ITEM 1. BUSINESS
GENERAL
FIRST ESSEX BANCORP, INC.
The Company is a Delaware corporation whose primary activity is to act as the parent holding company for First Essex Bank, FSB (the "Bank"). Until December 1, 1993, the business of First Essex Bancorp, Inc. was conducted through two banking subsidiaries, First Essex Savings Bank, a Massachusetts-chartered savings bank and First Essex Savings Bank of New Hampshire, a New Hampshire-chartered guaranty savings bank. The New Hampshire bank was owned through a second tier holding company, First Essex Bancorp of New Hampshire, Inc., which was merged into First Essex Bancorp, Inc. on December 1, 1993.
On December 30, 1996, Finest Financial Corp. ("Finest"), the parent holding company of Pelham Bank and Trust Company ("Pelham"), a New Hampshire chartered bank, was merged into the Company in a transaction that was accounted for as a purchase. Pelham was simultaneously merged into the Bank. The purchase price was composed of 1,353,998 shares of common stock issued at a price of $11.50 per share and a total cash outlay of $16.3 million. Included in the total acquisition cost was approximately $1.4 million of capitalized costs incurred in connection with the acquisition. This transaction was accounted for as a purchase and, accordingly, the consolidated statement of operations includes the results of Finest's operations since the acquisition.
FIRST ESSEX BANK, FSB
The Bank was originally founded under a Massachusetts legislative charter issued in 1847. On December 1, 1993, First Essex Savings Bank converted to a federal savings bank with a charter issued by the Office of Thrift Supervision (the "OTS") under the name of First Essex Bank, FSB. On the same day First Essex Savings Bank of New Hampshire was merged into First Essex Bank, FSB. As stated above, the Bank merged with Pelham on December 30, 1996.
Pursuant to a Purchase and Assumption Agreement, the Bank purchased certain assets and assumed certain deposit liabilities of another financial institution in June 1998. Because this branch acquisition was an acquisition of assets and not the acquisition of a business, separate entity or a subsidiary, no historical financial statements or pro-forma financial statements are required, and because the deposit liabilities assumed exceed the assets acquired, there was a cash payment made to the Bank as a result of this transaction.
At December 31, 1999, the Bank had total assets of $1.4 billion. The Bank is principally engaged in the business of attracting deposits from the general public and investing in residential mortgage, construction, commercial real estate, commercial and consumer loans. The Bank also makes investments in various investment securities to provide a source of interest and dividend income. The Bank currently maintains 19 full-service banking offices at various locations throughout its market area. Deposits at First Essex Bank, FSB are insured up to the applicable limits by the Federal Deposit Insurance Corporation (the "FDIC") and Massachusetts deposits in excess of FDIC limits are fully insured by the additional coverage provided contractually by the Depositors Insurance Fund of Massachusetts.
MARKET AREA
First Essex's market area is centered approximately 25 miles north of Boston at the intersection of two major highways: Interstate Route 93, the major north-south roadway connecting Boston with the northern Boston suburban communities and New Hampshire, and Interstate Route 495. The Bank's principal executive offices are located in Andover, Massachusetts, and its main banking office and two of its branches are located in Lawrence, Massachusetts. Other branches are in the surrounding communities of Andover, North Andover, Haverhill, Lowell and Methuen, Massachusetts and Concord, Hillsboro, Londonderry, Manchester, Pelham, Salem and Windham, New Hampshire.
CURRENT MARKET CONDITIONS
The New England region, including those portions of northeastern Massachusetts and southern New Hampshire that constitute First Essex's market area, continues to experience growth.
Loan demand to finance new and existing home sales has remained strong for the last four years. Commercial loans to small and mid-size businesses in the area continue to benefit from a growing economy characterized by expansion with little price inflation, although the competition among lenders for these loans remains intense. Automobile sales continued to show strength in 1999 and First Essex participated in that growth through an indirect automobile lending program that was begun early in 1994. The general improvement in consumer confidence and the consumer's willingness to take on additional debt was reflected in the growth in direct lending to consumers.
REGULATION
GENERAL
The Office of Thrift Supervision ("OTS") is the primary regulator of the Company and the Bank. The Bank's deposits are insured up to applicable limits by the Bank Insurance Fund ("BIF") of the FDIC. The Company and the Bank must file reports with the OTS concerning activities and financial condition, in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with or acquisitions of other financial institutions. Periodic examinations are conducted by the OTS to test the Company's and the Bank's compliance with various regulatory requirements. The Bank is also a member of the Federal Home Loan Bank ("FHLB") system, which provides a central credit facility primarily for member institutions. The Company, as a thrift holding company, is also required to file certain reports with, and otherwise comply with the rules and regulations of the OTS and the Securities and Exchange Commission ("SEC") under the federal securities laws.
BUSINESS ACTIVITIES
The activities of federal savings institutions are governed by the Home Owners' Loan Act, as amended (the "HOLA") and, in certain respects, the Federal Deposit Insurance Act (the "FDI Act"). The HOLA and the FDI Act were amended by the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"). FDICIA, among other things, requires that federal banking regulators intervene promptly when a depository institution experiences financial difficulties, mandates the establishment of a risk-based deposit insurance assessment system and requires the imposition of numerous additional safety and soundness operational standards and restrictions. FDICIA contains provisions affecting numerous aspects of the operations of federal savings institutions and empowers the OTS and the FDIC, among other agencies, to promulgate regulations implementing its provision.
QUALIFIED THRIFT LENDER TEST
The HOLA requires saving institutions to meet a qualified thrift lender ("QTL") test. Under the QTL test, as modified by FDICIA, a savings association is required to maintain at least 65% of its "portfolio assets" (total assets less (i) specified liquid assets up to 20% of total assets, (ii) intangibles, including goodwill, and (iii) the value of property used to conduct the association's business) in certain "qualified thrift investments" (primarily residential mortgages and related investments, including certain mortgage-backed securities) on a monthly basis in 9 out of every 12 months.
LIMITATION ON CAPITAL DISTRIBUTIONS
OTS regulations impose limitations upon all capital distributions, other than stock dividends, by savings institutions. The rule establishes three tiers of institutions, which are based primarily on an institution's capital level. An institution that meets or exceeds all fully phased-in capital requirements before and after a proposed capital distribution ("Tier I Bank") and has not been advised by the OTS that it is in need of more than normal supervision, could, after prior notice but without the approval of the OTS, make capital distributions during a calendar year equal to the greater of: (i) 100% of its net income to date during the calendar year plus the amount that would reduce by one-half its "surplus capital ratio" (the percentage by which its capital to assets ratio exceeds the ratio of its fully phased-in capital requirements to its assets) at the beginning of the calendar year; or (ii) 75% of its net income for the previous four quarters. Any additional capital distributions would require prior regulatory approval. In the event the Bank's capital fell below its fully phased in requirement or the OTS notified the Bank that it was in need of more than normal supervision, the Bank's ability to make capital distributions would be restricted. In addition, the OTS could prohibit any proposed capital distribution by any institution if it determines that such distribution would constitute an unsafe or unsound practice. Furthermore, under the OTS prompt corrective action regulations, which took effect on December 19, 1992, the Bank generally would be
prohibited from making any capital distribution if, after the distribution, the Bank would have (i) a total risk-based capital ratio of less than 8%, (ii) a Tier I risk-based capital ratio of less than 4% or (iii) a Tier I core capital ratio of less than 3%. As of December 31, 1999, the Bank exceeded all capital requirements.
BRANCHING
The Bank currently meets the tests provided in the HOLA and OTS regulations to permit savings institutions to branch nationwide. Additionally, the OTS authority preempts any state law purporting to regulate branching by savings institutions.
CAPITAL REQUIREMENTS
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company's capital amounts and classification are also subject to qualitative judgments by the regulators about the components of capital, risk weightings of assets, and other factors.
Quantitative measures are established by regulation regarding minimum amounts and ratios of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 1999, that the Company meets all capital adequacy requirements to which it is subject.
As of December 31, 1999, the most recent notification received from the OTS categorized the Company as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Company must maintain the total risk-based, Tier I risk-based and Tier I adjusted asset ratios. There are no conditions or events since that notification that management believes have changed the institution's category.
FDICIA required that the OTS revise risk-based capital standards, with appropriate transition rules, to ensure that they take account of interest rate risk, concentration of risk and the risks of nontraditional activities. Under OTS regulation effective January 1, 1994, a savings institution with interest rate risk exposure above a specified percentage must deduct a specified interest rate risk component when calculating total capital for purposes of determining whether it meets OTS risk-based capital requirements. As of December 31, 1999, the OTS did not deem it necessary for an interest-rate risk component to be deducted from capital in determining risk-based capital requirements.
The Company may not declare or pay cash dividends on its shares of common stock if the effect thereof would cause stockholders' equity to be reduced below applicable capital maintenance requirements or if such declaration and payment would otherwise violate regulatory requirements.
The capital ratios discussed above, along with the Company's actual capital amounts and ratios are presented in a table within Note 16 to the Consolidated Financial Statements included in Item 8 - "Financial Statements and Supplementary Data" of this report.
INSURANCE OF DEPOSIT ACCOUNTS
As required by FDICIA, in 1993, the FDIC established a risk-based assessment system for insured depository institutions that takes into account the risks attributable to different categories and concentrations of assets and liabilities, the likely amounts of any loss, and the revenue needs of the insurance fund.
Insurance of deposits may be terminated by the FDIC after notice and hearing, upon finding by the FDIC that the savings institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, rule, regulation, order or condition imposed by, or written agreement with, the FDIC. Additionally, if insurance termination proceedings are initiated against a savings institution, the FDIC temporarily may suspend insurance on new deposits received by an institution under certain circumstances. Management
is not aware of any activity or condition, which could result in a termination of its deposit insurance. Deposits in Massachusetts are insured in full by the coverage provided by the Depositors Insurance Fund of Massachusetts.
FEDERAL RESERVE SYSTEM
The Federal Reserve Board regulations require financial institutions to maintain noninterest earning reserves against their transaction accounts (primarily NOW and regular checking accounts). Due to the required reserves needing to be maintained in the form of either vault cash, a noninterest bearing account at a Federal Reserve Bank or a pass-through account as defined by the Federal Reserve Board, the effect of this reserve requirement is to reduce the Bank's interest-earning assets.
HOLDING COMPANY REGULATION
The Company is a nondiversified unitary savings and loan holding company within the meaning of the HOLA. As such, the Company has registered with the OTS and is subject to OTS regulations, examinations, supervision and reporting requirements. As a unitary savings and loan holding company, the Company generally will not be restricted under existing laws as to the types of business activities in which it may engage, provided that the Bank continues to be a QTL. The HOLA requires the Company to obtain regulatory approvals prior to entering into certain transactions such as mergers with or acquisitions of other institutions or holding companies.
LENDING ACTIVITIES
GENERAL
At December 31, 1999, the loan portfolio, before deducting the allowance for loan losses, totaled $812.3 million, which represented 59.0% of total assets and an increase of $78.4 million over the prior year. See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Allowance for Loan Losses."
Due to the Company's continued emphasis on higher yielding commercial and consumer loans, every major category of loans evidenced growth during 1999 with the exception of residential real estate. First Essex originates residential first mortgage loans, commercial real estate loans, construction loans, consumer loans and commercial loans. See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition."
The following table sets forth information concerning First Essex's loan portfolio, including mortgage loans held for sale, at the dates indicated. The balances shown in the table are net of unadvanced funds and unearned discounts and fees. Required disclosure regarding maturity distribution is shown on pages 30 and 31.
RESIDENTIAL MORTGAGE LOANS
The Bank originates residential first mortgage loans in its market area. At December 31, 1999, the residential mortgage loan portfolio was $144.0 million, representing 17.7% of the loan portfolio. The Bank's residential first mortgage loan products consist of six-month, one-year, three-year, five-year and seven-year adjustable-rate mortgages and fixed-rate mortgages, having terms of 15 to 30 years.
COMMERCIAL REAL ESTATE LOANS
The Bank also holds loans secured by commercial real estate, such as manufacturing, retail, apartment and office buildings. At December 31, 1999, the commercial real estate loan portfolio had an outstanding balance of $111.3 million, representing 13.7% of the Bank's loan portfolio.
Generally, commercial real estate loans in the portfolio have been made to finance the acquisition or retention of income producing properties. The current policy of the Company is to limit commercial real estate loans primarily to properties in eastern Massachusetts and southern New Hampshire.
Commercial real estate loans generally reprice over periods ranging from six months to five years based on a published prime rate or other index.
CONSTRUCTION LOANS
Construction loans are primarily made to developers and builders for the construction of commercial and single-family properties. Construction loans have generally been made with maturities of one year or less and a price based on the published prime rate, subject to renewal or extension by the Bank. Additionally, loans are made to qualified individuals for construction of single-family owner-occupied homes that convert to permanent mortgages upon completion of construction. At December 31, 1999, the Bank's construction loan portfolio had an outstanding balance of $51.4 million, representing 6.3% of the loan portfolio.
OWNER-OCCUPIED COMMERCIAL REAL ESTATE LOANS
Owner-occupied commercial real estate loans are extensions of credit to commercial borrowers for the construction or purchase of business space, primarily for the borrower's own use, or loans to commercial borrowers for operating purposes in which the Bank has taken real estate occupied by the borrower as collateral. In these instances, the cash flow of the borrower's business is the primary source of repayment. At December 31, 1999, this portfolio had total outstandings of $63.4 million, representing 7.8% of the Bank's loan portfolio.
COMMERCIAL LOANS
At December 31, 1999, the portfolio of commercial loans totaled $98.7 million, representing 12.1% of the loan portfolio. The Bank offers secured and unsecured demand loans, time loans, term loans, lines of credit and working capital loans, which are short term or have adjustable rates. Commercial loans are originated by the Bank's commercial lending officers who are supported by a credit, processing and documentation staff.
AIRCRAFT LOANS
The Bank also has an expanding market in commercial and consumer aircraft lending, which represented 13.2% of the loan portfolio, at December 31, 1999. At that date, commercial aircraft loans totaled $105.9 million and consumer aircraft loans totaled $1.1 million of the $107.0 million aircraft portfolio.
CONSUMER LOANS
The portfolio of consumer loans, representing 29.2% of the loan portfolio, consists of automobile loans, fully or partially secured personal loans, boat loans, second mortgage loans, home equity loans and unsecured personal loans, which totaled $236.6 million at December 31, 1999. Automobile loans include dealer indirect loans, as well as loans originated directly in retail branches. The Bank offers a variable rate home equity line of credit called "First Line Equity Credit". This product consists of a line of credit, secured by a second mortgage on residential property, with a monthly adjustable interest rate at a margin above a published prime rate.
RISKS ASSOCIATED WITH COMMERCIAL REAL ESTATE, COMMERCIAL, OWNER-OCCUPIED COMMERCIAL REAL ESTATE AND CONSTRUCTION LOANS
Commercial real estate and commercial lending involve significant additional risks compared with one-to-four family residential mortgage lending, and, therefore, typically account for a disproportionate share of delinquent loans and real estate owned through foreclosure. Such lending generally involves larger loan balances to single borrowers or groups of related borrowers than does residential lending, and repayment of the loan depends in part on the underlying business and financial condition of the borrower and is more susceptible to adverse future developments. If the cash flow from income-producing property is reduced (for example, because leases are not obtained or renewed), the borrower's ability to repay the loan may be materially impaired. These risks can be significantly affected by considerations of supply and demand in the market for office, manufacturing and retail space and by general economic conditions. As a result, commercial real estate and commercial loans are likely to be subject, to a greater extent than residential property loans, to adverse conditions in the economy generally.
Construction loans are, in general, subject to the same risks as commercial real estate loans, but involve additional risks as well. Such additional risks are due to uncertainties inherent in estimating construction costs, delays arising from labor problems, shortages of material, uncertain marketability of a complete project and other unpredictable contingencies that make it relatively difficult to determine accurately the total loan funds required to complete a project or the value of the completed project. Construction loan funds are advanced on the security of the project under construction, which is of uncertain value prior to the completion of construction. When a construction project encounters cost overruns, marketing or other problems, it may become necessary, in order to sustain the project and to preserve collateral values, for the lender to advance additional funds and to extend the maturity of its loan. In a declining market, there is no assurance that this strategy will successfully enable the lender to recover outstanding loan amounts and interest due. Moreover, foreclosing on such properties results in administrative expense and substantial delays in recovery of outstanding loan amounts and provides no assurance that the lender will recover all monies due to it, either by developing the property, subject to regulatory limitations and to the attendant risks of development, or by selling the property to another developer.
RESIDENTIAL LOAN SERVICING AND SALE OF LOANS
The Bank generally writes residential mortgage loans to meet the requirements for sale in the secondary market. From time to time, the Bank sells residential mortgage loans and residential loan servicing. Such loan sales represent a potential source of liquidity to meet lending demand and deposit flows. See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Asset/Liability Management."
At December 31, 1999, the Bank's residential loan servicing portfolio totaled $26.0 million.
NONPERFORMING ASSETS
GENERAL
Nonperforming assets consist of nonaccruing loans (including impaired and restructured loans) and foreclosed property. For further information regarding the impairment of loans see "Provision for Loan Losses" included in Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations".
NONACCRUING LOANS
It is the general practice of the Bank to discontinue accrual of interest on loans for which payment of interest or principal is 90 days or more past due and such other loans where collection of interest and principal is doubtful. All previously accrued but uncollected interest is reversed against current period interest income when a loan is placed on nonaccrual status. At December 31, 1999, the Bank's nonaccruing loans totaled $3.4 million, representing a decrease of $2.1 million or 37.7% from $5.5 million at December 31, 1998. For further information regarding the Bank's nonaccruing loans, see Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Non-Performing Assets."
RESTRUCTURED LOANS
These are loans on which concessions have been made in light of the debtor's financial difficulty with the objective of maximizing recovery. At December 31, 1999 and 1998, the Bank had restructured loans totaling $303,000 and $447,000 respectively. Restructured loans are nonperforming assets and are included in the totals for nonaccrual loans described above. For further information regarding restructured loans, see Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations Nonperforming Assets."
FORECLOSED PROPERTY
Foreclosed property at December 31, 1999 totaled $447,000 compared to $575,000 at December 31, 1998.
Foreclosed property consists of real or tangible property that collateralized a loan prior to foreclosure or repossession. These properties are carried at the lower of cost or the estimated net realizable values. Any decreases in value prior to sale are charged to operations.
For further information regarding the Bank's foreclosed property, see Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Nonperforming Assets."
INVESTMENT ACTIVITIES
The Company maintains an investment portfolio to provide a source of interest and dividend income and a potential source of liquidity to meet lending demand and deposit flows. At December 31, 1999, the investment portfolio, consisting of short-term investments, investment securities, mortgage-backed securities, stock in the Federal Home Loan Bank of Boston and stock of the Savings Bank Life Insurance Company of Massachusetts, totaled $455.2 million, or 33.1% of total assets.
Interest and dividend income on the investment portfolio generated 30.4% of total interest and dividend income for the year ended December 31, 1999. See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Investments" for further information regarding the investment portfolio.
The Bank's investment strategy seeks to provide liquidity and realize current income while preserving principal. The Bank will generally invest only in government or corporate bonds or securities issued in the United States and will only purchase bonds which are rated A or higher at the time of purchase.
DEPOSITS
The Bank offers a range of deposit accounts including regular and passbook savings, NOW, money market and demand deposit accounts. The Bank offers a number of relationship products that allow customers to combine balances in checking and savings accounts in order to avoid service and maintenance fees, and obtain free banking services. These relationship products also include discounts on installment loans and bonus rates on certificates of deposit. The Bank also offers term deposit certificates ranging from 32 days to seven years. Interest rates on these certificates vary according to the term selected. From time to time, the Bank promotes various types of accounts with the intention of changing the maturity schedule of its liabilities. See also Item 7. - "Management's Discussion and Analysis of Financial Condition and Results of Operation - Deposits."
The Bank offers its retail banking customers a wide range of deposit services and the convenience of drive-up ATMs. The Bank is a member of the NYCE-TM-, EXCHANGE-TM-, TX-TM- and CIRRUS-TM- networks. These networks allow the Bank's depositors access to their accounts through ATMs at the Bank, other banks and locations nationwide and worldwide.
COMPETITION
The Bank faces competition both in originating loans and in attracting deposits. Competition in originating loans comes from a variety of sources, including, but not limited to, other thrift institutions, commercial banks, mortgage companies, insurance companies and consumer and commercial finance companies. The Bank competes for loans principally on the basis of interest rates and loan fees, the types and terms of loans originated and the quality of services provided to borrowers. In attracting deposits, the primary competitors are other thrift institutions, commercial banks, mutual funds and credit unions. The ability to attract and retain deposits depends on the ability to provide investment opportunities that satisfy the requirements of investors with respect to rate of return, liquidity, risk, service, convenience and other factors.
The Bank competes for deposits on the basis of interest rates and by offering convenient branch locations, extended business hours and an automated teller network.
EMPLOYEES
At December 31, 1999, the Bank had 312 full time equivalent employees. None of the employees of the Bank are represented by a collective bargaining group and management considers its relations with its employees to be good.
ITEM 2.
ITEM 2. PROPERTIES
The following table sets forth certain information relating to properties owned or used in banking activities at December 31, 1999.
ITEM 2. PROPERTIES
(CONTINUED)
(1) This site also serves as a branch location.
(2) Includes two contiguous buildings at 284 Essex Street and 286-288 Essex Street which were aquired in 1972 and 1980, respectively, as well as an adjacent parking lot at 7 Lawrence Street which was acquired in 1981.
(3) Second floor of building is subleased for a two year term, commencing on April 1, 1998 and terminating on March 31, 2000. There is an option to renew for three additional 3 year terms.
(4) Second floor of building is leased for a two year term, commencing on March 1, 1999 and terminating on February 28, 2001. There is an option to renew for two additional 1 year terms.
(5) 4,000 s/f is leased for a three year term, commencing on January 1, 2000 and terminating December 31, 2002. There is an option to renew for one additional two year term.
Management believes that the Company's existing facilities are adequate for the conduct of its business.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is involved in various legal proceedings incident to its business, none of which are believed by management to be material to the financial condition or operations of the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of the shareholders during the fourth quarter of 1999.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S EQUITY AND RELATED STOCKHOLDER MATTERS
First Essex Bancorp, Inc. common stock is traded over-the-counter on the Nasdaq National Market System under the symbol FESX.
At December 31, 1999, there were 7,591,900 shares outstanding and approximately 1,200 shareholders of record. This does not reflect the number of persons or entities who hold their stock in nominee or street name through various brokerage firms.
The price information regarding the Company's common stock in the following table is based on high and low closing sales prices.
The only funds available to the Company for the payment of dividends are cash and cash equivalents held at the holding company level, dividends from the Bank and borrowings. In addition, bank regulatory authorities generally restrict the amounts available for the payment of dividends by the Bank to the Company to the net profit of the Bank for that year, see Item 1 - "Business - Regulation Limitation on Capital Distributions". The Federal Reserve Act also restricts the Bank in lending or advancing funds to the Company unless such loans are collateralized by specific obligations, and limits collateralized loans to 10% of the Bank's capital stock and surplus.
The Bank is prohibited from paying cash dividends, to the extent that any such payment would reduce its capital below required regulatory capital levels or would impair the liquidation account established in connection with its conversion from mutual to stock form. See Item 1. "Business - Regulation - Limitation on Capital Distributions" and Note 16 to the consolidated financial statements included in response to Item 8 - "Financial Statements and Supplementary Data" of this report for further discussion.
The payment of dividends by the Bank could carry significant adverse tax consequences. To the extent that distributions by the Bank to the holding company exceed the Bank's current and accumulated earnings and profits (as computed for federal income tax purposes for taxable years beginning after December 31, 1951), those distributions would be treated for tax purposes as first being made out of the Bank's bad debt reserve. In that case, the Bank would have federal taxable income equal to approximately one and one-half times the amount of the actual shareholder distribution that is treated as made out of the Bank's bad debt reserves.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
(1) Investment securities include short term investments, U.S. government and agency obligations, mortgage-backed securities, other bonds and obligations, stock in the Federal Home Loan Bank of Boston and stock in the Savings Bank Life Insurance Company.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
GENERAL
The results of operations of the Company consist primarily of the results of operations of the Bank, which is the Company's sole subsidiary. Net income for the year ended December 31, 1999 totaled $12.7 million (or $1.63 per diluted share) compared to $11.1 million (or $1.41 per diluted share) for the same period in 1998, an increase of 14.7% or $1.6 million. The improvement was primarily due to the increase in the net yield on average earnings assets, partially offset by higher provisions for loan losses, lower noninterest income and increases in noninterest expenses.
ANALYSIS OF AVERAGE YIELDS EARNED AND RATES PAID
The following table presents an analysis of average yields earned and rates paid for the years indicated:
(1) Loans on a non-accrual status are included in the average balance.
(2) Net interest income before provision for loan losses divided by average interest earnings assets.
RATE/VOLUME ANALYSIS
The following table presents, for the periods indicated, the changes in interest and dividend income and the changes in interest expense attributable to changes in interest rates and changes in the volume of interest earning assets and interest bearing liabilities. The change attributable to both volume and rate has been allocated proportionally to the two categories.
NET INTEREST INCOME
Net interest income increased by $5.6 million to $46.6 million for the year ended December 31, 1999, representing a 13.7% increase from $40.9 million in 1998. The increase in net interest income was primarily due to the increase of 27 basis points in the net yield on average earning assets combined with the volume increases in outstanding loans and investment securities.
Net interest income increased by $3.2 million to $40.9 million for the year ended December 31, 1998, representing an 8.6% increase from $37.7 million in 1997. The increase in net interest income was primarily due to the increase of 13 basis points in the net yield on average earning assets combined with the volume increases in outstanding loans and short term investments partially offset by the decreased investment securities.
INTEREST AND DIVIDEND INCOME
Interest and dividend income increased by $3.3 million (3.5%) to $96.7 million for the year ended December 31, 1999 from $93.5 million for the year ended December 31, 1998. This increase was due to a $65.3 million or 5.5% increase in average earning assets from $1,189.2 million in 1998 to $1,254.5 million in 1999. The net yield on average earning assets rose 27 basis points from the 1998 yield of 3.44% to 3.71% in 1999 primarily due to a decrease in the cost of funds.
Interest and dividend income increased by $3.4 million (3.8%) to $93.5 million for the year ended December 31, 1998 from $90.1 million for the year ended December 31, 1997. This increase was due to an overall increase in average earning assets from $1,138.6 million in 1997 to $1,189.2 million in 1998, a 4.4% increase. The net yield on average earning assets rose 13 basis points from the 1997 yield of 3.31% to 3.44% in 1998 primarily due to a decrease in the cost of funds and secondarily due to a shift to higher yielding commercial loans.
INTEREST EXPENSE
Interest expense decreased $2.3 million or 4.4% to $50.2 million for the year ended December 31, 1999 from $52.5 million in 1998. The volume increases in core deposits were more than offset by decreases in the rates paid on deposits
and borrowed funds combined with the volume decreases in borrowed funds. The total weighted cost of funds decreased 55 basis points from 5.02% in 1998 to 4.47% in 1999.
Interest expense increased marginally ($135,000 or 0.3%) to $52.5 million for the year ended December 31, 1998 from $52.4 million in 1997. The volume increases in savings and time deposits were more than offset by the volume decreases in borrowed funds. The total weighted cost of funds decreased 12 basis points from 5.14% in 1997 to 5.02% in 1998.
PROVISION FOR LOAN LOSSES
Losses on loans are provided for under the accrual method of accounting. Assessing the adequacy of the allowance for loan losses involves substantial uncertainties and is based upon management's evaluation of the amount required to meet estimated losses inherent in the loan portfolio after weighing various factors. Among the factors management may consider are the quality of specific loans, risk characteristics of the loan portfolio generally, the level of non-accruing loans, current economic conditions, trends in delinquencies and charge-offs and collateral values of the underlying security. See "Financial Condition - Allowance for Loan Losses". Ultimate losses may vary significantly from the current estimates. Losses on loans, including impaired loans, are charged against the allowance when management believes the collectability of principal is doubtful.
Provisions for loan losses totaled $2.4 million, $1.4 million, and $2.0 million for the years ended December 31, 1999, 1998 and 1997, respectively. Provisions result from management's continuing internal review of the loan portfolio as well as its judgment as to the adequacy of the reserves in light of the condition of the regional real estate market and the economy generally. As a result of increased loans, there is an expectation that the Bank will continue to find it necessary to make provisions for loan losses in the future. See "Financial Condition - Non-Performing Assets."
The Bank's total allowance for loan losses was $11.3 million or 331.1% of non-accruing loans at December 31, 1999 compared to $11.3 million or 204.8% at December 31, 1998 and $10.6 million or 190.7% at December 31, 1997.
NONINTEREST INCOME
Noninterest income consists of net gains from sales of securities, net gains from sales of loans and loan servicing rights, fee and other noninterest income.
Noninterest income decreased 11.2% to $6.1 million for the year ended December 31, 1999 compared to $6.9 million in 1998. The primary reasons for this decrease are attributable to nonrecurring gains on sales of investment securities during 1998, partially offset by increased fee income for 1999. Other noninterest income for 1999 includes approximately $345,000 of income from bank owned life insurance on policies purchased during 1999.
Noninterest income increased 34.9% to $6.9 million for the year ended December 31, 1998 compared to $5.1 million in 1997. The primary reasons for this $1.8 million increase were a $905,000 increase in gains on the sales of investment securities (of which approximately $231,000 were the result of gains realized on the sale of securities transferred from the held-to-maturity classification), and a $71,000 increase in total fee income, offset by a $290,000 decrease in gains on sales of mortgage loans. Other noninterest income was a result of a special payment received from the Massachusetts Depositors Insurance Fund of $346,000 and interest on a state tax refund of $145,000.
NONINTEREST EXPENSES
Noninterest expenses increased by $1.9 million (6.7%) to $30.1 million for the year ended December 31, 1999 compared to $28.2 million in 1998. The majority of this increase is related to the amortization of intangible assets associated with branches acquired during the second quarter of 1998. The remaining increases in other noninterest expenses reflect costs associated with the full year of operating those additional branch locations.
Noninterest expenses increased by $3.8 million (15.7%) to $28.2 million for the year ended December 31, 1998 compared to $24.4 million in 1997. The majority of this increase relates to the acquisition of four banking offices in June 1998, and the operation, throughout the reminder of the year, of these additional banking offices.
Salaries and employee benefits increased by $1.0 million (7.9%) to $14.1 million for the year ended December 31, 1999 from $13.0 million in 1998 and $11.6 million in 1997. The increases were primarily due to the acquisition of four additional branches in June of 1998.
Amortization of intangible assets associated with the branch acquisition in 1998 and the purchase of Finest Financial Corp. in 1996 amounted to $2.6 million in 1999, $1.7 million in 1998 and $780,000 in 1997.
The remaining categories of noninterest expenses remained flat at $13.4 million for the years ended December 31, 1999 and 1998, up from $11.9 million in 1997. Included in these expenses is "Other", which totaled $4.0 million in 1999 and represents a decrease of $1.2 million or 23.5% when compared to 1998. This decrease is primarily attributable to 1998 one-time write-downs in the carrying values of certain other assets associated with bank and branch acquisitions and the conversion to new operating systems. Other totaled $3.8 million in 1997.
INCOME TAXES
The net provision for income taxes amounted to $7.5 million in 1999 compared to provisions of $7.1 million and $6.7 million recorded in 1998 and 1997, respectively. The effective tax rate in 1999 is lower when compared to 1998 and 1997 due to favorable tax rates on certain investment income.
FINANCIAL CONDITION
Total assets increased by $129.3 million or 10.4% to $1.4 billion at December 31, 1999 compared to $1.2 billion at December 31, 1998.
LOANS
At December 31, 1999, the loan portfolio, excluding the allowance for loan losses, and including mortgage loans held-for-sale, was $812.3 million, representing 59.0% of total assets. This is an increase of $78.4 million or 10.7% when compared to $733.9 million or 58.8% of total assets at December 31, 1998. See Item 1 - "Business - Lending Activities - General" for a table setting forth the composition of the loan portfolio of the Bank at the end of each of the past five years.
NONPERFORMING ASSETS
Nonperforming assets consist of nonaccruing and restructured loans (including impaired loans), and foreclosed property. Nonperforming assets totaled $3.9 million at December 31, 1999, compared to $6.1 million at December 31, 1998 and $6.4 million at December 31, 1997.
The Bank's general practice is to discontinue the accrual of interest on loans (including impaired loans) for which payment of interest or principal is ninety days or more past due or for such other loans as considered necessary by management if collection of interest and principal is doubtful. When a loan is placed on nonaccrual status, all previously accrued but uncollected interest is reversed against current period interest income.
The recorded investment of restructured loans was $303,000 for the year ended December 31, 1999, $447,000 for the year ended December 31, 1998 and $905,000 for the year ended December 31, 1997.
The amount of interest that would have been earned had the nonaccrual and restructured loans performed in accordance with original terms and conditions was $164,000, $456,000 and $570,000 for the years ended December 31, 1999, 1998 and 1997, respectively.
Foreclosed property at December 31, 1999 totaled $447,000 compared to $575,000 at December 31, 1998 and consists mainly of real estate collateral from loans that were foreclosed, as well as repossessed automobiles.
At December 31, 1999, the recorded investment in loans that are considered to be impaired totaled $857,000 of which $507,000 had a related allowance for loan losses of $304,000. The remaining $350,000 of impaired loans did not require a related allowance for loan losses. The average recorded investment in impaired loans during 1999 was approximately $1.3 million.
The following table shows the composition of nonperforming assets for the five years ended December 31, 1999:
The following table summarizes the activity of foreclosed property during the year ended December 31, 1999:
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is maintained at a level determined by management to be adequate to provide for probable losses inherent in the loan portfolio including commitments to extend credit. The allowance for loan losses is maintained through the provision for loan losses, which is a charge to operations. The potential for loss in the portfolio reflects the risks and uncertainties inherent in the extension of credit.
The determination of the adequacy of the allowance for loan losses is based upon management's assessment of risk elements in the portfolio, factors affecting loan quality and assumptions about the economic environment in which the Company operates. The process includes identification and analysis of loss potential in various portfolio segments utilizing a credit risk grading process and specific reviews and evaluations of significant individual problem credits. In addition, management reviews overall portfolio quality through an analysis of current levels and trends in charge-off, delinquency and nonaccruing loan data, forecasted economic conditions and the overall-banking environment. These reviews are of necessity dependent upon estimates, appraisals and judgments, which may change quickly because of changing economic conditions and the Company's perception as to how these factors may affect the financial condition of debtors.
The methodology for assessing the appropriateness of the allowance consists of a review of the following key elements:
- A formula allowance for the various loan portfolio classifications,
- A valuation allowance for loans identified as impaired, and
- The unallocated allowance.
The formula allowance is a percentage-based reflection of historical loss experience and assigns required allowance allocations by loan classification based on a fixed percentage of all outstanding loan balances and commitments to extend credit. The formula allowance employs a risk-rating model that grades loans based on general characteristics of credit quality and relative risk. As credit quality becomes more suspect, so-called "watch list" loans, the risk rating and allocation percentage increase. The sum of these allocations comprise the Company's "formula" or "general" allowance.
The Company also has "valuation" allowances for impaired loans. Loans are evaluated for impairment by measuring the net present value of the expected future cash flows using the loan's original effective interest rate, or looking at the fair value of the collateral if the loan is collateral dependent. When the difference between the net present value of a loan (or fair value of the collateral if the loan is collateral dependent) is lower than the recorded investment of the loan, the difference is provided to expense with a resulting "valuation" allowance.
In addition to the formula and valuation components, there is an unallocated allowance that is composed of two additional elements. The first element, which is based on the Company's credit policy, consists of an amount that is at least 20% to 25% of the formula and valuation allowances. This element recognizes the estimation risks associated with the formula model and the valuation allowance. The second element is based upon management's evaluation of various conditions, the effects of which are not directly measured in determining the formula and valuation allowances. The evaluation of the inherent loss resulting from these conditions involves a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments. The conditions evaluated in connection with the unallocated allowance include the following:
- then-existing general economic and business conditions affecting the Company's key lending areas,
- credit quality trends, including trends in nonperforming loans expected to result from existing conditions,
- collateral values,
- loan volumes and concentrations,
- seasoning of the loan portfolio,
- specific industry conditions within portfolio segments,
- recent loss experience in particular segments of the portfolio,
- duration of the current business cycle,
- bank regulatory examination results, and
- findings of our internal credit examiners.
When an evaluation of these conditions signifies a change in the level of risk, the Company adjusts the formula allowance. Periodic credit reviews enable further adjustment to the allowance through the risk rating of loans and identification of loans requiring a valuation allowance. In addition, the formula model is designed to be self-correcting by taking into account recent loss experience.
The annual provision for loan losses is set based on the factors discussed above. In addition, it is management's intent to maintain the allowance at a level consistent with the Company's peers in the banking industry. The allowance to loans ratio of 1.40% at December 31, 1999 was slightly below the Company's peer group's average allowance ratio of 1.48% (1) Although the Company realized total loan growth of $78.4 million or 10.7% during 1999, there were no significant changes in loan concentrations, loan quality or loan terms during the period. Estimation methods and assumptions affecting the allowance for loan losses remained unchanged from those used in prior periods. There was no significant reallocation of the allowance for loan losses among the various segments of the portfolio.
The following table summarizes the activity in the allowance for loan losses for the five years ended December 31, 1999:
- ------------------------ (1) Based on the most recently available peer group date as of September 30, 1999.
INVESTMENTS
At December 31, 1999, the Company's investment portfolio, consisting of short-term investments, investment securities, mortgage-backed securities, Federal Home Loan Bank ("FHLB") stock and Savings Bank Life Insurance Company of Massachusetts stock, totaled $461.1 million or 33.5% of assets, compared to $367.4 million or 29.4% of assets at December 31, 1998. The portfolio included U.S. government and agency obligations having a book value of $114.0 million and mortgage-backed securities with a value of $310.0 million. Interest and dividend income on the Company's investment portfolio, which amounted to $29.4 million, generated 30.4% of total interest and dividend income for the year ended December 31, 1999.
To identify and control risks associated with the investment portfolio, the Company has established policies and procedures, which include stop loss limits and stress testing on a periodic basis. During the second quarter of 1998, the Company reclassified to available-for-sale all securities previously classified as held-to-maturity. This reclassification was the result of an analysis of the strategic alternatives for the securities portfolio. Under Securities and Exchange Commission guidelines, this reclassification prohibits the Company from classifying securities as held-to-maturity for a period of at least two years.
The Company does not have any investments in off-balance-sheet financial instruments, except as noted in Note 11 to the consolidated financial statements included in response to Item 8 - "Financial Statements and Supplementary Data" of this report.
The following table sets forth the composition of the investment portfolio for the years indicated:
For further information regarding the Company's investment portfolio, including information regarding amortized cost and fair value as of December 31, 1999, see notes 1, 4 and 21 to the Company's consolidated financial statements included in response to Item 8 hereof.
Set forth below is a breakdown of yields and contractual maturities for the amortized cost of indicated investment securities at December 31, 1999:
DEPOSITS
Deposits have historically been the Bank's primary source of funds for lending and investment activities. Deposit flows vary significantly and are influenced by prevailing interest rates, market conditions, economic conditions and competition. At December 31, 1999 the Bank had total deposits of $1,002.8 million, representing a net increase of $68.1 million compared to $934.7 million at December 31, 1998.
While deposit flows are unpredictable by nature, the Bank attempts to manage its deposits through selective pricing. Due to the uncertainty of market conditions, it is not possible for the Bank to predict how aggressively it will compete for deposits in the future or the likely effect of any such decision on deposit levels, interest expense and net interest income.
The following table sets forth the composition of average deposits and rates for the years indicated:
At December 31, 1999, 1998 and 1997, outstanding certificates of deposits in denominations of $100,000 and over had maturities as follows:
BORROWED FUNDS
The primary source of the Bank's borrowings come from the Federal Home Loan Bank ("FHLB"). The Bank also utilizes short-term repurchase agreements, generally with maturities less than three months, as an additional source of funds. Repurchase agreements are secured by U.S. government and agency securities. Borrowings are an alternative source of funds compared to deposits and totaled $269.0 million at December 31, 1999 compared to $201.5 million and $343.6 million at December 31, 1998 and 1997, respectively. The increase in borrowings in 1999 was used to fund the growth in the investment and loan portfolios during the year. The decrease in borrowings in 1998 to 1997 reflects the years' growth in deposits and the Company's diminished need to borrow funds to support its assets.
The following table summarizes the maximum and average amounts of borrowings outstanding, the majority of which are short-term, during 1999, 1998 and 1997 together with the weighted average interest rates thereon.
YEAR 2000
The following constitutes the Company's Year 2000 Readiness disclosure under the Year 2000 Information and Readiness Disclosure Act. The potential problem with the Year 2000 concerned the inability of information systems, primarily software programs, to properly recognize and process date sensitive information for the year 2000 and beyond.
The Company took numerous remedial steps over the past several years to prepare for the change of century. These steps included: forming a bank-wide project team to address and resolve Y2K issues; and forming a Year 2000 Compliance Oversight Committee of the Board of Directors to oversee the activities of management and others in dealing with Y2K issues; replacing or upgrading non-compliant hardware and software; working with third party service bureaus and other vendors to ensure that the Company's mission critical information systems were Y2K compliant; and establishing contingency plans in the event that an unforeseen problem were to arise.
Subsequent to December 31, 1999, the Company has not experienced any material Year 2000 transition issues. However there can be no assurance that a material vendor will not experience a Year 2000 transition issue, or that such transition issue will not have a material negative impact on the Company's consolidated financial position, results of operations or cash flows.
The following table details the aggregate expenditures (period and capital) incurred to date by the Company, to bring the Y2K project to closure. Period expenditures were expensed in the period incurred. Capital expenditures were capitalized and amortized over the estimated useful life of the item. All capital expenditures reflect hardware and software upgrades that were either previously planned or would have occurred in the normal course, and not as a direct result of Y2K remediation efforts.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ASSET/LIABILITY MANAGEMENT
The Bank's asset/liability management strategy is designed to increase net interest income and provide adequate earnings in expected future interest rate environments. As part of this strategy, a balance is sought between the repricing characteristics of its earning assets and funding sources while maximizing the spread between interest income and expense. The Bank adjusts the level of its liquid assets and the mix of its loans and investments based on management's judgment as to the quality of specific investment opportunities and the relative attractiveness of their maturities and yields.
In order to achieve a better repricing balance between its assets and liabilities, the Bank continued to originate and hold in portfolio adjustable rate residential mortgage loans. The Bank generally writes substantially all newly originated fixed rate residential loans to meet the requirements for sale in the secondary market. During 1999, the Bank sold $62.6 million of residential loans. As a result of this strategy residential loans decreased by $46.0 million during the year.
The Bank's commercial real estate, construction, consumer and commercial business lending programs also provide opportunities to better match the interest rate sensitivity of its loan portfolio and liabilities due to the adjustable rate or short term characteristics of these types of loans. These types of loans increased by $124.4 million during the year. Total loans increased by $78.4 million during the year.
During 1999, investments increased by $88.2 million. This was a result of management's planned strategy to grow the investment portfolio. These investments were funded by the increase in deposits and Federal Home Loan Bank borrowings. Total Federal Home Loan Bank borrowings increased by $77.1 million during the year.
Deposits increased by $68.1 million in 1999. The Bank maintains an aggressive marketing campaign for savings and time deposit products, which resulted in a significant increase in the balances of these products during 1999.
It is management's opinion that interest rates will continue to exhibit volatility. With this in mind, the Bank will continue to follow a strategy that seeks to achieve a balance in the repricing characteristics of its assets and liabilities and provide adequate earnings in a variety of interest rate environments.
MARKET RISK
Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates/prices such as interest rates, foreign currency exchange rates, commodity prices and equity prices. The Company's primary market risk exposure is interest rate risk. The ongoing monitoring and management of this risk is an important component of the Company's asset/liability management process which is governed by policies established by its Board of Directors that are reviewed and approved annually. The Board of Directors delegates responsibility for carrying out the asset/liability management policies to the Asset/Liability Committee ("ALCO"). In this capacity ALCO develops guidelines and strategies impacting the Company's asset/liability management related activities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels/trends.
INTEREST RATE RISK
Interest rate risk represents the sensitivity of earnings to changes in market interest rates. As interest rates change the interest income and expense streams associated with the Company's financial instruments also change thereby impacting net interest income (NII), the primary component of the Company's earnings. ALCO utilizes the results of a detailed and dynamic simulation model to quantify the estimated exposure of NII to sustained interest rate changes. While ALCO routinely monitors simulated NII sensitivity over a rolling two-year horizon, it also utilizes additional tools to monitor potential longer-term interest rate risk.
The simulation model captures the impact of changing interest rates on the interest income received and interest expense paid on all assets and liabilities reflected on the Company's balance sheet. This sensitivity analysis is compared to ALCO policy limits which specify a maximum tolerance level for NII exposure over a one year horizon, assuming no balance sheet growth, given both a 200 basis point (bp) upward and downward shift in interest rates. A parallel and pro rata shift in rates over a 12-month period is assumed. The following reflects the Company's NII sensitivity analysis as of December 31, 1999.
The preceding sensitivity analysis does not represent a Company forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions including: the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cashflows, and others. While assumptions are developed based upon current economic and local market conditions, the Company cannot make any assurances as to the predictive nature of these assumptions including how customer preferences or competitor influences might change.
Also, as market conditions vary from those assumed in the sensitivity analysis, actual results will also differ due to: prepayment/refinancing levels likely deviating from those assumed, the varying impact of interest rate change caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, and other internal/external variables. Furthermore, the sensitivity analysis does not reflect actions that ALCO might take in responding to or anticipating changes in interest rates.
The following table sets forth the maturity and repricing information relating to interest sensitive assets and liabilities at December 31, 1999. Fixed-rate investment securities, fixed rate mortgage-backed investments, fixed rate loans, loans held for sale, short-term investments, and other earning assets are shown in the table in the time period corresponding to computed principal amortization based on their respective contractual maturity. Adjustable rate investment securities, adjustable rate mortgage-backed investments, and adjustable rate loans are allocated to the period in which the rates are next adjusted. The table reflects an "expected" prepayment assumption on residential loans and mortgage-backed investments. Certificates of deposit and borrowed funds are shown in the table in the time period based on their respective contractual maturity. Money market deposit accounts and anniversary savings accounts are not subject to contractual interest rate adjustments, however, these products are generally more interest rate sensitive and are assumed to reprice within the 1-180 day time period. Regular savings and NOW accounts ("other deposits") are assumed to reprice within the 5 years + period. These deposit products are not subject to contractual interest rate adjustments either, however, the Bank believes that these deposits are less interest rate sensitive over long periods of time.
The following table reflects the scheduled maturities of selected loans at December 31, 1999:
A summary of the above categories of loans due after one year as to the rate variability follows (dollars in thousands):
LIQUIDITY AND CAPITAL RESOURCES
The Bank's principal sources of liquidity are customer deposits, borrowings from the FHLB, repurchase agreements, scheduled amortization and prepayments of loan principal, cash flow from operations, maturities and prepayments of various investments and loan sales.
Management believes it is prudent to maintain an investment portfolio that not only provides a source of income, but also provides a potential source of liquidity to meet lending demand and deposit flows. The Bank adjusts the level of its liquid assets and the mix of its loans and investments based upon management's judgment as to the quality of specific investment opportunities and the relative attractiveness of their maturities and yields. At December 31, 1999, short-term investments, bonds and obligations and mortgage-backed investments totaled $455.2 million, 10.13% of which either matures or is estimated to be prepaid within one year. At December 31, 1998, short-term investments, bonds and obligations and mortgage backed investments totaled $367.4 million, 34.8% of which matured or were estimated to be prepaid within one year.
At December 31, 1999, the Bank had total outstanding borrowings of $269.0 million, 75% of which matures within one year. At year-end 1998, the Bank had outstanding borrowings of $201.5 million, 58% of which matured in one year.
At December 31, 1999, the Bank had outstanding commitments to originate loans and unused balances on existing loans totaling $114.2 million, compared to $97.6 million in 1998. Management believes the sources of liquidity previously discussed are sufficient to meet its commitments.
Net cash provided by operating activities totaled $25.8 million in 1999 compared to net cash provided of $23.8 million in 1998. Net income was $12.7 million compared to a net income of $11.1 million for the respective periods. The provision for loan losses recorded in 1999 was $2.4 million compared to $1.4 million in 1998. Net cash provided by operating activities totaled $23.8 million in 1998 compared to $10.7 million provided in 1997. Net income was $11.1 million compared to a net income of $9.7 million for the respective periods. Provisions for loan losses recorded in 1998 totaled $1.4 million compared to $2.0 million in 1997.
Net cash used in investing activities totaled $205.3 million for the year ended December 31, 1999 compared to cash provided of $142.9 million in 1998 and $145.0 million used in 1997. The 1999 decrease in net cash provided by investing activities compared to 1998 was primarily attributable to reduced proceeds from the sale of securities and increased loan originations and purchases. Also, in 1998 the Company assumed deposit liabilities, and received the resultant cash, of $65.0 million associated with the purchase of five branches. The 1998 increase in net cash when compared to 1997 was primarily attributable to the cash received in the branch acquisition, the increased sales of investment securities and the increased levels of loan repayments.
Net cash provided by financing activities totaled $130.7 million for the year ended December 31, 1999 compared to net cash used of $98.9 million in 1998 and net cash provided of $118.7 million for 1997. Net cash provided by borrowed funds totaled $67.5 million in 1999, compared to net cash used to repay borrowings of $144.5 million in 1998 and net cash provided of $68.6 million in 1997. Net cash provided by increased deposits totaled $68.1 million in 1999 compared to increases of $50.1 million in 1998 and $53.4 million in 1997. Net cash of $5.0 million, $4.2 million and $3.6 million was used to pay dividends in 1999, 1998 and 1997, respectively.
The Bank is in compliance with and exceeds Federal regulatory capital requirements. The minimum standards are (i) a total risk-based capital ratio of 8%, (ii) a Tier I risk-based capital ratio of 4% or (iii) a Tier I leverage capital ratio of 4%. As of December 31, 1999, the Bank exceeds all capital requirements.
IMPACT OF INFLATION
The financial statements and related data presented herein have been prepared in accordance with generally accepted accounting principles which require measurement of financial position and operating results in terms of historical dollars without considering changes in the relative purchasing power of money over time due to inflation.
An important concept in understanding the effect of inflation on financial institutions is the distinction between monetary and nonmonetary items. In a stable environment, monetary items are those assets and liabilities that are or will be converted into a fixed amount of dollars regardless of changes in prices. Examples of monetary items include cash, investment securities, loans, deposits and borrowings. Nonmonetary items are those assets and liabilities that gain or lose general purchasing power as a result of the relationships between specific prices for the items and price change levels. Examples of nonmonetary items include premises and equipment and real estate in foreclosure. If real estate values decreased sharply, the deflationary impact of changing prices of real estate securing loans foreclosed upon could significantly affect a financial institution's performance. Additionally, interest rates do not necessarily move in the same direction, or in the same magnitude, as the prices of goods and services as measured by the consumer price index. In a volatile interest rate environment, liquidity and the management of the maturity structure of assets and liabilities are critical in maintaining acceptable profitability levels.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of FIRST ESSEX BANCORP, INC.:
We have audited the accompanying consolidated balance sheets of First Essex Bancorp, Inc. and subsidiaries (the "Company") as of December 31, 1999 and 1998, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of First Essex Bancorp, Inc. and subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Boston, Massachusetts January 20, 2000 (except with respect to the matters discussed in Notes 22 and 23, as to which the date is March 23, 2000)
FIRST ESSEX BANCORP, INC. CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these consolidated financial statements.
FIRST ESSEX BANCORP, INC. CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these consolidated financial statements.
FIRST ESSEX BANCORP, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
The accompanying notes are an integral part of these consolidated financial statements.
FIRST ESSEX BANCORP, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (CONTINUED)
The accompanying notes are an integral part of these consolidated financial statements.
FIRST ESSEX BANCORP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these consolidated financial statements.
FIRST ESSEX BANCORP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
The accompanying notes are an integral part of these consolidated financial statements.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of First Essex Bancorp, Inc. ("the Company"), and its sole subsidiary, First Essex Bank, FSB ("the Bank"). All significant intercompany balances have been eliminated in consolidation.
USE OF ESTIMATES IN PREPARATION OF FINANCIAL STATEMENTS
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the date of the financial statements and the reported amounts of income and expenses during the reporting periods. Operating results in the future could vary from the amounts derived from management's estimates and assumptions.
INVESTMENT SECURITIES
Investments in debt securities may be classified as held-to-maturity and measured at amortized cost only if the Company has the positive intent and ability to hold such securities to maturity. Investments in debt securities that are not classified as held-to-maturity and equity securities that have readily determinable fair values are classified as trading securities or available-for-sale securities. Trading securities are investments purchased and held principally for the purpose of selling in the near term; available-for-sale securities are investments not classified as trading or held-to-maturity. Unrealized holding gains and losses for trading securities are included in earnings; unrealized holding gains and losses for available-for-sale securities are reported in comprehensive income and as a separate component of stockholders' equity.
During the second quarter of 1998, the Company reclassified to available-for-sale all securities previously classified as held-to-maturity. This reclassification was the result of an analysis of the strategic alternatives for the securities portfolio. Under Securities and Exchange Commission guidelines, this reclassification prohibits the Company from classifying securities as held-to-maturity for a period of at least two years.
The amortized cost basis of the held-to-maturity securities transferred to the available-for-sale classification was $162.3 million. Subsequent to this reclassification, and as part of a balance sheet realignment, approximately $231 thousand of gains on sale of some of these transferred investment securities were realized. Also as a result of this reclassification, approximately $612 thousand of unrealized gains, net of $408 thousand of tax expense, were reflected in other comprehensive income and on the Statement of Stockholders' Equity.
Dividend and interest income, including amortization of premiums and discounts, is included in earnings for all categories of investment securities. Discounts and premiums related to debt securities are amortized using a method that approximates the level-yield method, adjusted for estimated prepayments in the case of mortgage-backed securities. Realized gains and losses on security transactions are computed using the specific identification method.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
LOANS RECEIVABLE
Loans are stated at the amount of unpaid principal, net of the allowance for loan losses, unearned discounts and unearned net loan origination fees. Loan origination fees, discounts and certain direct loan origination costs are deferred and amortized as an adjustment to the related loan yield over the contractual life of the loan. When loans are sold or fully repaid, the unamortized fees, discounts and costs are recognized in income.
Interest on loans is included in income as earned based upon interest rates applied to unpaid principal. Interest is not accrued on loans 90 days or greater past due or on other loans when management believes collection is doubtful. Loans considered impaired, as defined below, are nonaccruing. When a loan is placed on nonaccrual status, all interest previously accrued is reversed against current-period interest income.
A loan is impaired when, based on current information and events, it is probable that the Bank will be unable to collect all amounts due in accordance with the contractual terms of the loan agreement. All loans are individually evaluated for impairment, except for smaller balance homogeneous residential and consumer loans which are evaluated in aggregate, according to the Bank's normal loan review process, including overall credit evaluation, nonaccrual status and payment experience. Loans identified as impaired are further evaluated to determine the estimated extent of impairment.
Impaired loans are measured based on the present value of expected future cash flows discounted at each loan's effective interest rate or, as a practical expedient, at each loan's observable market price or the fair value of the collateral if the loan is collateral-dependent. For collateral-based loans, the extent of impairment is the shortfall, if any, between the collateral value, less costs to dispose of such collateral, and the carrying value of the loan.
The allowance for loan losses is based on management's estimate of the amount required to reflect the risks in the loan portfolio, based on circumstances and conditions known or anticipated at each reporting date. The methodology for assessing the appropriateness of the allowance consists of a review of the following three key elements:
o A formula allowance for the various loan portfolio classifications,
o A valuation allowance for loans identified as impaired, and
o The unallocated allowance.
The formula allowance is a percentage-based reflection of historical loss experience and assigns required allowance allocations by loan classification based on a fixed percentage of all outstanding loan balances and commitments to extend credit. The formula allowance employs a risk-rating model that grades loans based on general characteristics of credit quality and relative risk. As credit quality becomes more suspect, so-called "watch list" loans, the risk rating and allocation percentage increase. The sum of these allocations comprise the Company's "formula" or "general" allowance.
The Company also has "valuation" allowances for impaired loans. When impaired loans are evaluated, if the difference between the net present value of the impaired loan (or fair value of the collateral if the loan is collateral-dependent) is lower than the recorded investment of the loan, the shortfall is provided to expense with a resulting "valuation" allowance.
In addition to the formula and valuation components, there is an unallocated allowance that is based on the Company's credit policy and consists of an amount that is at least 20% to 25% of the formula and valuation allowances. This element recognizes the estimation risks associated with the formula model and the valuation allowance. It is further adjusted for qualitative factors including, among others, general economic and business conditions, credit quality trends, loan volumes and concentrations and specific industry conditions within portfolio segments.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
There are inherent uncertainties with respect to the final outcome of loans and nonperforming loans. Because of these inherent uncertainties, actual losses may differ from the amounts reflected in these consolidated financial statements. Factors considered in evaluating the adequacy of the allowance include previous loss experience, current economic conditions and their effect on borrowers, the performance of individual loans in relation to contract terms, and the estimated fair values of underlying collateral. Losses are charged against the allowance when management believes the collectibility of principal is doubtful.
Key elements of the above estimates, including assumptions used in independent appraisals, are dependent upon the economic conditions prevailing at the time of the estimates. Accordingly, uncertainty exists as to the final outcome of certain of the valuation judgments as a result of economic conditions in the region. The inherent uncertainties in the assumptions relative to projected sales prices or rental rates may result in the ultimate realization of amounts on certain loans that are significantly different from the amounts reflected in these consolidated financial statements.
Mortgage loans held-for-sale are carried at the lower of aggregate cost or fair value. Gains and losses on sales of mortgage loans are recognized at the time of sale.
MORTGAGE SERVICING RIGHTS
The transfer of financial assets in which the Company surrenders control over those financial assets is accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. Each time the Company undertakes an obligation to service financial assets it recognizes either a servicing asset or a servicing liability for that contract, unless it securitizes the asset, retains all of the securities, and classifies them as debt securities held-to-maturity. The carrying amount of capitalized mortgage-servicing rights at December 31, 1999 and 1998 was $77,000 and $104,000 respectively. Amortization of these rights totaled $27,000 and $26,000 for the years ended December 31, 1999 and 1998, respectively.
FORECLOSED PROPERTY
Collateral acquired through foreclosure is recorded at the lower of cost or fair value, less estimated costs to sell, at the time of acquisition. The excess, if any, of the loan balance over the fair value of the property at the time of transfer from loans to foreclosed property is charged to the allowance for loan losses. Subsequent impairments in the fair value of foreclosed property are charged to expense in the period incurred. Net operating income or expense related to foreclosed property is included in noninterest expense in the accompanying consolidated statements of operations. Because of current market conditions, there are inherent uncertainties in the assumptions with respect to the estimated fair value of foreclosed property. Because of these inherent uncertainties, the amount ultimately realized on foreclosed property may differ from the amounts reflected in the consolidated financial statements.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents consist of cash on hand, amounts due from banks, interest-bearing deposits, federal funds sold and investments with original maturities of less than three months.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
BANK PREMISES AND EQUIPMENT
Real estate held for banking purposes, leasehold improvements and furniture and fixtures are stated at cost, less accumulated depreciation and amortization. Depreciation is computed principally on the straight-line method over estimated service lives. Amortization of leasehold improvements is computed on the straight-line method over the shorter of the estimated useful lives of the assets or the related lease term. Expenditures for maintenance, repairs and renewals of minor items are charged to expense as incurred.
Bank premises and equipment are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Based on its review, the Company does not believe that any material impairment of its long-lived assets has occurred. Long-lived assets to be disposed of are reported at the lower of the carrying amount or fair value less cost to sell.
INTANGIBLE ASSETS
Intangible assets, comprised of goodwill and a core deposit premium, represent the excess of the purchase price over the fair value of net assets acquired in the acquisition of Finest Financial Corp. in 1996 and the 1998 branch acquisition (Note 3). Goodwill is being amortized on a straight-line basis over 15 and 20 years, respectively. The core deposit premium is being amortized over an eight-year period on an accelerated basis. The Company periodically evaluates the realizability of intangible assets based on expectations of nondiscounted future cash flows of the related acquired entity and branches. If the sum of the nondiscounted future cash flows is less than the carrying amount of the intangible asset, the Company would recognize an impairment loss. At December, 1999, the Company has not recorded any impairment of its intangible assets.
INCOME TAXES
The Company records income taxes under the liability method. Under this method, deferred tax assets and liabilities are established for the temporary differences between the accounting bases and the tax bases of the Company's assets and liabilities. Deferred taxes are measured using enacted tax rates that are expected to be in effect when the amounts related to such temporary differences are realized or settled. The Company's deferred tax asset is reviewed quarterly and adjustments are recognized in the provision for income taxes based on management's judgments relating to realizability.
OTHER ASSETS
Other assets include a $21 million long term fixed rate certificate of deposit with the FHLB and $15 million of Bank owned life insurance ("BOLI") policies at December 31, 1999. The certificate of deposit was purchased at a discount and this discount is accreted to income quarterly resulting in carrying amounts of $17.5 million and $17.4 million at December 31, 1999 and 1998, respectively. BOLI policies provide life insurance on the lives of certain employees. The Company is the beneficiary of the insurance. Increases in the cash value of the policies, as well as insurance proceeds received, are recorded in other income, and are not subject to income taxes if certain conditions are met.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
EARNINGS PER SHARE
Basic EPS amounts have been computed by dividing reported earnings available to common shareholders by the weighted average number of common and common equivalent shares outstanding during the year. Dilutive EPS amounts have been computed using the weighted average number of common and common equivalent shares and the dilutive potential common shares (stock options outstanding and exercisable) outstanding during the year. Included in diluted EPS are 174,275, 276,354 and 297,461 dilutive potential common shares for 1999, 1998 and 1997, respectively. Excluded from diluted earnings per share were options to purchase 494,544, 308,566 and 0 shares in 1999, 1998 and 1997, respectively. These shares were excluded as the exercise price was greater than the average market price of the common shares during the respective years.
COMPREHENSIVE INCOME
Comprehensive income is the total of net income and all non-owner related changes in a company's equity including, among other things, unrealized gains and losses on investment securities classified as available-for-sale. Other comprehensive income refers to revenues, expenses, gains, and losses that under generally accepted accounting principles are included in comprehensive income but excluded from net income. Gains on investment securities that were realized and included in net income of the current period that also had been included in other comprehensive income as unrealized holding gains in the period in which they arose are deducted through other comprehensive income of the period in which they are included in net income to avoid including them in comprehensive income twice.
RECLASSIFICATIONS
Certain reclassifications have been made to the 1998 and 1997 consolidated financial statements to conform to the 1999 presentation.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". The statement establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded on the balance sheet as either an asset or liability measured at its fair value. The statement requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement, and requires that a company must formally document, designate, and assess the effectiveness of transactions that receive hedge accounting.
Statement 133 as amended by SFAS No. 137 is effective for fiscal years beginning after June 15, 2000. A company may also implement the statement as of the beginning of any fiscal quarter after issuance (that is, fiscal quarters beginning June 16, 1998 and thereafter). Statement 133 cannot be applied retroactively. Statement 133 must be applied to (a) derivative instruments and (b) certain derivative instruments embedded in hybrid contracts that were issued, acquired, or substantively modified after December 31, 1997 (and, at the Company's election, before January 1, 1998).
The Company has not yet quantified the impact of adopting SFAS No. 133 on its financial statements, and has not determined the timing or method of the adoption of the statement. The adoption of SFAS No. 133 could have the effect of increasing volatility in reported earnings and accumulated other comprehensive income.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
In October 1998, the FASB issued SFAS No. 134, "Accounting for Mortgage-Backed Securities Retained After the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise." The statement requires that after the securitization of mortgage loans held for sale, a company engaged in mortgage banking activities classify the resulting mortgage-backed securities or other retained interests based on its ability and intent to sell or hold those investments. The statement did not have a material impact on the Company's financial condition or results of operations.
In March 1998, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) 98-1, "Accounting for the Costs of Computer Software Developed of Obtained for Internal Use." SOP 98-1 requires computer software costs associated with internal software to be expensed as incurred until certain capitalization criteria are met. The company adopted SOP 98-1 on January 1, 1999 and the adoption of SOP 98-1 did not have a material impact on the Company's financial statements.
In April 1998, the AICPA issued SOP 98-5, "Reporting on the Costs of Start-Up Activities." This position statement requires all costs associated with pre-opening, pre-operating and organization activities to be expensed as incurred. The Company adopted SOP 98-5 on January 1, 1999, and the adoption did not have a material impact on the Company's financial condition or results of operations.
2. BUSINESS SEGMENTS
In 1998, the Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which establishes standards for reporting operating segments of a business enterprise and descriptive information about the operating segments in financial statements. Operating segments are components of an enterprise, which are evaluated regularly by the chief operating decision-maker in deciding how to allocate resources and in assessing performance. The Company's chief operating decision-maker is the Chief Executive Officer and Chairman of the Board of the Company. The adoption of SFAS No. 131 did not have a material effect on the Company's primary financial statements, but did result in the disclosure of segment information contained herein. The Company has identified its reportable operating business segment as Community Banking, based on the products and services provided to its customers.
The Company's community banking business segment consists of commercial banking and retail banking. The community-banking segment is managed as a single strategic unit and derives its revenues from a wide range of banking services, including lending activities, and the acceptance of demand, savings and time deposits.
Nonreportable operating segments of the Company's operations which do not have similar characteristics to the community banking operations and do not meet the quantitative thresholds requiring disclosure, are included in the other category in the disclosure of business segments below. The nonreportable segment represents the holding company financial information (Note 17).
The accounting policies used in the disclosure of business segments are the same as those described in the summary of significant accounting policies (Note 1). The consolidation adjustments reflect certain eliminations of intersegment revenue, cash and investments in subsidiaries.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
3. BRANCH ACQUISITION
Pursuant to a Purchase and Assumption Agreement, the Company purchased certain assets from and assumed certain deposit liabilities relating to five branch offices of another financial institution on June 19 and June 26, 1998. The purchase price was allocated to assets acquired and liabilities assumed based on estimates of fair value at the date of acquisition. The assets acquired consisted of approximately $63.9 million of loans, fixed and other assets, real property related to the owned branches and cash at the branches. The premium, or the excess of the purchase price over the fair value of assets acquired, was approximately $15.1 million. Of this premium, approximately $10.5 million was allocated to a core deposit intangible (CDI) and the resulting residual amount, approximately $4.6 million, was recorded as goodwill. CDI will be amortized over eight years on a 125% declining balance method while the goodwill will be amortized over a twenty year life on a straight line basis.
Because the acquisition of the branches represents the acquisition of assets and does not represent the acquisition of a business, separate entity or subsidiary, no pro forma financial information is presented. Because the deposit liabilities assumed exceed the assets acquired, there was a cash payment made to the Company as a result of this transaction.
The following is a summarization of the components of the transaction based on estimates of fair value at the date of acquisition (in thousands):
4. INVESTMENT SECURITIES
Investment securities at December 31,1999 and 1998 are as follows:
At December 31, 1999 and 1998, U.S. government obligations and mortgage-backed securities with amortized cost of $56,492,000 and $82,995,000, respectively, and fair value of $54,715,000 and $83,307,000, respectively, were pledged to collateralize certain borrowings, deposit accounts and repurchase agreements.
For the year ended December 31, 1999, there were realized gross gains of $54,000 from the sale of investment securities available-for-sale. For the years ended December 31, 1998 and 1997, there were realized gains before taxes from the sale of investment securities of approximately $1,344,000 and $439,000, respectively.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
The following table shows the maturity distribution of the amortized cost of the Company's investment securities at December 31, 1999.
(1) Maturities of mortgage-backed securities are based on contractual maturities with scheduled amortization based on expected prepayments. Actual maturities will differ from the scheduled maturities due to the timing of actual prepayments.
The following table shows the maturity distribution of the fair value of the Company's investment securities at December 31, 1999.
(1) Maturities of mortgage-backed securities are based on contractual maturities with scheduled amortization. Actual maturities will differ from contractual maturities due to prepayments.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
5. LOANS
Major classifications of loans at December 31, 1999 and 1998 follow:
The Company's lending activities are conducted principally in eastern Massachusetts and southern New Hampshire. The Company originates single family and multifamily residential loans, commercial real estate loans, commercial loans, aircraft loans, automobile loans and a variety of consumer loans. In addition, the Company originates loans for the construction of residential homes, multifamily properties, commercial real estate properties and land development.
A significant portion of the loans originated by the Company are collateralized by real estate. The ability and willingness of the single family residential and consumer borrowers to honor their repayment commitments are generally dependent on the level of overall economic activity within the geographic areas and real estate values. The ability and willingness of commercial real estate, commercial and construction loan borrowers to honor their repayment commitments are generally dependent on the health of the real estate economic sector in the borrowers' geographic areas, the borrowers' financial conditions and the economy in general.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
A summary of changes in the allowance for loan losses for the years ended December 31, 1999, 1998 and 1997 follows:
The Company considers a loan impaired if it is 90 days or more past due as to principal and interest, or if management's credit risk assessment determines that it is probable that principal and interest will not be collected as contractually scheduled. In addition, loans that are restructured at market rates and comparable to loans with similar risks are considered impaired only in the year of the restructuring, so long as they continue to perform according to the restructured terms. Excluded from the impaired category, but otherwise considered nonaccruing loans, are small balance homogeneous loans that are ninety days or more past due. Small balance homogeneous loans include residential mortgage loans, residential construction loans to individuals (excluding builder construction loans) and consumer loans. The Company evaluates a loan's level of impairment by measuring the net present value of the expected future cash flows using the loan's original effective interest rate, or considering the fair value of the collateral if the loan is collateral dependent. When the difference between the net present value of the impaired loan (or fair value of the collateral if the loan is collateral dependent) is lower than the recorded investment of the loan, the difference is provided to expense with a resulting valuation allowance.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
The following table indicates the recorded investment in nonperforming assets and the related valuation allowance for impaired loans.
(1) The valuation allowance for impaired loans is included in the allowance for loan losses on the balance sheet.
The average recorded investment in impaired loans was approximately $1.3 million in 1999, $3.0 million in 1998 and $2.6 million in 1997. Interest income recognized on impaired loans, using the cash basis of income recognition, amounted to approximately $96,000 for the year ended December 31, 1999 compared to $265,000 in 1998 and $293,000 in 1997.
The maximum amount of aggregate loans to directors, executive officers and principal stockholders for the year ended December 31, 1999 was less than 5% of stockholders' equity.
At December 31, 1999 and 1998, the Bank was servicing loans sold to the Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, Massachusetts Home Finance Agency and various other banks and institutions on a nonrecourse basis (except as discussed in Note 11), in the amount of $25,996,000 and $23,249,000, respectively. The amount of loans sold and serviced for others is not included in loans receivable.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
6. BANK PREMISES AND EQUIPMENT
A summary of bank premises and equipment at December 31, 1999 and 1998 follows:
Depreciation and amortization expense was $2,082,000, $1,963,000, and $1,900,000 for 1999, 1998 and 1997, respectively.
7. DEPOSITS
A summary of deposits at December 31, 1999 and 1998 follows:
The following is a summary of original maturities of time deposits as of December 31, 1999:
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
At December 31, 1999 and 1998, time deposits in denominations of $100,000 and over totaled $118,682,000 and $71,111,000, respectively.
8. BORROWED FUNDS
Borrowed funds at December 31, 1999 and 1998 are summarized below:
Total lines of credit available under both short-term and long-term borrowings from the FHLB are dependent upon the amount of FHLB stock owned and other assets available as collateral. Total credit available was $417,064,000, of which $178,387,000 was unused at December 31, 1999. The advances from the FHLB are secured by all FHLB stock (book value of $19,985,000 at both December 31, 1999 and 1998) and a pledge of certain assets as collateral. Repurchase agreements outstanding at December 31, 1999 mature in three months or less with average interest rates of 4.35% and are secured by certain U.S. government and agency securities.
9. INCOME TAXES
The provision for income taxes for each of the three years in the period ended December 31, 1999 consists of the following:
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
The difference between the total expected provision for income taxes computed by applying the statutory federal income tax rate to income before provision for income taxes and the recorded provision for income taxes for the three years in the period ended December 31, 1999 follows:
In August of 1996, Congress passed the Small Business Job Protection Act of 1996. Included in the bill was the repeal of IRC Section 593, which allowed thrift institutions special provisions in calculating bad debt deductions for income tax purposes. Thrift institutions are now viewed as commercial banks for income tax purposes. The repeal is effective for tax years after December 31, 1995.
One effect of this legislative change was to suspend the Bank's bad debt reserve for income tax purposes as of its base year (October 31, 1988). Any bad debt reserve in excess of the base year amount is subject to recapture over a six-year time period. The suspended (i.e. base year) amount is subject to recapture upon the occurrence of certain events, such as a complete or partial redemption of the Bank's stock or if the Bank ceases to qualify as a bank for income tax purposes.
At December 31, 1999, the Bank's surplus includes approximately $7,700,000 of bad debt reserves, representing the base year amount, for which income taxes have not been provided. Since the Bank does not intend to use the suspended bad debt reserve for purposes other than to absorb the losses for which it was established, deferred taxes in the amount of $3,183,000 have not been recorded with respect to such reserve.
The components of the net deferred tax asset (included in other assets in the accompanying consolidated balance sheet) at December 31, 1999 and 1998 follow:
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
10. PENSION BENEFITS
The Company has a defined benefit pension plan covering most employees. Employees are eligible to participate upon the attainment of age 21 and the completion of one year of service. Benefits are based primarily on years of service and employees' final five-year average pay. Contributions by the Company are consistent with the funding requirements of federal law and regulations. Pension plan assets consist primarily of mutual funds, bonds and government securities.
The assumptions utilized include a weighted average discount rate of 6.75%, 7.25% and 7.50%, respectively, for the plan years ended in 1999, 1998 and 1997. The discount rates at October 31, 1999, 1998 and 1997 were 7.75% and 6.75% and 7.25%, respectively. The rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation was 4.0% in 1999, 1998 and 1997. The expected long-term rate of return on assets was 8.0% in 1999, 1998 and 1997.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
The following table sets forth the changes in the plan's benefit obligations and assets together with the plan's funded status and the amounts recognized in the Company's consolidated financial statements at December 31, 1999 and 1998 for the plan's October 31 fiscal year end.
Net periodic pension benefit cost for the years ended December 31, 1999, 1998 and 1997 included the following components:
The Company has no material postretirement or postemployment benefit arrangements other than pension benefits with its employees, except as stated in Note 11.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
11. COMMITMENTS AND CONTINGENCIES
FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments, held for purposes other than trading, include commitments to originate loans, standby letters of credit, recourse arrangements on sold assets, unadvanced portions of construction loans and forward commitments. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the accompanying consolidated balance sheets. The contract or notional amounts of these instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for loan commitments, standby letters of credit and recourse arrangements is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. For forward commitments, the contract or notional amounts do not represent exposure to credit loss. The Company controls the credit risk of its forward commitments through credit approvals, limits and monitoring procedures.
Financial instruments with off-balance sheet risk at December 31, 1999 and 1998 follow:
Commitments to originate loans are agreements to lend to customers provided there are no violations of any conditions established in the contracts. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based upon management's credit evaluation of the borrower.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance by a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
LEASE COMMITMENTS
The Company has operating leases on twelve of its facilities. Most of the leases have renewal options. Total rent expense under these leases for 1999, 1998 and 1997 was $1,039,000, $918,000 and $853,000, respectively.
The following is a schedule of future minimum lease payments for operating leases (dollars in thousands):
EMPLOYMENT AND TERMINATION AGREEMENTS
The Company and the Bank have entered into employment agreements with two executive officers. Each employment agreement is for a three-year term, commencing on January 1, 1997, and is extended daily until notice of non-renewal is given by either the officer or the Company or the Bank. Under both of the employment agreements, if the officer's employment is terminated for any reason other than for "cause", as defined in the employment agreement, or if the officer terminates his employment for "good reason", as defined therein, the officer will be entitled to receive a lump sum severance benefit equal to three times the officer's highest annual "Total Compensation," as defined therein, during the three preceding fiscal years as well as the continuation of certain benefits for the remaining term of the employment agreement and a pension adjustment as specified in the employment agreement.
In addition, the Company, the Bank and five officers (including the two officers referred to above) have entered into special termination agreements that provide for the payment, under certain circumstances, of a lump-sum amount upon termination following a "Change of Control" as defined therein. The lump-sum amounts for three of these officers are based on three times the officer's current base salary and the highest annual bonus paid during the three fiscal years preceding the termination of employment. The lump sum amounts for the other two officers are based on two times such base salary and highest bonus. Additionally, the first three officers would continue to receive disability and medical benefits for three years after such termination. Also, the pensions of the officers who do not have employment contracts would be credited with a number of additional years of accrual equal to the multiple of base salary applicable to such officer's severance benefit. In the case of such a termination, the two officers with employment agreements could elect to receive (in lieu of any benefits due under such officer's special termination agreement) such termination benefits as he may receive under his employment agreement.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
The Company and the Bank have entered into an Executive Salary Continuation Agreement ("SERP") with the Company's Chairman and Chief Executive Officer. Under this agreement, the officer would be entitled to certain payments following retirement at or after age 62. Payments under the agreement will equal 65% of the highest annual compensation (including bonuses) received during any of the five years preceding retirement, reduced by a portion of social security benefits payable as well as amounts payable pursuant to other qualified defined benefit pension plans. The agreement also provides for certain reduced payments if the officer's employment terminates before age 62,and for certain benefits in the event of disability and upon death, under certain circumstances. The Boards of Directors of the Company and the Bank have authorized the revision of the SEP to provide for the funding of a Trust by the Company in the event of a Change of Control, as defined therein, in an amount necessary to fulfill the Company's and the Bank's obligations thereunder.
The Company's former Chief Financial Officer, David W. Dailey, retired from the Company on December 31, 1998. In connection with his retirement, the Company entered into an agreement with Mr. Dailey which provides for certain retirement benefits, including a lump sum special payment of $237,500, accelerated vesting and extension of the exercise date of certain stock options held by him; and continuation of health insurance benefits for a period of six months following the date of retirement. Mr. Dailey's Employment Agreement and Special Termination Agreement terminated upon his retirement. The stock option exercise extension and the continuation of health benefits have likewise terminated.
LEGAL PROCEEDINGS
The Company is involved in various legal proceedings incidental to its business, none of which is believed by management, based on discussion with legal counsel, to be material to the financial condition or operations of the Company.
12. MANAGEMENT INCENTIVE COMPENSATION PLAN
The Company has a Management Incentive Compensation Plan (the "Incentive Plan") as a means of recognizing achievement on the part of individual officers and management as a whole. In 1999, 1998 and 1997 the Company awarded $601,000, $457,000, and $168,000, respectively, for bonuses in connection with the Incentive Plan.
13. STOCK PLANS
The Company has three stock plans. The first was adopted in 1987 as a performance incentive for its directors, officers, employees and other key persons (the "1987 Stock Option Plan"). The 1987 Stock Option Plan provided for the granting of "Incentive Stock Options" and "Non-qualified Stock Options". Options granted under the 1987 Stock Option Plan have an exercise price per share equal to at least the fair market value of a share of the Company's common stock on the date the option is granted and expire no later than 10 years after the date of grant. As of December 31, 1999, 408,281 shares are reserved for issuance under this plan with respect to the current outstanding options; no more options may be granted under this plan.
The second stock plan (the "1996 Stock Option Plan") was assumed under the terms of the agreement related to the Company's purchase of Finest Financial Corp. on December 30, 1996. Non-qualified options totaling 114,465 shares have been granted under this plan at an exercise price of $7.67 per share to two former officers of Finest. During 1997, 26,415 options were exercised. The remaining 88,050 options were vested and exercisable at December 31, 1999 and 1998, and expire October 1, 2005. None of these options were exercised during 1999. The weighted average estimated life of these outstanding options is 5.8 years. The estimated fair value of these options was recorded as part of the acquisition price and, accordingly, the pro forma compensation cost discussed below excludes the effect of these options. No more options may be granted under this plan.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
The third stock plan (the "1997 Stock Incentive Plan") was adopted in 1997 as a performance incentive for the Company's directors, officers, and employees. Incentive stock options, non-qualified stock options, unrestricted stock awards, conditioned stock awards, performance share awards, and stock appreciation rights may be granted pursuant to the 1997 Stock Incentive Plan. Incentive stock options granted under the 1997 Stock Incentive Plan have an exercise price per share equal to at least the fair market value of a share of the Company's common stock on the date the option is granted and expire no later than 10 years after the date of grant. The Company has reserved 800,000 shares for issuance pursuant to awards granted under the 1997 Stock Incentive Plan.
The Company accounts for stock options at intrinsic value with disclosure of the effects of fair value accounting on net income and earnings per share on a pro forma basis. Had compensation costs for the stock option plans been determined using the fair value method based upon the Modified Black-Scholes American option model, the Company's 1999, 1998 and 1997 net income and earnings per share from operations would have been reduced to the following pro forma amounts (dollars in thousands except per share amounts).
Pro forma compensation cost may not be representative of that in future years.
The following table summarizes various facts and assumptions pertaining to the 1987 Stock Option Plan and the 1997 Stock Incentive Plan for the three years ended December 31, 1999, 1998 and 1997.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
14. 401(K) PLAN
Under the 401(k) Plan (the "Plan"), eligible employees ("participants") may make contributions up to 15% of their compensation, with certain limitations. The Company may elect to make basic matching contributions. During 1999, 1998 and 1997, the Company made basic matching contributions equal to 50% of the first 4% of each participant's compensation, or a maximum of 2%. Basic matching contributions for 1999, 1998 and 1997 amounted to $156,000, $147,000 and $136,000, respectively. The Plan also provides for discretionary supplemental matching contributions. These contributions are allocated to participants in the same manner as described above. Supplemental matching contributions to the Plan for 1997 amounted to $66,000. There were no supplemental matching contributions in 1999 and 1998.
15. STOCKHOLDERS' EQUITY
At the time of conversion to stock form, the Bank established a liquidation account in the amount of $41,426,000 (unaudited). In accordance with Massachusetts statutes, the liquidation account is maintained for the benefit of Eligible Account Holders who continue to maintain their accounts in the Bank after the conversion. The liquidation account is reduced annually to the extent that Eligible Account Holders have reduced their qualifying deposits. Subsequent increases will not restore an Eligible Account Holder's interest in the liquidation account. In the event of a complete liquidation, each Eligible Account Holder is entitled to receive a distribution from the liquidation account in a proportionate amount to the current adjusted qualifying balances for the account then held.
16. REGULATORY CAPITAL REQUIREMENTS
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 1999, that the Bank meets all capital adequacy requirements to which it is subject.
As of December 31, 1999, the most recent notification from the Office of Thrift Supervision ("OTS") categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management is aware of that would have changed the institution's category.
The Bank's actual capital amounts and ratios are also presented in the table. As of December 31, 1999, the OTS did not deem it necessary for an interest-rate risk component to be deducted from capital in determining risk-based capital requirements.
The Bank may not declare or pay cash dividends on its shares of common stock if the effect thereof would cause stockholders' equity to be reduced below applicable capital maintenance requirements or if such declaration and payment would otherwise violate regulatory requirements.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
The following table displays the Bank's capital calculations as defined under prompt corrective action for the periods indicated:
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
17. CONDENSED PARENT COMPANY FINANCIAL STATEMENTS - FIRST ESSEX BANCORP, INC.
Condensed financial statements of First Essex Bancorp, Inc. as of December 31, 1999 and 1998 and for the years ended December 31, 1999, 1998 and 1997 follow:
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
18. RESTRICTIONS ON SUBSIDIARY BANK LOANS, ADVANCES AND DIVIDENDS
The Federal Reserve Act restricts the Bank with respect to lending or advancing funds to the Company unless such loans are collateralized by specific obligations and limits collateralized loans to 10% of the Bank capital stock and surplus. At December 31, 1999, no amounts were available to be transferred from the Bank to the Company in the form of loans or advances. In addition, under the OTS prompt corrective action regulations, which took effect on December 19, 1992, the Bank generally would be prohibited from making any capital distribution if, after the distribution, the Bank would have (i) a total risk-based capital ratio of less than 8%, (ii) a Tier I risk-based capital ratio of less than 4% or (iii) a Tier I core capital ratio of less than 3%.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
19. QUARTERLY DATA (UNAUDITED)
A summary of quarterly financial data for the years ended December 31, 1999 and 1998 follows:
(1) Approximately $525,000 of the increase in the quarter was due to one-time write-downs in the carrying values of certain assets.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
20. PREFERRED STOCK
The Company's Board of Directors has authorized a series of 100,000 shares of preferred stock designated as Series A Junior Participating Cumulative Preferred Stock, par value $0.10 per share ("Series A Stock") and has declared a dividend distribution of one Preferred Stock Purchase Right (the "Right") for each outstanding share of the Company's common stock.
Pursuant to the Company's Shareholder Rights Plan, each Right entitles the holder to purchase from the Company a unit consisting of one one-hundredth of a share of Series A Stock, par value $0.10 per share, at an initial cash exercise price of $28 per unit, subject to adjustment. The Rights are not exercisable and remain attached to all outstanding shares of the Company's common stock until the earliest of (i) 10 days following a public announcement that a person or group of affiliated or associated persons (an "Acquiring Person") has acquired beneficial ownership of 20% or more of the outstanding shares of the Company's common stock (the date of said announcement being referred to as the "Stock Acquisition Date"), (ii) 10 business days following the commencement of a tender offer or exchange offer that would result in a person or group becoming an Acquiring Person or (iii) the declaration by the Company's Board of Directors that a person is an "Adverse Person," as such term is defined in the Company's Shareholder Rights Plan.
In the event that a Stock Acquisition Date occurs or the Board determined that a person is an Adverse Person, each holder of a Right will be entitled to receive, upon exercise, that number of units of Series A Stock having a fair value of two times the exercise price of the Right. In the event that, at any time following the Stock Acquisition Date, (i) the Company is acquired in a merger or other business combination transaction or (ii) 50% or more of the Company's assets or earning power is sold, each holder of a Right shall thereafter have the right to receive, upon exercise, common stock of the acquiring company having a fair value equal to two times the exercise price of the Right. The holders of Series A Stock would be entitled to preferred rights with respect to dividends, voting and liquidation.
21. FAIR VALUE OF FINANCIAL INSTRUMENTS
CASH AND CASH EQUIVALENTS
Cash and cash equivalents consist of cash on hand, amounts due from banks, interest-bearing deposits, federal funds sold and investments with original maturities of less than three months. Cash and cash equivalents are recorded at cost, which approximates fair value.
INVESTMENT SECURITIES
Fair values for investment securities, excluding Federal Home Loan Bank (FHLB) and Savings Bank Life Insurance (SBLI) stock, are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. The carrying values of FHLB and SBLI stock approximate fair value.
LOANS RECEIVABLE
For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values for certain mortgage loans (e.g., one-to-four family residential) are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for differences in loan
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
characteristics. The fair values of other loans (e.g., commercial real estate and rental property mortgage loans, commercial, industrial loans, and consumer loans) are estimated using a discounted cash flow analysis, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. The carrying amount of mortgage loans held-for-sale and accrued interest approximates fair value.
OTHER EARNING ASSETS
Other earning assets consist of a long term fixed rate certificate of deposit with the Federal Home Loan Bank of Boston. The fair value for this certificate of deposit is estimated using a discounted cash flow calculation that applies an interest rate currently being offered on a time deposit of similar maturity.
DEPOSITS
The fair values disclosed for certain deposits (e.g., interest and noninterest-bearing checking, passbook savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on a schedule of aggregated expected monthly maturities on time deposits. The carrying amount of accrued interest payable approximates fair value.
BORROWED FUNDS
The carrying amount of borrowings payable within 90 days approximates fair value. Fair values of other borrowings are estimated using discounted cash flow analyses based on the Company's current borrowing rates for similar types of borrowing arrangements. The carrying value for repurchase agreements approximates fair value due to the short-term nature of these instruments.
OFF-BALANCE-SHEET INSTRUMENTS
The fair values of the Company's off-balance-sheet instruments (lending commitments and letters of credit) are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreement and the counterparties' credit standing.
At December 31, 1999 and 1998, the estimated fair value of off-balance-sheet financial instruments, consisting primarily of loan commitments, were not material.
ASSUMPTIONS
Fair value estimates are made at a specific point in time, based on relevant market information about specific financial instruments. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
FIRST ESSEX BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999
The estimated fair values of the Company's financial instruments follow:
22. STOCK REPURCHASE PROGRAM
On January 8, 1998, the Company announced that its Board of Director had authorized the Company to repurchase up to 375,000 shares of its outstanding common stock from time to time at prevailing market prices. During 1999 and 1998, the Company repurchased 56,800 shares and 110,500 shares, respectively. At December 31, 1999, there were approximately 207,700 shares still authorized to be repurchased under this plan. On March 9, 2000, the Company's Board of Directors authorized the repurchase of additional shares of its common stock up to a total of 970,000 shares.
23. SUBSEQUENT EVENT
In March 2000, the Company organized a wholly owned Delaware business trust which issued $10 million face amount of the trust's 10.875% Fixed Rate Capital Trust Pass-Through Securities ("Capital Securities") to a private investor. Simultaneously, the trust used the proceeds of that sale to purchase $10 million principal amount of the Company's 10.875% Fixed Rate Junior Subordinated Deferrable Interest Debentures due 2030 ("Subordinated Debt"). Both the Capital Securities and the Subordinated Debt are callable at any time after 10 years from the issue date. The Subordinated Debt is an unsecured obligation of the Company and is junior in right of payment to all present and future senior indebtedness of the Company. The Capital Securities are guaranteed by the Company on a subordinated basis.
The Company intends to use the net proceeds of approximately $9.7 million for general corporate purposes, including the possible repurchase from time to time of shares of the Company's outstanding common stock. See Note 22 - "Stock Repurchase Program."
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There were no changes in, or disagreements with, accountants on accounting and financial disclosures.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item will appear under the headings "Information Regarding Directors and Nominees", "Executive Officers" and "Compliance with Section 16(a) of the Exchange Act" of the Company's definitive Proxy Statement for the Annual Meeting of Stockholders to be held May 4, 2000 to be filed with the Securities and Exchange Commission within 120 days after December 31, 1999 (the "Proxy Statement"), and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item will appear in the Proxy Statement under the headings "Summary Compensation Table," "Stock Options Granted in Fiscal 1999," " Aggregated Option/SAR Exercises in Last Fiscal Year and FY-end Option/SAR Values," "Pension Plan," "Executive Salary Continuation Agreement," "Employment Contracts, Termination of Employment and Change in Control Arrangements," and "Compensation/Nominating Committee Interlocks and Insider Participation" and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item will appear in the Proxy Statement under the headings "Security Ownership of Certain Beneficial Owners and Management" and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item will appear in the Proxy Statement under the heading "Certain Transactions with Management and Others" and is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) (1) INDEX OF FINANCIAL STATEMENTS: The following financial statements appear in response to Item 8 of this Report. Reports of Independent Public Accountants Consolidated Balance Sheets as of December 31, 1999 and 1998 Consolidated Statements of Operations for the Years Ended December 31, 1999, 1998 and 1997 Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 1999, 1998 and 1997 Consolidated Statements of Cash Flows for the Years Ended December 31, 1999, 1998 and 1997 Notes to Consolidated Financial Statements
(a) (2) INDEX OF FINANCIAL STATEMENT SCHEDULES: The following financial statement schedules appear in response to Item 8 of this Report or as part of this Item 14: SCHEDULE I - Indebtedness to Related Parties. The information required by this schedule is not material and is therefore omitted. SCHEDULE II - Guarantees of Securities of other Issuers. Not applicable.
(b) REPORTS ON FORM 8-K: No reports on Form 8-K were filed by First Essex during the fiscal quarter ended December 31, 1999.
(c) EXHIBITS:
(3) ARTICLES OF INCORPORATION AND BY-LAWS:
3.1 The Restated Certificate of Incorporation of the Company is incorporated herein by reference to Exhibit 3.1 to Amendment No. 1 to the Company's Registration Statement on Form S-1, Registration No. 33-10966, filed with the Securities and Exchange Commission on April 17, 1987 ("Amendment No. 1 to the Form S-1");
3.1 The Amended and Restated By-laws of the Company are incorporated herein by reference to Exhibit 4.1 of the Company's current report on Form 8-K filed on December 28, 1992.
(10) - MATERIAL CONTRACTS:
10.1 - The First Essex Bancorp, Inc. 1987 Stock Option Plan is incorporated herein by reference to Appendix B to the prospectus included in the Company's Registration Statement on Form S-8, registration number 33-21292, filed on April 15, 1988;
10.2 - The First Essex Bancorp, Inc. Rights Agreement is incorporated herein by reference to Exhibit 1 to the Company's Report on Form 8-A filed on October 12, 1999.
*10.3 - Executive Salary Continuation Agreement between First Essex Bancorp, Inc., First Essex Bank, FSB and Leonard A. Wilson incorporated herein by reference to Exhibit 10.15 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988;
*10.4 - (a) Amended and Restated Employment Agreement dated as of October 9, 1997 between Leonard A. Wilson and First Essex Bancorp, Inc., incorporated herein by reference to Exhibit 10.4 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1997. (b) Letter Agreement between First Essex Bancorp, Inc., First Essex Bank, FSB and Leonard A. Wilson dated as of December 16, 1999, amending Special Termination Agreement and Employment Agreements.
*10.5 - (a) Amended and Restated Employment Agreement dated as of October 9, 1997 between Leonard A. Wilson and First Essex Bank, FSB, incorporated herein by reference to Exhibit 10.5 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1997. (b) Letter Agreement between First Essex Bancorp, Inc., First Essex Bank, FSB and Leonard A. Wilson dated as of December 16, 1999, amending Special Termination Agreement and Employment Agreements (see Exhibit 10.4(b)).
*10.6 - Amended and Restated Employment Agreement dated as of December 16, 1999 between Brian W. Thompson and First Essex Bancorp, Inc.
*10.7 - Amended and Restated Employment Agreement dated as of December 16, 1999 between Brian W. Thompson and First Essex Bank, FSB.
*10.8 - (a) Special Termination Agreement dated January 1, 1994 and restated as of October 9, 1997 between Leonard A. Wilson and First Essex Bancorp, Inc. incorporated by reference to Exhibit 10.10 to the Company's Quarterly report on Form 10-Q for the quarter ended September 30, 1997.
(b) Letter Agreement between First Essex Bancorp, Inc., First Essex Bank, FSB and Leonard A. Wilson dated as of December 16, 1999, amending Special Termination Agreement and Employment Agreements (see Exhibit 10.4(b)).
*10.9 - (a) Special Termination Agreement dated January 1, 1994 and restated as of October 9, 1997 between Brian W. Thompson and First Essex Bancorp, Inc. incorporated by reference to Exhibit 10.12 to the Company's Quarterly report on Form 10-Q for the quarter ended September 30, 1997. (b) Letter Agreement between First Essex Bancorp, Inc., First Essex Bank, FSB and Brian W. Thompson, dated as of December 16, 1999, amending Special Termination Agreement.
*10.10-(a) Form of Special Termination Agreement between First Essex Bancorp, Inc., First Essex Bank, FSB, and each of William F. Burke, John M. DiGaetano, and Wayne C. Golon, incorporated herein by reference to Exhibit 10.13 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1997. (b) Letter Agreement between First Essex Bancorp, Inc., First Essex Bank, FSB and William F. Burke, dated as of December 16, 1999, amending Special Termination Agreement. (c) Form of Letter Agreement between First Essex Bancorp, Inc., First Essex Bank, FSB and each of John M. DiGaetano and Wayne C. Golon, dated as of December 16, 1999, amending Special Termination Agreements.
*10.11-Common Stock Option Agreement with Brian W. Thompson incorporated herein by reference to Form S-8, Registration No.333-22183, filed on February 21, 1997.
*10.12-First Essex Bancorp, Inc. 1997 Stock Incentive Plan incorporated herein by reference to Form S-8, Registration No. 333-35057, filed on September 5, 1997.
*10.13-Deferred Compensation Plan for Directors of First Essex Bancorp, Inc. and Its Subsidiaries incorporated by reference to Exhibit 10.13 to the Company's Annual Report on Form 10-K for the year ended December 31, 1998.
*10.14-First Essex Bancorp, Inc. Senior Management Incentive Compensation Plan incorporated by reference to Exhibit 10.14 to the Company's Annual Report on Form 10-K for the year ended December 31, 1998.
*10.15-Agreement between First Essex Bancorp, Inc., First Essex Bank, FSB and David W. Dailey incorporated by reference to Exhibit 10.15 to the Company's Annual Report on Form 10-K for the year ended December 31, 1998.
*10.16-Agreement between First Essex Bank, FSB and David L. Savoie incorporated by reference to Exhibit 10.16 to the Company's Annual Report on Form 10-K for the year ended December 31, 1998.
(12) STATEMENTS REGARDING COMPUTATION OF RATIOS: Not applicable, as First Essex does not have any debt securities registered under Section 12 of the Securities Exchange Act of 1934. (21) SUBSIDIARIES OF REGISTRANT: A list of the subsidiaries of the Company is attached hereto as Exhibit 21. (23) CONSENT OF EXPERTS AND COUNSEL: Consent of Arthur Andersen LLP is attached hereto as Exhibit 23. (27) FINANCIAL DATA SCHEDULE Financial data schedule is attached hereto as Exhibit 27. *Management contract or compensatory plan.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
FIRST ESSEX BANCORP, INC.
Date: March 9, 2000
by /S/ LEONARD A. WILSON ----------------------------------------- Leonard A. Wilson Chairman and Chief Executive Officer
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BY THE FOLLOWING PEOPLE ON BEHALF OF THE REGISTRANT IN THE CAPACITIES AND ON THE DATES INDICATED.