Item 1. Business
General
In 2003, NewAlliance was organized as a Delaware business corporation in connection with the conversion of NewAlliance Bank (the “Bank”), formerly New Haven Savings Bank, from mutual to capital stock form, which became effective on April 1, 2004. The Bank’s conversion resulted in the Company owning all of the Bank’s outstanding capital stock. The Bank is now a wholly-owned subsidiary of the Company, a bank holding company regulated by the Federal Reserve Board. On April 1, 2004, the Bank changed its name to NewAlliance Bank. The Bank was originally founded in 1838 as a Connecticut-chartered mutual savings bank and is regulated by the State of Connecticut Department of Banking and the Federal Deposit Insurance Corporation.
NewAlliance is the third largest banking institution headquartered in Connecticut and the fourth largest based in New England with consolidated assets of $8.21 billion and stockholders’ equity of $1.41 billion at December 31, 2007. NewAlliance delivers financial services to individuals, families and businesses throughout Connecticut and Western Massachusetts. NewAlliance Bank provides commercial banking, retail banking, consumer financing, trust and investment services through 88 banking offices, 107 ATMs and its internet website (www.newalliancebank.com). NewAlliance common stock is traded on the New York Stock Exchange under the symbol “NAL”.
Lending Activities
General
The Company originates commercial loans, commercial real estate loans, residential and commercial construction loans, residential real estate loans collateralized by one- to four-family residences, home equity lines of credit and fixed rate loans and other consumer loans predominately in the States of Connecticut and Massachusetts.
In 2005, the Company began a strategy of purchasing adjustable rate and 10 and 15 year fixed rate residential mortgages and currently has purchased loans with property locations throughout the United States. The purchased portfolio is made up of prime loans individually underwritten by the Company to its underwriting criteria. Mid-way through 2007, the mortgage market began experiencing extreme volatility and unusual pricing due to lower liquidity which led the Company to temporarily discontinue its purchased loan program. The Company resumed this program in January 2008, but expects the purchases to be at significantly lower levels than in prior years due to tightening of the credit markets and NewAlliance’s ensuing tightening of underwriting guidelines as a condition of resuming the program.
Real estate secured the majority of the Company’s loans as of December 31, 2007, including some loans classified as commercial loans. Interest rates charged on loans are affected principally by the Company’s current asset/liability strategy, the demand for such loans, the supply of money available for lending purposes and the rates offered by competitors. These factors are, in turn, affected by general economic and credit conditions, monetary policies of the federal government, including the Federal Reserve Board, federal and state tax policies and budgetary matters.
Residential Real Estate Loans
A principal lending activity of the Company is to originate prime loans secured by first mortgages on one- to four-family residences in the States of Connecticut and Massachusetts. The Company originates residential real estate loans primarily through commissioned mortgage representatives and brokers across our branch footprint. The Company originates both fixed rate and adjustable rate mortgages and purchases both adjustable rate and 10 and 15 year fixed rate mortgages. Residential lending represents the largest single component of our total portfolio.
The Company currently sells all of the fixed rate residential real estate loans it originates with terms of over 15 years except for certain long term fixed rate loans to borrowers in low to moderate income areas. Loans are originated for sale under forward rate commitments. The percentage of loans the Company sells will vary depending upon interest rates and our strategy for the management of interest rate risk. In May 2007, the Company began selling the majority of these loans without retaining the servicing, known as servicing-released, versus its previous practice of continuing to service loans that it sold to Federal Home Loan Mortgage Corporation or Federal National Mortgage Association and others. The Company also continues to service its portfolio of fixed rate loans sold prior to May 2007.
The retention of adjustable rate and shorter term fixed rate, as opposed to longer term, fixed rate residential mortgage loans in the portfolio helps reduce the Company’s exposure to interest rate risk. However, adjustable rate mortgages generally pose credit risks different from the credit risks inherent in fixed rate loans primarily because as interest rates rise, the underlying debt service payments of the borrowers rise, thereby increasing the potential for default. Management believes that these risks, which have not had a material adverse effect on the Company to date, generally are less onerous than the interest rate risks associated with holding long-term fixed rate loans in the loan portfolio. The Company’s residential real estate loan purchase program purchases adjustable rate mortgages and fixed rate mortgages with terms of maturity of less than 15 years. The servicing for these loans is retained by the seller. These purchases were originally concentrated in the Northeast following underwriting standards no less stringent than that used for the organic residential loan portfolio, but has since expanded to locations across the United States based on an analysis of relevant state economic data and other considerations. Beginning in 2008, we tightened the underwriting guidelines for the program before deciding to reenter the secondary market for purchases due to volatility and unusual pricing in that market. The Company also purchases some fixed rate mortgages with terms greater than 15 years in low or moderate income areas within its Community Reinvestment Act assessment area.
Commercial Real Estate Loans
The Company makes commercial real estate loans throughout its market area for the purpose of acquiring, developing, constructing, improving or refinancing commercial real estate where the property is the primary collateral securing the loan, and the income generated from the property is the primary repayment source. Office buildings, light industrial, retail facilities or multi-family income properties, normally collateralize commercial real estate loans. These properties are located primarily in Connecticut and Massachusetts. Among the reasons for management’s continued emphasis on commercial real estate lending is the desire to invest in assets with yields which are generally higher than yields on one- to four-family residential mortgage loans, and are more sensitive to changes in market interest rates. These loans typically have terms of up to 25 years and interest rates which adjust over periods of 3 to
10 years based on one of various rate indices. Over recent months, the spread advantage of commercial real estate loans to residential real estate loans has declined. While these conditions exist, the Company expects to reduce its origination of those commercial real estate loans with sub-residential pricing.
Commercial real estate lending generally poses a greater credit risk than residential mortgage lending to owner occupants. The repayment of commercial real estate loans depends on the business and financial condition of the borrower. Economic events and changes in government regulations, which the Company and its borrowers do not control, could have an adverse impact on the cash flows generated by properties securing commercial real estate loans and on the market value of such properties. Commercial properties tend to decline in value more rapidly than residential owner-occupied properties during economic recessions and individual loans on commercial properties tend to be larger than individual loans on residential properties.
Construction Loans
The Company originates both residential and commercial construction loans. Typically loans are made to owner-borrowers who will occupy the properties (residential construction) and to licensed and experienced developers for the construction of single-family home developments (commercial construction).
The proceeds of commercial construction loans are disbursed in stages and the terms may require developers to pre-sell a certain percentage of the properties they plan to build before the Company will advance any construction financing. Company officers, appraisers and/or independent engineers inspect each project’s progress before additional funds are disbursed to verify that borrowers have completed project phases.
Residential construction loans to owner-borrowers generally convert to a fully amortizing long-term mortgage loan upon completion of construction. Commercial construction loans generally have terms of six months to two years. Some construction to permanent loans have fixed interest rates for the permanent portion, but the Company originates mostly adjustable rate construction loans.
Construction lending, particularly commercial construction lending, poses greater credit risk than mortgage lending to owner occupants. The repayment of commercial construction loans depends on the business and financial condition of the borrower and on the economic viability of the project financed. A number of borrowers have more than one construction loan outstanding with the Company at any one time. Economic events and changes in government regulations, which the Company and its borrowers do not control, could have an adverse impact on the value of properties securing construction loans and on the borrower’s ability to complete projects financed and, if not the borrower’s residence, sell them for anticipated amounts at the time the projects commenced.
Commercial Loans
Commercial loans are primarily collateralized by equipment, inventory, accounts receivable and/or leases. Many of the Company’s commercial loans are also collateralized by real estate, but are not classified as commercial real estate loans because such loans are not made for the purpose of acquiring, refinancing or constructing the real estate securing the loan. Commercial loans provide primarily working capital, equipment financing, financing for leasehold improvements and financing for expansion. The Company offers both term and revolving commercial loans. Term loans have either fixed or adjustable rates of interest and, generally, terms of between two and seven years. Term loans generally amortize during their life, although some loans require a balloon payment at maturity. Revolving commercial lines of credit typically have one or two-year terms, are renewable annually and have a floating rate of interest which are normally indexed to the Company’s “base rate” of interest.
Commercial lending generally poses a higher degree of credit risk than real estate lending. Repayment of both secured and unsecured commercial loans depends substantially on the success of the borrower’s underlying business, financial condition and cash flows. Unsecured loans generally involve a higher degree of risk of loss than do secured loans because, without collateral, repayment is primarily dependent upon the success of the borrower’s business. Secured commercial loans are generally collateralized by equipment, inventory, accounts receivable and leases. Compared to real estate, such collateral is more difficult to monitor, its value is more difficult to validate, it may depreciate more rapidly and it may not be as readily saleable if repossessed.
At December 31, 2007, the Company’s outstanding commercial loan portfolio included the following business sectors: manufacturing, professional services, wholesale trade, retail trade, transportation, educational and health services, contractors and real estate rental and leasing. Industry concentrations are reported quarterly to the Loan Committee of the Board of Directors.
Consumer Loans
The Company originates various types of consumer loans, including auto, mobile home, boat, educational and personal installment loans. However, approximately 95% of our consumer loan portfolio is comprised of home equity loans and lines of credit secured by one- to four-family owner-occupied properties. These loans are typically secured by second mortgages. Home equity loans have fixed
interest rates, while home equity lines of credit normally adjust based on the Company’s base rate of interest. Consumer loans are originated through the branch network.
Credit Risk Management and Asset Quality
One of management’s key objectives has been and continues to be to maintain a high level of asset quality. NewAlliance utilizes the following general practices to manage credit risk:
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Limiting the amount of credit that individual lenders may extend;
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Establishing a process for credit approval accountability;
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Careful initial underwriting and analysis of borrower, transaction, market and collateral risks;
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Ongoing servicing of individual loans and lending relationships;
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Continuous monitoring of the portfolio, market dynamics and the economy;
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Periodically reevaluating the Bank’s strategy and overall exposure as economic, market and other relevant conditions change
NewAlliance’s lending strategy, which focuses on relationship-based lending within our markets continues to produce excellent credit quality. As measured by relative levels of nonperforming assets, delinquencies, and net charge-offs, NewAlliance’s asset quality has remained significantly better than industry published averages.
Credit Administration is independent of the lending groups, and is responsible for the completion of credit analyses for all loans above a specific threshold, for determining loan loss reserve adequacy and for preparing monthly and quarterly reports regarding the credit quality of the loan portfolio, which are submitted to senior management and the Board of Directors, to ensure compliance with the credit policy. In addition, Credit Administration is responsible for managing the reduction in nonperforming and classified assets. On a quarterly basis, the Criticized Asset Committee reviews commercial and commercial real estate loans that are risk rated Special Mention or worse, focusing on the current status and strategies to improve the credit.
The loan review function is outsourced to a third party to provide an evaluation of the creditworthiness of the borrower and the appropriateness of the risk rating classifications. The findings are then presented to the Loan Committee of the Board of Directors.
Trust Services
The Company provides a range of fiduciary and trust services and general investment management services to individuals, families and institutions. The Company will continue to emphasize the growth of its trust and investment management services to increase feebased income. At December 31, 2007, Trust Services managed approximately 1,300 account relationships and had assets under management of $1.23 billion. These assets are not included in the Consolidated Financial Statements. For the years ended December 31, 2007, 2006 and 2005, revenues for this area were $6.8 million, $6.4 million and $4.8 million, respectively.
Brokerage, Investment Advisory and Insurance Services
Through its wholly owned subsidiary, NewAlliance Investments, Inc., member FINRA/SIPC, the Company offers securities services, including brokerage and investment advice and is a registered investment advisor with over 25 registered representatives offering customers an expansive array of investment products including stocks, bonds, mutual funds, fixed annuities, estate and retirement planning and life insurance. In March 2007, the Company acquired Connecticut Investment Management Inc., an investment advisory firm with $175.2 million of assets under management. These assets are not included in the Consolidated Financial Statements.
Investment Activities
The primary objective of the investment portfolio is to achieve a profitable rate of return on the investments over a reasonable period of time based on prudent management practices and sensible risk taking. The portfolio is also used to help manage the net interest rate risk position of the Company. As a tool to manage interest rate risk, the flexibility to utilize long term fixed rate investments is quite limited. In view of the Company’s lending capacity and generally higher rates of return on loans, management prefers lending activities as its primary source of revenue with the securities portfolio serving a secondary role. The investment portfolio, however, is expected to continue to represent a significant portion of the Company’s assets, and includes U.S. Government and Agency securities, mortgage-backed securities, collateralized mortgage obligations, asset backed securities, high quality corporate debt, municipal bonds and corporate equities. The portfolio will continue to serve the Company’s liquidity needs as projected by management and as required by regulatory authorities. Also, during the first half of the year, the Company focused on using cash flows from available for-sale and held-to-maturity mortgage-backed securities to fund the residential loan purchase program.
Sources of Funds
The Company uses deposits, repayments and prepayments of loans and securities, proceeds from sales of loans and securities and proceeds from maturing securities and borrowings to fund lending, investing and general operations. Deposits represent the Company’s primary source of funds.
Deposits
The Company offers a variety of deposit accounts with a range of interest rates and other terms, which are designed to meet customer financial needs. The Federal Deposit Insurance Corporation (“FDIC”) insures deposits up to certain limits (generally, $100,000 per depositor and $250,000 for certain retirement plan accounts). Retail and commercial deposits are received through the Company’s banking offices. Additional deposit services provided to customers are ATM, telephone, Internet Banking and Internet Bill Pay.
Deposit flows are significantly influenced by economic conditions, the general level of interest rates and the relative attractiveness of competing deposit and investment alternatives. Deposit pricing strategy is monitored weekly by the Pricing Committee and results are reported monthly to the Asset/Liability Committee. When determining our deposit pricing, we consider strategic objectives, competitive market rates, deposit flows, funding commitments and investment alternatives, FHLB advance rates and rates on other sources of funds.
National, regional and local economic and credit conditions, changes in competitor money market, savings and time deposit rates, prevailing market interest rates and competing investment alternatives all have a significant impact on the level of the Company’s deposits.
Borrowings
The Company is a member of the Federal Home Loan Bank (“FHLB”) system which functions in a reserve credit capacity for regulated, federally insured depository institutions and certain other home financing institutions. Members of the system are required to own capital stock in the FHLB and are authorized to apply for advances on the security of their FHLB stock and certain home mortgages and other assets (principally securities, which are obligations of, or guaranteed by, the United States Government or its agencies) provided certain creditworthiness standards have been met. Under its current credit policies, the FHLB limits advances based on a member’s assets, total borrowings and net worth. Long-term and short-term FHLB advances are utilized as a source of funding to meet liquidity and planning needs when the cost of these funds are favorable as compared to deposits or alternate funding sources.
Additional funding sources are available through securities sold under agreements to repurchase and the Federal Reserve Bank of Boston (“FRB”).
Acquisitions
The Company’s growth and increased market share have been achieved through both internal growth and acquisitions. The Company continually evaluates acquisition opportunities that would help meet our strategic objectives. NewAlliance will continue to pursue economically advantageous acquisitions of banks, asset managers and leasing and finance companies, and may pursue other strategic opportunities to grow existing businesses or expand into other related financial businesses. NewAlliance’s acquisition strategy is focused on three primary objectives:
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A return on investment that exceeds the Bank’s cost of capital;
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Earnings accretion and/or franchise enhancement;
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An appropriate trade off between tangible book value dilution and EPS accretion/franchise enhancement.
Since 2004 NewAlliance consummated acquisitions of four banking institutions, a non-depository trust company and a registered investment advisory firm. In the long-term NewAlliance expects to continue to take advantage of the consolidation in the financial services industry and expand and enhance its franchise through mergers and acquisitions. The consideration paid for these acquisitions may be in the form of cash, debt or NewAlliance common stock. The amount of consideration paid to complete these transactions may be in excess of the book value of the underlying net assets acquired, which could have a dilutive effect on NewAlliance’s earnings. In addition, acquisitions often result in front-end charges against earnings; however, cost savings and revenue enhancements, are also typically anticipated.
In 2007 acquisitions included Westbank Corporation (“Westbank”) and Connecticut Investment Management, Inc. (“CIMI”) which were completed in January 2007 and March 2007, respectively. The results of operations of Westbank and CIMI are included in the Consolidated Financial Statements for periods subsequent to the date of acquisition.
Subsidiary Activities
NewAlliance Bancshares, Inc. is a bank holding company and currently has the following wholly-owned subsidiaries. The Company has not participated in asset securitizations.
Alliance Capital Trust I and Alliance Capital Trust II were organized by Alliance Bancorp of New England, Inc. (“Alliance”) to facilitate the issuance of “trust preferred” securities. The Company acquired these subsidiaries when it acquired Alliance. The Company’s debt to Alliance Capital Trust I and II is recorded as “Junior Subordinated Debentures issued to affiliated trusts” in Note 10 of the Notes to Consolidated Financial Statements contained elsewhere in this report, and amounted to a total of $7.4 million at December 31, 2007.
Westbank Capital Trust II and Westbank Capital Trust III were organized by Westbank solely for the purpose of trust preferred financing. The Company acquired these subsidiaries when it acquired Westbank on January 2, 2007. The Company’s debt to Westbank Capital Trust II and III is recorded as “Junior Subordinated Debentures issued to affiliated trusts” in Note 10 of the Notes to Consolidated Financial Statements contained elsewhere in this report, and amounted to a total of $17.5 million at December 31, 2007.
NewAlliance Bank is a Connecticut chartered capital stock savings bank and also has the following wholly-owned subsidiaries all of which are incorporated in Connecticut.
NewAlliance Bank Community Development Corporation (“CDC”) was organized in 1999 pursuant to a federal law which encourages the creation of such bank subsidiaries to further community development programs. The CDC has been funded with $7.5 million in cash to provide flexible capital for community development and neighborhood revitalization. The Bank intends to provide additional funding to the CDC, up to $10.0 million in total, as the funds can be utilized. The CDC investments can be in the form of equity, debt or mezzanine financing. Current investments include artist housing, affordable housing loan pools, equity investments in downtown real estate development and small business development funds. Fairbank Corporation is a wholly-owned subsidiary of the CDC. Fairbank Corporation owns a 121 unit apartment building in New Haven, Connecticut. The building includes tenants eligible for federal “Section 8” housing cost assistance and a branch of the Bank. Fairbank Corporation was formed and the investment made in 1971 to further the Bank’s commitment to the New Haven community.
The Loan Source, Inc. is used to hold certain real estate that we may acquire through acquisitions or foreclosure and other collection actions and investments in certain limited partnerships. The Loan Source, Inc. currently has no such foreclosure property under ownership. The subsidiary does have an investment in a limited partnership and ownership of several properties previously owned by a subsidiary of Westbank.
NewAlliance Servicing Company operates as the Bank’s passive investment company (“PIC”). A 1998 Connecticut law allows for the creation of PICs. A properly created and maintained PIC allows the Bank to contribute its real estate loans to the PIC where they are serviced. The PIC does not recognize income generated by the PIC for the purpose of Connecticut business corporations’ tax, nor does the Bank recognize income for these purposes on the dividends it receives from the PIC. Since its establishment in 1998, the PIC has allowed the Bank, like many other banks with Connecticut operations, to experience substantial savings on the Connecticut business corporations tax that otherwise would have applied.
NewAlliance Investments, Inc. offers brokerage and investment advisory services and fixed annuities and other insurance products to its customers. NewAlliance Investments, Inc. is a registered broker-dealer, registered investment advisor and is a member of FINRA/SIPC.
Employees
At December 31, 2007, the Company had 1,217 employees consisting of 979 full-time and 238 part-time employees. None of the employees were represented by a collective bargaining group. The Company maintains a comprehensive employee benefit program providing, among other benefits, group medical and dental insurance, life insurance, disability insurance, a pension plan, an employee 401(k) investment plan and an employee stock ownership plan. Management considers relations with its employees to be good. See
Notes 11 and 12 of the Notes to Consolidated Financial Statements contained elsewhere within this report for additional information on certain benefit programs.
Market Area
The Company is headquartered in New Haven, Connecticut in New Haven County. The Company has 88 banking offices located throughout New Haven, Middlesex, Hartford, Tolland, Windham and Fairfield Counties in Connecticut and Hampden and Worcester Counties in Massachusetts. The Company’s primary deposit gathering area consists of the communities and surrounding towns that are served by its branch network. The Company’s primary lending area is much broader than its deposit gathering area and includes the entire State of Connecticut and Central and Western Massachusetts, although most of the Company’s loans are made to borrowers in its primary deposit gathering area.
Economy
Many analysts are now predicting the U.S. Economy will have limited or flat growth or will experience a recession in the near term. The deterioration in the economy was due in part to the sub prime housing crisis which surfaced in mid-2007 and the subsequent tightening of credit markets, an increase in energy costs, rising consumer prices, growing personal debt and a weakening U.S. dollar abroad. The economic slowdown is particularly being felt in the housing market as housing starts and new home sales are down and loan delinquencies and foreclosures have risen. To help stabilize the economy, the Federal Reserve Board drastically reduced interest rates during the beginning of 2008.
The Northeast, and specifically Connecticut, has not been hit as hard as other parts of the country although we expect Connecticut will see a slow down in its economy in 2008. On the positive side, Connecticut has low unemployment and attractive demographics. The housing market did not get overbuilt, real estate pricing appreciation was not over heated and unemployment levels remained slightly below the national average.
Competition
The Company is subject to strong competition from banks and other financial institutions, including savings and loan associations, commercial banks, finance and mortgage companies, credit unions, consumer finance companies, brokerage firms and insurance companies. Certain of these competitors are larger financial institutions with substantially greater resources, lending limits, larger branch systems and a wider array of commercial banking services than NewAlliance. Competition from both bank and non-bank organizations is expected to continue.
The banking industry is also experiencing rapid changes in technology. In addition to improving customer services, effective use of technology increases efficiency and enables financial institutions to reduce costs. Technological advances are likely to increase competition by enabling more companies to provide cost effective products and services.
The Company faces substantial competition for deposits and loans throughout its market areas. The primary factors in competing for deposits are interest rates, personalized services, the quality and range of financial services, convenience of office locations, automated services and office hours. Competition for deposits comes primarily from other savings institutions, commercial banks, credit unions, mutual funds and other investment alternatives. The primary factors in competing for loans are interest rates, loan origination fees, the quality and range of lending services and personalized service. Competition for origination of first mortgage loans comes primarily from other savings institutions, mortgage banking firms, mortgage brokers, commercial banks and insurance companies. Competition is likely to further increase due to the entrance of non-traditional lending financial service providers such as internet based lenders and insurance and securities companies. Competition for deposits, for the origination of loans and for the provision of other financial services may limit the Company’s future growth.
Regulation and Supervision
General
The Company is required to file reports and otherwise comply with the rules and regulations of the FRB, the Connecticut Banking Commissioner and the Securities and Exchange Commission (“SEC”) under the Federal securities laws.
The Bank is subject to extensive regulation by the Connecticut Department of Banking, as its chartering agency, and by the Federal Deposit Insurance Corporation (“FDIC”), as its deposit insurer. The Bank is required to file reports with, and is periodically examined by, the FDIC and the Connecticut Department of Banking concerning its activities and financial condition. It must obtain regulatory approvals prior to entering into certain transactions, such as mergers.
In addition to federal and state banking laws and regulations, NewAlliance and certain of its subsidiaries including those that engage in brokerage, investment advisory and insurance activities, are subject to other federal and state laws and regulations. Changes in these laws and regulations are frequently introduced at both the federal and state levels. The likelihood and timing of any such changes and the impact such changes might have on NewAlliance and its subsidiaries are impossible to determine with certainty.
The following discussion of the laws and regulations material to the operations of the Company and the Bank is a summary and is qualified in its entirety by reference to such laws and regulations. Any change in such regulations, whether by the Department of Banking, the FDIC, the SEC or the FRB, could have a material adverse impact on the Bank or the Company.
Holding Company Regulation
NewAlliance Bancshares, Inc. is a registered bank holding company under the Bank Holding Company Act (“BHCA”) and is subject to comprehensive regulation and regular examinations by the Federal Reserve Board. The Federal Reserve Board also has extensive enforcement authority over bank holding companies, including, among other things, the ability to assess civil money penalties, to issue cease and desist or removal orders and to require that a holding company divest subsidiaries (including its bank subsidiaries). In general, enforcement actions may be initiated for violations of law and regulations and unsafe or unsound practices. Under Connecticut banking law, no person may acquire beneficial ownership of more than 10% of any class of voting securities of a Connecticut-chartered bank, or any bank holding company of such a bank, without prior notification of, and lack of disapproval by, the Connecticut Banking Commissioner. The Connecticut Banking Commissioner will disapprove the acquisition if the bank or holding company to be acquired has been in existence for less than five years, unless the Connecticut Banking Commissioner waives this five-year restriction, or if the acquisition would result in the acquirer controlling 30% or more of the total amount of deposits in insured depository institutions in Connecticut. Similar restrictions apply to any person who holds in excess of 10% of any such class and desires to increase its holdings to 25% or more of such class.
Under Federal Reserve Board policy, a bank holding company must serve as a source of strength for its subsidiary bank. Under this policy, the Federal Reserve Board may require, and has required in the past, a holding company to contribute additional capital to an undercapitalized subsidiary bank.
Bank holding companies must obtain Federal Reserve Board approval before: (i) acquiring, directly or indirectly, ownership or control of any voting shares of another bank or bank holding company if, after such acquisition, it would own or control more than 5% of such shares (unless it already owns or controls the majority of such shares); (ii) acquiring all or substantially all of the assets of another bank or bank holding company; or (iii) merging or consolidating with another bank holding company.
The BHCA also prohibits a bank holding company, with certain exceptions, from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank or bank holding company, or from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. The principal exceptions to these prohibitions involve certain non-bank activities which, by statute or by FRB regulation or order, have been identified as activities closely related to the business of banking or managing or controlling banks. The list of activities permitted by the FRB includes, among other things: (i) operating a savings institution, mortgage company, finance company, credit card company or factoring company; (ii) performing certain data processing operations; (iii) providing certain investment and financial advice; (iv) underwriting and acting as an insurance agent for certain types of credit-related insurance; (v) leasing property on a full-payout, non-operating basis; (vi) selling money orders, travelers’ checks and United States Savings Bonds; (vii) real estate and personal property appraising; (viii) providing tax planning and preparation services; (ix) financing and investing in certain community development activities; and (x) subject to certain limitations, providing securities brokerage services for customers.
Dividends
The Federal Reserve Board has issued a policy statement on the payment of cash dividends by bank holding companies, which expresses the Federal Reserve Board’s view that a bank holding company should pay cash dividends only to the extent that the holding company’s net income for the past year is sufficient to cover both the cash dividends and a rate of earnings retention that is consistent with the holding company’s capital needs, asset quality and overall financial condition. The FRB also indicated that it would be inappropriate for a company experiencing serious financial problems to borrow funds to pay dividends. Furthermore, under the prompt corrective action regulations adopted by the Federal Reserve Board, the Federal Reserve Board may prohibit a bank holding company from paying any dividends if the holding company’s bank subsidiary is classified as “undercapitalized.”
Financial Modernization
The Gramm-Leach-Bliley Act (“GLBA”) permits greater affiliation among banks, securities firms, insurance companies, and other companies under a new type of financial services company known as a “financial holding company”. A financial holding company essentially is a bank holding company with significantly expanded powers. Financial holding companies are authorized by statute to engage in a number of financial activities previously impermissible for bank holding companies, including securities underwriting,
dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency; and merchant banking activities. The act also permits the Federal Reserve Board and the Treasury Department to authorize additional activities for financial holding companies if they are “financial in nature” or “incidental” to financial activities. A bank holding company may become a financial holding company if each of its subsidiary banks is well capitalized, well managed, and has at least a “satisfactory” Community Reinvestment Act rating. A financial holding company must provide notice to the Federal Reserve Board within 30 days after commencing activities previously determined by statute or by the Federal Reserve Board and Department of the Treasury to be permissible. The Company has not submitted notice to the Federal Reserve Board of its intent to be deemed a financial holding company. However, it is not precluded from submitting a notice in the future should it wish to engage in activities only permitted to financial holding companies.
Under GLBA, all financial institutions are required to establish policies and procedures to restrict the sharing of nonpublic customer data with nonaffiliated parties and to protect customer data from unauthorized access. In addition, the Fair and Accurate Credit Transactions Act of 2003 (“FACT Act”) includes many provisions concerning national credit reporting standards, and permits consumers, including customers of NewAlliance, to opt out of information sharing among affiliated companies for marketing purposes. The FACT Act also requires banks and other financial institutions to notify their customers if they report negative information about them to a credit bureau or if they are granted credit on terms less favorable than those generally available. The Federal Reserve and the Federal Trade Commission are granted extensive rulemaking authority under the FACT Act, and NewAlliance Bank and its affiliates are subject to those provisions. NewAlliance has developed policies and procedures for itself and its subsidiaries, including NewAlliance Bank, and believes it is in compliance with all privacy, information sharing, and notification provisions of GLBA and the FACT Act.
Connecticut Banking Laws and Supervision
NewAlliance Bank is a state-chartered savings bank under Connecticut law and as such is subject to regulation and examination by the Commissioner and the Department of Banking of the State of Connecticut. The Department of Banking regulates savings banks, among other financial institutions, for compliance with the laws and regulations of the State of Connecticut, as well as the appropriate rules and regulations of federal agencies. The approval of the Commissioner is required for, among other things, the establishment of branch offices and business combination transactions. The Commissioner conducts periodic examinations of Connecticut-chartered banks. The FDIC also regulates many of the areas regulated by the Commissioner, and federal law may limit some of the authority provided to Connecticut-chartered banks by Connecticut law.
Lending Activities
Connecticut banking laws grant savings banks broad lending authority, generally identical to commercial banks. With certain limited exceptions, total secured and unsecured loans made to any one obligor under this statutory authority may not exceed 10% and 15%, respectively, of a bank’s equity capital and reserves for loan and lease losses.
Dividends
The Bank may pay cash dividends out of its net profits. For purposes of this restriction, “net profits” represents the remainder of all earnings from current operations. Further, the total amount of all dividends declared by the Bank in any year may not exceed the sum of its net profits for the year in question combined with its retained net profits from the preceding two years, unless the Commissioner approves the larger dividend. Federal law also prevents the Bank from paying dividends or making other capital distributions that would cause it to become “undercapitalized.” The FDIC may limit the Bank’s ability to pay dividends. No dividends may be paid to the Bank’s stockholders if such dividends would reduce stockholders’ equity below the amount of the liquidation account required by the Connecticut conversion regulations.
Powers
Connecticut law permits Connecticut banks to sell insurance and fixed- and variable-rate annuities if licensed to do so by the Connecticut Insurance Commissioner. With the prior approval of the Commissioner, Connecticut banks are also authorized to engage in a broad range of activities related to the business of banking, or that are financial in nature or that are permitted under the Bank Holding Company Act (“BHCA”) or the Home Owners’ Loan Act (“HOLA”), both federal statutes, or the regulations promulgated as a result of these statutes. Connecticut banks are also authorized to engage in any activity permitted for a national bank or a federal savings association upon filing notice with the Commissioner, unless the Commissioner disapproves the activity.
Assessments
Connecticut banks are required to pay annual assessments to the Connecticut Department of Banking to fund the Department’s operations. The general assessments are paid pro-rata based upon a bank’s asset size.
Enforcement
Under Connecticut law, the Commissioner has extensive enforcement authority over Connecticut banks and, under certain circumstances, affiliated parties, insiders, and agents. The Commissioner’s enforcement authority includes cease and desist orders, fines, receivership, conservatorship, removal of officers and directors, emergency closures, dissolution and liquidation.
Federal Regulations
Capital Requirements
Under FDIC regulations, federally insured state-chartered banks that are not members of the Federal Reserve System (“state nonmember banks”), such as NewAlliance Bank, are required to comply with minimum leverage capital requirements. If the FDIC determines that an institution is not anticipating or experiencing significant growth and is, in general, a strong banking organization, rated composite 1 under the Uniform Financial Institutions Ranking System established by the Federal Financial Institutions Examination Council, the minimum capital leverage requirement is a ratio of Tier 1 capital to total assets of 3%. For all other institutions, the minimum leverage capital ratio is not less than 4%. Tier 1 capital is the sum of common stockholders’ equity, noncumulative perpetual preferred stock (including any related surplus) and minority investments in certain subsidiaries, less intangible assets (except for certain servicing rights and credit card relationships) and certain other specified items.
The FDIC regulations require state non-member banks to maintain certain levels of regulatory capital in relation to regulatory risk-weighted assets. The ratio of regulatory capital to regulatory risk-weighted assets is referred to as a bank’s “risk-based capital ratio.” Risk-based capital ratios are determined by allocating assets and specified off-balance sheet items (including recourse obligations, direct credit substitutes and residual interests) to four risk-weighted categories ranging from 0% to 100%, with higher levels of capital being required for the categories perceived as representing greater risk. For example, under the FDIC’s risk-weighting system, cash and securities backed by the full faith and credit of the U.S. government are given a 0% risk weight, loans secured by one- to four-family residential properties generally have a 50% risk weight, and commercial loans have a risk weighting of 100%.
State non-member banks, such as the Bank, must maintain a minimum ratio of total capital to risk-weighted assets of at least 8%, of which at least one-half must be Tier 1 capital. Total capital consists of Tier 1 capital plus Tier 2 or supplementary capital items, which include allowances for loan losses in an amount of up to 1.25% of risk-weighted assets, cumulative preferred stock and certain other capital instruments, and a portion of the net unrealized gain on equity securities. The includable amount of Tier 2 capital cannot exceed the amount of the institution’s Tier 1 capital. Banks that engage in specified levels of trading activities are subject to adjustments in their risk based capital calculation to ensure the maintenance of sufficient capital to support market risk.
The Federal Deposit Insurance Corporation Improvement Act (the “FDICIA”) required each federal banking agency to revise its risk-based capital standards for insured institutions to ensure that those standards take adequate account of interest-rate risk, concentration of credit risk, and the risk of nontraditional activities, as well as to reflect the actual performance and expected risk of loss on multifamily residential loans. The FDIC, along with the other federal banking agencies, has adopted a regulation providing that the agencies will take into account the exposure of a bank’s capital and economic value to changes in interest rate risk in assessing a bank’s capital adequacy. The FDIC also has authority to establish individual minimum capital requirements in appropriate cases upon determination that an institution’s capital level is, or is likely to become, inadequate in light of the particular circumstances.
As a bank holding company, the Company is subject to capital adequacy guidelines for bank holding companies similar to those of the FDIC for state-chartered banks.
Prompt Corrective Regulatory Action
Federal law requires, among other things, that federal bank regulatory authorities take “prompt corrective action” with respect to banks that do not meet minimum capital requirements. For these purposes, the law establishes five capital categories:
• Well capitalized - at least 5% leverage capital, 6% tier one risk based capital and 10% total risk based capital.
• Adequately capitalized - at least 4% leverage capital, 4% tier one risk based capital and 8% total risk based capital.
• Undercapitalized - less than 4% leverage capital, 4% tier one risk based capital and less than 8% total risk based capital. “Undercapitalized” banks must adhere to growth, capital distribution (including dividend) and other limitations and are required to submit a capital restoration plan. A bank’s compliance with such a plan is required to be guaranteed by any company that controls the undercapitalized institution in an amount equal to the lesser of 5% of the institution’s total assets when deemed undercapitalized or the amount necessary to achieve the status of adequately capitalized.
• Significantly undercapitalized - less than 3% leverage capital, 3% tier one risk based capital and less than 6% total risk-based capital. “Significantly undercapitalized” banks must comply with one or more of a number of additional restrictions, including but not limited to an order by the FDIC to sell sufficient voting stock to become adequately capitalized, requirements to reduce
total assets, cease receipt of deposits from correspondent banks or dismiss directors or officers, and restrictions on interest rates paid on deposits, compensation of executive officers and capital distributions by the parent holding company.
• Critically undercapitalized - less than 2% tangible capital. “Critically undercapitalized” institutions are subject to additional measures including, subject to a narrow exception, the appointment of a receiver or conservator within 270 days after it obtains such status.
As of December 31, 2007, NewAlliance Bank was “well capitalized”.
Transactions with Affiliates
Under federal law, transactions between depository institutions and their affiliates are governed by Sections 23A and 23B of the Federal Reserve Act (the “FRA”). In a holding company context, at a minimum, the parent holding company of a bank and any companies which are controlled by such parent holding company are affiliates of the bank. Generally, sections 23A and 23B are intended to protect insured depository institutions from suffering losses arising from transactions with non-insured affiliates, by limiting the extent to which a bank or its subsidiaries may engage in covered transactions with any one affiliate and with all affiliates of the bank in the aggregate, and by requiring that such transactions be on terms that are consistent with safe and sound banking practices.
Further, Section 22(h) of the FRA restricts loans to directors, executive officers, and principal stockholders (“insiders”). Under Section 22(h), loans to insiders and their related interests may not exceed, together with all other outstanding loans to such persons and affiliated entities, the institution’s total capital and surplus. Loans to insiders above specified amounts must receive the prior approval of the board of directors. Further, under Section 22(h), loans to directors, executive officers and principal stockholders must be made on terms substantially the same as offered in comparable transactions to other persons, except that such insiders may receive preferential loans made under a benefit or compensation program that is widely available to the bank’s employees and does not give preference to the insider over the employees. Section 22(g) of the FRA places additional limitations on loans to executive officers.
Enforcement
The FDIC has extensive enforcement authority over insured banks, including NewAlliance Bank. This enforcement authority includes, among other things, the ability to assess civil money penalties, issue cease and desist orders and remove directors and officers. In general, these enforcement actions may be initiated in response to violations of laws and regulations and unsafe or unsound practices.
Insurance of Deposit Accounts
NewAlliance deposit accounts are insured by the FDIC up to applicable legal limits.
The FDIC has adopted a risk-based insurance assessment system. The FDIC assigns an institution to one of three capital categories based on the institution’s financial condition consisting of (1) well capitalized, (2) adequately capitalized or (3) undercapitalized, and one of three supervisory subcategories within each capital group. The supervisory subgroup to which an institution is assigned is based on a supervisory evaluation provided to the FDIC by the institution’s primary federal regulator and information which the FDIC determines to be relevant to the institution’s financial condition and the risk posed to the deposit insurance funds. An institution’s assessment rate depends on the capital category and supervisory category to which it is assigned. Assessment rates for insurance fund deposits currently range from five basis points for the strongest institution to 43 basis points for the weakest. The FDIC may adjust rates up or down by 3 basis points from the base rate schedule without further notice-and-comment rulemaking, provided that any single adjustment from one quarter to the next cannot change rates more than 3 basis points. If such action is taken by the FDIC, it could have an adverse effect on the earnings of the Bank. In November 2006, the FDIC Board of Directors approved a final rule to implement a One-Time Assessment Credit, as required by the Federal Deposit Insurance Reform Act of 2005 (“Reform Act”). For 2007 assessment periods, effective with the June 2007 invoice, credits were used to fully offset the Bank’s assessment. For assessment periods beginning in 2008-2010, credits may not be applied to more than 90 percent of an institution’s assessment.
In addition, FDIC insured institutions are required to pay assessments to the Federal Deposit Insurance Corporation at an annual rate of approximately 0.0114 of insured deposits to fund interest payments on bonds issued by the Financing Corporations (“FICO”), an agency of the federal government established to recapitalize the predecessor to the Savings Association Insurance Fund. These assessments will continue until the Financing Corporation bonds mature in 2017 through 2019. The FICO assessment rate is adjusted quarterly to reflect changes in the assessment bases of the fund based on quarterly Call Report and Thrift Financial Report submissions.
The FDIC may terminate insurance of deposits if it finds that the institution is in an unsafe or unsound condition to continue operations, has engaged in unsafe or unsound practices, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance.
Federal Reserve System
The FRB regulations require depository institutions to maintain non-interest-earning reserves against their transaction accounts (primarily NOW and regular checking accounts). The FRB regulations generally require that reserves be maintained against aggregate transaction accounts as follows: for that portion of transaction accounts aggregating $43.9 million or less (which may be adjusted by the FRB) the reserve requirement is 3%; and for amounts greater than $43.9 million, 10% (which may be adjusted by the FRB between 8% and 14%), against that portion of total transaction accounts in excess of $43.9 million. The first $9.3 million of otherwise reservable balances (which may be adjusted by the FRB) are exempted from the reserve requirements. The Bank is in compliance with these requirements.
Federal Home Loan Bank System
The Bank is a member of the Federal Home Loan Bank System, which consists of 12 regional Federal Home Loan Banks. The Federal Home Loan Bank provides a central credit facility primarily for member institutions. Member institutions are required to acquire and hold shares of capital stock in the Federal Home Loan Bank in an amount at least equal to the sum of 0.35% of the aggregate principal amount of its unpaid residential mortgage loans and similar obligations at the beginning of each year and 4.5% of its advances (borrowings) from the Federal Home Loan Bank. The Bank was in compliance with this requirement with an investment in Federal Home Loan Bank stock at December 31, 2007 of $113.8 million. At December 31, 2007, the Bank had approximately $2.13 billion in Federal Home Loan Bank advances.
The Federal Home Loan Banks are required to provide funds for certain purposes including the resolution of insolvent thrifts in the late 1980s and to contributing funds for affordable housing programs. These requirements could reduce the amount of dividends that the Federal Home Loan Banks pay to their members and result in the Federal Home Loan Banks imposing a higher rate of interest on advances to their members. If dividends were reduced, or interest on future Federal Home Loan Bank advances increased, a member bank affected by such reduction or increase would likely experience a reduction in its net interest income. Recent legislation has changed the structure of the Federal Home Loan Banks’ funding obligations for insolvent thrifts, revised the capital structure of the Federal Home Loan Banks and implemented entirely voluntary membership for Federal Home Loan Banks. There can be no assurance that such dividends will continue in the future. Further, there can be no assurance that the impact of recent or future legislation on the Federal Home Loan Banks also will not cause a decrease in the value of the Federal Home Loan Bank stock held by the Bank.
Other Regulation
Sarbanes-Oxley Act of 2002
The stated goals of the Sarbanes-Oxley Act of 2002 (“SOX”) are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws.
SOX includes very specific additional disclosure requirements and new corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules and mandates further studies of certain issues by the SEC and the Comptroller General. SOX represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees.
SOX addresses, among other matters, audit committees; certification of financial statements and internal controls by the Chief Executive Officer and Chief Financial Officer; the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer’s securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement; a prohibition on insider trading during pension plan black out periods; disclosure of off-balance sheet transactions; a prohibition on certain loans to directors and officers; expedited filing requirements for Forms 4; disclosure of a code of ethics and filing a Form 8-K for significant changes or waivers of such code; “real time” filing of periodic reports; the formation of a public accounting oversight board; auditor independence; and various increased criminal penalties for violations of securities laws. The SEC has enacted rules to implement various provisions of SOX.
USA PATRIOT Act
Under Title III of the USA PATRIOT Act, all financial institutions are required to take certain measures to identify their customers, prevent money laundering, monitor customer transactions and report suspicious activity to U.S. law enforcement agencies. Financial institutions also are required to respond to requests for information from federal banking regulatory authorities and law enforcement agencies. Information sharing among financial institutions for the above purposes is encouraged by an exemption granted to complying financial institutions from the privacy provisions of GLBA and other privacy laws. Financial institutions that hold correspondent accounts for foreign banks or provide private banking services to foreign individuals are required to take measures to avoid dealing with certain foreign individuals or entities, including foreign banks with profiles that raise money laundering concerns, and are prohibited from dealing with foreign “shell banks” and persons from jurisdictions of particular concern. The primary federal
banking regulators and the Secretary of the Treasury have adopted regulations to implement several of these provisions. All financial institutions also are required to establish internal anti-money laundering programs. The effectiveness of a financial institution in combating money laundering activities is a factor to be considered in any application submitted by the financial institution under the Bank Merger Act or the BHCA. NewAlliance has in place a Bank Secrecy Act and USA PATRIOT Act compliance program, and engages in very few transactions of any kind with foreign financial institutions or foreign persons.
Community Reinvestment Act and Fair Lending Laws
NewAlliance has a responsibility under the Community Reinvestment Act of 1977 (“CRA”) to help meet the credit needs of our communities, including low- and moderate-income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. In connection with its examination, the FDIC assesses our record of compliance with the CRA. In addition, the Equal Credit Opportunity Act and the Fair Housing Act prohibit discrimination in lending practices on the basis of characteristics specified in those statutes. Our failure to comply with the provisions of the CRA could, at a minimum, result in regulatory restrictions on our activities. Our failure to comply with the Equal Credit Opportunity Act and the Fair Housing Act could result in enforcement actions against us by the FDIC as well as other federal regulatory agencies and the Department of Justice. The Bank’s latest FDIC CRA rating was “satisfactory”.
New York Stock Exchange Disclosure
The annual certification of NewAlliance’s Chief Executive Officer required to be furnished to the New York Stock Exchange pursuant to Section 303A.12(a) of the NYSE Listed Company Manual was previously filed with the New York Stock Exchange on May 22, 2007.
Impact of Inflation and Changing Prices
The Consolidated Financial Statements and their Notes presented within this document have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”), which requires the measurement of financial position and operating results in terms of historical dollar amounts without considering changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Company’s operations. Unlike the assets and liabilities of industrial companies, nearly all of the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a greater impact on the Company’s performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.
Statistical Disclosure by Bank Holding Companies
The following information required by Securities Act Guide 3 “Statistical Disclosure by Bank Holding Companies” is located on the pages noted below.
Page
I.
Distribution of Assets, Liabilities and Stockholder Equity; Interest Rates and Interest Differential
32-34
II.
Investment Portfolio
38-39
III.
Loan Portfolio
40-41
IV.
Summary of Loan Loss Experience
41-45
V.
Deposits
45-46
VI.
Return on Equity and Assets
VII.
Short-Term Borrowings
n/a
Availability of Information
NewAlliance makes available free of charge on our website (http://www.newalliancebank.com), our annual report on Form 10-K, our quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934 as soon as practicable after we electronically file such reports with or furnish it to the Securities and Exchange Commission (“SEC”). NewAlliance is an electronic filer and as such reports filed with the SEC are also available on their website (http://www.sec.gov). The public may also read and copy any materials filed with the SEC at the SEC’s Public Reference Room, 100 F Street, NE, Washington, DC 20549. Information about the Public Reference Room can be obtained by calling 1-800-SEC-0330. Information on our website is not incorporated by reference into this report. Investors are encouraged to access these reports and the other information about our business and operations on our website.
Item 1A.
Item 1A. Risk Factors
An investment in our common stock involves certain risks inherent to our business. The material risks and uncertainties that management believes affect the Company are described below. To understand these risks and to evaluate an investment in our common stock, you should read this entire report, including the following risk factors.
If any of the following risks actually occur, the Company’s financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of the Company’s common stock could decline significantly.
Changes in Interest Rates and Spreads Could Have an Impact on Earnings and Results of Operations, Which Could Have a Negative Impact on The Value of NewAlliance Stock.
NewAlliance’s earnings and financial condition are dependent to a large degree upon net interest income, which is the difference between interest earned from loans and investments and interest paid on deposits and borrowings. The narrowing of interest rate spreads, meaning the difference between interest rates earned on loans and investments and the interest rates paid on deposits and borrowings, could adversely affect NewAlliance’s earnings and financial condition. The Company cannot predict with certainty or control changes in interest rates. Regional and local economic conditions and the policies of regulatory authorities, including monetary policies of the Federal Reserve Board, affect interest income and interest expense. The Company has ongoing policies and procedures designed to manage the risks associated with changes in market interest rates.
However, changes in interest rates still may have an adverse effect on NewAlliance’s profitability. For example, high interest rates could also affect the amount of loans that we originate, because higher rates could cause customers to apply for fewer mortgages, or cause depositors to shift funds from accounts that have a comparatively lower cost, to accounts with a higher cost or experience customer attrition due to competitor pricing. If the cost of interest-bearing deposits increases at a rate greater than the yields on interest-earning assets increase, net interest income will be negatively affected. Changes in the asset and liability mix may also affect net interest income. Similarly, lower interest rates cause higher yielding assets to prepay and floating or adjustable rate assets to reset to lower rates. If the Bank is not able to reduce its funding costs sufficiently, due to either competitive factors or the maturity schedule of existing liabilities, then the Bank’s net interest margin will decline.
NewAlliance’s Business Strategy of Growth Through Acquisitions Could Have an Impact on Earnings and Results of Operations That May Negatively Impact the Value of NewAlliance Stock.
In recent years, NewAlliance has focused, in part, on acquisitions. Over the past four years, the Company has acquired four banking institutions, a non-depository trust company and a registered investment advisory firm. From time to time in the ordinary course of business, the Company engages in preliminary discussions with potential acquisition targets. As of the date of this filing, there are no binding or definitive agreements, plans, arrangements, or understandings for such acquisitions by the Company. Although our business strategy includes both internal expansion and acquisitions, there can be no assurance that, in the future, we will successfully identify suitable acquisition candidates, complete acquisitions successfully, integrate acquired operations into our existing operations or expand into new markets. Further, there can be no assurance that acquisitions will not have an adverse effect upon our operating results while the operations of the acquired businesses are being integrated into our operations. In addition, once integrated, acquired operations may not achieve levels of profitability comparable to those achieved by our existing operations, or otherwise perform as expected. Further, transaction-related expenses may adversely affect our earnings. These adverse effects on our earnings and results of operations may have a negative impact on the value of our stock.
If The Goodwill That The Company Has Recorded in Connection With Its Acquisitions Becomes Impaired, It Could Have a Negative Impact on The Company’s Profitability.
Applicable accounting standards require that the purchase method of accounting be used for all business combinations. Under purchase accounting, if the purchase price of an acquired company exceeds the fair value of the company’s net assets, the excess is carried on the acquirer’s balance sheet as goodwill. At December 31, 2007, the Company had approximately $531.2 million of goodwill on its balance sheet. Companies must evaluate goodwill for impairment at least annually. Write-downs of the amount of any impairment, if necessary, are to be charged to the results of operations in the period in which the impairment occurs. There can be no assurance that future evaluations of goodwill will not result in findings of impairment and related write-downs, which may have a material adverse effect on NewAlliance’s financial conditions and results of operations.
NewAlliance May Experience Higher Levels of Loan Losses Due to Recent Growth.
NewAlliance’s growth strategy depends on generating an increasing level of loans to produce an acceptable return to our stockholders. We will also need to accomplish this loan growth while maintaining low loan losses in our portfolio. We expect growth to occur in markets that are relatively new to us, including central and western Massachusetts through our recent acquisition of Westbank. As such, NewAlliance’s allowance for loan losses may need to be increased, or may be deemed insufficient by various regulatory agencies. Such agencies may require the Bank to recognize an increase to the allowance for loan losses. Any increases in the
allowance for loan losses will result in a decrease in net income and, possibly capital, and may have a material adverse effect on NewAlliance’s financial condition and results of operations. See the sections titled “Allowance for Loan Losses” and “Classification of Assets and Loan Review” in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operation, located elsewhere in the Report for further discussion related to the process for determining the appropriate level of the allowance for loan losses.
NewAlliance May Experience Higher Levels of Loan Losses Due to Economic Conditions.
NewAlliance’s business is subject to periodic fluctuations based on national and local economic conditions. These fluctuations are not predictable, cannot be controlled and may have a material adverse impact on the Company’s operations and financial condition. For example, recent declines in housing activity including declines in building permits, housing starts and home prices may make it more difficult for our borrowers to sell their homes or refinance their debt. Sales may also slow, which could strain the resources of real estate developers and builders. Many analysts are now predicting the U.S. Economy is in or will experience a recession in the near term. This could affect employment levels and the ability of our borrowers to service their debt. The Bank may suffer higher loan losses as a result of these factors and the resulting impact on our borrowers.
Strong Competition Within NewAlliance’s Market Areas May Limit Growth and Profitability.
Competition in the banking and financial services industry is intense. In our market areas, we compete with commercial banks, savings institutions, mortgage brokerage firms, credit unions, finance companies, mutual funds, insurance companies, and brokerage and investment banking firms operating locally and elsewhere. As we grow, we will be expanding into market areas where we may not be as well known as other institutions that have been operating in those areas for some time. In addition, regional, super regional and national interstate banking institutions have become increasingly active in our market areas. Many of these competitors, in particular the regional, super regional and national institutions, have substantially greater resources and lending limits than we have and may offer certain services that we do not or cannot efficiently provide. Our profitability depends upon our continued ability to successfully compete in our market areas. The greater resources and deposit and loan products offered by some of our competitors may limit our ability to grow profitably.
NewAlliance May Not Pay You Dividends if NewAlliance is Not Able to Receive Dividends From Its Subsidiary, NewAlliance Bank.
Cash dividends from NewAlliance Bank and our liquid assets are our principal sources of funds for paying cash dividends on our common stock. Unless we receive dividends from NewAlliance Bank or choose to use our liquid assets, we may not be able to pay dividends. NewAlliance Bank’s ability to pay us dividends is subject to its ability to earn net income and to meet certain regulatory requirements.
NewAlliance is Subject To Extensive Government Regulation and Supervision
NewAlliance, primarily through NewAlliance Bank and certain non-bank subsidiaries, is subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds and the banking system as a whole, not stockholders. These regulations affect the Company’s lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect the Company in substantial and unpredictable ways. Such changes could subject the Company to additional costs, limit the types of financial services and products we may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on the Company’s business, financial condition and results of operations. While NewAlliance has policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur. See the section captioned “Supervision and Regulation” in Item 1. of this report for further information.
NewAlliance May Not Be Able To Attract and Retain Skilled People
NewAlliance’s success depends, in large part, on its ability to attract and retain key people. Competition for the best people in most activities engaged in by the Company can be intense and we may not be able to hire people or to retain them. The unexpected loss of services of one or more of the Company’s key personnel could have a material adverse impact on the business because of their skills, knowledge of the market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.
NewAlliance Continually Encounters Technological Change
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology can increase efficiency and enable financial institutions to better serve customers and to reduce costs. However, some new technologies needed to compete effectively result in incremental operating costs. The Company’s future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in operations. Many of the
Company’s competitors have substantially greater resources to invest in technological improvements. The Company may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on the Company’s business and, in turn, its financial condition and results of operations.
NewAlliance’s Controls and Procedures May Fail or Be Circumvented
Management regularly reviews and updates the Company’s internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Company’s business, results of operations and financial condition.
Customer Information May be Obtained and Used Fraudulently
Risk of theft of customer information resulting from security breaches by third parties exposes the Company to reputation risk and potential monetary loss. The Company has exposure to fraudulent use of our customer’s personal information resulting from its general business operations and through customer use of financial instruments, such as debit cards. If a breach in security does occur in the marketplace and the financial data of our customers is compromised, the Company will react as quickly as possible to protect customer accounts and limit potential losses to the Company.
NewAlliance’s Stock Price Can be Volatile.
NewAlliance’s stock price can fluctuate widely in response to a variety of factors including:
• actual or anticipated variations in quarterly operating results;
• recommendations by securities analysts;
• new technology used, or services offered, by competitors;
• significant acquisitions or business combinations, strategic partnerships, joint ventures or capital commitments by or involving the Company or the Company’s competitors;
• failure to integrate acquisitions or realize anticipated benefits from acquisitions;
• operating and stock price performance of other companies that investors deem comparable to NewAlliance;
• news reports relating to trends, concerns and other issues in the financial services industry;
• changes in government regulations; and
• geopolitical conditions such as acts or threats of terrorism or military conflicts.
General market fluctuations, industry factors and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes, credit loss trends or currency fluctuations could also cause NewAlliance’s stock price to decrease regardless of the Company’s operating results.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
The Company conducts business from its executive offices at 195 Church Street, New Haven, Connecticut and its 76 banking offices located in Connecticut and 12 banking offices located in Massachusetts. Of the 88 banking offices, 30 are owned and 58 are leased. Lease expiration dates range from 5 months to 14 years with renewal options of 5 to 60 years.
The following table sets forth certain information with respect to our offices:
The total net book value of properties and equipment at December 31, 2007 was $61.9 million. For additional information regarding our premises and equipment and lease obligations, see Notes 6 and 14 to the Consolidated Financial Statements.
Item 3.
Item 3. Legal Proceedings
NewAlliance is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. NewAlliance believes that those routine proceedings involve, in the aggregate, amounts which are immaterial to the financial condition and results of operations of the Company.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
The Company’s common stock is traded on the New York Stock Exchange under the symbol “NAL”. The following table sets forth the high and low prices of our common stock and the dividends declared per share of common stock for the periods indicated.
Holders
As of January 31, 2008, there were 108,741,712 shares of common stock outstanding, which were held by approximately 11,721 holders of record. The number of stockholders of record was determined by American Stock Transfer and Trust Company. Such number of record holders does not reflect the number of persons or entities holding stock in nominee name through banks, brokerage firms, and other nominees.
Dividends
The Company began paying quarterly dividends in 2004 on its common stock and currently intends to continue to do so in the foreseeable future. The Company’s ability to pay dividends depends on a number of factors, however, including the ability of the Bank to pay dividends to the Company under federal laws and regulations, and as a result there can be no assurance that dividends will continue to be paid in the future. See the section captioned “Supervision and Regulation” in Item 1. of this report for further information.
Securities Authorized for Issuance Under Equity Compensation Plans
Information regarding equity-based compensation awards outstanding and available for future grants as of December 31, 2007, segregated between equity-based compensation plans approved by the stockholders and equity-based compensation plans not approved by stockholders, is presented in the table below.
(1) This figure includes 2,871,464 shares that may be issued pursuant to options presently authorized but unissued, and 1,240,982 shares that may be issued as restricted stock, all in accordance with the 2005 Long-Term Compensation Plan approved by the Company’s stockholders in April 2005.
Recent Sales of Unregistered Securities; Use of Proceeds From Registered Securities
None.
Purchases of Equity Securities by the Issuer and Affiliated Purchases
The following table sets forth information about the Company’s stock repurchases for the three months ended December 31, 2007. Management may engage in future share repurchases as market conditions warrant.
On January 31, 2006, a second stock repurchase plan was announced and provides for the repurchase of up to 10.0 million shares of common stock of the Company. There is no set expiration date for this plan.
The first stock repurchase plan was completed in March 2006, under which the Company repurchased approximately 10.7 million shares of common stock at a weighted average price of $14.55 per share.
Stock Performance Graph
The following graph compares the cumulative total return on the common stock for the period beginning April 1, 2004, the date on which NewAlliance common stock commenced trading, as reported by NASDAQ or NYSE through December 31, 2007, with (i) the cumulative total return on the S&P 500 Index and (ii) the cumulative total return on the Keefe, Bruyette & Woods, Inc. 50 Index for the period.
This graph assumes the investment of $100 on April 1, 2004 in our common stock (at the initial public offering price of $10.00 per share), the S&P 500 Index and the Keefe, Bruyette & Woods, Inc 50 Index and assumes that dividends are reinvested.
COMPARISON OF CUMULATIVE TOTAL RETURN
AMONG NEWALLIANCE BANCSHARES,
S&P 500 INDEX AND KBW 50 INDEX
Item 6.
Item 6.
Selected Financial Data
The following tables contain certain information concerning the financial position and results of operations of the Company at the dates and for the periods indicated. This information should be read in conjunction with the Consolidated Financial Statements and related notes. Effective December 31, 2003, the Company changed its fiscal year end from March 31 to December 31. Data for the twelve months ended December 31, 2003 and the nine months ended December 31, 2002 are being shown for comparability purposes.
On April 1, 2004, the Bank completed its conversion from a state-chartered mutual bank to a state-chartered stock bank. Concurrent with the conversion, the Company completed its acquisitions of two banking institutions and subsequent acquisitions have also been completed. Accordingly, Selected Financial Data includes the effect of those transactions. See Note 3 of the Notes to Consolidated Financial Statements for additional information related to the most recent transactions.
Additionally, in July 2007 a restructuring of part of the available-for-sale securities portfolio was completed. A recognized loss in the amount of $28.3 million, or $18.4 million net of tax, was recorded to non-interest income as a result of this restructuring. Select Financial Data includes the effect of this transaction at and for the year ended December 31, 2007. See Note 4 of the Notes to Consolidated Financial Statements for additional information.
(1)
Earnings per share for 2004 were calculated using net income and weighted-average shares outstanding from the date of conversion, April 1, 2004, through December 31, 2004. Net income for this nine-month period was $2.1 million. Earnings per share for all prior periods are not presented as the Company had no shares outstanding until the second quarter of 2004.
(2)
Loans are stated at their principal amounts outstanding, net of deferred loan fees and costs and net unamortized premium on acquired loans.
(3)
Nonperforming loans include loans for which the Company does not accrue interest (nonaccrual loans), loans 90 days past due and still accruing interest and renegotiated loans due to a weakening in the financial condition of the borrower.
(4)
Nonperforming assets consist of nonperforming loans and other real estate owned.
(5)
Performance ratios are based on average daily balances during the periods indicated and are annualized where appropriate. Regulatory Capital Ratios and Asset Quality Ratios are end-of-period ratios.
(6)
Interest rate spread represents the difference between the weighted average yield on average interest-bearing assets and the weighted average cost of average interest-bearing liabilities.
(7)
Net interest margin represents net interest income as a percentage of average interest-earning assets.
(8)
No tax equivalent adjustments were made due to the fact that ratio would not be materially different.
(9)
The efficiency ratio represents the ratio of non-interest expenses, net of OREO expenses, to the sum of net interest income and non-interest income, excluding security and limited partnership gains or losses. The efficiency ratio is not a financial measurement required by accounting principles generally accepted in the United States of America. However, management believes such information is useful to investors in evaluating company performance.
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operation
Overview
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help the reader understand NewAlliance Bancshares, Inc., our operations and our present business environment. We believe transparency and clarity are the primary goals of successful financial reporting. We remain committed to increasing the transparency of our financial reporting, providing our stockholders with informative financial disclosures and presenting an accurate view of our financial disclosures and presenting an accurate view of our financial position and operating results.
In accordance with Section 404 of the Sarbanes-Oxley Act of 2002, our management, including our Chief Executive Officer and Chief Financial Officer, conducted an evaluation of our internal control over financial reporting and concluded that such control was effective as of December 31, 2007. Management’s report on the effectiveness of our internal control over financial reporting is included in Item 8, Financial Statements and Supplementary Data, of this report.
MD&A is provided as a supplement to-and should be read in conjunction with-our Consolidated Financial Statements and the accompanying notes thereto contained in Item 8, Financial Statements and Supplementary Data of this report. This overview summarizes the MD&A, which includes the following sections:
• Our Business - a general description of our business, our objectives and the challenges and risks of our business.
• Critical Accounting Estimates - a discussion of accounting estimates that require critical judgments and estimates.
• Operating Results - an analysis of our Company’s consolidated results of operations for the three years presented in our Consolidated Financial Statements.
• Financial Condition, Liquidity and Capital Resources - an overview of financial condition; contractual obligations and liquidity and capital resources.
Our Business
General
NewAlliance is the third largest banking institution headquartered in Connecticut and the fourth largest based in New England with consolidated assets of $8.21 billion and stockholders’ equity of $1.41 billion at December 31, 2007. Its business philosophy is to operate as a community bank with local decision-making authority.
The Company’s results of operations depend primarily on net interest income, which is the difference between the income earned on its loan and securities portfolios and its cost of funds, consisting of the interest paid on deposits and borrowings. Results of operations are also affected by the Company’s provision for loan losses, income and expenses pertaining to other real estate owned, gains and losses from sales of loans and securities and non-interest income and expenses. Non-interest income primarily consists of fee income from depositors and wealth management services and bank owned life insurance (“BOLI”). Non-interest expenses consist principally of compensation and employee benefits, occupancy, data processing, amortization of acquisition related intangible assets, marketing, professional services and other operating expenses.
Results of operations are also significantly affected by general economic and competitive conditions and changes in interest rates as well as government policies and actions of regulatory authorities. Future changes in applicable laws, regulations or government policies may materially affect the Company.
Our Objectives
NewAlliance seeks to continually deliver superior value to its customers, stockholders, employees and communities through achievement of its core operating objectives which are to:
•
Build high quality, profitable loan portfolios using organic, purchase and acquisition strategies;
•
Increase core deposit relationships with a focus on checking and savings accounts;
•
Increase the non-interest income component of total revenues through development of banking-related fee income and growth in wealth management services;
•
Grow through a disciplined acquisition strategy, supplemented by de-novo branching;
•
Improve operating efficiencies; and
•
Utilize technology to enhance superior customer service and products.
Significant factors management reviews to evaluate achievement of the Company’s operating objectives and its operating results and financial condition include, but are not limited to: net income and earnings per share, performance of acquisitions and integration activities, return on equity and assets, net interest margin, non-interest income, operating expenses related to total assets and efficiency ratio: asset quality; loan and deposit growth, capital management, liquidity and interest rate sensitivity levels, customer service standards; market share and peer comparisons.
Challenges and Risks
As we look forward, management has identified certain challenges and risks that demand the attention of the banking industry and NewAlliance. Of these, four key challenges and risks are described below:
Net interest margin. The growth of the net interest margin is vital to our continued success and profitability. We believe that a crucial aspect of increasing net interest margin is to reduce deposit pricing relative to wholesale funding and focus on growth of core deposits. The risk associated with this, however, is a potential outflow of deposits to competitors in search of higher rates. We will continue to focus on enhancing and developing new products in a cost effective manner and believe that will help mitigate the risk of deposit outflow. A second aspect is to increase the yield earned on the loan portfolio. We believe that we are well positioned to take advantage of the pricing opportunities in our lending area which have been created by recent dislocations in the credit market which has had the effect of diminishing competition in the short term.
Maintaining credit quality and rigorous risk management. 2007 will be remembered as the year of the housing meltdown. The implosion of the sub-prime market continues to reverberate throughout the industry. Over this turbulent time, NewAlliance continued to maintain its strong credit quality, as evidenced by positive asset quality indicators, (i.e. the ratio of nonperforming loans to loans of 0.35% and total delinquencies to loans of 0.63%), due to its vigilant underwriting standards and rigorous risk management process. The effects of the housing meltdown will continue to be felt throughout 2008 as home sales slow and delinquencies and foreclosures are expected to increase across the country. However, because we have not experienced the industry wide problems associated with the housing crisis, we expect to be able to continue to maintain strong asset quality and risk management relative to industry levels.
Deploying capital. We ended 2007 with Tier 1 capital at 10.92%, which is substantially above our peer group . We are tasked with using our capital position judiciously to maximize shareholder value. Our capital strategy to date has been mainly to utilize our capital for acquisitions, stock buybacks and dividend payments. We expect to continue this strategy in the future and stress only acquisitions that are accretive to earnings per share in the short term. We believe that the coming year may provide unique opportunities given the current volatile market.
Competition in the marketplace. NewAlliance is facing strong competition from some well established companies and many local players. On the deposit side, rates are decreasing but at the same time we have to be mindful of the importance of the total customer relationship. On the lending side we are well poised to take advantage of the current market conditions. We must continue to expand our product offerings, improve operating efficiencies and develop and maintain our brand to increase market share.
All four of these challenges and risks-net interest margin, maintaining credit quality and rigorous risk management, deploying capital and competition in the marketplace-have the potential to have a material adverse effect on NewAlliance; however, we believe NewAlliance is well positioned to appropriately address these challenges and risks.
See also Item 1A, Risk Factors in Part I of this report for additional information about risks and uncertainties facing NewAlliance.
Critical Accounting Estimates
Our Consolidated Financial Statements are prepared in accordance with GAAP. In connection with the preparation of our financial statements, we are required to make assumptions and estimates about future events, and apply judgments that affect the reported amounts of assets, liabilities, revenue, expenses and the related disclosures. We base our assumptions, estimates and judgments on historical experience, current trends and other factors that management believes to be relevant at the time our Consolidated Financial Statements are prepared. On a regular basis, management reviews the accounting policies, assumptions, estimates and judgments to ensure that our financial statements are presented fairly and in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material.
Our significant accounting policies are discussed in Note 1, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this report. Management believes that the following accounting estimates are the most critical to aid in fully understanding and evaluating our reported financial results, and they require management’s most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. Management has reviewed these critical accounting estimates and related disclosures with the Audit Committee of our Board.
Goodwill and Identifiable Intangible Assets
Critical Estimates
Judgment and Uncertainties
Effect if Actual Results Differ from Assumptions
We evaluate goodwill and identifiable intangible assets for impairment annually or whenever events or changes in circumstances indicate the carrying value of the goodwill or identifiable intangible assets may not be recoverable. We complete our impairment evaluation by performing internal valuation analyses, considering other publicly available market information and using an independent valuation firm, as appropriate.
In the first quarter of fiscal 2007, we completed our annual impairment testing of goodwill using the methodology described herein, and determined there was no impairment. Through year end, no events or circumstances subsequent to the annual testing date indicate that the carrying value of the Company’s goodwill may not be recoverable.
The carrying value of goodwill and identifiable intangible assets at December 31, 2007, was $531.2 million and $53.3 million, respectively.
We determine fair value using widely accepted valuation techniques, including estimated future cash flows and discount rates and market multiple analyses. These types of analyses contain uncertainties because they require management to make assumptions and to apply judgment to estimate industry economic factors and the profitability of future business strategies. It is our policy to conduct impairment testing based on our current business strategy in light of present industry and economic conditions, as well as future expectations.
If actual results are not consistent with our estimates or assumptions, we may be exposed to an impairment charge that could be material. Management has evaluated the effect of lowering the estimated future cash flows or increasing the discount rate by 10% and determined that no impairment of goodwill would have been recognized under this evaluation.
Allowance for Loan Losses
Critical Estimates
Judgment and Uncertainties
Effect if Actual Results Differ from Assumptions
It is the policy of NewAlliance to maintain an allowance for loan losses that equals management’s best estimate of probable credit losses that are inherent in the portfolio at the balance sheet date.
Management follows a guiding principle that the level of the reserve should be directionally consistent with asset quality indicators. The adequacy of the allowance for loan losses is determined based upon a detailed evaluation of the portfolio and subportfolios through a process which considers numerous factors, including levels and direction of delinquencies, non-performing loans and assets, risk ratings, estimated credit losses using both internal and external portfolio reviews, current economic and market conditions, concentrations, portfolio volume and mix, changes in underwriting, experience of staff, and historical loss rates over the business cycle.
The allowance for loan losses is reviewed and approved by the Board of Directors on a quarterly basis.
We determine the adequacy of the allowance for loan losses by analyzing and estimating losses inherent in the portfolio. The allowance for loan losses contains uncertainties because the calculation requires management to use historical information as well as current economic data to make judgments on the adequacy of the allowance. As the allowance is affected by changing economic conditions and various external factors, it may impact the portfolio in a way currently unforeseen.
Adverse changes in management’s assessment of the factors used to determine the allowance for loan losses could lead to additional provisions. Actual loan losses could differ materially from management’s estimates if actual losses and conditions differ significantly from the assumptions utilized. These factors and conditions include general economic conditions within NewAlliance’s market, trends within industries, real estate and other collateral values, interest rates and the financial condition of the individual borrower. While management believes that it has established adequate specific and general allowances for probable losses on loans, there can be no assurance that the regulators, in reviewing the Company’s loan portfolio, will not request an increase in the allowance for losses, thereby negatively affecting the Company’s financial condition and results of operations.
Stock Based Compensation
Critical Estimates
Judgment and Uncertainties
Effect if Actual Results Differ from Assumptions
We have a stock-based compensation plan, which includes non-qualified stock options and non vested share awards. See Note 1, Summary of Significant Accounting Policies, and Note 12, Stock Based Compensation, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data of this Annual Report on Form 10-K for a complete discussion of our stock-based compensation programs.
We determine the value of our non-qualified stock option awards at the date of grant using the Black-Scholes option-pricing model.
We determine the fair value of our market-based nonvested share awards at the date of grant using generally accepted valuation techniques and the closing market price of our stock. Management reviews its assumptions to determine the fair value of stock-based compensation awards.
Option pricing models and generally accepted valuation techniques require management to make assumptions and to apply judgment to determine the fair value of our awards. These assumptions and judgments include estimating the future volatility of our stock price, expected dividend yield, future employee turnover rates and future employee stock option exercise behaviors. Changes in these assumptions, can materially affect the fair value estimate.
We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to determine stock-based compensation expenses.
If actual results are not consistent with the assumptions used, the stock-based compensation expense reported in our financial statements may not be representative of the actual economic cost of the stock-based compensation.
Income Taxes
Deferred Tax Assets and Liabilities
Critical Estimates
Judgment and Uncertainties
Effect if Actual Results Differ from Assumptions
Management uses the asset and liability method of accounting for income taxes in which deferred tax assets and liabilities are established for the temporary differences between the financial reporting basis and the tax basis of the Company’s asset and liabilities. The realization of the net deferred tax asset generally depends upon future levels of taxable income and the existence of prior years’ taxable income, to which "carry back" refund claims could be made. A valuation allowance is maintained for deferred tax assets that we estimate are more likely than not to be unrealizable based on available evidence at the time the estimate is made.
Each quarter, we reevaluate our estimate related to the valuation allowance, including our assumptions about future profitability. At December 31, 2007 and December 31, 2006, our valuation allowance was $23.8 million and $16.8 million, respectively.
As a result of reviews of the factors discussed above related to the adequacy of the valuation allowance, our income tax expense for the year-ended December 31, 2007 included an increase in the valuation allowance attributable to the charitable contribution carryover of $3.6 million. The increase in 2007 was due mainly to reevaluation of forecasted future taxable income available to offset this carryover. For further discussion on our deferred taxes and valuation allowance, see Note 13 of the Notes to Consolidated Financial Statements.
Significant management judgment is required in determining income tax expense and deferred tax assets and liabilities. Some judgments are subjective and involve estimates and assumptions about matters that are inherently uncertain. In determining the valuation allowance, we use historical and forecasted future operating results, based upon approved business plans, including a review of the eligible carryforward periods, tax planning opportunities and other relevant considerations. Management believes that the accounting estimate related to the valuation allowance is a critical accounting estimate because the underlying assumptions can change from period to period. For example, tax law changes or variances in future projected operating performance could result in a change in the valuation allowance.
Should actual factors and conditions differ materially from those used by management, the actual realization of net deferred tax assets or deferred tax liabilities could differ materially from the amounts recorded in the financial statements. If we were not able to realize all or part of our net deferred tax assets in the future, an adjustment to our deferred tax assets valuation allowance would be charged to income tax expense in the period such determination was made. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our income taxes.
Management believes that the valuation allowance against deferred tax assets is adequate and reasonable. However, if future projected profitability were to decline by 10%, the valuation allowance would need to be increased by an additional $200,000 to $400,000.
Tax Contingencies
Critical Estimates
Judgment and Uncertainties
Effect if Actual Results Differ from Assumptions
We regularly face challenges from domestic tax authorities regarding the amount of taxes due. These challenges include questions regarding the timing and amount of deductions and the allocation of income among various tax jurisdictions. At any one time, multiple tax years are subject to audit by the various tax authorities. In evaluating the exposures associated with our various tax filing positions, we record reserves for probable exposures. A number of years may elapse before a particular matter, for which we have established a reserve, is audited and fully resolved or clarified. We adjust our tax contingencies reserve and income tax provision in the period in which actual results of a settlement with tax authorities differs from our established reserve, the statute of limitations expires for the relevant tax authority to examine the tax position or when more information becomes available.
Our tax contingencies reserve contains uncertainties because management is required to make assumptions and to apply judgment to estimate the exposures associated with our various filing positions.
Our effective income tax rate is also affected by changes in tax law, entry into new tax jurisdictions, the level of earnings and the results of tax audits.
We believe that our tax reserves reflect the probable outcomes of known contingencies. Although we think that our estimates and judgments discussed herein are reasonable, actual results may differ, which could be material to our financial statements. To the extent we prevail in matters for which reserves have been established, or are required to pay amounts in excess of our reserves, our effective income tax rate in a given financial statement period could be materially affected. An unfavorable tax settlement would require use of our cash and would result in an increase in our effective income tax rate in the period of resolution. A favorable tax settlement would be recognized as a reduction in our effective income tax rate or through goodwill in the period of resolution.
Pension and Other Post Retirements
Critical Estimates
Judgment and Uncertainties
Effect if Actual Results Differ from Assumptions
Pension costs and liabilities are dependent on assumptions used in calculating such amounts. Management uses key assumptions that include discount rates, expected return on plan assets, benefits earned, interest costs, mortality rates, increases in compensation, and other factors. The two most critical assumptions-estimated return on plan assets and the discount rate-are important elements of plan expense and asset/liability measurements. These critical assumptions are evaluated at least annually on a plan basis. Other assumptions are evaluated periodically and are updated to reflect actual experience and expectations for the future. Actual results in any given year will often differ from actuarial assumptions because of economic and other factors, and in accordance with U.S. GAAP the impact of these differences is accumulated and amortized over future periods.
The discount rate assumptions used to measure the postretirement benefit obligations is set by reference to published high-quality bond indices, as well as certain yield curves. The Company used the Citigroup Pension Liability Index as a benchmark. A higher discount rate decreases the present value of benefit obligations and decreases pension expense.
The expected rate of return on plan assets is based on current and expected asset allocations, as well as the long-term historical risks and returns with each asset class within the plan portfolio. A lower expected rate of return on plan assets increases pension costs.
To reflect market interest rate conditions in calculating the projected benefit obligation, the pension discount rate was increased from 5.75% at September 30, 2006 to 6.25% at September 30, 2007.
An expected rate of return of 8.0% and 8.25% was utilized at September 30, 2007 and 2006, respectively.
While management believes that the assumptions used are appropriate, differences in actual experience or changes in assumptions may affect future pension or other postretirement obligations and expense. Continued volatility in pension expense is expected as assumed investment returns vary from actual.
A 25 basis point decrease or increase in the discount rate would increase or decrease annual pension expense, respectively, by $260,000.
A 25 basis point decrease or increase in the expected return on assets would increase or decrease annual pension expense, respectively, by $223,000.
Operating Results
Table 1: Summary Income Statements
Earnings Summary
Comparison of 2007 and 2006
As shown in Table 1, for the year ended December 31, 2007, net income was $23.8 million, a decrease of $25.0 million from the comparative period in 2006. During the year ended December 31, 2007, NewAlliance sold approximately $759.0 million of available for- sale securities and realized net losses totaling $28.3 million. The sale was undertaken to reduce the Company’s exposure to fixed rate assets as well as to increase the yield on the portfolio, thereby providing a prospective improvement in the net interest margin. NewAlliance replaced substantially all of the assets sold with higher yielding agency hybrid adjustable rate mortgage-backed securities and expects to recover the $28.3 million loss through higher earnings from July 2007 through the end of 2009. As a result of this restructuring, the Company reported significantly lower net income for the year ended December 31, 2007 as compared to the same period in 2006.
For the year ended December 31, 2007, operating expenses were higher than the year ended 2006 due mostly to increased salaries and employee benefits, occupancy expenses and amortization of identifiable intangible assets, primarily resulting from the Westbank and CIMI acquisitions. The provision for loan losses also increased in 2007 over 2006 as a result of growth in the loan portfolio, chargeoffs incurred during the year and an increase in non-accrual loans.
Net interest income increased by $5.4 million for the year ended December 31, 2007 to $175.0 million, compared to $169.6 million for the year ended December 31, 2006. The increase was primarily due to growth in the loan portfolio as a result of the Westbank acquisition, residential loan purchases and originations. Net interest income for the year ended December 31, 2007 continued to be hampered by the shape of the yield curve and declining spreads and a decline in net interest-earning assets due to acquisitions, share buybacks and dividends paid. The impact to the net interest margin was partially offset by the 58 basis point improvement in the average yield earned on investment securities due in part to the restructuring of the investment portfolio.
The decrease to income tax expense of $8.7 million is due to lower pretax earnings as a result of the $28.3 million loss incurred on the restructuring of the investment portfolio. This decrease is partially offset by a $3.6 million increase in the deferred tax asset valuation allowance related to the charitable contribution carryforward.
Comparison of 2006 and 2005
Net income decreased $3.8 million, to $48.8 million for the year ended December 31, 2006 from $52.6 million for the year ended December 31, 2005. This decrease is primarily a result of higher operating expenses and conversion and merger related charges coupled with a decline in net interest income, partially offset by an increase in non-interest income and a decrease in income tax expense.
Higher operating expenses were largely due to the acquisitions of Trust Company and Cornerstone in the areas of salaries and employee benefits and occupancy expenses. Additionally, charges in 2006 associated with the implementation of SFAS No. 123R, “Share Based Payment”, for options which were granted under the Company’s 2005 Long-Term Compensation Plan (“LTCP”) and executive severance benefits paid were also significant factors in the increase of salaries and employee benefits. Conversion and merger related charges were primarily due to the Trust Company and Cornerstone acquisitions and the commencement of charges related to the Westbank acquisition that occurred on January 2, 2007.
Net interest income declined as the average balance of interest-bearing liabilities outpaced the growth rate in the average balance of interest-earning assets. The average rate paid on all interest-bearing liabilities increased more than the average yield on all interest-earning assets. Combined, these caused a decrease of 44 basis points in the interest rate spread which was primarily driven by the increase in the average rate paid on time deposits of 107 basis points.
Non-interest income increased primarily due to depositor service charges, an increase in net gains on limited partnerships as a result of a cumulative adjustment due to a change from the cost to equity method of accounting on investments in four limited partnerships, an increase in trust fees as a result of the Trust Company acquisition, an increase in Bank owned life insurance income and gains recorded on the sale of Small Business Administration (“SBA”) loans.
Average Balances, Interest and Average Yields/Cost
Table 2 below sets forth certain information concerning average interest-earning assets and interest-bearing liabilities and their associated yields or rates for the periods indicated. The average yields and costs are derived by dividing income or expenses by the average balances of interest-earning assets or interest-bearing liabilities, respectively, for the periods shown and reflect annualized yields and costs. Average balances are computed using daily balances. Yields and amounts earned include loan fees and fair value adjustments related to acquired loans. Loans held for sale and nonaccrual loans have been included in interest-earning assets for purposes of these computations. Unrealized gain or losses on available-for-sale investment securities are excluded from average yield calculations.
Table 2: Average Balance Sheets for the Years Ended December 31, 2007, 2006 and 2005
Net Interest Income Analysis
Net interest income is the amount that interest and fees on earning assets (loans and investments) exceeds the cost of funds, primarily interest paid to the Company’s depositors and interest on external borrowings. Net interest margin is the difference between the income on earning assets and the cost of interest-bearing funds as a percentage of earning assets.
Comparison of 2007 and 2006
As shown in Table 2, net interest income for the year ended December 31, 2007 was $175.0 million, an increase of $5.4 million from December 31, 2006. This year over year increase in net interest income was primarily due to growth in the loan portfolio, an improved asset/liability mix and an increase in investment interest income as a result of the investment portfolio restructuring. These
increases during the year were somewhat masked by the slope of the yield curve, and the average rates paid, particularly on time deposits, due to intense deposit competition. Throughout 2007, the net interest margin was also compressed by a reduction in the profitability of new loans and deposits, as competitive pressures reduced the profit margin on new business. Both the net interest rate spread and the net interest margin declined 24 basis points to 1.91% and 2.48%, respectively from 2006 levels.
Interest and dividend income for the year ended December 31, 2007 was $403.3 million, compared to $331.0 million for the year ended December 31, 2006, an increase of $72.2 million, or 21.8%. The increase in interest income was primarily driven by loans due to an increase in the average balances of $913.8 million. While all loan categories experienced increases in average balances and average yields, the residential and commercial real estate loan portfolios continued to be the drivers of growth. The increases in average balances are due to the acquisition of Westbank, the Company’s continued strategy of purchasing residential mortgages in the secondary market throughout most of 2007 and increased organic loan originations. The loan portfolio volume increase accounted for approximately $56.0 million of the increase in interest income. The remaining increase in interest income was primarily due to the higher yield earned on investment securities as a result of the restructuring of the available for sale portfolio. In 2008, the Company expects to purchase residential loans in the secondary market, but at lower levels than in 2007 due to the tightening in the credit markets.
The cost of funds for the year ended December 31, 2007 increased $66.8 million, or 41.4% to $228.2 million compared to the prior year period. The average rate on interest-bearing liabilities increased 64 basis points to 3.80% from 3.16%. The overall increase in interest expense was primarily due to increases in interest expense on time deposits and FHLB advances and other borrowings of $26.0 million and $24.3 million, respectively. The increase in interest expense on time deposits was due to a 63 basis point increase in the average rate on these deposits coupled with an average balance increase of $339.0 million. The time deposit balances acquired from Westbank were approximately $375.0 million. The 63 basis point increase in the average rate was due to market interest rate increases and the Company’s continued strategy of offering promotional rates in a challenging market to customers who either had or established a checking relationship with the Bank. The increase in interest expense of $24.3 million on FHLB advances and other borrowings was predominately due to an increase in the average balance of $396.5 million. Borrowings were used to fund the Company’s organic loan growth, purchases of residential mortgages and investment securities and offset deposit outflow. There was also a 38 basis point increase in the average rate paid on these borrowings due to increases in market interest rates. Increasing market interest rates, balances acquired from Westbank and ongoing checking and savings promotions were the primary factors for the higher interest expense in the other deposit categories, but were partially offset by a decline in the average balances of money market deposits.
Comparison of 2006 and 2005
Net interest income for the year ended December 31, 2006 was $169.6 million, compared to $176.1 million for the same period in 2005. This decrease of $6.5 million was primarily due to the decline in the interest rate spread of 44 basis points which was driven by the increases in the average rate paid and the average balance of time deposits. The average rate paid and average balance of time deposits increased 107 basis points and $353.3 million, respectively, since December 31, 2005 and reflects both the increase in general market interest rates as well as continuing to offer promotional rates on these deposits to maintain market share. The increase in the interest rate environment also had a positive effect on the average yield of total interest-earning assets, increasing 52 basis points to 5.31% from 4.79%. Even though there has been a $460.8 million increase in the average balances of interest-earning assets due to the acquisition of Cornerstone at the beginning of 2006 and growth in the loan portfolio, it was outpaced by the increase in the average balances of interest-bearing liabilities mainly as a result of share buybacks, additional borrowings to fund loan growth and the purchase of bank owned life insurance, and to a lesser extent, the net increase in deposit balances. Downward pressure on the net interest margin of 33 basis points was the resulting effect of this decline in net interest-earning assets of $91.1 million when coupled with the increase of 96 basis points in the average rate paid on interest-bearing liabilities. Throughout 2006, the net interest margin was also compressed by a reduction in the profitability of new loans and deposits, as competitive pressures reduced the profit margin on new business.
Interest income for the twelve months ended December 31, 2006 was $331.0 million, compared to $276.6 million for the year ended December 31, 2005, an increase of $54.4 million, or 19.7%. The increase in interest income was driven primarily by loans due to both an increase in the average balances of $472.2 million and a 40 basis point increase in the average yield earned. While all loan categories experienced increases in average balances and average yields, the commercial and residential real estate loan portfolios were the drivers of growth. The increase in average balances was due to the acquisition of Cornerstone, the Company’s continued strategy of purchasing residential mortgages in the secondary market and increased organic loan originations. The increase in average loan balances accounted for approximately $27.4 million of the increase in interest income. The remainder of the increase in interest income was due to increases in market interest rates of 40 basis points on the loan portfolio and 51 basis points on investment securities.
The cost of funds for the year ended December 31, 2006 increased $61.0 million, or 60.7% to $161.5 million compared to the prior year period. The average rate paid on interest-bearing liabilities increased 96 basis points to 3.16% from 2.20%. The increase in interest expense was primarily due to interest expense on time deposits and FHLB advances of $52.5 million in total. The increase in time deposits interest expense was the result of a 107 basis point increase in the average rate coupled with an average balance increase of $353.3 million due to market interest rate increases and offering promotional rates to customers who either had or established a checking relationship with the Bank. Increasing market interest rates and checking and savings promotions were the primary factors for the higher interest expense in the other deposit categories, but partially offset by a decline in the average balances of money market and savings deposits as monies shifted to higher paying time deposits or were lost to competitors. The increase in interest expense on FHLB advances was predominantly due to an increase in the average balance of $436.8 million which was used to fund the purchase of residential mortgages, bank owned life insurance, held to maturity investment securities and to a lesser extent helped fund the Company’s stock buy-back program. There was also a 54 basis point increase in the average rate paid on these borrowings due to increases in market interest rates.
Rate/Volume Analysis
The following table presents the extent to which changes in interest rates and changes in volume of interest-earning assets and interestbearing liabilities have affected the Company’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to: (i) changes attributable to changes in volume (changes in volume multiplied by prior rate); (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume); and (iii) the net change. The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate.
Table 3: Rate/Volume Analysis
Provision for Loan Losses
The provision for loan losses (“provision”) is based on management’s periodic assessment of the adequacy of the loan loss allowance which, in turn, is based on such interrelated factors as the composition of the loan portfolio and its inherent risk characteristics, the level of nonperforming loans and charge-offs, both current and historic, local economic and credit conditions, the direction of real
estate values, and regulatory guidelines. The provision for loan losses is charged against earnings in order to maintain an allowance for loan losses that reflects management’s best estimate of probable losses inherent in the loan portfolio at the balance sheet date.
Management performs a monthly review of the loan portfolio, and based on this review determines the level of the provision necessary to maintain an adequate allowance for loan losses (“allowance”). Management recorded a provision for loan losses of $4.9 million for the year ended December 31, 2007. The provision was recorded throughout the year due to an increase in nonperforming and criticized loans, growth in the loan portfolio, the periodic re-rating of loans, an increase in net charge-offs and maintenance of certain key coverage ratios. A provision for loan losses of $500,000 and $400,000 was recorded for the years ended December 31, 2006 and 2005, respectively.
The Company’s asset quality ratios remained strong throughout 2007. At December 31, 2007, the allowance for loan losses was $43.8 million, which represented 267.38% of nonperforming loans and .93% of total loans. In comparison, the allowance for loan losses was $37.4 million at December 31, 2006 representing 300.03% of nonperforming loans and .98% of total loans. The allowance acquired in the Westbank acquisition was $3.9 million. The reduction in the ratio of allowance for loan losses to total loans reflects growth in the portfolio and acceptable asset quality measures.
Table 4: Non-Interest Income
Non-Interest Income Analysis
The Company has two primary sources of non-interest income: (a) banking services related to loans, deposits and other core customer activities typically provided through the branch network as well as Merchant Services and (b) financial services, comprised of trust, investment and insurance products and brokerage and investment advisory services. The principal categories of non-interest income are shown in table 4.
Comparison of 2007 and 2006
As displayed in Table 4, non-interest income decreased $20.4 million to $31.2 million for the twelve months ended December 31, 2007 from $51.6 million for the twelve months ended December 31, 2006. The decrease in non-interest income was primarily attributable to the investment portfolio restructuring that resulted in a net loss of $28.3 million. See Note 4 of Notes to Consolidated Financial Statements for further information. Excluding the restructuring charges, non-interest income increased $7.9 million and was primarily due to increases in depositor service charges, bank owned life insurance (“BOLI”), investment management, brokerage and insurance fees and net gain on securities.
•
The increase in depositor service charges was mainly the result of increases in overdraft, check card, and ATM fees which was primarily due to additional volume created by the acquisition of Westbank and an increase in the per item fee. In addition, there was an increase in merchant services income primarily due to the additional merchants, increased volume and pricing concessions negotiated by the Company and the vendor.
•
BOLI increased due to having a full year of income generated from the purchase of $50.0 million of life insurance coverage during the third quarter of 2006, $9.5 million acquired from Westbank and an increase in the average yield earned.
•
The increase in investment management, brokerage & insurance fees was primarily due to the acquisition of CIMI, additional and more experienced financial advisors on staff and more favorable market conditions as compared to the prior year; which have all boosted trading activity and higher sales of investment and insurance products.
•
Excluding the securities restructuring, there were increased gains on securities as a result of gains on sales of: U.S. agency securities due to excess collateral, mortgage-backed securities for liquidity purposes; several utility stocks due to low dividend yields; and the call of trust preferred securities, partially offset by the loss on the sale of a bank stock as a result of
the market downturn in the financial sector and a write-down on two perpetual preferred securities due to a determination that
these securities were other than temporarily impaired.
Comparison of 2006 and 2005
For the twelve months ended December 31, 2006, non-interest income increased $6.1 million to $51.6 million from $45.5 million for the twelve months ended December 31, 2005. The Company had significant year-to-date increases in depositor service charges, trust fees, BOLI and other income. These increases were partially offset by decreases in loan and servicing income, and investment and insurance fees.
• The increase in depositor service charges was mainly the result of increases in overdraft fees on demand deposit accounts due to the increase in the number of overdraft transactions resulting in part to the implementation of a check card overdraft program during the second quarter of 2005, additional volume from the accounts acquired from Cornerstone Bank and an increase in the per item fee.
• The increase in BOLI income was due to income generated on the additional assets from the purchase of $50 million of life insurance coverage during the third quarter and the amount acquired from Cornerstone of $4.7 million as well as an increase in the average yield earned.
• Net gain on sale of loans increased primarily due to the Company’s strategy of selling the guaranteed portion of SBA loans that meet certain criteria, a result of the Cornerstone acquisition as Cornerstone was already an active participant in the secondary SBA market.
• The increase in other income was due to the net gain on limited partnerships due to implementing the equity method of accounting relating to four investments in limited partnerships which resulted in a cumulative adjustment of $1.9 million. This was partially offset by lower miscellaneous income in 2006 as non-recurring income was received in 2005 which primarily related to gains on two lease terminations, the sale of excess real estate, income tax refunds, and income received in the prior year related to the sale of a portion of the merchant services book of business that was greater than the income received on a similar sale in the fourth quarter of 2006.
• Trust fees increased due to the acquisition of Trust Company in July 2005.
• Loan and servicing income decreased in part due to a larger write-up of previously recorded impairment in the valuation of the mortgage servicing assets during the year ended December 31, 2005 compared to the same period in 2006.
• Investment and insurance fees decreased due to the unfavorable market for fixed annuity insurance products.
Comparison of 2007 and 2006
As displayed in Table 5, non-interest expense increased $14.3 million to $162.4 million for the twelve months ended December 31, 2007 from $148.1 million for the same period a year ago. The main drivers of the increase were salaries and employee benefits, occupancy, advertising, public relations, and sponsorships, amortization of identifiable intangible assets and other non-interest expense.
• The increase in salaries and employee benefits was primarily attributable to the acquisition of Westbank and higher pension and medical benefit costs, partially offset by lower accruals for incentive payouts and decreases in restricted stock and option expense due to the timing of executive and director retirements and severance payments in 2006 for an executive who is no longer with the Company. Pension costs increased primarily due to a greater number of employees in the plan and changes in the actuarial assumptions used to calculate net periodic benefit cost.
• Occupancy expense increased due to the increased branch network as a result of the Westbank acquisition and the opening of a de novo office in the fourth quarter of 2006. Electricity expense also served to increase the Company’s occupancy expenses due to the rate increases imposed by utility companies throughout the State of Connecticut as well as a non-recurring charge of $366,000 related to the disposition of excess space.
• Advertising, public relations, and sponsorships increased due to various media advertising and bonus campaigns to promote free savings and home equity products, to enhance business banking relationships and to maintain market share.
• The increase in amortization of intangibles was primarily due to new amortization of customer intangibles recorded in conjunction with the acquisition of Westbank, partially offset by fewer non-compete agreements remaining from prior acquisitions. The amortization of the non-compete agreements concluded in the third quarter of 2007.
• Other expense increased due primarily to the added branch locations which increased office supplies, telephones and postage expenses.
• Conversion and merger related charges decreased due to various charges recorded in the fourth quarter of 2006 for the Westbank acquisition that included legal fees, consulting and disclosure and compliance mailings.
Comparison of 2006 and 2005
Non-interest expense increased $6.9 million to $148.1 million for the year ended December 31, 2006 from $141.2 million for the year ended December 31, 2005. The main driver of this increase was salaries and employee benefits. Other increases include occupancy, conversion and merger related charges and advertising, public relations and sponsorships.
• The majority of the increase in salaries and employee benefits was due to the additional employees as a result of the acquisitions of Cornerstone Bank and Trust Company that occurred January 2, 2006 and July 1, 2005, respectively, severance that was recorded for an executive who left the Company and expenses associated with the LTCP that was implemented in June 2005. The Company adopted the provisions of SFAS No. 123R as of January 1, 2006 and upon adoption, the Company began expensing stock options that were awarded under the LTCP. These increases in salaries were partially offset by decreases in pension and bonus expenses. The decrease in bonus expense was mainly the result of a modification to the Company’s performance incentive plan and the decrease in pension expense was primarily due to the Company’s 2005 cash contribution to the qualified pension plan in the amount of $24.5 million.
• The increase in occupancy expenses was mainly due to the increased branch network resulting from the acquisition of Cornerstone.
• Conversion and merger related charges increased mostly due to consulting and data processing expenses related to Cornerstone for system conversions, the onset of expenses related to the Westbank acquisition that occurred January 2, 2007 and legal and consulting expenses related to a potential plan of merger that was abandoned during the due-diligence phase in the first quarter of 2006.
• Advertising expenses, largely newspaper, radio and direct mail campaigns which correlated with the Company’s deployment of various deposit and loan product promotions accounted for much of the increase in advertising, public relations and sponsorships.
• Amortization of identifiable intangible assets decreased due to fewer non-compete agreements remaining in 2006 as they began to expire in 2005. Additionally, the Company experienced a slight reduction of amortization on core deposit intangibles, due to the Company utilizing an accelerated method which calls for a higher level of expense in earlier periods relating to the Connecticut Bancshares and Alliance acquisitions, partially offset by new amortization of a core deposit intangible recorded in conjunction with the Cornerstone acquisition.
• The net decrease in outside services for the year ended December 31, 2006 compared to the same period in 2005 was comprised of various components including reductions in: i) consulting relating to Sarbanes Oxley (“SOX”), the 2005 LTCP and systems projects; and ii) a reduction in data processing fees due to a new contract extension; partially offset by increases due to: iii) additional transactional volume related to the acquisitions and iv) outsourced internal audit services.
• Other expense also decreased and was largely due to a reduction in the Company’s operating insurance premiums.
Income Tax Expense
Income tax expense for 2007, 2006 and 2005 was $15.1 million, $23.8 million and $27.4 million, respectively. The effective tax rates for the years ended 2007, 2006 and 2005 were 38.8%, 32.7% and 34.3% respectively. The change in the effective tax rate for the year ended December 31, 2007 in comparison to the year ended December 31, 2006 was primarily due to the $3.6 million increase in the valuation allowance required for the contribution carryforward offset partially by investments in bank owned life insurance made by the Company that produce tax exempt income.
The change in the effective tax rate for the year ended December 31, 2006 in comparison to the year ended December 31, 2005 was primarily due to the additional bank owned life insurance purchased in 2006 and due to the decrease in the valuation allowance for capital assets.
NewAlliance continually monitors and evaluates the potential impact of current events and circumstances on the estimates used in the analysis of its income tax positions, and accordingly, NewAlliance’s effective tax rate may fluctuate in the future on a periodic basis. NewAlliance evaluates its income tax positions based on tax laws and appropriate regulations and financial reporting considerations, and records adjustments as appropriate. This evaluation takes into consideration the status of current taxing authorities’ examinations of NewAlliance’s tax returns and recent positions taken by the taxing authorities on similar transactions, if any. Accordingly, the results of these examinations may alter the timing or amount of taxable income or deductions taken by the Company.
Financial Condition, Liquidity and Capital Resources
Financial Condition Summary
From December 31, 2006 to December 31, 2007, total assets and liabilities increased approximately $963.3 million and $918.5 million, respectively, due mainly to increases in loans, deposits and borrowings. Of the total increases, approximately $716.8 million of assets and approximately $673.9 million of liabilities are attributable to the Westbank acquisition. Stockholders’ equity increased $44.8 million to $1.41 billion due primarily to stock issued to acquire Westbank, year-to-date net income and an increase in the after tax fair value of investment securities, partially offset by treasury shares acquired and dividends.
Investment Securities
The Company maintains an investment securities portfolio that is primarily structured to provide a source of liquidity for operating needs, to generate interest income and to provide a means to balance interest-rate sensitivity. The securities portfolio is managed in accordance with regulatory guidelines and established internal corporate investment policies. The following table sets forth certain financial information regarding the amortized cost and fair value of the Company’s investment portfolio at the dates indicated.
At December 31, 2007 the Company had total investments of $2.49 billion, or 30.3%, of total assets. This is an increase of $11.2 million from $2.48 billion at December 31, 2006. The increase was primarily due to an increase in the fair value of investments available for sale and purchases of available for sale mortgage-backed securities using funds borrowed from the Federal Home Loan Bank, mostly offset by the use of portfolio cash flows to fund the purchase of residential real estate loans during the year.
SFAS No. 115 requires the Company to designate its securities as held to maturity, available for sale or trading depending on the Company’s intent regarding its investments at the time of purchase. The Company does not currently maintain a portfolio of trading securities. As of December 31, 2007, $2.20 billion, or 88.3% of the portfolio, was classified as available for sale. The Company believes that the high concentration of securities available for sale allows flexibility in the day-to-day management of the overall investment portfolio, consistent with the objectives of optimizing profitability and mitigating interest rate risk. Securities available for sale are carried at estimated fair value. Unrealized market valuation gains or losses on securities classified available for sale are recorded as a separate component of stockholders equity, net of deferred income taxes. The net unrealized gain on securities classified as available for sale as of December 31, 2007 was $15.9 million compared to an unrealized loss of $30.4 million as of December 31, 2006. The increase in the fair value of securities available for sale was primarily due to fluctuations in market interest rates during the period along with the restructuring in the available-for-sale portfolio as discussed below. The available for sale securities portfolio is primarily composed of mortgage-backed securities. Mortgage-backed securities comprised 78.4% of the total available for sale securities portfolio at year end 2007. The duration of the mortgage-backed securities was 1.92 years at December 31, 2007 compared to 2.28 years at December 31, 2006. The duration of the investment portfolio was 1.73 years at December 31, 2007 compared to 2.05 years at December 31, 2006.
In July, 2007, the Company completed a restructuring of part of its available for sale investment portfolio to reduce the Company’s exposure to fixed rate assets, as well as to increase the portfolio yield. In the restructuring, the book value of securities sold was $787.3 million and consisted of $138.3 million of seasoned 10 and 15 year fixed rate and $177.6 million of balloon agency mortgage backed securities, $388.3 million of fixed rate agency CMO’s, $46.8 million of fixed rate AAA-rated CMO’s, and $36.3 million of other odd lot positions. The cash proceeds were reinvested in higher yielding agency hybrid adjustable rate mortgage backed securities.
Management performed a review of all investments with unrealized losses and determined that two perpetual preferred stock equity securities had an other-than-temporary impairment. An impairment charge of $850,000 was recorded, reducing the book value of these two equity securities to $1.9 million at December 31, 2007 and there is no expectation of further other-than-temporary impairment because market value for these investments increased during January 2008. All other investment securities with unrealized losses were determined not to have an other-than-temporary impairment. The investment portfolio consists approximately of 89% of: (a) mortgage-backed securities that are issued by Federal National Mortgage Association, Federal Home Loan Mortgage Corporation and AAA rated securities issued by private institutions; (b) U.S. Treasury obligations and (c) U.S. Agency securities. These investments as well as the remainder of the portfolio do not have any exposure to sub-prime lending, do not include collateralized debt obligations or structured investment vehicles. The Company does not invest in securities issued by sub-prime lenders.
The following table sets forth certain information regarding the carrying value, weighted average yield and contractual maturities of the Company’s investment portfolio as of December 31, 2007. In the case of mortgage-backed securities and asset-backed securities, the table shows the securities by their contractual maturities; however, there are scheduled principal payments and there will be unscheduled prepayments prior to their contractual maturity. Income on obligations of states and political subdivisions are taxable and no yield adjustment for dividend receivable deduction is made because it is not material.
Lending Activities
The Company originates residential real estate loans secured by one- to four-family residences, commercial real estate loans, residential and commercial construction loans, commercial loans, multi-family loans, home equity lines of credit and fixed rate loans and other consumer loans throughout the States of Connecticut and Massachusetts. Additionally, within the residential real estate loan category are loans with property locations spread throughout the United States, as a result of the Company’s residential real estate loan purchase program.
The following table summarizes the composition of the Company’s total loan portfolio as of the dates presented:
As shown in Table 8, total loans were $4.73 billion at December 31, 2007, up $905.1 million from year-end 2006. The Company experienced increases across all loan categories, which was primarily attributable to the acquisition of Westbank, residential real estate loan purchases and organic loan growth.
Residential real estate loans continue to represent the largest segment of the Company’s loan portfolio as of December 31, 2007, comprising just over fifty percent of total loans. The increase of $465.3 million was due to loan portfolio purchases, organic originations and balances acquired from Westbank of approximately $145.0 million, partially offset by principal loan payments. The purchased portfolio, which is made up of prime loans individually underwritten by the Company to our underwriting criteria, includes adjustable rate and 10 and 15 year fixed rate residential real estate loans with property locations throughout the United States. For 2007, loan purchases accounted for $278.8 million of the year-to-date increase in residential real estate loans and were primarily purchased with cash flows from the available for sale investment portfolio and funds borrowed from the FHLB. Midway through 2007, the mortgage market began experiencing extreme volatility and unusual pricing due to lower liquidity which led the Company to temporarily discontinue its purchased loan program. The Company has resumed this program in January 2008, but expects the purchases to be at lower levels.
Commercial real estate and commercial business loans increased $341.2 million from December 31, 2006 to December 31, 2007. The increase was attributable to the acquisition of Westbank which added approximately $235.0 million to the portfolio as well as continued organic growth. The Company’s continued strategy is to build a larger percentage of the Company’s assets in commercial loans including real estate and other commercial loans. To accomplish this goal, the Company is expanding penetration of its geographical target area as well as promoting stronger business development efforts to obtain new business banking relationships, while maintaining strong credit quality. Over recent months, the spread advantage of commercial real estate loans to residential real estate loans has declined. While these conditions exist, the Company expects to reduce its origination of those commercial real estate loans with sub residential pricing.
Home equity loans and lines of credit increased $81.6 million from December 31, 2006 to December 31, 2007, with Westbank contributing approximately $30.2 million of the increase. These products were promoted by the Company through competitive pricing and marketing campaigns as the Company is committed to growing this loan segment while maintaining credit quality as a higher yielding alternative to first mortgage loans. Other consumer loans increased $17.0 million from December 31, 2006 with Westbank adding approximately $31.5 million.
Selected Loan Maturities
The following table shows the contractual maturity of the Company’s construction and commercial business loan portfolios at December 31, 2007.
Asset Quality
Loans are placed on nonaccrual if collection of principal or interest in full is in doubt, if the loan has been restructured, or if any payment of principal or interest is past due 90 days or more. A loan may be returned to accrual status if it has demonstrated sustained contractual performance or if all principal and interest amounts contractually due are reasonably assured of repayment within a reasonable period. For the years ended December 31, 2007, 2006 and 2005 had interest been accrued at contractual rates on nonaccrual and renegotiated loans, interest income would have increased by approximately $1.1 million, $612,000 and $558,000, respectively.
Other Real Estate Owned
The Company classifies property acquired through foreclosure or acceptance of a deed-in-lieu of foreclosure as other real estate owned in its financial statements. When a property is placed in other real estate owned, the excess of the loan balance over the estimated fair market value of the collateral, based on a recent appraisal, is charged to the allowance for loan losses. Estimated fair value usually represents the sales price a buyer would be willing to pay on the basis of current market conditions, including normal loan terms from other financial institutions, less the estimated costs to sell the property. Management inspects all other real estate owned properties periodically. Subsequent writedowns in the carrying value of other real estate owned are charged to expense if the carrying value exceeds the estimated fair value. At December 31, 2007, the Company had $897,000 in other real estate owned.
Classification of Assets and Loan Review
An internal risk rating system is used to monitor and evaluate the credit risk inherent in the loan portfolio. Under our internal risk rating system, we currently identify criticized loans as “special mention,” “substandard,” “doubtful” or “loss”. The Bank has outsourced to a third party to conduct loan reviews of all loan portfolios. On a quarterly basis, a Criticized Asset Committee composed of the Chief Credit Officer, Executive Vice President of Business Banking and other senior officers meet to review Criticized Asset Reports on commercial and commercial real estate loans that are risk rated special mention, substandard, or doubtful. The reports focus on the current status, strategy, financial data, and appropriate risk rating of the criticized loan.
At December 31, 2007, loans classified as substandard (both accruing and nonaccruing) totaled $28.2 million, and consisted of $17.2 million in commercial real estate loans and $11.0 million in commercial loans. Special mention loans totaled $150.3 million, and consisted of $117.2 million of commercial real estate loans and $33.1 million of commercial loans. There were no loans classified as doubtful at December 31, 2007.
At December 31, 2006, loans classified as substandard totaled $22.7 million, and consisted of $11.3 million in commercial real estate loans and $11.4 million in commercial loans. Special mention loans totaled $113.1 million, and consisted of $82.7 million of commercial real estate loans and $30.4 million of commercial loans. There were no loans classified as doubtful at December 31, 2006.
Allowance For Loan Losses
The Board of Directors and management of the Company are committed to the establishment and maintenance of an adequate allowance for loan losses, determined in accordance with GAAP. Our approach is to follow the most recent guidelines that have been provided by our regulators. Management believes that the methodology it employs to develop, monitor and support the allowance for loan losses is consistent with those guidelines.
While management believes that it has established adequate specific and general allowances for probable losses on loans, there can be no assurance that the regulators, in reviewing the Company’s loan portfolio, will not request an increase in the allowance for losses, thereby negatively affecting the Company’s financial condition and earnings. Moreover, actual losses may be dependent upon future events and, as such, further additions to the allowance for loan losses may become necessary.
The allowance for loan losses is established through provisions for loan losses based on management’s on-going evaluation of the risks inherent in the Company’s loan portfolio. Charge-offs against the allowance for loan losses are taken on loans when it is determined that the collection of loan principal is unlikely. Recoveries made on loans that have been charged-off are credited to the allowance for loan losses.
As displayed in Table 12, net charge-offs of approximately $2.4 million were recorded for the year ended December 31, 2007 and were predominantly attributable to fourth quarter charge-offs in the commercial loan portfolio relating to several commercial relationships. As a result of the net charge-offs, an increase of nonaccrual loans, the periodic re-rating of loans, and the overall growth in the portfolio, a provision for loan losses of $4.9 million was recorded for the year ended December 31, 2007. This compares to net charge-offs of $868,000 and a provision of $500,000 for the year ended December 31, 2006. Management believes that the allowance for loan losses is appropriate based on the Bank’s net loss experience, sound asset quality and delinquency indicators, as well as a softening in the real estate market. The Company had an allowance of $43.8 million and $37.4 million at December 31, 2007 and December 31, 2006, respectively.
The following table sets forth the Company’s percent of allowance by loan category and the percent of the loans to total loans in each of the categories listed at the dates indicated:
The allowance for loan losses and the provision are determined based upon a detailed evaluation of the portfolio and sub-portfolios through a process which considers numerous factors, including levels and direction of delinquencies, nonperforming loans, risk ratings, estimated credit losses using both internal and external portfolio reviews, current economic and market conditions, concentrations, portfolio volume and mix, changes in underwriting, experience of staff, and historical loss rates over the business cycle. Management follows a guiding principle that the level of the allowance for loan losses should be directionally consistent with asset quality indicators.
The allowance is computed by segregating the portfolio into pools of loans that have similar loan product type and risk rating characteristics. Management uses historical default and loss rates, internal risk ratings, industry data, peer comparisons, and other risk-
based characteristics. The data is then analyzed and estimates of losses inherent in the portfolio are determined using formula allowances for homogeneous pools of loans and criticized loans, and specific reserve requirements for impaired loans. The provision and allowance for loan losses are then reviewed and approved by the Company’s Board of Directors on a quarterly basis.
Intangible Assets
At December 31, 2007, the Company had intangible assets of $584.5 million, an increase of $80.8 million, or 16.1%, from $503.7 million at December 31, 2006. The increase was predominately due to the acquisition of Westbank on January 2, 2007 which resulted in the Company recording additional goodwill of $79.8 million and a core deposit intangible of $14.2 million and the acquisition of CIMI which increased intangible assets by $2.0 million. The increase in identifiable intangible assets was partially offset by year-to- date amortization expense of $11.7 million and the reversal of a portion of the deferred tax liability related to Connecticut Bancshares bond investments of $3.2 million which offset the increase to goodwill. In accordance with SFAS No. 141, the assets acquired and liabilities assumed are recorded based on their fair values on the acquisition date.
Identifiable intangible assets are amortized on a straight-line or accelerated basis, over their estimated lives. Management assesses the recoverability of intangible assets subject to amortization whenever events or changes in circumstances indicate that their carrying value may not be recoverable. If the carrying amount exceeds fair value an impairment charge is recorded to income. Goodwill is not amortized, but instead is reviewed for impairment on an annual basis. The Company performs its annual test for goodwill impairment during the first quarter of the year and no impairment was recorded in 2007. No events or circumstances subsequent to those evaluations through year end indicate that the carrying value of the Company’s goodwill may not be recoverable.
Other Assets
The Company’s other assets decreased $58.7 million, or 38.6%, to $93.3 million at December 31, 2007 from $152.0 million at December 31, 2006. This decrease was primarily due to a $58.7 million cash prepayment for the Westbank acquisition which closed on January 2, 2007 which had been recorded as a prepaid asset for the year ended December 31, 2006.
Sources of Funds
Cash flows from deposits, loan and mortgage-backed securities repayments, securities sales proceeds and maturities, borrowings and earnings are the primary sources of the Company’s funds available for use in its lending and investment activities and in meeting its operational needs. While scheduled loan and securities repayments are a relatively stable source of funds, deposit flows and loan and investment security prepayments are influenced by prevailing interest rates and local and economic conditions and are inherently uncertain. The borrowings primarily include FHLB advances and repurchase agreement borrowings. See Note 10 of Notes to Consolidated Financial Statements contained elsewhere within this Report for further borrowings information.
The Company attempts to control the flow of funds in its deposit accounts according to its need for funds and the cost of alternative sources of funding. A Loan and Deposit Pricing Committee meets weekly to determine pricing and marketing initiatives. It influences the flow of funds primarily by the pricing of deposits, which is affected to a large extent by competitive factors in its market area and asset/liability management strategies.
Deposits
The Company receives retail and commercial deposits through its main office and 87 other banking offices throughout Connecticut (76 locations) and Massachusetts (12 locations). Customer deposits generated through the NewAlliance banking network are the largest source of funds used to support asset growth. Deposit customers can access their accounts in a variety of ways including branch banking, ATM’s, internet banking or telephone banking. Effective advertising, direct mail, well-designed product offerings, good service and competitive pricing policies are strategies that attract and retain deposits. A key strategic objective is to grow the base of checking customers by retaining existing relationships while attracting new customers. The deposit base provides a source of funding for the bank as well as an ongoing stream of fee revenue. The Company offers a wide variety and attractive array of deposit accounts including checking, savings and certificate of deposit accounts that meet the needs of both the consumer and business customer.
As displayed in Table 14, deposits increased $473.0 million compared to December 31, 2006, primarily attributable to the acquisition of Westbank which added approximately $600.0 million in deposits and an organic increase in the savings category. The increase is partially offset by a decrease in organic time deposits due primarily to the competitive market environment and competitor pricing. Throughout 2007, the Company continued to offer product promotions, and has focused on both maintaining and increasing core deposits with “free checking” and “free savings” promotions. As a result of these promotions, through direct mail campaigns, cash bonuses and effective advertising, the Company was able to attract both new retail and business customers and opened approximately 22,000 checking and 32,000 savings accounts throughout 2007, the majority of which were the “free” products. The Company also continues to offer premium certificate of deposit rates to select customers who either have or establish a checking relationship with the Company.
The Company had $696.4 million in time deposits of $100,000 or more outstanding as of December 31, 2007, maturing as follows:
Borrowings
NewAlliance also uses various types of short-term and long-term borrowings in meeting funding needs. While customer deposits remain the primary source for funding loan originations, management uses short-term and long-term borrowings as a supplementary funding source for loan growth and other liquidity needs when the cost of these funds are favorable compared to alternative funding, including deposits.
The Company is a member of the Federal Home Loan Bank of Boston which is part of the Federal Home Loan Bank System. Members are required to own capital stock in the FHLB and borrowings are collateralized by certain home mortgages or securities of the U.S. Government and its agencies. The maximum amount of credit which the FHLB will extend varies from time to time depending on their policies. The Company maintains a borrowing capacity at the FHLB Boston that is a percentage of its total regulatory assets, subject to capital stock and collateralization requirements.
The following table summarizes the Company’s recorded borrowings at December 31, 2007.
(1) Includes fair value adjustments on acquired borrowings, in accordance with SFAS No. 141,“Business Combinations,” of $9.6 million and $13.5 million at December 31, 2007 and 2006, respectively.
(2) Includes fair value adjustments on acquired borrowings, in accordance with SFAS No. 141, “Business Combinations,” of $300,000 and $500,000 at December 31, 2007 and 2006, respectively. The trusts were organized to facilitate the issuance of “trust preferred” securities. The Company acquired these subsidiaries when it acquired Alliance and Westbank. The affiliated trusts are wholly-owned subsidiaries of the Company and the payments of these securities are irrevocably and unconditionally guaranteed by the Company.
Table 16 above summarizes the Company’s recorded borrowings of $2.36 billion at December 31, 2007, an increase of $451.6 million, or 23.7%, from the balance recorded at December 31, 2006, mainly in FHLB advances. This increase in FHLB advances was primarily due to funding loan growth and to cover deposit outflows while managing interest rate risk and liquidity. At December 31, 2007, the majority of the Company’s outstanding FHLB advances were at fixed rates, while only $60.0 million had floating rates.
Stockholders’ Equity
Total stockholders’ equity equaled $1.41 billion at December 31, 2007, $44.8 million higher than the balance at December 31, 2006. The increase consisted primarily of common stock issued for the Westbank acquisition of $58.9 million, an increase in other comprehensive income of $30.0 million primarily due to the restructuring of the investment portfolio and the after tax appreciation in the fair market value of investments available for sale, net income of $23.8 million, and stock option and restricted stock expense of $12.0 million. These increases were partially offset by our repurchase of 4,602,787 shares of our common stock for $62.0 million and the payment of $27.0 million of cash dividends declared on our common stock during the year. Dividends declared in 2007 were $0.255 compared to $0.235 for the year ended December 31, 2006. Book value per share amounted to $12.93 and $12.43 at December 31, 2007 and 2006, respectively. For information regarding our compliance with applicable capital requirements, see “Liquidity and Capital Resources” below.
Liquidity and Capital Resources
Liquidity is the ability to meet current and future short-term financial obligations. The Company further defines liquidity as the ability to respond to the needs of depositors and borrowers as well as maintaining the flexibility to take advantage of investment opportunities. The Company’s primary sources of funds consist of deposit inflows, loan repayments and sales, maturities, paydowns and sales of investment and mortgage-backed securities, borrowings from the Federal Home Loan Bank and repurchase agreements.
The Company has expanded its use of borrowings from the Federal Home Loan Bank to fund loan growth while managing interest rate risk and liquidity. At December 31, 2007, total borrowings from the Federal Home Loan Bank amounted to $2.13 billion, exclusive of $9.6 million in purchase accounting adjustments, and the Company had the immediate capacity to increase that total to $2.32 billion. Additional borrowing capacity of approximately $819.4 million would be readily available by pledging eligible investment securities as collateral. Depending on market conditions and the Company’s liquidity and gap position, the Company may continue to borrow from the Federal Home Loan Bank or initiate borrowings through the repurchase agreement market. At December 31, 2007 the Company’s repurchase agreement lines of credit totaled $125.0 million, $100.0 million of which was available on that date.
Factors affecting liquidity include loan origination volumes, loan prepayment rates, maturity structure of existing loans, core deposit growth levels, time deposit maturity structure and retention, investment portfolio cash flows, the market value of investment securities that can be used to collateralize FHLB advances and repurchase agreements. The liquidity position is influenced by general interest rate levels, economic conditions and competition. For example, as interest rates decline, payments of principal from the loan and mortgage-backed securities portfolio accelerate, as borrowers are more willing to prepay. Additionally, the market value of the securities portfolio generally increases as rates decline, thereby increasing the amount of collateral available for funding purposes.
The Company determines its cash position daily. The Investment Department compiles reports detailing the Company’s cash activity and cash balances occurring at its various correspondents and through its various funding sources. The Investment Department then settles all correspondent and bank accounts either investing excess funds or borrowing to cover the projected shortfall.
The Company’s most liquid assets are cash and due from banks, short-term investments and debt securities. The levels of these assets are dependent on the Company’s operating, financing, lending and investment activities during any given period. At December 31, 2007, cash and due from banks, short-term investments and debt securities maturing within one year amounted to $432.9 million, or 5.27% of total assets.
NewAlliance’s main source of liquidity at the parent company level is dividends from NewAlliance Bank. The main uses of liquidity are payments of dividends to common stockholders, repurchase of NewAlliance’s common stock, and the payment of principal and interest to holders of trust preferred securities. There are certain restrictions on the payment of dividends. See Note 15 of Notes to Consolidated Financial Statements contained elsewhere within this report for further information on dividend restrictions.
Management believes that the cash and due from banks, short term investments and debt securities maturing within one year, coupled with the borrowing line at the Federal Home Loan Bank and the available repurchase agreement lines at selected broker dealers, provide for sufficient liquidity to meet its operating needs.
At December 31, 2007, the Company had commitments to originate loans, unused outstanding lines of credit and standby letters of credit totaling $810.7 million. Management anticipates that it will have sufficient funds available to meet its current loan commitments. Time deposits maturing within one year from December 31, 2007 amount to $1.87 billion.
The following tables present information indicating various obligations and commitments made by the Company as of December 31, 2007 and the respective maturity dates. 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 and generally have fixed expiration dates or other termination clauses.
(1) Secured under a blanket security agreement on qualifying assets, principally, mortgage loans.
(2) Represents non-cancelable operating leases for offices.
(1) Commitments for loans are extended to customers for up to 180 days after which they expire.
(2) Unadvanced portions of construction loans are available to be drawn on at any time by the borrower for up to 2 years.
(3) Unadvanced portions of home equity loans are available to be drawn on at any time by the borrower for up to 9.5 years. Commercial lines of credit are available to be drawn on at any time by the borrower for up to 1 or 2 years.
Applicable regulations require the Company and the Bank to satisfy certain minimum capital requirements. At December 31, 2007, the Company and the Bank were in full compliance with all applicable capital requirements and met the FDIC requirements for a well capitalized institution. See Note 15 of Notes to Consolidated Financial Statements contained in Item 8 of this report, and the section titled Regulation and Supervision in Item 1, concerning capital requirements.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Management Of Market And Interest Rate Risk
General
Market risk is the exposure to losses resulting from changes in interest rates, foreign currency exchange rates, commodity prices and equity prices. The Company has no foreign currency or commodity price risk. Credit risk related to investment securities is low as substantially all are investment grade or have government guarantees. There is no sub-prime mortgage exposure in the investment portfolio. The chief market risk factor affecting financial condition and operating results is interest rate risk. Interest rate risk is the exposure of current and future earnings and capital arising from adverse movements in interest rates and spreads. This risk is managed by periodic evaluation of the interest rate risk inherent in certain balance sheet accounts, determination of the level of risk considered appropriate given the Company’s capital and liquidity requirements, business strategy, performance objectives and operating environment and maintenance of such risks within guidelines approved by the Board of Directors. Through such management, the Company seeks to reduce the vulnerability of its net earnings to changes in interest rates. The Asset/Liability Committee, comprised of several senior executives, is responsible for managing interest rate risk. On a quarterly basis, the Board of Directors reviews the Company’s gap position and interest rate sensitivity exposure described below and Asset/Liability Committee minutes detailing the Company’s activities and strategies, the effect of those strategies on the Company’s operating results, interest rate risk position and the effect changes in interest rates would have on the Company’s net interest income. The extent of movement of interest rates is an uncertainty that could have a negative impact on earnings.
The principal strategies used to manage interest rate risk include (i) emphasizing the origination, purchase and retention of adjustable rate loans, and the origination and purchase of loans with maturities matched with those of the deposits and borrowings funding the loans, (ii) investing in debt securities with relatively short maturities and/or average lives and (iii) classifying a significant portion of its investment portfolio as available for sale so as to provide sufficient flexibility in liquidity management. By its strategy of limiting the Bank’s risk to rising interest rates, the Bank is also limiting the benefit of falling interest rates.
The Company employs two approaches to interest rate risk measurement; gap analysis and income simulation analysis.
Gap Analysis
The matching of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are “interest rate sensitive” and by monitoring a bank’s interest rate sensitivity “gap.” An asset or liability is deemed to be interest rate sensitive within a specific time period if it will mature or reprice within that time period. The “interest rate sensitivity gap” is defined as the difference between the amount of interest-earning assets maturing or repricing within a specific time period and the amount of interest-bearing liabilities maturing or repricing within that same time period. At December 31, 2007, the Company’s cumulative one-year interest rate gap (which is the difference between the amount of interest-earning assets maturing or repricing within one year and interest-bearing liabilities maturing or repricing within one year), was negative $203.4 million, or negative 2.48% of total assets. The Bank’s approved policy limit is plus or minus 20%. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. A gap is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets. During a period of rising interest rates, a negative gap would tend to adversely affect net interest income while a positive gap would tend to result in an increase in net interest income. Conversely, during a period of falling interest rates, a negative gap would tend to result in an increase in net interest income while a positive gap would tend to adversely affect net interest income.
The following table sets forth the Company’s cumulative maturity distribution of interest-earning assets and interest-bearing liabilities at December 31, 2007, interest rate sensitivity gap, cumulative interest rate sensitivity gap, cumulative interest rate sensitivity gap ratio, and cumulative interest-earning assets as a percentage of cumulative interest-bearing liabilities ratio. This table indicates the time periods in which interest-earning assets and interest-bearing liabilities will mature or may reprice in accordance with their contractual terms. Assumptions are made on the rate of prepayment of principal on loans and investment securities. However, this table does not necessarily indicate the impact of general interest rate movements on the Company’s net interest yield because the repricing of various categories of assets and liabilities is discretionary and is subject to competitive and other pressures. Additionally, certain assets, such as adjustable rate loans, have features that restrict changes in interest rates both on a short-term basis and over the life of the asset. Further, in the event of changes in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in the gap analysis, so that when interest rates rise, the gap becomes more negative, and when
interest rates fall, the gap becomes more positive. As a result, various assets and liabilities indicated as repricing within the same time period may, in fact, reprice at different times and at different rate levels. It should also be noted that this table reflects certain assumptions regarding the categorization of assets and liabilities and represents a one-day position; in fact, variations occur daily as management adjusts interest rate sensitivity throughout the year.
Income Simulation Analysis
Income simulation analysis considers the maturity and repricing characteristics of assets and liabilities, as well as the relative sensitivities of these balance sheet components over a range of interest rate scenarios. Tested scenarios include instantaneous rate shocks, rate ramps over a six-month or one-year period, static rates, non-parallel shifts in the yield curve and a forward rate scenario. The simulation analysis is used to measure the exposure of net interest income to changes in interest rates over a specified time horizon, usually a three-year period. Simulation analysis involves projecting future balance sheet structure and interest income and expense under the various rate scenarios. The Company’s internal guidelines on interest rate risk specify that for a range of interest rate scenarios, the estimated net interest margin over the next 12 months should decline by less than 12% as compared to the forecasted net interest margin in the base case scenario. However, in practice, interest rate risk is managed well within these 12% guidelines.
For the base case rate scenario the flat yield curve as of December 31, 2007 was utilized. This yield curve was utilized due to the recent excessive volatility in the rates markets. As of December 31, 2007, the Company’s estimated exposure as a percentage of estimated net interest income for the next twelve-month period as compared to the forecasted net interest income in the base case scenario are as follows:
As of December 31, 2007, a downward twelve month ramp of 200 basis points was a realistic representation of the risk of falling rates as the Federal Reserve was reducing rates to increase market liquidity. For an increase in rates, an upward twelve month ramp of 200 basis points is also a relevant representation of potential risk given the possibility of the economy rebounding due to the recent reductions in the federal funds rate and the potential for the government stimulus package to be enacted in the second half of the year.
Based on the scenarios above, net interest income would increase slightly in the 12-month period after an upward movement in rates, and would decrease after a downward movement in rates. Computation of prospective effects of hypothetical interest rate changes are based on a number of assumptions including the level of market interest rates, the degree to which certain assets and liabilities with similar maturities or periods to repricing react to changes in market interest rates, the degree to which non-maturity deposits react to changes in market rates, the expected prepayment rates on loans and investments, the degree to which early withdrawals occur on time deposits and other deposit flows. As a result, these computations should not be relied upon as indicative of actual results. Further, the computations do not reflect any actions that management may undertake in response to changes in interest rates.
Item 8.
Item 8.
Financial Statements and Supplementary Data
For the Company’s Consolidated Financial Statements, see index on page 53.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A.
Controls and Procedures
The Company’s management, including our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) or Rule 15d-15(e) under the Exchange Act) as of December 31, 2007. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective.
Disclosure controls and procedures are our controls and other procedures that are designed to ensure that the information required to be disclosed by us in our reports filed or submitted under the Securities Exchange Act of 1934 (the “Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in our reports filed under the Exchange Act is accumulated and communicated to our management, including the principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure for the year ending December 31, 2007.
In addition, based on that evaluation, no change in the Company’s internal control over financial reporting occurred during the fourth quarter ended December 31, 2007 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
The Company’s independent registered public accounting firm has issued a report on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2007. The report, which expresses an unqualified opinion on the effective operation of the Company’s internal control over financial reporting as of December 31, 2007, is included on page 55 of this Form 10-K.
Item 9A(T). Controls and Procedures
Not applicable
Item 9B.