidiary, P.W.B. Realty, L.L.C. SB Portfolio is a fixed income portfolio management subsidiary that currently has no assets under management. On June 2, 2008, the Bank completed the previously announced sale of substantially all of the assets of its leasing subsidiary, SB Equipment. SB Equipment and SB Financial were dissolved on December 29, 2008. State Bancorp, Inc. and subsidiaries are collectively referred to hereafter as the “Company.” All intercompany accounts and transactions have been eliminated.
Use of Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the reporting periods. Actual results could differ from those estimates. The allowance for loan and lease losses, fair values of financial instruments, accounting for income taxes and other-than-temporary impairment of investment securities are particularly subject to change.
Securities Held to Maturity and Securities Available for Sale - At the time of purchase of a security, the Bank designates the security as either available for sale or held to maturity, depending upon investment objectives, liquidity needs and intent. Securities held to maturity are stated at cost, adjusted for premium amortized or discount accreted, if any. The Bank has the positive intent and ability to hold such securities to maturity. Securities available for sale are stated at estimated fair value. Unrealized gains and losses are excluded from income and reported net of tax as accumulated other comprehensive income (loss) as a separate component of stockholders’ equity until realized. Interest earned on investment securities is included in interest income. Realized gains and losses on the sale of securities are reported in the consolidated statements of operations and determined using the adjusted cost of the specific security sold.
Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized on the level-yield method without anticipating prepayments, except for mortgage-backed securities and collateralized mortgage obligations where prepayments are anticipated.
Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation.
Income Recognition - Interest on loans and leases is credited to income when earned. The Bank generally discontinues the accrual of interest on loans and leases whenever there is reasonable doubt that interest and/or principal will be collected, or when either principal or interest is 90 days or more past due. Income is not accrued for installment loans which are 90 days past due unless the Bank holds cash collateral. Interest received on non-accrual loans and leases is either applied against principal or reported as income, according to management’s judgment as to the collectibility of the principal.
Allowance for Loan and Lease Losses - The allowance for loan and lease losses is established through a provision for loan and lease losses charged to expense. Loans and leases are charged against the allowance when management believes that the collectibility of the principal is unlikely, while recoveries of previously charged-off loans and leases are credited to the allowance. The balance in the allowance for loan and lease losses is maintained at a level that, in the opinion of management, is sufficient to absorb probable inherent losses. To determine that level, management evaluates problem loans and leases based on the financial condition of the borrower, the value of collateral and/or guarantor support. Based upon the resultant risk categories assigned to each loan and lease and the procedures regarding impairment described below, an appropriate allowance level is determined. Management also evaluates the quality of, and changes in, the portfolio, while taking into consideration the Bank’s historical loss experience, the existing economic climate of the service area in which the Bank operates, examinations by regulatory authorities, internal reviews and other evaluations in determining the appropriate allowance balance. While management utilizes all available information to estimate the adequacy of the allowance for loan and lease losses, the ultimate collectibility of a substantial portion of the loan and lease portfolio and the need for future additions to the allowance will be based upon changes in economic conditions and other relevant factors.
Commercial loans and commercial real estate loans are considered impaired when, based on current information and events, it is probable that the Company will not be able to collect all of the principal and interest due under the contractual terms of the loan. Management considers all non-accrual loans in excess of $250 thousand for impairment. Those with balances less than $250 thousand as well as other groups of smaller-balance homogeneous loans and leases, such as consumer and residential mortgages, are collectively evaluated for impairment. Loans, for which the terms have been modified, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired.
The allowance for loan and lease losses related to loans and leases that are impaired includes reserves which are based upon the expected future cash flows, discounted at the effective interest rate, or the fair value of the underlying collateral for collateral-dependent loans or leases, or the observable market price. This evaluation is inherently subjective as it requires material estimates, including the amount and timing of future cash flows expected to be received on impaired loans and leases, which may be susceptible to significant change.
Bank Premises and Equipment - Net - Land is carried at cost. Bank premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation expense is computed on the straight-line method over the estimated useful lives of the related assets which range from 3 to 10 years for furniture and equipment and 30 years for premises and related components. Leasehold improvements are amortized over the shorter of their estimated useful lives or the remaining terms of the leases.
Loan and Lease Origination Fees and Costs - Certain loan and lease origination fees and direct origination costs are capitalized and recognized as an adjustment of the yield on the related loan or lease.
Income Taxes - The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in the Company’s financial statements or tax returns. The Company recognizes deferred tax assets and liabilities that reflect the temporary differences between the financial accounting and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Judgment is required in assessing the future tax consequences of events that have been recognized in the Company’s consolidated financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences could impact the Company’s consolidated financial condition or results of operations. As changes in tax laws and regulations are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.
A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.
Treasury Stock - Stock held in treasury by the Company is reported as a reduction to total stockholders’ equity. Treasury stock purchases are recorded at cost.
Stock Dividends and Splits - Stock dividends issued are recorded by transferring the aggregate market value of the shares issued from retained earnings to common stock and surplus. Stock splits are recorded by transferring the aggregate par value of the shares issued from surplus to common stock. All per share information, included in the consolidated financial statements and the notes thereto, has been restated to give retroactive effect to stock dividends and splits.
Earnings Per Common Share - Basic earnings per common share is computed based on the weighted-average number of shares outstanding. Diluted earnings per share is computed based on the weighted average number of shares outstanding, increased by the number of common shares that are assumed to have been purchased with the proceeds from the exercise of stock options and common stock warrants. These purchases were assumed to have been made at the average market price of the common stock. The average market price is based on the average closing price for the common stock. Retroactive recognition has been given for stock dividends and splits. For periods in which a loss is reported, the impact of restricted stock, stock options and common stock warrants is not considered as the result would be anti-dilutive.
Comprehensive Income (Loss) - Comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) includes unrealized gains and losses on securities available for sale and cash flow hedges which are also recognized as separate components of equity.
Statements of Cash Flows - For the purpose of presenting the statements of cash flows, the Company considers federal funds sold and securities purchased under agreements to resell to be cash equivalents because such assets are convertible into fixed amounts of cash within several days of initial purchase. Net cash flows are reported for customer loan and deposit transactions, federal funds purchased and repurchase agreements.
Securities Sold Under Agreements to Repurchase - The Company may utilize borrowings collateralized by U.S. Treasury, Government Agency and mortgage-backed securities. These funds generally mature within one to seven days and are reflected on the balance sheet at the amount of the cash received.
Loans Held for Sale - Loans held for sale are carried at the lower of aggregate cost, net of discounts or premiums and a valuation allowance, or estimated fair market value.
Loans Foreclosed - Property acquired through foreclosure (other real estate owned or “OREO”) is initially recorded at fair value less estimated selling costs and carried at the lower of cost or fair value less costs to sell. Carrying value in excess of net fair value at the time of foreclosure is charged against the allowance for loan and lease losses. Revenues and expenses from operations or changes in the carrying value of these assets subsequent to acquisition are included in operating expenses.
Accounting for Stock-Based Compensation - The Company accounts for stock-based compensation on a modified prospective basis with the fair value of any subsequent grants of stock-based compensation to be reflected in the statement of operations.
Accounting for Derivatives - From time to time, the Bank may execute customer interest rate swap transactions together with offsetting interest rate swap transactions with institutional dealers. Each swap is mutually exclusive, and the swaps are marked to market with changes in fair value recognized as other income, with the fair value for each individual swap offsetting the corresponding other. In the event of default, future changes in the fair value of these swap agreements are no longer offset and are recognized as income or loss as appropriate. The customer swap program provides a customer financing option that can result in longer maturity terms without incurring the associated interest rate risk. The Company does not currently hold any derivative financial instruments for trading purposes.
Accounting for Bank Owned Life Insurance - The Bank is the beneficiary of a policy that insures the lives of certain current and former senior officers of the Bank and its subsidiaries. The Company has recognized the cash surrender value, or the amount that can be realized under the insurance policy, as an asset in the consolidated balance sheets. Changes in the cash surrender value are recorded in other income.
Employee Benefit Plans - The Company has an Employee Stock Ownership Plan (the “ESOP”) which is a defined contribution plan covering substantially all full-time employees. Company contributions to the ESOP represent a minimum of 3% of an employee’s annual gross compensation. The Bank has nonqualified deferred compensation plans for certain officers for whom contributions under the ESOP are limited by the applicable provisions of the Internal Revenue Code. Employee 401(k) expense is the amount of Bank matching contributions.
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.
Dividend Restriction - Banking regulations require maintaining certain capital levels and may limit the dividends paid by the Bank to the Company or by the Company to stockholders. (See the “Regulatory Matters” note for more specific disclosure.)
Fair Value of Financial Instruments - Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.
Operating Segments - While the chief decision-makers monitor 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.
Adoption of New Accounting Guidance - In June 2009, the Financial Accounting Standards Board (“FASB”) replaced “The Hierarchy of Generally Accepted Accounting Principles” with “The FASB Accounting Standards Codification” as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with GAAP. Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. The impact of adoption on September 30, 2009 was not material.
In April 2009, the FASB amended existing guidance to require disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements and to require those disclosures in summarized financial information at interim reporting periods. The impact of adoption on June 30, 2009 was not material as it required only disclosures which are included in the Fair Value footnote.
In April 2009, the FASB amended existing guidance for determining whether impairment is other-than-temporary for debt securities. The guidance requires an entity to assess whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of these criteria is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to other factors, which is recognized in other comprehensive income and 2) OTTI related to credit loss, which must be recognized in the statement of operations. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. Additionally, disclosures about other-than-temporary impairments for debt and equity securities were expanded. The impact of adoption on June 30, 2009 was not material.
In April 2009, the FASB issued guidance that emphasizes that the objective of a fair value measurement does not change even when market activity for the asset or liability has decreased significantly. Fair value is the price that would be received for an asset sold or paid to transfer a liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. When observable transactions or quoted prices are not considered orderly, then little, if any, weight should be assigned to the indication of the asset or liability’s fair value. Adjustments to those transactions or prices should be applied to determine the appropriate fair value. The impact of adoption on June 30, 2009 was not material.
In June 2008, the FASB issued guidance addressing whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing EPS under the two-class method. The guidance concluded that unvested share-based payment awards that contain non-forfeitable rights to dividend equivalents are participating securities and shall be included in the computation of EPS pursuant to the two-class method. Our restricted stock awards are considered participating securities. The impact of adoption on January 1, 2009 was not material.
In March 2008, the FASB amended existing guidance in order to provide users of financial statements with an enhanced understanding of: (1) how and why an entity uses derivative instruments, (2) how derivative instruments and related hedged items are accounted for and (3) how such items affect an entity’s financial position, performance and cash flows. The amended guidance requires qualitative disclosures about objectives and strategies for using derivative instruments, quantitative disclosures about fair value amounts of gains and losses on derivative instruments and disclosures about credit-risk-related contingent features in derivative agreements. The impact of adoption on January 1, 2009 was not material.
In December 2007, the FASB enhanced existing guidance for the use of the acquisition method of accounting (formerly the purchase method) for all business combinations, for an acquirer to be identified for each business combination and for intangible assets to be identified and recognized separately from goodwill. An entity in a business combination is required to recognize the assets acquired, the liabilities assumed and any non-controlling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions. Additionally, there were changes in requirements for recognizing assets acquired and liabilities assumed arising from contingencies and recognizing and measuring contingent consideration. Disclosure requirements for business combinations were also enhanced. The impact of adoption on January 1, 2009 was not material. In April 2009, the FASB issued amended clarifying guidance to address application issues raised by preparers, auditors, and members of the legal profession on initial recognition and measurement, subsequent measurement and accounting, and disclosure of assets and liabilities arising from contingencies in a business combination. The impact of adoption on January 1, 2009 was not material.
Newly Issued But Not Yet Effective Accounting Guidance - In June 2009, the FASB amended existing guidance to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets. This amended guidance addresses (1) practices that are not consistent with the intent and key requirements of the original guidance and (2) concerns of financial statement users that many of the financial assets (and related obligations) that have been derecognized should continue to be reported in the financial statements of transferors. This amended guidance must be applied as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter. Earlier application is prohibited. This amended guidance must be applied to transfers occurring on or after the effective date. The impact of adoption is not expected to be material.
In June 2009, the FASB amended guidance for consolidation of variable interest entities by replacing the quantitative-based risks and rewards calculation for determining which enterprise, if any, has a controlling financial interest in a variable interest entity. The new approach focuses on identifying which enterprise has the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and (1) the obligation to absorb losses of the entity or (2) the right to receive benefits from the entity. Additional disclosures about an enterprise’s involvement in variable interest entities are also required. This amended guidance shall be effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. Earlier application is prohibited. The impact of adoption is not expected to be material.
Reclassifications - Certain reclassifications have been made to prior years’ amounts to conform them to the current year’s presentation.
2. Investment Securities
The amortized cost, gross unrealized gains and losses and estimated fair value of securities available for sale at December 31, 2009 and 2008, are as follows:
The amortized cost and estimated fair value of securities available for sale at December 31, 2009, by contractual maturity, are shown in the following table. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The proceeds from sales of securities available for sale and the associated recognized gross gains, gross losses and taxes are shown below:
At December 31, 2009 and 2008, the Company owned no securities held to maturity and no securities available for sale for one issuer, other than the U.S. Government and its agencies, in excess of 10% of stockholders’ equity.
Securities available for sale with an amortized cost of $359,837,764 and $387,863,531 and an estimated fair value of $358,328,902 and $395,286,148 at December 31, 2009 and 2008, respectively, were pledged for public deposits and short-term borrowings.
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, (3) whether the market decline was affected by macroeconomic conditions and (4) whether the Company has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. In analyzing an issuer’s financial condition, the Company’s management considers whether the securities are issued by the U.S. Government or its agencies, whether downgrades by bond rating agencies have occurred and industry analysts’ reports.
In the first quarter of 2009, a $4.0 million OTTI charge was recorded on one $10 million par value trust preferred CDO that had previously incurred a non-cash OTTI write down of $5.2 million in the fourth quarter of 2008. Management determined that it intended to sell this bond and continued to review developments and other considerations with respect to this trust preferred CDO, including the limited prospects for its ultimate price recovery, the expected time involved and the downside risks involved in continuing to hold this investment. As a result of this review and with some limited liquidity appearing in the trust preferred CDO market, management determined that an immediate liquidation was appropriate. As a result, the bond was liquidated in July 2009 at a price of 13.45% of par representing a gain of 5.2% of par or $520,000 which was recognized in the Company’s third quarter 2009 financial statements.
Information pertaining to securities with gross unrealized losses at December 31, 2009 and 2008, aggregated by investment category and length of time that individual securities have been in a continuous loss position, follows:
Unrealized losses have not been recognized in operations because the issuers’ bonds are of high credit quality, management does not intend to sell and it is not more likely than not that management would be required to sell the securities prior to recovery, and the decline in fair value is largely due to interest rates.
In the case of adjustable rate securities, the coupon rate resets periodically and is typically comprised of a base market index rate plus a spread. The market value on these securities is primarily influenced by the length of time remaining before the coupon rate resets to market levels. As an adjustable rate security approaches that reset date, it is likely that an unrealized loss position would dissipate.
The market value for fixed rate securities changes inversely with changes in interest rates. When interest rates are falling, the market value of fixed rate securities will appreciate, whereas in a rising interest rate environment, the market value of fixed rate securities will depreciate. The market value of fixed rate securities is also affected with the passage of time. As a fixed rate security approaches its maturity date, the market value of the security typically approaches its par value.
3. Loans and Leases - Net
At December 31, 2009 and 2008, net loans and leases consisted of the following:
The Bank’s real estate loans and loan commitments are primarily for properties located throughout Long Island, New York. It is the Bank’s policy to spread risk among a broad range of industries and to monitor concentration and associated levels of risk on an ongoing basis. As of December 31, 2009, 2008 and 2007, the concentration of loans exceeding 10% of total loans was the Bank’s loans totaling $386,801,000, $274,212,000 and $150,896,000, respectively, to real estate operators, lessors and developers and, as of December 31, 2008 and 2007, $160,921,000 and $159,510,000, respectively, to building construction contractors. At December 31, 2009, the concentration of loans to building construction contractors was less than 10% of total loans. Repayment of these loans is dependent in part upon the overall economic health of the Company’s market area and current real estate values. The Bank considers the credit circumstances, the nature of the project and loan to value ratios for all real estate loans.
The Bank makes loans to its directors and executive officers, and other related parties, in the ordinary course of its business. Loans made to directors and executive officers, either directly or indirectly, totaled $475,309, $1,135,040 and $3,039,982 at December 31, 2009, 2008 and 2007, respectively. New loans totaling $630,572, $1,058,445 and $1,696,992 were extended and payments of $1,290,303, $2,963,387 and $1,399,451 were received during 2009, 2008 and 2007, respectively, on these loans.
Activity in the allowance for loan and lease losses for the three years ended December 31, 2009 is as follows:
As of December 31, 2009, 2008 and 2007, the recorded investment in loans and leases that are considered to be impaired is summarized below.
At December 31, 2009, 2008 and 2007, loans and leases with unpaid principal balances on which the Bank is no longer accruing interest income were $6,733,281, $16,071,672 and $5,791,733, respectively. Interest income would have been approximately $735,000, $951,000 and $459,000 greater in 2009, 2008 and 2007 respectively, had these loans and leases been current. Interest income on total non-accrual loans and leases, which is recorded only when received, amounted to approximately $6,000, $68,000, and $19,000 for 2009, 2008 and 2007, respectively. At December 31, 2009, there was one loan, a residential mortgage with a principal balance of $436,000, restructured and still accruing interest. At December 31, 2008 and 2007, there were no restructured loans and leases still accruing interest. At December 31, 2009, 2008 and 2007, loans and leases 90 days or more past due and still accruing interest totaled $3,800,000, $2,500 and $28,429, respectively.
At December 31, 2009, 2008 and 2007, commercial real estate mortgages of $185,034,931, $179,761,252 and $179,709,211, respectively, were pledged as collateral for borrowings from the FHLB.
4. Bank Premises and Equipment - Net
At December 31, 2009 and 2008, Bank premises and equipment consisted of the following:
Depreciation expense totaled $1,572,527, $1,595,621 and $1,322,902 for the years ended December 31, 2009, 2008 and 2007, respectively.
5. Other Assets
At December 31, 2009 and 2008, other assets consisted of the following:
6. Deposits
At December 31, 2009 and 2008, certificates of deposit of $100 thousand or more were $188,688,190 and $300,292,328, respectively. Scheduled maturities of all certificates of deposit are as follows:
7. Lines Of Credit and Other Temporary Borrowings
As of December 31, 2009 and 2008, correspondent banks extended unsecured lines of credit aggregating $81,000,000 and $82,000,000, respectively, to the Bank for the purchase of federal funds and for foreign exchange transactions. At December 31, 2009, correspondent banks also extended secured lines of credit aggregating $5,000,000. Federal funds purchased generally mature within one to seven days from the transaction date. Securities sold under agreements to repurchase mature within five years.
In addition to the above, the Bank may use a secured line of credit with the FHLB for overnight funding or on a term basis to match fund asset purchases. Based upon a multiple of the FHLB stock that the Bank currently owns combined with approximately $240,000,000 of collateral, including approximately $185,000,000 in commercial real estate mortgages, it currently has pledged at FHLB, approximately $148,000,000 of this line may be drawn on a term or overnight basis. The FHLB line is renewed annually.
On June 6, 2006, the Company entered into a revolving credit agreement with a correspondent bank. Under the agreement, the correspondent bank had made available to the Company a revolving line of credit of up to $10,000,000. During 2008 the Company exited this agreement. On August 14, 2008 the Company entered into a Revolving Credit Agreement (the “Credit Agreement”) with a different correspondent bank. Under the Credit Agreement, the correspondent bank had made available to the Company a revolving line of credit of up to $15,000,000. All amounts outstanding under the Credit Agreement would bear interest at a rate equal to LIBOR plus a margin assessed on a sliding scale between 110 and 140 basis points, based on the Company’s non-performing asset ratio and return on average assets ratio. The Credit Agreement provided for certain customary affirmative and negative covenants and events of default, including but not limited to limitations on other encumbrances, other indebtedness, mergers, acquisitions, asset sales, and investments. In addition, the Bank had to maintain its categorization as “well-capitalized” as defined in the “Regulatory Matters” footnote. During 2009 the Company exited the Credit Agreement. At December 31, 2008, no amount was outstanding under the Credit Agreement.
The following summarizes borrowed funds at December 31, 2009 and 2008:
For securities sold under agreements to repurchase, the following table provides additional information:
Of the total borrowings outstanding at December 31, 2009, required payments of $45,000,000, $1,000,000 and $2,000,000 will be made in 2010, 2011 and 2014, respectively.
8. Senior Unsecured Debt, Subordinated Notes and Junior Subordinated Debentures
On March 31, 2009, the Bank issued $29,000,000 in senior unsecured debt due March 30, 2012 guaranteed by the FDIC under the FDIC’s TLGP. Interest at 2.625% per annum is payable semi-annually in arrears on the 30th day of each March and September, beginning September 30, 2009.
In 2006, the Company issued $10,000,000 in aggregate principal amount of its 8.25% Subordinated Notes due June 15, 2013 (the “Notes”) pursuant to a purchase agreement dated June 6, 2006 between the Company and the initial purchaser named therein. The Notes were issued pursuant to an Indenture dated June 8, 2006 by and between the Company and Wilmington Trust Company, as trustee (the “Indenture”). The Notes were unsecured and ranked subordinate and junior to all of the Company’s senior indebtedness to the extent and in the manner set forth in the Indenture. Interest on the Notes was payable semi-annually in arrears at an annual rate of 8.25% on June 15 and December 15 of each year, beginning December 15, 2006. The Notes were scheduled to mature on June 15, 2013 and were not redeemable before that date. The net proceeds from the sale of the Notes, after deducting offering expenses and the initial purchaser’s discount, were approximately $9,450,000 and qualified as Tier II capital for the Company. The Company contributed proceeds from the offering to the Bank which qualified as Tier I capital. The Notes were not registered under the Securities Act of 1933, as amended, or any state securities laws, and may not have been offered or sold in the United States absent registration or an applicable exemption from registration requirements. In December 2009, the Company exchanged the Notes plus accrued interest and a premium for an aggregate of 1,656,600 shares of common stock. Each share of common stock in the exchange was valued at $6.50.
In 2003, State Bancorp Capital Trust II (“Trust II”), subsidiary of the Company and a statutory trust created under the Delaware Statutory Trust Act, issued $10,000,000 of capital securities. The coupon rate is three-month LIBOR plus 285 basis points and is reset quarterly. Trust II’s obligations under the capital securities issued are fully and unconditionally guaranteed by the Company. The proceeds from the sale of the capital securities of Trust II were utilized by Trust II to invest in $10,000,000 of junior subordinated debentures of the Company. The debentures bear a coupon rate of three-month LIBOR plus 285 basis points which is reset quarterly. The debentures are unsecured and rank subordinate and junior in right of payment to all indebtedness, liabilities and obligations of the Company. The debentures represent the sole assets of Trust II. The Company has the right to optionally redeem the debentures prior to the maturity date of January 23, 2034 at par. Due to the Company’s participation in the Treasury’s Capital Purchase Program, permission must be obtained from the Treasury in order to call these securities.
In 2002, State Bancorp Capital Trust I (“Trust I”), subsidiary of the Company and a statutory trust created under the Delaware Statutory Trust Act, issued $10,000,000 of capital securities. The coupon rate is three-month LIBOR plus 345 basis points and is reset
quarterly. Trust I’s obligations under the capital securities issued are fully and unconditionally guaranteed by the Company. The proceeds from the sale of the capital securities of Trust I were utilized by Trust I to invest in $10,000,000 of junior subordinated debentures of the Company. The debentures bear a coupon rate of three-month LIBOR plus 345 basis points which is reset quarterly. The debentures are unsecured and rank subordinate and junior in right of payment to all indebtedness, liabilities and obligations of the Company. The debentures represent the sole assets of Trust I. The Company has the right to optionally redeem the debentures prior to the maturity date of November 7, 2032 at par. Due to the Company’s participation in the Treasury’s Capital Purchase Program, permission must be obtained from the Treasury in order to call these securities.
Trust I and II are unconsolidated wholly owned subsidiaries of the Company, have no independent operations and issued securities that contained the full and unconditional guarantee of its parent, the Company. Although the Company may be dependent on Bank dividends to pay the trust preferred interest, and the Bank may not be able to declare dividends, the subordinated debentures allow for up to two extension periods of 20 consecutive quarters each during which time payment of interest may be deferred by the Company. As such, the Company would not be in default if it were unable to pay interest on the subordinated debentures. The weighted average cost of all of the Company’s junior subordinated debentures was 4.12% in 2009 and 6.35% in 2008.
9. Income Taxes
The components of income tax expense for the years ended December 31, 2009, 2008 and 2007, are as follows:
Total income tax (benefit) expense was different from the amounts computed by applying the statutory federal income tax rate to income before income taxes due to the following:
At December 31, 2009 and 2008, the deferred tax assets and liabilities are composed of the following:
As of December 31, 2009, the Company had deferred tax assets arising from deductible temporary differences and tax losses before being offset against certain deferred liabilities for presentation on the Company’s balance sheet. Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining deferred tax assets. The Company will continue to evaluate the realizability of the deferred tax assets quarterly by assessing the need and amount for a valuation allowance account. The deferred tax assets and liabilities are netted and presented in a single amount as net deferred income taxes in the accompanying consolidated balance sheets.
Effective January 1, 2007, the Company included earnings of the Delaware Subsidiaries for purposes of its financial statement provision for New York State (“NYS”) taxes. The impact of this inclusion for the years ended December 31, 2008 and 2007 was immaterial to the financial statements and earnings per share.
In December 2007, the Company executed tax closing agreements with the New York State and local taxation authorities which constituted a final and conclusive settlement of the previously reported audit covering the 1999-2006 period. The final settlement was for an amount less than the reserve previously accrued in the fourth quarter of 2006 and resulted in a reduction of the Company’s year ended December 31, 2007 provision for income taxes and effective tax rate for the year ended December 31, 2007. The effective tax rate in 2007 was impacted negatively by the non-deductible $2.4 million non-cash goodwill impairment accounting charge.
As of December 31, 2009, the Company has recorded an allowance of $20,000 for an uncertain tax position related to determination of state nexus for various states other than New York. Upon audit by these states, the Company may be obligated to pay a cumulative total between $15,000 and $20,000 in additional taxes, interest and penalties. The Company’s continuing practice is to recognize interest and penalties related to uncertain tax positions in tax expense. This allowance is not likely to change by a significant amount within the next year. In the event of subsequent recognition, the entire amount recognized would have an immaterial impact on the Company’s effective tax rate.
To date, the Company has not been audited on this tax position. Accordingly, the past three years of the state income tax returns are subject to examination in various states other than New York.
The Company has net operating loss carryforwards of approximately $43.7 million for Federal income tax and $64.2 million for NYS tax purposes which may be applied against future taxable income. Both the Federal and NYS unused net operating loss carryforwards are expected to expire between the year 2027 and 2029. It is anticipated that these carryforwards, both Federal and NYS, will be utilized prior to their expiration based on the Company’s future years’ projected earnings.
At December 31, 2009, the Company assessed its earnings history and trend over the prior two years, its estimate of future earnings and the expiration dates of its net operating loss carryforwards. In the current year, management has positioned the Company for future earnings by selling underperforming assets and redeploying the proceeds to more attractive investments. In addition, the Company has enhanced the quality of its capital through a debt for equity swap. Based on these assessments, the Company determined that it was more likely than not that the deferred tax assets will be realized before their expiration.
The Company is no longer subject to examination by NYS and NYC taxing authorities for years before January 1, 2007, and by Federal taxing authorities for years before January 1, 2005.
10. Stock-Based Compensation
Incentive Stock Options - Under the terms of the Company’s incentive stock option plans adopted in April 1994, February 1999 and February 2002, options have been granted to certain key personnel that entitle each holder to purchase shares of the Company’s common stock. The option price is the higher of the fair market value or the book value of the shares at the date of grant. Such options were exercisable commencing one year from the date of grant, at the rate of 25% per year, and expire within ten years from the date of grant. Any optionee-owned stock may be used as full or partial payment of the exercise price and shall be valued at the fair market value of the stock on the date of exercise of the option.
No incentive stock options were granted during 2009, 2008 and 2007. At December 31, 2009, incentive stock options for the purchase of 254,319 shares were outstanding and exercisable. No options were exercised in 2009. The total intrinsic value of options exercised for the twelve months ended December 31, 2008 and 2007 was $292,899 and $2,515,923, respectively. The total cash received from option exercises for the twelve months ended December 31, 2008 and 2007 was $552,065 and $1,511,799, respectively, excluding the tax benefit realized for the twelve months ended December 31, 2008 and 2007of $37,069 and $69,800, respectively. In exercising those options, certain employees paid their option exercise price in full or in part by surrendering 36,381 shares at a fair market value of $509,408 during 2008 and 138,721 shares at a fair market value of $2,633,321 during 2007. The total exercisable shares at December 31, 2009 had no intrinsic value. A summary of stock option activity follows:
The following summarizes shares subject to purchase from incentive stock options outstanding and exercisable as of December 31, 2009:
Restricted Stock Awards - Under the Company’s 2006 Equity Compensation Plan (the “2006 Plan”), the Company can award options, stock appreciation rights (“SARs”), restricted stock, performance units and unrestricted stock. The 2006 Plan also allows the Company to make awards conditional upon attainment of vesting conditions and performance targets.
During 2009, the Company awarded 89,507 shares of restricted stock to certain key employees. The restricted stock awarded in 2009 and 2008 primarily vests one-third on each of the third through fifth anniversaries of the award date. The restricted stock awarded in 2006 vested in full in September 2009 at a fair value of $66,590. The fair value of restricted stock awards vested during 2008 was $259,989. No restricted stock awards vested during 2007. Based on an estimated forfeiture rate, of those shares awarded in 2009 and 2008, 205,531 shares are expected to vest over the five year period. The Company recognizes compensation expense over the vesting period at the fair market value of the shares on the award date. If a participant’s service terminates for any reason other than death or disability, then the participant shall forfeit to the Company any shares acquired by the participant pursuant to the restricted stock award which remain subject to vesting conditions. The total remaining unrecognized compensation cost related to nonvested shares of restricted stock is $1,664,498 at December 31, 2009 and is expected to be expensed over the weighted average remaining vesting life of 2.6 years. For the years ended December 31, 2009, 2008 and 2007, $481,805, $184,214 and $125,349, respectively, were recognized as compensation expense, net of estimated forfeitures. The Company recognized tax benefits resulting from the compensation expense for the years ended December 31, 2009, 2008 and 2007 of $163,814, $36,843 and $40,112, respectively.
A summary of restricted stock activity follows:
At December 31, 2009, 349,814 shares were reserved for possible issuance of awards of options, SARs, restricted stock, performance units and unrestricted stock.
Non-Plan Stock-Based Compensation - In November 2006, non-qualified stock options and restricted stock awards were granted to Thomas M. O’Brien, the Company’s and the Bank’s President and Chief Executive Officer, pursuant to the terms of his employment agreement. The non-qualified stock options to purchase 164,745 shares have an exercise price of $17.84 and will vest 20% per year over five years. The estimated fair value of the options was $5.42 per share and was estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions used: (1) dividend yield 3.32%; (2) expected volatility 34.7%; (3) risk-free interest rate 4.57%; and (4) expected life of options 7.3 years. At December 31, 2009, 98,847 of these options were exercisable, but none have been exercised. The options outstanding and those exercisable at December 31, 2009 have no intrinsic value.
The restricted stock awarded to Mr. O’Brien totals 83,612 shares and was awarded at an average price of $17.94 to vest in 20 equal quarterly installments over five years. The fair value of restricted stock awards vested during the years ended December 31, 2009, 2008 and 2007 was $130,531, $200,981 and $274,650, respectively. A summary of restricted stock activity follows:
The total remaining unrecognized compensation cost related to nonvested options and shares of restricted stock awarded to Mr. O’Brien is $877,800 and will be expensed over the weighted average remaining vesting life of 1.2 years. For the years ended December 31, 2009,
2008 and 2007, $478,800 was recognized as compensation expense in each period. The non-qualified stock options and the restricted stock awards were not issued as part of any of the Company’s registered stock-based compensation plans.
11. Employee Benefit Plans
The Bank has an ESOP which is a defined contribution plan covering substantially all full-time employees. Bank contributions to the ESOP represent a minimum of 3% of an employee’s annual gross compensation. Employees become 20% vested after two years of employment, with an additional 20% vesting each year. Full vesting takes place upon the completion of six years of employment. Employee contributions are not permitted. At December 31, 2009, the ESOP had all of its assets invested in the Company’s common stock and cash. The Bank funds all amounts when due. At December 31, 2009 and 2008, the number of shares of stock held by the ESOP totaled 1,200,985 and 1,323,077, respectively, all of which were allocated to employee accounts. None of the allocated shares are subject to a repurchase obligation. Contributions under the ESOP charged to operations amounted to $1,185,330, $1,404,823 and $1,459,347 in 2009, 2008 and 2007, respectively.
The Bank has a 401(k) Retirement Plan and Trust (the “401(k) Plan”), which covers substantially all full-time employees. Employees may elect to contribute up to 16% (or up to 35% for employees with annual earnings less than $110,000) of their annual gross compensation to the 401(k) Plan, and the Bank will fully match the employee’s contribution for the first 1% of gross annual compensation and will match one-half of additional employee contributions to a maximum of 3.5%. Employees are fully vested in their own contributions and, after one year of service, the Bank’s contributions. Bank contributions under the 401(k) Plan amounted to $590,005, $521,721and $489,179 in 2009, 2008 and 2007, respectively. The Bank funds all amounts on the last day of the plan year. At December 31, 2009, Bank contributions to the 401(k) Plan were made in shares of the Company’s common stock. Employee contributions to the 401(k) Plan were invested in various bond, equity, stable value or diversified funds as directed by each employee.
The Bank has nonqualified deferred compensation plans (the “Plans”) for certain officers for whom contributions under the ESOP are limited by the applicable provisions of the Internal Revenue Code. Bank contributions under the Plans totaled $1,555, $49,899 and $48,329 in 2009, 2008 and 2007, respectively.
12. Commitments and Contingent Liabilities
Leases - The Company is obligated under various leases covering certain equipment, branches, office space and the land on which its head office is built. The minimum payments under these leases, certain of which contain escalation clauses, are:
Rent expense was approximately $3,382,000, $3,500,000, and $3,380,000 for 2009, 2008 and 2007, respectively.
Directors’ Stock Plan - The Company approved a Directors’ Stock Plan (the “1998 DSP”) in 1998 for each outside director and the secretary to the Board of Directors that expired in April 2008. Pursuant to the 1998 DSP, each participant received an award of share credits in the period 1999 - 2004. Effective annually as of January 1, 2005, each participant was granted an award of share credits in respect to the preceding year in an amount equal to $14,000 divided by the market value of one share of stock as of the last reported sale price on the last day of the calendar year. All awards are pro-rated where a participant did not serve for all of the preceding year. After termination of service as a director or secretary, all awards are paid in shares of stock to the participant, or, in the case of death, to his or her designated beneficiary or estate. During 2008, a total of 9,842 shares were distributed to retired directors and 41,609 shares, awarded to participating directors, were transferred to a Rabbi Trust and subsequently distributed in January 2009. The Bank charged approximately $159,000 during 2008 to operations related to this Plan.
In 2008, the Company adopted a new Directors’ Stock Plan (the “2008 DSP”) for each outside director and provides for the award of up to 1,500 shares annually of the Company’s stock to participating directors. All grants may be pro-rated where a participant does not serve for the entire year. The 2008 DSP will expire in April of 2018 and the maximum aggregate number of shares of stock which may be issued under the 2008 DSP is 200,000 shares. The 2008 DSP replaces the 1998 DSP that expired in April 2008. For the initial calendar year beginning on May 1, 2008, a total of 10,625 share grants were awarded to eleven outside directors which shares were distributed in 2009. In 2009, the Company awarded 13,875 shares to ten outside directors which shares will be distributed in 2010. The Bank charged approximately $140,000 and $135,000 in 2009 and 2008, respectively, to operations related to this Plan.
Severance Commitments - The Company has change of control employment agreements (the “Agreements”) for certain key executives. The Agreements provide for certain rights accruing to participants in the event of a termination of the participant’s employment within one year after a change in control of the Company. These rights include a cash payment and the continuation of certain employee benefits. In addition, all stock-based compensation awards held by a participant will become fully vested. In the event that the participant enters into an employment contract, as defined in the Agreements, all rights to the severance payment and other benefits set forth above will terminate. No amounts have been paid or accrued under the Agreements. Pursuant to the Letter Agreement dated December 5, 2008 and the Securities Purchase Agreement between the Company and the Treasury, Mr. O’Brien and each of the Company’s senior executive officers (as defined in the Securities Purchase Agreement) entered into an amendment to their change of control agreements in 2008 to provide for a recovery of any bonus or incentive compensation paid to such senior executive officers based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate. In addition, pursuant to such amendment, payments to Mr. O’Brien and the Company’s senior executive officers in the event of involuntary discharge or resignation with good reason while the Treasury owns any debt or equity position in the Company arising from the Securities Purchase Agreement will be limited, if applicable, to less than three times the average compensation for the prior five years.
Employment Agreement - Effective November 6, 2006, the Company and the Bank have entered into an employment agreement with Thomas M. O’Brien for a term of five years. The employment agreement provides for an annual base salary and a target annual bonus. Mr. O’Brien was also granted non-qualified stock options and restricted stock awards that are more fully disclosed in Note 10, Non-Plan Stock-Based Compensation.
In the event that Mr. O’Brien’s employment is terminated without cause or he resigns with good reason in the absence of a change in control, he is entitled to receive a cash severance payment equal to two times the sum of the most recent year’s incentive award and base salary rate, all stock options and restricted stock awards vest and life and health insurance is continued until age 65. If he is terminated without cause or resigns with good reason following a change in control, he is entitled to receive a cash severance payment equal to three times the sum of annual salary plus target bonus amount, the most recent year’s annual incentive is paid, all stock options and restricted stock awards vest and life insurance is continued until age 65. Vesting of stock options and restricted stock will be accelerated in the event of death and will continue to vest as if employment had not terminated in the event of disability. No cash severance payments are due in the event of termination of employment as a result of death, disability, discharge with cause or voluntary resignation without good reason. Pursuant to the Securities Purchase Agreement between the Company and the Treasury, payments to Mr. O’Brien and the Company’s senior executive officers (as defined in the Securities Purchase Agreement) in the event of involuntary discharge or resignation with good reason while the Treasury owns any debt or equity position in the Company arising from the Securities Purchase Agreement will be limited, if applicable, to less than three times the average compensation for the prior five years.
Pending Claims and Contingent Liabilities - The Company and the Bank are subject to legal proceedings and claims that arise in the ordinary course of business. In the opinion of management, the amount of ultimate liability, if any, with respect to such matters will not materially affect future operations and will not have a material impact on the Company’s financial statements.
Other - The Bank is required to maintain balances with the Federal Reserve Bank of New York to satisfy reserve requirements. These balances averaged approximately $12,736,000 and $5,534,000 in 2009 and 2008, respectively.
13. State Bancorp, Inc. (Parent Company Only)
Certain condensed financial information follows (dollars in thousands):
14. Derivative Financial Instruments and Other Financial Instruments with Off-Balance Sheet Risk
The Company does not currently hold any derivative financial instruments for trading purposes. From time to time, the Bank may execute customer interest rate swap transactions together with offsetting interest rate swap transactions with institutional dealers. The customer swap program provides a customer financing option that can result in longer maturity terms without incurring the associated interest rate risk. Each swap is mutually exclusive, and the swaps are marked to market with changes in fair value recognized in other income, with the fair value for each individual swap offsetting the corresponding other.
On September 15, 2008 and October 3, 2008, respectively, Lehman and Lehman Special Financing filed Voluntary Petitions under Chapter 11 of the U.S. Bankruptcy Code, each of which constituted an event of default under the swap agreements the Bank had with Lehman
Special Financing. The Bank filed proofs of claim with the United States Bankruptcy Court, Southern District, on January 13, 2009. As a result of the events of default, the Bank terminated the interest rate swap agreements with Lehman Special Financing. The terminations resulted in several customer interest rate swap transactions no longer being offset by that institutional dealer and a loss to the Company on those swap agreements of approximately $584 thousand was recorded in the third quarter of 2008. During the third quarter of 2009, the Company recorded a gain of $221 thousand on the sale of its claims against Lehman and Lehman Special Financing.
In addition, during the second and third quarters of 2009, the unhedged customer interest rate swap transactions were once again offset by an institutional dealer. As all customer interest rate swap transactions are now hedged, we expect that their future impact on the Company’s financial statements will be immaterial. For the twelve months ended December 31, 2009, a net loss of $38 thousand was recognized. The 2009 amount includes the gain of $221 thousand on the sale of the Bank’s claims against Lehman and Lehman Special Financing. For the twelve months ended December 31, 2008, a net gain of $1.1 million was recognized. For the twelve months ended December 31, 2007, neither income nor losses associated with interest rate swap transactions were material to the financial statements. At December 31, 2009 and 2008, the total gross notional amount of swap transactions outstanding was $37 million and $28 million, respectively.
In 2005, the Bank terminated two interest rate swap agreements that hedged a portion of the interest rate variability in its portfolio of prime rate loans in support of enhancing its interest rate sensitivity position. The entire cost to unwind the swap agreements was fully amortized at December 31, 2007, and thus no expenses were recognized during the year ended December 31, 2008. For the year ended December 31, 2007, the Company recognized $300 thousand of such expenses.
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. These financial instruments include commitments to extend credit and standby and documentary letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated financial statements. The Bank uses the same credit policies in making commitments and conditional obligations 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 generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the customer. Collateral required varies, but may include accounts receivable, inventory, equipment, real estate and income-producing commercial properties. At December 31, 2009 and 2008, commitments to originate loans and leases and commitments under unused lines of credit for which the Bank is obligated amounted to approximately $232,011,000 and $262,721,000, respectively. Approximately $195,201,000 and $212,931,000 of these commitments were at variable rates and $36,810,000 and $49,790,000 were at fixed rates, including LIBOR-based loans, at December 31, 2009 and 2008, respectively. At December 31, 2009 and 2008, the fixed rate commitments had interest rates ranging from approximately 2.30% to 7.23% and 2.40% to 8.92%, respectively.
Letters of credit are conditional commitments guaranteeing payments of drafts in accordance with the terms of the letter of credit agreements. Commercial letters of credit are used primarily to facilitate trade or commerce and are also issued to support public and private borrowing arrangements, bond financing and similar transactions. Collateral may be required to support letters of credit based upon management’s evaluation of the creditworthiness of each customer. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. Most letters of credit expire within one year. At December 31, 2009 and 2008, the
Bank had letters of credit outstanding of approximately $15,258,000 and $17,039,000, respectively. At December 31, 2009, the uncollateralized portion was approximately $3,015,000.
15. Fair Value
Fair value estimates are made as of a specific point in time based on the characteristics of financial instruments and market information. Where available, quoted market prices are used. However, markets do not exist for a portion of the Company’s financial instruments and, as a result, fair value estimates require judgments regarding future cash flows. These judgments are subjective in nature, involve uncertainties and therefore may change significantly at future measurement dates. The fair value information that follows is intended to supplement, but not replace, the basic consolidated financial statements and other traditional financial data presented throughout this report. The calculation of estimated fair values is based on market conditions at December 31, 2009 and 2008 and is not reflective of current or future fair values. Furthermore, the value of long-term relationships with depositors is not reflected. The value of those relationships is significant.
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value.
Cash and Cash Equivalents - For cash and cash equivalents (due from banks, federal funds sold and securities purchased under agreements to resell), the carrying amount is a reasonable estimate of fair value.
Accrued Interest Receivable - For accrued interest receivable, the carrying amount is a reasonable estimate of fair value.
Federal Home Loan Bank and Other Restricted Stock - Determining the fair value of Federal Home Loan Bank stock is not practicable due to restrictions placed on its transferability. For other restricted stock, the carrying amount is a reasonable estimate of fair value.
Loans and Leases - For certain homogeneous categories of loans, such as some residential mortgages and other consumer loans, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.
Deposits - The fair value of demand deposits, savings accounts and time deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the interest rate swap rates of similar term points.
Senior Unsecured Debt, Subordinated Notes and Junior Subordinated Debentures - The fair value of senior unsecured debt, subordinated notes and junior subordinated debentures is estimated using the interest rate swap rates of similar term and repricing points and spreads of equivalent new issues.
Temporary Borrowings and Accrued Interest Payable - Temporary borrowings (FHLB overnight and term advances, federal funds purchased and securities sold under agreements to repurchase) and accrued interest payable are considered to have fair values equal to their carrying amounts due to their short-term nature.
Commitments to Extend Credit, Standby Letters of Credit and Commercial Letters of Credit - The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of standby letters of credit and commercial letters of credit is based on fees currently charged for similar agreements, which are not material to the financial statements.
The estimated fair values of the Company’s financial instruments are as follows (in thousands):
Current accounting standards establish a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standards describe three levels of inputs that may be used to measure fair value:
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
For the Company’s securities available for sale, the estimated fair value equals quoted market price, if available (Level 1 inputs). If a quoted market price is not available, fair value is estimated using a quoted market price for similar securities (Level 2 inputs). Our derivative instruments consist of interest rate swap transactions with customers on loans. As such, significant fair value inputs can generally be verified and do not typically involve significant management judgments (Level 2 inputs). The market value adjustment of the derivatives considers the credit risk of the counterparties to the transaction and the effect of any credit enhancements related to the transaction. The fair value of loans held for sale and impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Unobservable inputs are typically significant and result in a Level 3 classification for determining fair value of loans held for sale and impaired loans.
Assets and Liabilities Measured on a Recurring Basis
Assets and liabilities measured at fair value on a recurring basis are summarized below:
The table below presents a reconciliation and statement of operations classification of gains and losses for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3):
Due to credit deterioration noted in the financial institution industry in general and the Company’s intent for the security changed to an intent to sell, the Company incurred a first quarter 2009 charge to write down to the fair value a CDO classified as a Level 3 asset as of December 31, 2008. This valuation was based upon comparable prices of similar instruments obtained from an outside broker. The asset was classified as a Level 2 asset from March 31, 2009 until its liquidation in July 2009.
Assets and Liabilities Measured on a Non-Recurring Basis
Assets and liabilities measured at fair value on a non-recurring basis are summarized below:
Impaired loans with specific allocations had a principal amount of $4,431,583 and $11,908,500, with a valuation allowance of $836,433 and $1,954,590 at December 31, 2009 and December 31, 2008, respectively. The provision for losses on impaired loans was ($144,062) and $1,742,004 for the twelve months ended December 31, 2009 and 2008, respectively. Charge-offs of $13,255,057 and $5,914,132 were incurred on the transfer of loans to loans held for sale for the twelve months ended December 31, 2009 and 2008, respectively. (See also Loans and Leases - Net footnote.)
16. Regulatory Matters
The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under the capital adequacy guidelines, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Company’s and the Bank’s capital amounts and the Bank’s
classification are also subject to qualitative judgments by the federal banking regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of total capital and Tier I capital, as defined in the federal banking regulations, to risk-weighted assets and of Tier I capital to average assets as shown in the following table. Each of the Company’s and the Bank’s capital ratios exceeds applicable regulatory capital requirements and the Bank meets the requisite capital ratios to be well-capitalized as of December 31, 2009 and December 31, 2008. There are no subsequent conditions or events that management believes have changed the Company’s or the Bank’s capital adequacy. The Company’s and the Bank’s capital amounts (in thousands) and ratios are as follows:
State banking regulations limit, absent regulatory approval, the Bank’s dividends to the Company to the lesser of the Bank’s undivided profits and the Bank’s retained net income for the current year plus its retained net income for the preceding two years (less any required transfers to capital surplus) up to the date of any dividend declaration in the current calendar year. As of December 31, 2009, no dividends were available to the Company from the Bank according to these limitations without seeking regulatory approval.
In December 2008, the Treasury purchased 36,842 shares of the Company’s Series A Preferred Stock with a redemption and liquidation value of $36,842,000 and an initial annual dividend of 5% for five years and 9% thereafter. When originally issued, the preferred stock could not be redeemed for a period of three years from the date of the investment, except with the proceeds from a qualified equity offering (the sale by the Company of common or preferred stock for cash). After the third anniversary of the date of this investment, the preferred stock could be redeemed, in whole or in part, at any time, at the option of the Company. However, pursuant to the ARRA, subject to approval by the Treasury and the Company’s federal regulator, the Company may redeem the preferred stock without regard to whether the Company has replaced such funds from any other source or to any waiting period. The preferred stock qualifies as Tier I capital for regulatory reporting purposes.
The Treasury also received a warrant to purchase 465,569 shares of the Company’s common stock with an exercise price of $11.87 per share representing an aggregate market value of $5,526,300 or 15% of the preferred stock investment. The warrant is immediately exercisable and expires in ten years. The Company allocated $1,056,842 of the proceeds from the issuance of the preferred stock to the value of the warrant representing an unamortized discount on preferred stock. The discount is being amortized to preferred stock using an effective yield method over a five-year period. Through December 31, 2009, $231,218 of the discount has been accreted to preferred stock.
The proceeds from the issuance to the U.S. Treasury were allocated based on the relative fair value of the warrant as compared to the fair value of the preferred stock. The fair value of the warrant was determined using a Black-Scholes valuation model. The assumptions used in the warrant valuation were a dividend yield of 3.8%, stock price volatility of 34% and a risk-free interest rate of 2.7%. The fair value of the preferred stock was determined using a discounted cash flow analysis based on assumptions regarding the market rate for preferred stock, which was estimated to be approximately 9% at the date of issuance.
17. Selected Quarterly Financial Data (Unaudited)
(dollars in thousands, except per share data)
(1) 1st quarter 2009 and 4th quarter 2008 amounts include other-than-temporary impairment losses on securities.
(2) The sum of the four quarters’ (loss) earnings per common share in 2009 will not equal the full year amount as a result of the December 2009 exchange of the Company’s $10 million of 8.25% subordinated notes for an aggregate of 1,656,600 shares of common stock.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
The Company carried out an evaluation, under the supervision and with the participation of its principal executive officer and principal financial officer, of the effectiveness of the design and operation of its disclosure controls and procedures as defined in Rule 13a-15(e) and Rule 15d-15(e) under the Exchange Act. Based on this evaluation, the Company’s principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures are effective in timely alerting them to material information required to be included in the Company’s periodic reports filed with the SEC. There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls subsequent to the date the Company carried out its evaluation.
There were no changes to the Company’s internal control over financial reporting as defined in Rule 13a-15(f) and Rule 15d-15(f) under the Exchange Act that occurred in the fourth quarter of 2009 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Management’s Report on Internal Control Over Financial Reporting
The management of State Bancorp, Inc. (the “Company”) is responsible for establishing and maintaining effective internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. The Company’s 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 in the United States of America.
The internal control over financial reporting includes those policies and procedures that:
•
Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company.
•
Provide reasonable assurance that the transactions are recorded as necessary to permit preparation of financial statements in accordance with the generally accepted accounting principles in the United States of America, and that our receipts and expenditures are being made only in accordance with authorizations of the Company’s management and directors; and
•
Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our 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.
Management assessed the effectiveness of the Company’s internal control over financial reporting for financial presentations as of December 31, 2009. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission as described in Internal Control-Integrated Framework. Based on this assessment, management concluded that the Company maintained effective internal control over financial reporting presented in conformity with generally accepted accounting principles in the United States of America as of December 31, 2009.
The Company’s independent registered public accounting firm has audited and issued their report on the effectiveness of the Company’s internal control over financial reporting.
Thomas M. O’Brien
President and Chief Executive Officer
State Bancorp, Inc.
March 12, 2010
Brian K. Finneran
Chief Financial Officer
State Bancorp, Inc.
March 12, 2010
Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting
Please refer to “Report of Independent Registered Public Accounting Firm” contained in Item 8. Financial Statements and Supplementary Data.
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
None
PART III
ITEM 10.
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Incorporated herein by reference is the Company’s 2010 Proxy Statement. The identification of the directors of the Company may be found under “Proposal 1 - Election of Directors.” The identification of the executive officers of the Company may be found under “Executive Officers.” There exists no family relationship between any director and executive officer. Disclosure of the Audit Committee financial expert may be found under “Corporate Governance - Audit Committee Independence, Financial Literacy and Audit Committee Financial Expert.” Compliance with section 16(a) of the Exchange Act may be found under “Section 16(a) Beneficial Ownership Reporting Compliance.” The Company has a Code of Business Conduct and Ethics that applies to all employees, officers and directors of the Company and its direct and indirect subsidiaries, as well as a Code of Ethics for the Chief Executive and Senior Financial Officers, and they are posted on the Company’s website at www.statebankofli.com.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
Incorporated herein by reference is the Company’s 2010 Proxy Statement. Executive compensation may be found under “Executive Compensation.”
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Incorporated herein by reference is the Company’s 2010 Proxy Statement. Security ownership of certain beneficial owners and management may be found under “Stock Ownership of Certain Beneficial Owners” and “Stock Ownership of Directors, Executive Officers and Additional Officers.”
Additionally, information about the Company’s equity compensation plans is as follows:
(1) The amount in column (a) of 164,745 represents non-qualified stock options granted to Mr. O’Brien pursuant to the terms of his employment agreement. The amount in column (b) represents the exercise price of the options granted to Mr. O’Brien. For a further discussion, see the Notes to the Company’s Consolidated Financial Statements.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Incorporated herein by reference is the Company’s 2010 Proxy Statement. Certain relationships and related transactions may be found under “Certain Relationships and Related Party Transactions” and “Proposal 1 - Election of Directors.”
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
Incorporated herein by reference is the Company’s 2010 Proxy Statement. Audit fees, audit-related fees, tax fees and all other fees may be found under “Proposal 2 - Ratification of the Appointment of Crowe Horwath LLP - Audit Fees.” Disclosure of the Audit Committee’s pre-approval of policies and procedures may be found under “Proposal 2 - Ratification of the Appointment of Crowe Horwath LLP - Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Registered Accounting Firm.”
PART IV
ITEM 15.
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
The Report of Independent Registered Public Accounting Firm, the Consolidated Financial Statements and the Notes to Consolidated Financial Statements may be found in Part II, Item 8 of this 10-K. As to any schedules omitted, they are not applicable or the required information is shown in the Consolidated Financial Statements or the Notes thereto.
Exhibits:
Upon payment of the Company’s reasonable expenses, State Bancorp, Inc. will furnish any exhibit upon written request of the stockholder directly to the Secretary of the Company, State Bancorp, Inc., Two Jericho Plaza, Jericho, NY 11753.
SIGNATURES
Pursuant to the requirements of Section 13 or 15d of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned.
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 on the dates indicated.
EXHIBIT INDEX