Susquehanna Bancshares Inc--Form 10-K
Table of Contents

 

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Annual Report

 

on Form 10-K

 

2004

 


Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549


FORM 10-K


FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR

15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

(Mark One)

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2004

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission file number 0-10674


Susquehanna Bancshares, Inc.

(Exact Name of Registrant as Specified in Its Charter)


Pennsylvania   23-2201716

(State or Other Jurisdiction

of Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

26 North Cedar St., Lititz, Pennsylvania   17543
(Address of Principal Executive Offices)   (Zip Code)

Registrant’s telephone number, including area code (717) 626-4721

Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class


 

Name of Each Exchange on Which Registered


None   None

Securities registered pursuant to Section 12(g) of the Act:

common stock, par value $2.00 per share


Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b2). Yes  x    No  ¨

The aggregate market value of voting stock held by non-affiliates of the registrant was approximately $1,074,647,783 as of June 30, 2004, based upon the closing price quoted on the Nasdaq National Market for such date. Shares of common stock held by each executive officer and director and by each person who beneficially owns more than 5% of the outstanding common stock have been excluded in that such persons may under certain circumstances be deemed to be affiliates. This determination of executive officer or affiliate status is not necessarily a conclusive determination for other purposes. The number of shares issued and outstanding of the registrant’s common stock as of February 28, 2005, was 46,618,074.

 

DOCUMENTS INCORPORATED BY REFERENCE

Portions of Susquehanna’s definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held May 17, 2005 are incorporated by reference into Part III of this Annual Report.

 



Table of Contents

SUSQUEHANNA BANCSHARES, INC.

 

TABLE OF CONTENTS

 

         Page

   

Part I

    

Item 1.

  Business    3

Item 2.

  Properties    15

Item 3.

  Legal Proceedings    17

Item 4.

  Submission of Matters to a Vote of Security Holders    17
   

Part II

    

Item 5.

  Market for Susquehanna’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities    18

Item 6.

  Selected Financial Data    19

Item 7.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations    20

Item 7A.

  Quantitative and Qualitative Disclosures about Market Risk    56

Item 8.

  Financial Statements and Supplementary Data    57

Item 9.

  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure    99

Item 9A.

  Controls and Procedures    99

Item 9B.

  Other Information    99
   

Part III

    

Item 10.

  Directors and Executive Officers of Susquehanna    100

Item 11.

  Executive Compensation    100

Item 12.

  Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters    100

Item 13.

  Certain Relationships and Related Transactions    100

Item 14.

  Principal Accountant Fees and Services    100
   

Part IV

    

Item 15.

  Exhibits, Financial Statement Schedules and Reports on Form 8-K    101


Table of Contents

Unless the context otherwise requires, the terms “Susquehanna,” “we,” “us,” and “our” refer to Susquehanna Bancshares, Inc. and its subsidiaries.

 

PART I

 

Item 1. Business

 

General

 

Susquehanna Bancshares, Inc. is a financial holding company that provides a wide range of retail and commercial banking and financial services through our subsidiaries in the mid-Atlantic region. In addition to our commercial banks, we operate a trust and investment company, an asset management company, a property and casualty insurance brokerage company, a commercial leasing company and a vehicle leasing company. As of December 31, 2004, we had total assets of $7.5 billion, consolidated net loans and leases of $5.3 billion, deposits of $5.1 billion and shareholders’ equity of $752 million.

 

Susquehanna was incorporated in Pennsylvania in 1982. Our executive offices are located at 26 North Cedar Street, Lititz, Pennsylvania 17543. Our telephone number is (717) 626-4721, and our web-site address is www.susquehanna.net. Our stock is traded on the Nasdaq National Market under the symbol SUSQ. We make available free of charge, through the Investor Relations section of our web site, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission. We include our web-site address in this Annual Report on Form 10-K only as an inactive textual reference and do not intend it to be an active link to our web site.

 

As a financial holding company with operations in multiple states, we manage our subsidiaries on a local community basis. We believe that this approach differentiates us from other large competitors because it gives our subsidiaries greater flexibility to better serve their markets and increase responsiveness to the needs of local customers. We do, however, continuously review our business in order to achieve greater economies of scale and cost savings, and enhance earnings. In 2004, we began implementing our corporate-wide branding and bank realignment projects, which are continuing in 2005, with the specific goals of enhancing operational and administrative efficiencies while further improving service to our banking customers. In addition, the bank realignment effort will create banks of greater size, allowing us to increase our presence in target markets. We believe the combination of all these goals will produce a number of the operational benefits of a larger organization while allowing us to continue to work effectively at the local level. At the holding company level, we provide our banking subsidiaries guidance in the areas of credit policy and administration, risk assessment, investment advisory administration, strategic planning, investment portfolio management, asset liability management, liquidity management and other financial and administrative services. We seek to grow the organization profitably by increasing market share, standardizing products, closely managing yields, increasing certain lines of income while reducing the proportional contribution of others as appropriate, considering acquisitions that fit our business model and future direction, and controlling expenses. We believe the branding strategy and bank realignment projects are two significant steps forward towards many of these objectives.

 

Market Areas

 

Our Bank Subsidiaries

 

    Market Area 1. Susquehanna Patriot Bank was formed in June 2004 by the merger of Equity Bank, our wholly-owned subsidiary, and Patriot Bank, which we acquired on June 10, 2004. Susquehanna Patriot Bank operates primarily in the Suburban Philadelphia, Pennsylvania and Southern New Jersey market area, which is comprised of Berks, Chester, Delaware, Lehigh, Montgomery, Northampton and Philadelphia counties in Pennsylvania and Gloucester, Burlington and Camden counties in New Jersey. The New Jersey state-chartered bank operates 37 banking offices.

 

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    Market Area 2. Susquehanna Bank PA (formerly Farmers First Bank), First Susquehanna Bank & Trust and WNB Bank operate primarily in the Central Pennsylvania market area, which is comprised of York, Lancaster, Snyder, Union, Lycoming, Columbia and Northumberland counties in Pennsylvania. As part of the corporate-wide branding strategy mentioned above, Farmers First Bank changed its name to Susquehanna Bank PA on November 5, 2004. First Susquehanna Bank & Trust and WNB Bank became part of Susquehanna Bank PA on January 21, 2005. The Pennsylvania state-chartered bank operates 58 Pennsylvania banking offices.

 

    Market Area 3. Susquehanna Bank operates primarily in the suburban Baltimore and Central Maryland market area, which is comprised of the City of Baltimore and the counties of Harford, Baltimore, Anne Arundel, Howard and Carroll in Maryland. Farmers & Merchants Bank and Trust, Citizens Bank of Southern Pennsylvania and First American Bank of Pennsylvania operate primarily in the Western Maryland market area, the southwestern most part of our Pennsylvania market area and a small area of West Virginia, which is comprised of Garret, Allegany, and Washington counties in Maryland, Bedford, Blair and Franklin counties in Pennsylvania and Berkeley and Jefferson counties in West Virginia. As part of the bank realignment discussed above, and pending regulatory approval, on or about April 1, 2005, Susquehanna Bank, Citizens Bank of Southern Pennsylvania and First American Bank of Pennsylvania will be merged into Farmers & Merchants Bank and Trust, who will subsequently change its name to Susquehanna Bank. Upon completion of this particular bank realignment, it is projected that the Maryland state-chartered bank will operate a total of 62 banking offices.

 

The following table sets forth information, for the year ended December 31, 2004, regarding our bank subsidiaries and our non-bank subsidiaries that had annual revenues in excess of $5.0 million:

 

Subsidiary


   Assets

   

Percent

of Total


    Revenues(1)

   

Percent

of Total


    Net Income

   

Percent

of Total


 
     (dollars in thousands)  

Bank Subsidiaries:

                                          

Market Area 1:

                                          

Susquehanna Patriot Bank(2)

   $ 2,021,696     27.0 %   $ 57,986     17.6 %   $ 20,072     28.6 %

Market Area 2:

                                          

Susquehanna Bank PA(3)

     1,672,085     22.4       64,157     19.5       20,223     28.8  

First Susquehanna Bank & Trust

     351,742     4.7       16,242     4.9       3,961     5.6  

WNB Bank

     312,167     4.2       16,373     5.0       5,665     8.1  

Market Area 3:

                                          

Susquehanna Bank

     1,438,719     19.2       48,829     14.9       12,486     17.8  

Farmers and Merchants Bank & Trust

     949,631     12.7       41,905     12.8       10,975     15.6  

Citizens Bank of Southern Pennsylvania

     244,911     3.3       10,828     3.3       3,043     4.3  

First American Bank of Pennsylvania

     217,973     2.9       9,130     2.8       2,637     3.8  

Non-Bank Subsidiaries:

                                          

Susquehanna Trust & Investment Company

     3,588     0.1       10,617     3.2       1,592     2.3  

Valley Forge Asset Management Corp.

     24,005     0.3       12,959     3.9       2,023     2.9  

Boston Service Company, Inc.
(t/a Hann Financial Service Corp.)

     610,437     8.2       30,811     9.4       (3,114 )(4)   (4.4 )

Susquehanna Patriot Commercial Leasing Company, Inc.

     104,805     1.4       12,039     3.7       1,446     2.1  

The Addis Group, LLC

     29,796     0.4       8,608     2.6       1,414     2.0  

Consolidation adjustments and other non-bank subsidiaries

     (506,482 )   (6.8 )     (11,876 )   (3.6 )     (12,243 )   (17.5 )
    


 

 


 

 


 

TOTAL

   $ 7,475,073     100.0 %   $ 328,608     100.0 %   $ 70,180     100.0 %
    


 

 


 

 


 

 

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(1) Revenue equals net interest income and other income.
(2) Excludes Susquehanna Patriot Commercial Leasing Company, Inc., a wholly-owned subsidiary.
(3) Excludes Susquehanna Trust & Investment Company, a wholly-owned subsidiary.
(4) Does not include corporate tax benefits generated by Hann nor incremental benefits to the banks for loans and leases originated by Hann. When these benefits not recorded on Hann’s books are taken into consideration, Hann’s net income for 2004 would have been $291 with a corresponding reduction in net income in the bank subsidiaries.

 

As of December 31, 2004, non-interest income represented 35% of our total revenue. Bank subsidiaries contributed 47% of total non-interest income, and non-bank affiliates 53% of total non-interest income.

 

We are managed from a long-term perspective with financial objectives that emphasize loan quality, balance sheet liquidity and earnings stability. Consistent with this approach, we emphasize a low-risk loan portfolio derived from our local markets. In addition, we focus on not having any portion of our business dependent upon a single customer or limited group of customers or a substantial portion of our loans or investments concentrated within a single industry or a group of related industries. Our net charge-offs over the past five years have averaged 0.2% of total average loans and leases.

 

As of December 31, 2004, our total loans and leases (net of unearned income) in dollars and by percentage were as follows:

 

     (dollars in thousands)  

Commercial, financial and agricultural

   $ 760,106    14.5 %

Real estate – construction

     741,660    14.1  

Real estate secured – residential

     1,611,999    30.7  

Real estate secured – commercial

     1,252,753    23.8  

Consumer

     351,846    6.7  

Leases

     534,644    10.2  
    

  

Total loans and leases

   $ 5,253,008    100.0 %
    

  

 

As of December 31, 2004, core deposits funded 70% of our lending and investing activities. The following chart reflects the total assets, loans and deposits of our banking operations in each of our primary markets as of December 31, 2004:

 

     Assets

   

Percent

of
Total


   

Loans

and Leases


   

Percent

of
Total


    Deposits

  Percent
of
Total


 
     (dollars in thousands)  

Market Area 1

   $ 2,021,696     28.3 %   $ 1,261,871     24.7 %   $ 1,358,444   26.4 %

Market Area 2

     2,335,994     32.7       1,731,228     33.9       1,720,825   33.5  

Market Area 3

     2,842,234     39.8       2,167,639     42.5       2,064,742   40.1  

Consolidation and elimination adjustments

     (61,000 )   -0.8       (61,000 )   -1.1       0   0  
    


 

 


 

 

 

Total

   $ 7,138,924     100.0 %   $ 5,099,738     100.0 %   $ 5,144,011   100.0 %
    


 

 


 

 

 

 

Our Non-bank Subsidiaries. Susquehanna Trust & Investment Company and Valley Forge Asset Management Corp. operate primarily in the same market areas as our bank subsidiaries. The Addis Group, LLC operates primarily in Southeastern Pennsylvania, Southern New Jersey and Northern Delaware. Boston Service Company, Inc. (t/a Hann Financial Service Corp.) operates primarily in New Jersey, Eastern Pennsylvania and Southeastern New York. Susquehanna Patriot Commercial Leasing Company, Inc. operates throughout the continental United States.

 

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While conditions in our market area are presently stable, a variety of factors (e.g., any substantial rise in inflation or unemployment rates, decrease in consumer confidence, war or political instability) may affect such stability, both in our markets as well as national markets. We will continue our emphasis on managing our funding costs and lending rates to effectively maintain profitability. In addition, we will seek relationships that can generate fee income that is not directly tied to lending relationships. We anticipate that this approach will help mitigate profit fluctuations that are caused by movements in interest rates, business and consumer loan cycles and local economic factors.

 

Products and Services

 

Our Bank Subsidiaries. Our commercial bank subsidiaries operate as an extensive branch network and maintain a strong market presence in our primary markets. They provide a wide-range of retail banking services, including checking, savings and club accounts, check cards, debit cards, money market accounts, certificates of deposit, individual retirement accounts, home equity lines of credit, residential mortgage loans, home improvement loans, student loans, automobile loans, personal loans and internet banking services. They also provide a wide-range of commercial banking services, including business checking accounts, cash management services, money market accounts, land acquisition and development loans, commercial loans, floor plan, equipment and working capital lines of credit, small business loans and internet banking services.

 

Our Non-bank Subsidiaries. Our non-bank subsidiaries offer a variety of financial services to complement our core banking operations, broaden our customer base, and diversify our revenue sources. The Addis Group, LLC provides commercial and personal property and casualty insurance, and risk management programs, for medium and large size companies. Susquehanna Trust & Investment Company, a subsidiary of Susquehanna Bank PA, provides traditional trust and custodial services, and acts as administrator, executor, guardian and managing agent for individuals, businesses and non-profit entities. Valley Forge Asset Management Corp. offers investment advisory, asset management and brokerage services for institutional and high net worth individual clients. Boston Service Company, Inc. (t/a Hann Financial Service Corp.) provides comprehensive consumer vehicle financing services. Susquehanna Patriot Commercial Leasing Company, Inc., a subsidiary of Susquehanna Patriot Bank, provides comprehensive commercial leasing services.

 

Our Long-Term Strategy

 

General. We manage our business for sustained long-term growth and profitability. Our primary strategies are internal growth through expansion of our customer base in existing markets and external growth through acquisitions in selected markets. We focus on leveraging customer relationships by cross-selling a comprehensive range of financial services and products by a highly trained and motivated employee sales force. In 2002, we implemented a long-term strategic plan to enhance shareholder value. Its three main components are: growing our business profitably through the specific methods mentioned above; developing our sales culture; and focusing on risk management. Integrated into our strategic plan under these components are various company-wide initiatives we believe are important to achieving our plan, including technology, rewards, teamwork, training, communications and organizational structure.

 

2004 Strategic Results. In 2004, we further refined our strategic plan and focused on the following strategic priorities:

 

    core bank performance and sales culture development;

 

    implementation of platform automation;

 

    integration of Patriot Bank Corp.;

 

    strengthening our mortgage company; and

 

    devising and implementing a company-wide branding strategy.

 

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A summary of our 2004 strategic results is as follows:

 

Core Bank Performance and Sales Culture Development. An integral part of our strategic plan in 2004 was to improve our core bank growth by continuing our emphasis on building a sales culture throughout our bank subsidiaries. With a focused effort on training our employees, we achieved significant results. Deposits at December 31, 2004 increased 24% over December 31, 2003, rising from $4.1 billion to $5.1 billion year over year. Excluding the $648.8 million in deposits assumed through the Patriot acquisition, deposits increased 8%. Loans and leases rose to $5.3 billion at December 31, 2004, an increase of 23% over December 31, 2003. Excluding the $651.5 million in loans acquired from Patriot, loans increased 8%.

 

Implementation of Platform Automation. We furthered our sales culture development by implementing platform automation throughout our banking affiliates beginning in June 2004. Platform automation, which is now fully operational at all of our branches, improves the banking experience for both customers and employees by making the account opening process easier and faster, allowing our employees more time to focus on developing customer relationships. Concurrent with the implementation of platform automation, we are engaged in testing a new automated loan processing system, which we intend to implement in 2005.

 

Integration of Patriot Bank Corp. On June 10, 2004, we consummated our acquisition of Patriot Bank Corp. On the same date, Patriot Bank, which previously had been a wholly-owned subsidiary of Patriot Bank Corp., was merged into Equity Bank, our wholly-owned subsidiary. Equity Bank, the surviving entity in the merger, subsequently changed its name to Susquehanna Patriot Bank. The merger expanded our presence in the Pennsylvania counties of Chester and Montgomery and introduced us to the growing markets in Pennsylvania’s Berks, Lehigh and Northampton counties.

 

Strengthening our Mortgage Company. In 2004 we developed and deployed our SMC On-Line mortgage application product. This tool combines the benefits of a customized internet-based system with the expertise of our banking representatives. A customer is able to visit any of our bank affiliates and meet with a representative, who may then use SMC On-Line with the customer to expedite the loan application process. This combination allows the customer to get rapid, comprehensive answers while reducing the difficulties of a self-application process, which can oftentimes result in frustrating errors and incorrect information. The result of our approach is a significantly enhanced loan application experience that improves customer service.

 

Devising and Implementing a Corporate-Wide Branding Strategy. In December 2003 we embarked on a corporate-wide branding study involving outside corporate identity and brand specialists, as well as input from employees and customers. We unveiled the results of that study and introduced a new brand identity program at our 2004 annual shareholders meeting. Our new look, which is called our brand identity, is the unique combination of name and graphic elements – color, shape, symbol and typeface – and is now being used to represent our organization and operating affiliates under one brand.

 

The new brand identity debuted at Susquehanna Patriot Bank in June, and was applied to Susquehanna in September and Susquehanna Bank PA in November. Over the next year, the new brand identity will be applied to our other affiliates on a rolling schedule.

 

Mergers and Acquisitions

 

Bank Charter Consolidations. In connection with our new corporate-wide branding strategy, on October 1, 2004, we announced our decision to combine our eight banking subsidiaries into three entities:

 

    Susquehanna Patriot Bank. Susquehanna Patriot Bank resulted from the merger of Patriot Bank and Equity Bank in June 2004, as described above.

 

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    Susquehanna Bank PA. On November 5, 2004, Farmers First Bank changed its name to Susquehanna Bank PA. On January 21, 2005, WNB Bank and First Susquehanna Bank & Trust merged into Susquehanna Bank PA.

 

    Susquehanna Bank. Subject to regulatory approval, we expect to merge Susquehanna Bank, Citizens Bank of Southern Pennsylvania and First American Bank of Pennsylvania into Farmers & Merchants Bank and Trust, who will subsequently change its name to Susquehanna Bank, in the second quarter of 2005.

 

Brandywine Benefits Corporation. On February 1, 2005, we acquired Brandywine Benefits Corporation and Rockford Pensions, LLC (collectively, “Brandywine”). Brandywine is a financial planning, consulting and administration firm specializing in retirement benefits plans for small to medium-sized businesses.

 

Future Acquisitions. We routinely evaluate possible future acquisitions of other banks, and may also seek to enter businesses closely related to banking or that are financial in nature, or to acquire existing companies already engaged in such activities, including investment advisory services and insurance brokerage services. Any acquisition by us may require notice to or approval of the Board of Governors of the Federal Reserve System, the Pennsylvania Department of Banking, other regulatory agencies and, in some instances, our shareholders. While any such acquisition may occur in any market area, the four major growth corridors that we are currently focused on are as follows:

 

    the Lancaster/York/Baltimore corridor, comprised of Lancaster and York counties in Pennsylvania, the City of Baltimore, and Baltimore, Harford, Howard, Carroll and Anne Arundel counties in Maryland;

 

    the Greater Delaware Valley corridor, comprised of Chester, Montgomery, Delaware and Bucks counties in Pennsylvania, the City of Philadelphia, and Gloucester, Camden, Burlington and Mercer counties in New Jersey;

 

    the Interstate 81 corridor, comprised of Franklin, Cumberland and Adams counties in Pennsylvania, Washington and Frederick counties in Maryland, and Berkeley and Jefferson counties in West Virginia; and

 

    the contiguous market area that would fill in between our current bank subsidiaries.

 

We currently have no formal commitments with respect to the acquisition of any entities, although discussions with prospects occur on a regular and continuing basis.

 

Employees

 

As of December 31, 2004, we had 2,027 full-time and 279 part-time employees.

 

Competition

 

Financial holding companies and their subsidiaries compete with many institutions for deposits, loans, trust services and other banking-related and financial services. We are subject to competition from less heavily regulated entities such as brokerage firms, money market funds, credit unions, consumer finance and credit card companies and other financial services companies.

 

The Gramm-Leach-Bliley Act has liberalized many of the regulatory restrictions previously imposed on us, including our subsidiaries. Further legislative proposals are pending or may be introduced which could further affect the financial services industry. It is not possible to assess whether any of such proposals will be enacted, and if enacted, what effect such a proposal would have on our competitive positions in our marketplace.

 

As a result of state and federal legislation enacted over the past 20 years, consolidation in the industry has continued at a rapid pace. Further, as a result of the relaxation of laws and regulations pertaining to branch banking in the state, and the opportunity to engage in interstate banking, consolidation within the banking

 

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industry has had a significant effect on us and our markets. At present, our bank subsidiaries and we compete with numerous super-regional institutions with significantly greater resources and assets that conduct banking business throughout the region.

 

Supervision and Regulation

 

General. We are a financial holding company registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”) and are subject to regulation under the Bank Holding Company Act of 1956, as amended. The Bank Holding Company Act requires prior approval of an acquisition of assets or of ownership or control of voting shares of any bank if the acquisition would give us more than 5% of the voting shares of any bank or bank holding company. It also imposes restrictions, summarized below, on the assets or voting shares of non-banking companies that we may acquire.

 

Our bank subsidiaries are also subject to regulation and supervision. Susquehanna Bank PA (including First Susquehanna Bank & Trust and WNB Bank, which were both merged into Susquehanna Bank PA on January 21, 2005), Citizens Bank of Southern Pennsylvania, and First American Bank of Pennsylvania are all Pennsylvania state banks subject to regulation and periodic examination by the Pennsylvania Department of Banking and the Federal Deposit Insurance Corporation (the “FDIC”). Susquehanna Patriot Bank is a New Jersey state member bank subject to regulation and periodic examination by the New Jersey Department of Banking and Insurance and the Federal Reserve Board. Farmers & Merchants Bank and Trust and Susquehanna Bank are both Maryland state banks subject to regulation and periodic examination by the Division of Financial Regulation of the Maryland Department of Labor, Licensing and Regulation and the FDIC. Susquehanna Trust & Investment Company is a Pennsylvania non-depository trust company subject to regulation and periodic examination by the Pennsylvania Department of Banking. All of our subsidiaries are subject to examination by the Federal Reserve Board even if not otherwise regulated by the Federal Reserve Board, subject to certain conditions in the case of “functionally regulated subsidiaries,” such as broker/dealers and registered investment advisers.

 

Consistent with the requirements of the Bank Holding Company Act, our only lines of business in 2004 consisted of providing our customers with banking, trust and other financial products and services. These services include commercial banking through our subsidiary banks, trust and related services through Susquehanna Trust & Investment Company, consumer vehicle financing through Boston Service Company, Inc. (t/a Hann Financial Service Corp.), commercial leasing through Susquehanna Patriot Commercial Leasing Company, Inc., investment advisory, asset management, retirement plan consulting and brokerage services through Valley Forge Asset Management Corp. and property and casualty insurance brokerage services through The Addis Group, LLC. Of these activities, banking activities accounted for 84% of our gross revenues in 2004 and 80% of our gross revenues in 2003.

 

Regulations governing our bank subsidiaries restrict extensions of credit by such institutions to Susquehanna and, with some exceptions, the other Susquehanna affiliates. For these purposes, extensions of credit include loans and advances to and guarantees and letters of credit on behalf of Susquehanna and such affiliates. These regulations also restrict investments by our bank subsidiaries in the stock or other securities of Susquehanna and the covered affiliates, as well as the acceptance of such stock or other securities as collateral for loans to any borrower, whether or not related to Susquehanna.

 

Our bank subsidiaries are subject to comprehensive federal and state regulations dealing with a wide variety of subjects, including reserve requirements, loan limitations, restrictions as to interest rates on loans and deposits, restrictions as to dividend payments, requirements governing the establishment of branches and numerous other aspects of their operations. These regulations generally have been adopted to protect depositors and creditors rather than shareholders.

 

Additional Activities. Susquehanna is a “financial holding company” (an “FHC”) under the Gramm-Leach-Bliley Act (the “GLB Act”). As an FHC, we are permitted to engage, directly or through subsidiaries, in a wide

 

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variety of activities which are financial in nature or are incidental or complimentary to a financial activity, in addition to all of the activities otherwise allowed to us. The additional activities permitted to us as an FHC (if we so determine to conduct them) include, among others, insurance and securities underwriting, merchant banking activities, issuing and selling annuities and securitized interests in financial assets and engaging domestically in activities that bank holding companies previously have been permitted to engage in only overseas. It is expected that in the future other activities will be added to the permitted list. All of these listed activities can be conducted, through an acquisition or on a start-up basis, without prior Federal Reserve Board approval and with only notice to the Federal Reserve Board afterward.

 

The GLB Act also generally permits well-capitalized national banks and, if state law permits, well-capitalized state chartered banks as well, to form or acquire financial subsidiaries to engage in most of these same activities, with the exception of certain specified activities (insurance underwriting, for example) which must be conducted only at the level of the holding company or a non-bank subsidiary. State chartered banks in Pennsylvania, New Jersey and Maryland are generally allowed to engage (with proper regulatory authority) in activities that are permitted to national banks.

 

As an FHC, Susquehanna is generally subject to the same regulation as other bank holding companies, including the reporting, examination, supervision and consolidated capital requirements of the Federal Reserve Board. However, in some respects the regulation is modified as a result of FHC status. For example, Susquehanna must continue to satisfy certain conditions (discussed below) to preserve our full flexibility as an FHC. However, as an FHC, Susquehanna (unlike traditional bank holding companies) is permitted to undertake several new types of activities, and to acquire companies engaged in several additional kinds of activities, without prior Federal Reserve Board approval and with only notice afterward. To preserve our FHC status, we must ensure that all of our insured depository institution subsidiaries remain well-capitalized and well-managed for regulatory purposes and earn “satisfactory” or better ratings on their periodic Community Reinvestment Act (“CRA”) examinations.

 

An FHC ceasing to meet these standards is subject to a variety of restrictions, depending on the circumstances. If the Federal Reserve Board determines that any of the FHC’s subsidiary depository institutions are either not well-capitalized or not well-managed, it must notify the FHC. Until compliance is restored, the Federal Reserve Board has broad discretion to impose appropriate limitations on the FHC’s activities. If compliance is not restored within 180 days, the Board may ultimately require the FHC to divest its depository institutions or in the alternative, to discontinue or divest any activities that are permitted only to FHC bank holding companies.

 

The potential restrictions are different if the lapse pertains to the CRA requirement. In that case, until all the subsidiary institutions are restored to at least “satisfactory” CRA rating status, the FHC may not engage, directly or through a subsidiary, in any of the additional activities permissible under the GLB Act nor make additional acquisitions of companies engaged in the additional activities. However, completed acquisitions and additional activities and affiliations previously begun are left undisturbed, as the GLB Act does not require divestiture for this type of situation.

 

Capital Adequacy. Under the risk-based capital requirements applicable to them, bank holding companies must maintain a ratio of total capital to risk-weighted assets (including the asset equivalent of certain off-balance sheet activities such as acceptances and letters of credit) of not less than 8% (10% in order to be considered “well-capitalized”). At least 4% out of the total capital (6% to be well capitalized) must be composed of common stock, related surplus, retained earnings, qualifying perpetual preferred stock and minority interests in the equity accounts of certain consolidated subsidiaries, after deducting goodwill and certain other intangibles (“tier 1 capital”). The remainder of total capital (“tier 2 capital”) may consist of certain perpetual debt securities, mandatory convertible debt securities, hybrid capital instruments and limited amounts of subordinated debt, qualifying preferred stock, allowance for loan and lease losses, and unrealized gains on equity securities.

 

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At December 31, 2004, our tier 1 capital and total capital (i.e., tier 1 plus tier 2) ratios were 8.13% and 11.30%, respectively.

 

The Federal Reserve Board has also established minimum leverage ratio guidelines for bank holding companies. These guidelines mandate a minimum leverage ratio of tier 1 capital to adjusted quarterly average total assets less certain amounts (“leverage amounts”) equal to 3% for bank holding companies meeting certain criteria (including those having the highest regulatory rating). All other banking organizations are generally required to maintain a leverage ratio of at least 3% plus an additional cushion of at least 100 basis points and in some cases more. The Federal Reserve Board’s guidelines also provide that bank holding companies experiencing internal growth or making acquisitions are expected to maintain capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Furthermore, the guidelines indicate that the Federal Reserve Board will continue to consider a “tangible tier 1 leverage ratio” (i.e., after deducting all intangibles) in evaluating proposals for expansion or new activities. The Federal Reserve Board has not advised us of any specific minimum leverage ratio applicable to us. At December 31, 2004, our leverage ratio was 7.30%.

 

Our subsidiary depository institutions are all subject to similar capital standards promulgated by their respective federal regulatory agencies. No such agency has advised any of our subsidiary institutions of any specific minimum leverage ratios applicable to it.

 

The federal regulatory authorities’ risk-based capital guidelines are based upon the 1988 capital accord of the Basel Committee on Banking Supervision (the “BIS”). The BIS is a committee of central banks and bank supervisors from the major industrialized countries. It develops broad policy guidelines for use by each country’s supervisors in determining the supervisory policies they apply. In 2004, the BIS published a new capital accord to replace the 1988 accord. The new capital accord sets capital requirements for operational risk and refines the existing capital requirements for credit risk and market risk exposures. “Operational risk” in this context means the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems in connection with external events. The 1988 capital accord does not include separate capital requirements for operational risk. The ultimate timing for the effectiveness of the new accord, and the specifics of capital assessments for addressing operational risk, are uncertain. However, we currently anticipate that the U.S. federal banking agencies will release the proposed implementing rules during 2005 with a view to their becoming final during 2006 and effective in 2008. The new capital rules that may arise out of the new BIS capital accord could increase the minimum capital requirements applicable to us and could otherwise have a competitive impact on us.

 

Prompt Corrective Action. The Federal Deposit Insurance Corporation Improvement Act of 1991, or FDICIA, requires the federal regulators to take prompt corrective action against any undercapitalized institution. FDICIA establishes five capital categories: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. Well-capitalized institutions significantly exceed the required minimum level for each relevant capital measure. Adequately capitalized institutions include depository institutions that meet but do not significantly exceed the required minimum level for each capital measure. Undercapitalized institutions consist of those that fail to meet the required minimum level for one or more relevant capital measures. Significantly undercapitalized characterizes depository institutions with capital levels significantly below the minimum requirements for any relevant capital measure. Critically undercapitalized refers to depository institutions with minimal capital and at serious risk for government seizure.

 

Under certain circumstances, a well-capitalized, adequately capitalized or undercapitalized institution may be treated as if the institution were in the next lower capital category. A depository institution is generally prohibited from making capital distributions, including paying dividends, or paying management fees to a holding company if the institution would thereafter be undercapitalized. Institutions that are adequately but not well-capitalized cannot accept, renew or roll over brokered deposits except with a waiver from the FDIC and are subject to restrictions on the interest rates that can be paid on such deposits. Undercapitalized institutions may not accept, renew or roll over brokered deposits.

 

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The banking regulatory agencies are permitted or, in certain cases, required to take certain actions with respect to institutions falling within one of the three undercapitalized categories. Depending on the level of an institution’s capital, the agency’s corrective powers include, among other things:

 

    prohibiting the payment of principal and interest on subordinated debt;

 

    prohibiting the holding company from making distributions without prior regulatory approval;

 

    placing limits on asset growth and restrictions on activities;

 

    placing additional restrictions on transactions with affiliates;

 

    restricting the interest rate the institution may pay on deposits;

 

    prohibiting the institution from accepting deposits from correspondent banks; and

 

    in the most severe cases, appointing a conservator or receiver for the institution.

 

A banking institution that is undercapitalized is required to submit a capital restoration plan, and such a plan will not be accepted unless, among other things, the banking institution’s holding company guarantees the plan up to a certain specified amount. Any such guarantee from a depository institution’s holding company is entitled to a priority of payment in bankruptcy. As of December 31, 2004, all of our depository institution subsidiaries exceeded the required capital ratios for classification as “well capitalized.”

 

Cross Guarantees. Our insured depository institution subsidiaries are also subject to cross-guaranty liability under federal law. This means that if one FDIC-insured depository institution subsidiary of a multi-institution bank holding company fails or requires FDIC assistance, the FDIC may assess “commonly controlled” depository institutions for the estimated losses suffered by the FDIC. Such liability could have a material adverse effect on the financial condition of any assessed subsidiary institution and on Susquehanna as the common parent. While the FDIC’s cross-guaranty claim is generally junior to the claims of depositors, holders of secured liabilities, general creditors and subordinated creditors, it is generally superior to the claims of shareholders and affiliates.

 

Source of Strength Doctrine. Under Federal Reserve Board policy, a bank holding company is expected to serve as a source of financial strength to each of its subsidiary banks and to stand prepared to commit resources to support each of them. Consistent with this policy, the Federal Reserve Board has stated that, as a matter of prudent banking, a bank holding company should generally not maintain a given rate of cash dividends unless its net income available to common shareholders has been sufficient to fully fund the dividends and the prospective rate of earnings retention appears to be consistent with the organization’s capital needs, asset quality and overall financial condition.

 

Interstate Banking and Branching. Under the Pennsylvania Banking Code of 1965, there is no limit on the number of banks that may be owned or controlled by a Pennsylvania-based bank holding company and the Pennsylvania bank subsidiaries may branch freely throughout the Commonwealth and, with Department of Banking approval, elsewhere in the United States and abroad.

 

Substantially all state law barriers to the acquisition of banks by out-of-state bank holding companies have been eliminated. In addition, the federal banking agencies are generally permitted to approve merger transactions resulting in the creation of branches by banks outside their home states if the host state into which they propose to branch has enacted authorizing legislation. Of the middle-Atlantic states, Pennsylvania and West Virginia have enacted legislation authorizing de novo branching by banks located in states offering reciprocal treatment to their institutions. Maryland and Ohio have as well, but without the reciprocity requirement. Delaware, New Jersey and New York do not allow entry through de novo branching by sister-state banks and require that they enter the state through mergers of established institutions. Liberalizing the branching laws in recent years has had the effect of increasing competition within the markets in which we now operate.

 

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USA Patriot Act of 2001. A major focus of governmental policy applicable to financial institutions in recent years has been the effort to combat money laundering and terrorism financing. The USA Patriot Act of 2001 was enacted to strengthen the ability of the U.S. law enforcement and intelligence communities to achieve this goal. The Act requires financial institutions, including our banking and broker-dealer subsidiaries, to assist in the prevention, detection and prosecution of money laundering and the financing of terrorism. The Act established standards to be followed by institutions in verifying client identification when accounts are opened and provides rules to promote cooperation among financial institutions, regulators and law enforcement organizations in identifying parties that may be involved in terrorism or money laundering. Although we cannot predict the ultimate impact of the Act and its implementing regulations, we believe that the additional cost to us of complying with them is not likely to be material.

 

Regulation of Non-bank Subsidiaries. In addition to Susquehanna Trust & Investment Company, we have other primary non-bank subsidiaries whose activities subject them to licensing and regulation. Boston Service Company, Inc. (t/a Hann Financial Service Corp.) is organized under the laws of New Jersey. It is regulated by Connecticut as a motor vehicle leasing company, by Delaware as a finance or small loan agency, and by New Jersey and Pennsylvania as a sales finance company. Valley Forge Asset Management Corp. is organized under the laws of Pennsylvania. It is registered with the Securities and Exchange Commission (the “SEC”) as an investment adviser under the Investment Advisers Act of 1940. It is also a registered broker-dealer and is a member of the National Association of Securities Dealers. It is also licensed with the securities commissions of various states. The Addis Group, LLC is organized under the laws of Pennsylvania. It is licensed with the Pennsylvania Insurance Commissioner and the insurance commissioners of 29 other states.

 

Privacy. Title V of the GLB Act is intended to increase the level of privacy protection afforded to customers of financial institutions, including customers of the securities and insurance affiliates of such institutions, partly in recognition of the increased cross-marketing opportunities created by the Act’s elimination of many of the boundaries previously separating various segments of the financial services industry. Among other things, these provisions require institutions to have in place administrative, technical and physical safeguards to ensure the security and confidentiality of customer records and information, to protect against anticipated threats or hazards to the security or integrity of such records and to protect against unauthorized access to or use of such records that could result in substantial harm or inconvenience to a customer. The Act also requires institutions to furnish consumers at the outset of the relationship and annually thereafter written disclosures concerning the institution’s privacy policies.

 

Future Legislation. From time to time, various legislation is introduced in Congress and state legislatures with respect to the regulation of financial institutions. Such legislation may change banking statutes and our operating environment or that of our subsidiaries in substantial and unpredictable ways. We cannot determine the ultimate effect that potential legislation, if enacted, or any regulations issued to implement it, would have upon our financial condition or results of operations.

 

National Monetary Policy. In addition to being affected by general economic conditions, the earnings and growth of Susquehanna and our subsidiaries are affected by the policies of the Federal Reserve Board. An important function of the Federal Reserve Board is to regulate the money supply and credit conditions. Among the instruments used by the Federal Reserve Board to implement these objectives are open market operations in U.S. Government securities, adjustments of the discount rate and changes in reserve requirements against bank deposits. These instruments are used in varying combinations to influence overall economic growth and the distribution of credit, bank loans, investments and deposits. Their use also affects interest rates charged on loans or paid on deposits.

 

The monetary policies and regulations of the Federal Reserve Board have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. The effects of such policies upon our future business, earnings and growth cannot be predicted.

 

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Executive Officers

 

As of December 31, 2004, the executive officers of Susquehanna, their ages and their positions with Susquehanna, are set forth in the following table:

 

Name


   Age

  

Title


William J. Reuter

   55    Chairman of the Board, President and Chief Executive Officer

Gregory A. Duncan

   49    Executive Vice President and Chief Operating Officer

Drew K. Hostetter

   50    Executive Vice President, Treasurer and Chief Financial Officer

Edward Balderston, Jr.

   57    Executive Vice President and Chief Administrative Officer

Michael M. Quick

   56    Senior Vice President and Group Executive

David D. Keim

   56    Senior Vice President and Chief Risk and Credit Officer

James G. Pierné

   53    Senior Vice President and Group Executive

Peter J. Sahd

   45    Senior Vice President and Group Executive

Rodney A. Lefever

   38    Senior Vice President and Chief Technology Officer

William T. Belden

   55    Vice President and Group Executive

Bernard A. Francis, Jr.

   54    Vice President and Director of Wealth Management

David T. Swoyer

   47    Vice President and Group Executive

Lisa M. Cavage

   40    Vice President, Secretary and Counsel

 

William J. Reuter has been a Director of Susquehanna since 1999 and became Chairman of the Board in May 2002. He has been Chief Executive Officer since May 2001 and President since January 2000. From January 1998 until he was named President, he was Senior Vice President. He has also been Chairman of the Board of Susquehanna Bank PA (including its predecessor, Farmers First Bank) since March 2001, and a Director of Farmers & Merchants Bank and Trust since 1985, Boston Service Company, Inc. (t/a Hann Financial Service Corp.) since February 2000, Valley Forge Asset Management Corp. since March 2000, and The Addis Group, LLC. since September 2002.

 

Gregory A. Duncan was appointed Chief Operating Officer in May 2001 and Executive Vice President in January 2000. From January 1998 until his appointment as Executive Vice President, he was Senior Vice President–Administration.

 

Drew K. Hostetter was appointed Executive Vice President in May 2001 and has been Treasurer and Chief Financial Officer since 1998. From January 2000 until his appointment as Executive Vice President, he was Senior Vice President. He was also appointed as Chairman of Hann Financial Service Corp. in February 2004.

 

Edward Balderston, Jr. was appointed Executive Vice President and Chief Administrative Officer in June 2004. From May 2001 until his appointment as Executive Vice President and Chief Administrative Officer, he was Senior Vice President and Group Executive. From May 1998 until his appointment as Senior Vice President and Group Executive, he was Vice President in Charge of Marketing and Human Resources.

 

Michael M. Quick was appointed Senior Vice President and Group Executive in June 2004. From May 2001 until his appointment as Senior Vice President and Group Executive, he was Vice President and Group Executive of Susquehanna. He was appointed Chairman of Susquehanna Patriot Bank in June 2004. From March 1998 until his appointment as Chairman of the bank, he was President and Chief Executive Officer of Equity Bank.

 

David D. Keim was appointed Senior Vice President and Chief Risk and Credit Officer in April 2002. From May 2001 until his appointment as Senior Vice President and Chief Risk and Credit Officer, he was Senior Vice President and Group Executive. From April 1998 until his appointment as Senior Vice President and Group Executive, he was Vice President.

 

James G. Pierné was appointed as Senior Vice President and Group Executive in June 2004. From May 2001 until his appointment as Senior Vice President and Group Executive, we was Vice President and Group

 

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Executive. He was appointed as Chairman, President and Chief Executive Officer of Farmers & Merchants Bank and Trust in March 2002. He also served as President and Chief Executive Officer of Farmers & Merchants Bank and Trust from March 2000 to March 2002. From March 1999 until his appointment as President and Chief Executive Officer, he was Executive Vice President of Farmers & Merchants Bank and Trust. From 1993 until his appointment as Executive Vice President, he was Senior Vice President of Farmers & Merchants Bank and Trust.

 

Peter J. Sahd was appointed Senior Vice President and Group Executive in June 2004. From May 2001 until his appointment as Senior Vice President and Group Executive, he was Vice President and Group Executive. From April 1999 until his appointment as Vice President and Group Executive, he was Director - Alternative Delivery Services. Prior to joining Susquehanna, Mr. Sahd served as Senior Vice President, Operations, of Fulton Bank from August 1994 until April 1999.

 

Rodney A. Lefever was appointed Senior Vice President and Chief Technology Officer in June 2004. From May 2002 until his appointment as Senior Vice President and Chief Technology Officer, he was Vice President and Chief Technology Officer. From April 2001 until his appointment as Vice President and Chief Technology Officer, he was Chief Technology Officer. Prior to joining Susquehanna, he served as Director, Earthlink Everywhere, Earthlink, Inc. from September 2000 until April 2001, as the President of New Business Development, OneMain.com Inc. from December 1999 until September 2000 and the President of D&E Supernet (and its predecessors) from March 1995 until December 1999.

 

William T. Belden was appointed Vice President and Group Executive in December 2001 and Chief Executive Officer of Farmers First Bank in March 1999. From 1995 until his appointment as Chief Executive Officer, he was President and Chief Operating Officer of Farmers First Bank.

 

Bernard A. Francis, Jr. was appointed Vice President in June 2004. From March 2000, he has been President and Chief Executive Officer of Valley Forge Asset Management Corp.

 

David T. Swoyer was appointed Vice President and Group Executive in December 2004. He was appointed President and Chief Executive Officer of Susquehanna Patriot Bank in July 2004. Prior to his employment with Susquehanna, he was President and Chief Executive Officer of Goodwill Industries of Southern New Jersey/Quaker City Goodwill from 2002 to 2004. Prior to his employment with Goodwill, he was the Managing Director of First Union National Bank’s Capital Markets Group from 1999 to 2001.

 

Lisa M. Cavage was appointed Vice President in May 2001 and has been Counsel to Susquehanna since March 1998.

 

There are no family relationships among the executive officers of Susquehanna. The executive officers are elected or appointed by the Board of Directors of Susquehanna and serve until the appointment or election and qualification of their successor or their earlier death, resignation or removal. There are no arrangements or understandings between any of them and any other person pursuant to which any of them was selected an officer of Susquehanna.

 

Item 2. Properties

 

We reimburse our subsidiaries for space and services utilized. In 2004, we also leased office space located at Topflight Airpark, Showalter Road, Hagerstown, Maryland for our loan servicing center. In 2005, we intend to re-locate this loan servicing center to a leased office space located at 13511 Label Lane, Hagerstown, Maryland.

 

Our bank subsidiaries operate 157 branches and 16 free-standing automated teller machines. They own 68 of the branches and lease the remaining 89. Seven additional locations are owned or leased by our bank

 

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subsidiaries to facilitate operations and expansion. We believe that the properties currently owned and leased by our subsidiaries are adequate for present levels of operation.

 

As of December 31, 2004, the offices (including executive offices) of our bank subsidiaries were as follows:

 

Subsidiary


  

Location of Executive Office


  

Executive Office

Owned/Leased


  

Location of Offices

(including executive office)


Susquehanna Bank PA

  

9 East Main Street

Lititz, Pennsylvania

   Owned    40 banking offices in Lancaster and York Counties, Pennsylvania

Citizens Bank of

Southern Pennsylvania

  

35 North Carlisle Street

Greencastle, Pennsylvania

   Owned    7 banking offices in Franklin County, Pennsylvania
First Susquehanna
Bank & Trust
  

400 Market Street

Sunbury, Pennsylvania

   Owned    11 banking offices in Northumberland, Snyder, Columbia and Union Counties, Pennsylvania

WNB Bank

  

329 Pine Street

Williamsport, Pennsylvania

   Owned    7 banking offices in Lycoming County, Pennsylvania
Farmers & Merchants
Bank and Trust
  

59 West Washington Street

Hagerstown, Maryland

   Owned    28 banking offices in Washington, Allegany and Garrett Counties, Maryland and Jefferson and Berkeley Counties, West Virginia

Susquehanna Bank

  

100 West Road

Towson, Maryland

   Leased    21 banking offices located in Baltimore City and Baltimore, Harford, Howard, Anne Arundel, Carroll and Worcester Counties, Maryland
First American Bank of Pennsylvania   

140 East Main Street

Everett, Pennsylvania

   Owned    6 banking offices in Bedford and Blair Counties, Pennsylvania

Susquehanna Patriot Bank

  

8000 Sagemore Drive

Suite 8101

Marlton, New Jersey

   Leased    37 banking offices in Camden, Gloucester and Burlington Counties, New Jersey and Montgomery, Berks, Chester, Lehigh, Northamption and Delaware Counties, Pennsylvania

 

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As of December 31, 2004, the offices (including executive offices) of our non-bank subsidiaries were as follows:

 

Subsidiary


  

Location of Executive Office


  

Executive Office

Owned/Leased


  

Location of Offices

(including executive office)


Susquehanna Trust & Investment Company   

26 North Cedar Street

Lititz, Pennsylvania

   Leased    8 offices in Franklin, Lancaster, Lycoming, Montgomery and Northumberland Counties, Pennsylvania, Camden County, New Jersey and Washington County, Maryland
Boston Service Company, Inc., t/a Hann Financial Service Corp.   

One Centre Drive

Jamesburg, New Jersey

   Leased    2 offices located in Middlesex and Gloucester Counties, New Jersey
Valley Forge Asset Management Corp.   

120 South Warner Road

King of Prussia, Pennsylvania

   Leased    2 offices located in Chester and Montgomery County, Pennsylvania
The Addis Group, LLC   

2500 Renaissance Boulevard

King of Prussia, Pennsylvania

   Leased    1 office located in Montgomery County, Pennsylvania
Susquehanna Patriot Commercial Leasing Company, Inc.   

1566 Medical Drive

Suite 201

Pottstown, PA 19464

   Leased    1 office located in Montgomery County, Pennsylvania

 

Item 3. Legal Proceedings.

 

There are no material proceedings to which Susquehanna or any of our subsidiaries are a party or by which, to Susquehanna’s knowledge, we, or any of our subsidiaries, are threatened. All legal proceedings presently pending or threatened against Susquehanna or our subsidiaries involve routine litigation incidental to our business or that of the subsidiary involved and are not material in respect to the amount in controversy.

 

Item 4. Submission of Matters to a Vote of Security Holders.

 

There were no matters submitted to a vote of security holders during the fourth quarter of 2004.

 

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PART II

 

Item 5. Market for Susquehanna’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities

 

Market Information. Susquehanna common stock is listed for quotation on the Nasdaq National Market System. Set forth below are the quarterly high and low sales prices of Susquehanna’s common stock as reported on the Nasdaq National Market System for the years 2004 and 2003, and cash dividends paid. The table represents prices between dealers and does not include retail markups, markdowns or commissions and does not necessarily represent actual transactions.

 

Year


  

Period


  

Cash

Dividends
Paid


   Price Range Per
Share


         Low

   High

2004

  

1st Quarter

   $ 0.22    $ 24.33    $ 27.12
    

2nd Quarter

     0.22      22.18      26.47
    

3rd Quarter

     0.22      22.36      25.64
    

4th Quarter

     0.23      24.35      26.55

2003

  

1st Quarter

   $ 0.21    $ 20.13    $ 22.05
    

2nd Quarter

     0.21      20.66      24.00
    

3rd Quarter

     0.22      23.35      27.47
    

4th Quarter

     0.22      24.60      27.99

 

As of February 28, 2005, there were 6,981 record holders of Susquehanna common stock.

 

Dividend Policy. Dividends paid by Susquehanna are provided from dividends paid to us by our subsidiaries. Our ability to pay dividends is largely dependent upon the receipt of dividends from our bank subsidiaries. Both federal and state laws impose restrictions on the ability of these subsidiaries to pay dividends. These include the Pennsylvania Banking Code in the case of Susquehanna Bank PA, Citizens Bank of Southern Pennsylvania, First American Bank of Pennsylvania, First Susquehanna Bank & Trust and WNB Bank, the Financial Institutions Article of the Annotated Code of Maryland in the case of Farmers & Merchants Bank and Trust and Susquehanna Bank, the Federal Reserve Act and the New Jersey Banking Act of 1948 in the case of Susquehanna Patriot Bank, and the applicable regulations under such laws. The net capital rules of the SEC under the Securities Exchange Act of 1934 also limit the ability of Valley Forge Asset Management Corp. to pay dividends to us. In addition to the specific restrictions, summarized below, the banking and securities regulatory agencies also have broad authority to prohibit otherwise permitted dividends proposed to be made by an institution regulated by them if the agency determines that their distribution would constitute an unsafe or unsound practice.

 

The Federal Reserve Board has issued policy statements which provide that, as a general matter, insured banks and bank holding companies should pay dividends only out of current operating earnings.

 

For state-chartered banks which are members of the Federal Reserve System, the approval of the Federal Reserve Board is required for the payment of dividends by the bank subsidiary in any calendar year if the total of all dividends declared by the bank in that calendar year, including the proposed dividend, exceeds the current year’s net income combined with the retained net income for the two preceding calendar years. “Retained net income” for any period means the net income for that period less any common or preferred stock dividends declared in that period. Moreover, no dividends may be paid by such bank in excess of its undivided profits account.

 

Dividends by a Pennsylvania state-chartered bank may be paid only out of accumulated net earnings and are restricted by the requirement that the bank set aside to a surplus fund each year at least 10% of its net earnings until the bank’s surplus equals the amount of its capital (a requirement presently satisfied in the case of all of our Pennsylvania state bank subsidiaries). Furthermore, a Pennsylvania bank may not pay a dividend if the payment would result in a reduction of the surplus account of the bank.

 

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A Maryland state-chartered bank may pay dividends out of undivided profits or, with the approval of the Maryland Commissioner of Financial Regulation, from surplus in excess of 100% of required capital stock. If, however, the surplus of a Maryland bank is less than 100% of its capital stock, cash dividends may not be paid in excess of 90% of net earnings.

 

A New Jersey state-chartered bank may pay dividends on its capital stock unless the capital stock of the bank would be impaired after the payment. In addition, the bank must have a capital surplus after payment of the dividend of at least 50% of its capital stock or, if not, the payment would not reduce the surplus of the bank.

 

Within the regulatory restrictions described above, each of our bank subsidiaries presently has the ability to pay dividends. At December 31, 2004, $62.4 million in the aggregate was available for dividend distributions during calendar 2005 to us from our bank subsidiaries without regulatory approval. Also, our non-bank subsidiaries at December 31, 2004 had approximately $72.5 million which they could dividend to us without regulatory approval. We presently expect that cash dividends will continue to be paid by our subsidiaries in the future at levels comparable with those of prior years.

 

Item 6. Selected Financial Data.

 

Susquehanna Bancshares, Inc. & Subsidiaries

 

Year ended December 31,


  2004(1)

    2003

    2002

    2001

    2000

 
    ( Amounts in thousands, except per share data)  

Interest income

  $ 321,759     $ 286,020     $ 316,713     $ 341,295     $ 353,416  

Interest expense

    107,741       99,014       129,473       169,051       188,464  

Net interest income

    214,018       187,006       187,240       172,244       164,952  

Provision for loan and lease losses

    10,020       10,222       10,664       7,310       3,726  

Noninterest income

    114,590       101,750       94,150       84,166       74,010  

Noninterest expenses

    219,042       189,430       181,663       167,763       155,581  

Income before taxes

    99,546       89,104       89,063       81,337       79,655  

Net income

    70,180       62,373       61,721       55,716       54,962  

Cash dividends declared on common stock

    38,471       34,167       31,985       30,228       27,092  

Per Common Share Amounts

                                       

Net income:

                                       

Basic

  $ 1.61     $ 1.57     $ 1.56     $ 1.42     $ 1.40  

Diluted

    1.60       1.56       1.55       1.41       1.40  

Cash dividends declared on common stock

  $ 0.89     $ 0.86     $ 0.81     $ 0.77     $ 0.70  

Dividend payout ratio

    54.8 %     54.8 %     51.8 %     54.3 %     49.3 %

Financial Ratios

                                       

Return on average total assets

    1.04 %     1.09 %     1.17 %     1.14 %     1.15 %

Return on average shareholders’ equity

    10.73       11.58       12.02       11.78       13.01  

Net interest margin

    3.60       3.65       3.96       3.91       3.83  

Average shareholders’ equity to average assets

    9.65       9.41       9.73       8.85       8.85  

Year-End Balances

                                       

Total assets

  $ 7,475,073     $ 5,953,107     $ 5,544,647     $ 5,088,954     $ 4,792,856  

Investment securities

    1,245,414       988,222       1,126,407       1,021,091       898,604  

Loans and leases, net of unearned income

    5,253,008       4,263,272       3,830,953       3,519,498       3,433,610  

Deposits

    5,130,682       4,134,467       3,831,315       3,484,331       3,249,013  

Total borrowings

    1,395,365       1,099,403       1,021,194       1,016,845       1,030,812  

Shareholders’ equity

    751,694       547,382       533,855       493,536       453,437  

Selected Share Data

                                       

Common shares outstanding (period end)

    46,593       39,861       39,638       39,344       39,221  

Average common shares outstanding:

                                       

Basic

    43,585       39,742       39,496       39,263       39,262  

Diluted

    43,872       40,037       39,781       39,593       39,365  

At December 31:

                                       

Book value per share

  $ 16.13     $ 13.73     $ 13.47     $ 12.54     $ 11.56  

Market price per common share

  $ 24.95     $ 25.01     $ 20.84     $ 20.85     $ 16.50  

Common shareholders

    6,981       6,650       6,131       6,340       6,543  

(1) On June 10, 2004, we completed our acquisition of Patriot Bank Corp. The acquisition was accounted for under the purchase method, and all transactions since that date are included in our consolidated financial statements.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following pages of this report present management’s discussion and analysis of the consolidated financial condition and results of operations of Susquehanna Bancshares, Inc. and its subsidiaries. Unless the context requires otherwise, the terms “Susquehanna,” “we,” “us,” and “our” refer to Susquehanna Bancshares, Inc. and its subsidiaries.

 

Certain statements in this document may be considered to be “forward-looking statements” as that term is defined in the U.S. Private Securities Litigation Reform Act of 1995, such as statements that include the words “expect,” “estimate,” “project,” “anticipate,” “should,” “intend,” “probability,” “risk,” “target,” “objective” and similar expressions or variations on such expressions. In particular, this document includes forward-looking statements relating, but not limited to, Susquehanna’s potential exposures to various types of market risks, such as interest rate risk; credit risk; whether Susquehanna’s allowance for loan and lease losses is adequate to meet probable loan and lease losses; the impact of a breach by Auto Lenders on residual loss exposure; the likelihood of an occurrence of an Early Amortization Event (as defined in this report); expectations regarding our branding strategy and internal realignment plans and their potential impact on our efficiency ratios and earnings; and our ability to maintain contingent vehicle liability insurance coverage in vicarious liability states and the impact on us if we cannot. Such statements are subject to certain risks and uncertainties. For example, certain of the market risk disclosures are dependent on choices about essential model characteristics and assumptions and are subject to various limitations. By their nature, certain of the market risk disclosures are only estimates and could be materially different from what actually occurs in the future. As a result, actual income gains and losses could materially differ from those that have been estimated. Other factors that could cause actual results to differ materially from those estimated by the forward-looking statements contained in this document include, but are not limited to:

 

    adverse changes in our loan and lease portfolios and the resulting credit risk-related losses and expenses;

 

    interest rate fluctuations which could increase our cost of funds or decrease our yield on earning assets and therefore reduce our net interest income;

 

    continued levels of our loan and lease quality and origination volume;

 

    the adequacy of the allowance for loan and lease losses;

 

    the loss of certain key officers, which could adversely impact our business;

 

    continued relationships with major customers;

 

    the inability to continue to grow our business internally and through acquisition and successful integration of bank and non-bank entities while controlling our costs;

 

    adverse economic and business conditions;

 

    compliance with laws and regulatory requirements of federal and state agencies;

 

    competition from other financial institutions in originating loans, attracting deposits, and providing various financial services that may affect our profitability;

 

    the inability to hedge certain risks economically;

 

    our ability to effectively implement technology driven products and services;

 

    changes in consumer confidence, spending and savings habits relative to the bank and non-bank financial services we provide; and

 

    our success in managing the risks involved in the foregoing.

 

We encourage readers of this report to understand forward-looking statements to be strategic objectives rather than absolute targets of future performance. Forward-looking statements speak only as of the date they are made. We do not intend to update publicly any forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events except as required by law.

 

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The following discussion and analysis, the purpose of which is to provide investors and others with information that we believe to be necessary for an understanding of Susquehanna’s financial condition, changes in financial condition, and results of operations, should be read in conjunction with the financial statements, notes, and other information contained in this document.

 

The following information refers to the parent company and its wholly owned subsidiaries: Boston Service Company, Inc., (t/a Hann Financial Service Corporation) (“Hann”), Conestoga Management Company, Susquehanna Bank PA and subsidiaries, Farmers & Merchants Bank and Trust and subsidiaries (“F&M”), First American Bank of Pennsylvania (“FAB”), First Susquehanna Bank & Trust (“First Susquehanna”), WNB Bank (“WNB”), Citizens Bank of Southern Pennsylvania (“Citizens”), Susquehanna Patriot Bank and subsidiaries, (“Susquehanna Patriot”), Susquehanna Bank and subsidiaries, Susque-Bancshares Life Insurance Co. (“SBLIC”), Valley Forge Asset Management Corp. and subsidiaries (“VFAM”), and The Addis Group, LLC (“Addis”).

 

Critical Accounting Estimates

 

Susquehanna’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. Application of these principles involves significant judgments and assumptions by management that have a material impact on the carrying value of certain assets and liabilities. The judgments and assumptions that we used are based on historical experiences and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions that we have made, actual results could differ from these judgments and estimates, which could have a material impact on the carrying values of assets and liabilities and the results of our operations.

 

Our most critical accounting estimates are presented in Note 1 to the consolidated financial statements. Furthermore, we believe that the determination of the allowance for loan and lease losses, the valuation of recorded interests in securitized assets, and the valuation of leased asset residual values to be the accounting areas that require the most subjective and complex judgments. The treatment of securitizations and off-balance sheet financing is discussed in detail in the section titled “Securitizations and Off-Balance Sheet Vehicle Lease Financings.

 

The allowance for loan and lease losses represents management’s estimate of probable credit losses inherent in the loan and lease portfolio. Determining the amount of the allowance for loan and lease losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan and lease portfolio also represents the largest asset type on the consolidated balance sheet. Note 1 to the consolidated financial statements describes the methodology used to determine the allowance for loan and lease losses.

 

Recorded interests in securitized assets are established and accounted for based on discounted cash flow modeling techniques which require management to make estimates regarding the amount and timing of expected future cash flows, including assumptions about lease repayment rates, credit loss experience, and discount rates that consider the risk involved. Since the values of these assets are sensitive to changes in assumptions, the valuation of recorded interests in securitized assets is considered a critical accounting estimate. Note 1 and the section titled “Securitizations and Off-Balance Sheet Vehicle Lease Financings” provide additional information regarding recorded interests.

 

Lease financing receivables include a residual value component, which represents the estimated value of the leased asset upon the expiration of the lease. The valuation of residual assets is considered critical due to the sensitivity in forecasting the impact of product and technology changes, consumer behavior, competitor initiatives, shifts in supply and demand, and economic conditions, among other factors, on the fair value of residual assets. We protect ourselves against this risk with a third-party guarantee of residual values. However, the future cost of this guarantee will be affected by our residual loss experience.

 

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Any material effect on the consolidated financial statements related to these critical accounting areas is also discussed within the body of this document.

 

Subsequent Events

 

On January 21, 2005, we merged two of our subsidiary banks, First Susquehanna Bank and Trust (Sunbury, Pa.) and WNB Bank (Williamsport, Pa.), into our Susquehanna Bank PA subsidiary. As a result, the Pennsylvania state-chartered Susquehanna Bank PA will have assets of approximately $2.3 billion. This action was taken as part of the consolidation plan we announced in October 2004. In April 2005, we plan to form our third branded bank, Susquehanna Bank, by combining the following subsidiaries: Citizens Bank of Southern Pennsylvania (Greencastle, Pa.), Farmers & Merchants Bank and Trust (Hagerstown, Md.), First American Bank of Pennsylvania (Everett, Pa.), and Susquehanna Bank (Towson, Md.).

 

On February 1, 2005, we acquired Brandywine Benefits Corporation and Rockford Pensions, LLC (collectively “Brandywine”) located in Wilmington, Delaware. Brandywine is a financial planning, consulting and administration firm specializing in retirement benefit plans for small-to-medium-sized businesses. We will merge Brandywine into Valley Forge Asset Management Enterprises, LLC, a wholly owned subsidiary of our wealth management affiliate, VFAM.

 

Executive Overview

 

Our Business and Strategy

 

Susquehanna was incorporated in Pennsylvania in 1982. We manage our subsidiaries on a local community basis. We believe that this approach differentiates us from other large competitors because it gives our subsidiaries greater flexibility to better serve their markets and increase responsiveness to the needs of local customers. We do, however, continuously review our business in order to achieve greater economies of scale and cost savings, and to enhance earnings. In 2004, we began implementing our corporate-wide branding and bank realignment projects, which are continuing in 2005, with the specific goals of enhancing operational and administrative efficiencies while allowing us to further improve service to our banking customers. In addition, the bank realignment effort will create banks of greater size, allowing us to increase our presence in target markets. We believe the combination of all these goals will produce a number of the operational benefits of a larger organization while allowing us to continue to work effectively at the local level. At the holding company level, we also provide our banking subsidiaries guidance in the areas of credit policy and administration, risk assessment, investment advisory administration, strategic planning, investment portfolio management, asset liability management, liquidity management and other financial and administrative services. We seek to grow the organization profitably by increasing market share, standardizing products, closely managing yields, increasing certain lines of income while reducing the proportional contribution of others as appropriate, consider acquisitions that fit our business model and future direction, and controlling expenses. We believe the branding strategy and bank realignment projects are two significant steps forward towards many of these objectives.

 

As a $7.5 billion asset financial holding company operating in multiple states, we seek to attain diversified revenue streams and income. At December 31, 2004, we had eight commercial banks, a trust and investment company, an asset management company, a property and casualty insurance brokerage company, a commercial leasing company and a vehicle leasing company. These businesses have specific metrics by which management evaluates their performance. We believe this diversification strategy allows us to extend additional services to our customers and opportunities to our shareholders.

 

We manage our business for sustained long-term growth and profitability. Our primary strategies are internal growth through expansion of our customer base in existing markets and external growth through acquisitions in selected markets. We focus on leveraging customer relationships by cross-selling a comprehensive range of financial services and products by a highly trained and motivated employee sales force.

 

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In 2002, we implemented a long-term strategic plan to enhance shareholder value. Its three main components are: growing our business profitably through the specific methods mentioned above; developing our sales culture; and focusing on risk management. Integrated into our strategic plan under these components are various company-wide initiatives that we believe are important to achieving our plan, including technology, rewards, teamwork, training, communications and organizational structure.

 

Trends and Events

 

We met most of our financial goals set for 2004. The banks and wealth management improved as planned in 2004. Total deposits on an organic basis grew 10% in 2004. Loans and leases on an organic basis grew 8%. Our target for both of these areas for 2004 was 8%. Wealth management slightly exceeded $5 billion in assets under management and administration. Our target for 2004 was to reach $5 billion. If not for the underperformance of our auto leasing business, Hann Financial, we would have achieved each of our publicly stated goals. While Hann has been accretive to earnings from 2000 to 2003 by 22 cents per share, it was 8 cents dilutive to earnings per share for 2004. We are working on several improvements to Hann’s business plan including new revenue producing initiatives and a new process to attain better execution of securitization transactions. Additionally, Auto Lenders, Hann’s third party residual value guarantor, has established a fourth retail facility and will bring on line a new central vehicle reconditioning center in the second quarter of 2005. Approximately 84% of our revenue is derived from the banks, where we are seeking to increase income through a variety of means.

 

Susquehanna seeks net income through diversified, quality revenues. Our major source of operating revenues is net interest income, which is largely derived from our banking operations. As a result, net interest income and many of its components are important metrics by which management evaluates our banks and the holding company’s return on its investments. Noninterest income is derived across multiple business units including but not limited to our banks, wealth management and insurance organizations, and automobile leasing business. We have sought to increase the proportional contribution of noninterest income through targeted efforts that would increase fee income, most specifically from our wealth management organization. The wealth management organization experienced robust growth in 2004, increasing assets 19%, to $5.0 billion at December 31, 2004. Our acquisition of the Brandywine Benefits Corporation and Rockford Pensions, LLC on February 1, 2005, is an example of how we try to enhance this area and our noninterest income opportunities.

 

We look to increase revenue and income through revenue generation efforts and efficiency improvements. The efficiency ratio is an important metric for our industry and for us as it measures how well we are accomplishing these objectives. We consider two efficiency ratios when we evaluate the overall business: efficiency ratio including Hann and efficiency ratio excluding Hann. (Efficiency ratio excluding Hann is a non-GAAP financial measure. For disclosures relating to this ratio, see the section entitled “Supplemental Reporting of Non-GAAP Financial Measures” on the following page.) Efficiency ratio including Hann for 2004 was 66.15%. Organizations with significant nonbank fee-income-generating operations generally have higher efficiency ratios. Our efficiency ratio excluding Hann improved to 61.09% for 2004, from 62.25% in 2003. Susquehanna has targeted an efficiency ratio excluding Hann of 57.0% for 2006. Management believes efficiency ratio excluding Hann to be the preferred measurement because it excludes the volatility of full-term ratios, securitization gains, and residual values of Hann and provides more focused visibility into our core business activities.

 

Results of Operations

 

Acquisition of Patriot Bank Corp.

 

On June 10, 2004, we completed our acquisition of Patriot Bank Corp (“Patriot”). The acquisition was accounted for under the purchase method, and all transactions since that date are included in our consolidated financial statements.

 

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Summary of 2004 Compared to 2003

 

Net income for the year ended December 31, 2004 was $70.2 million, an increase of $7.8 million, or 12.5%, over 2003 net income of $62.4 million. Net interest income increased to $214.0 million for 2004, from $187.0 million in 2003. Our earnings performance continues to be enhanced by improvements in non-interest income, which, during the year 2004, equaled 35% of total revenues and increased $12.8 million over 2003. Non-interest expenses increased 15.6%, to $219.0 million for 2004, from $189.4 million for 2003.

 

Additional information is as follows:

 

    

Twelve Months Ended

December 31,


 
         2004    

        2003    

 

Diluted Earnings per Share

   $ 1.60     $ 1.56  

Return on Average Assets

     1.04 %     1.09 %

Return on Average Equity

     10.73 %     11.58 %

Return on Average Tangible Equity(1)

     14.36 %     13.16 %

Efficiency Ratio

     66.15 %     65.09 %

Efficiency Ratio excluding Hann(1)

     61.09 %     62.25 %

 

The following discussion details the factors that contributed to these results.

 

(1) Supplemental Reporting of Non-GAAP Financial Measures

 

Susquehanna has presented a return on average tangible equity, which is a non-GAAP financial measure and is most directly comparable to the GAAP measurement of return on average equity. For purposes of computing return on average tangible equity, we have excluded the balance of intangible assets and their related amortization expense from our calculation of return on average tangible equity to allow us to review the core operating results of our company. This is consistent with the treatment by bank regulatory agencies, which excludes goodwill and other intangible assets from the calculation of risk-based capital ratios. A reconciliation of return on average tangible equity to return on average equity is set forth below.

 

Return on average equity (GAAP basis)

   10.73 %   11.58 %

Effect of excluding average intangible assets and related amortization

   3.63 %   1.58 %

Return on average tangible equity

   14.36 %   13.16 %

 

Susquehanna has presented an efficiency ratio excluding Hann, which is a non-GAAP financial measure and is most directly comparable to the GAAP presentation of efficiency ratio. We measure our efficiency ratio by dividing noninterest expenses by the sum of net interest income, on an FTE basis, and noninterest income. The presentation of an efficiency ratio excluding Hann is computed as the efficiency ratio excluding the effects of our auto leasing subsidiary, Hann. Management believes this to be a preferred measurement because it excludes the volatility of full-term ratios, securitization gains, and residual values of Hann and provides more focused visibility into our core business activities. A reconciliation of efficiency ratio excluding Hann to efficiency ratio is set forth below.

 

Efficiency ratio (GAAP basis)

   66.15 %   65.09 %

Effect of excluding Hann

   5.06 %   2.84 %

Efficiency ratio excluding Hann

   61.09 %   62.25 %

 

Net Interest Income — Taxable Equivalent Basis

 

Our major source of operating revenues is net interest income, which increased in 2004, to $214.0 million, as compared to the $187.0 million attained in 2003. Net interest income as a percentage of net interest income plus other income was 65% for the twelve months ended December 31, 2004, 65% for the twelve months ended December 31, 2003, and 67% for the twelve months ended December 31, 2002.

 

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Net interest income is the income that remains after deducting, from total income generated by earning assets, the interest expense attributable to the acquisition of the funds required to support earning assets. Income from earning assets includes income from loans, investment securities, and short-term investments. The amount of interest income is dependent upon many factors including the volume of earning assets, the general level of interest rates, the dynamics of the change in interest rates, and the levels of non-performing loans. The cost of funds varies with the amount of funds necessary to support earning assets, the rates paid to attract and hold deposits, the rates paid on borrowed funds, and the levels of noninterest-bearing demand deposits and equity capital.

 

Table 1 presents average balances, taxable equivalent interest income and expense and yields earned or paid on these assets and liabilities. For purposes of calculating taxable equivalent interest income, tax-exempt interest has been adjusted using a marginal tax rate of 35% in order to equate the yield to that of taxable interest rates. Table 2 illustrates the changes in net interest income caused by changes in average volume, rates, and yields.

 

The increase in our net interest income in 2004, as compared to 2003, was primarily the result of the net contribution from interest-earning assets and interest-bearing liabilities acquired from Patriot. In addition, since we are an asset-sensitive institution, where assets reprice more quickly than liabilities, we experienced modest improvements in our net interest margin in the third and fourth quarters of 2004, due to recent increases in interest rates. These improvements, however, have not been enough to significantly offset the decline experienced in the first half of 2004, and consequently, our net interest margin for 2004 decreased five basis points, to 3.60%, from 3.65% for 2003. We believe that the Federal Reserve will continue to raise the federal funds target rate in small increments throughout 2005, and as a result, we anticipate additional improvement in our net interest margin.

 

Variances do occur in the net interest margin, as an exact repricing of assets and liabilities is not possible. A further explanation of the impact of asset and liability repricing is found in the section titled “Market Risks.

 

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TABLE 1 - Distribution of Assets, Liabilities and Shareholders' Equity

 

Interest Rates and Interest Differential - Tax Equivalent Basis

 

    2004

  2003

  2002

   

Average

Balance


    Interest

  Rate
(%)


  Average
Balance


    Interest

  Rate
(%)


  Average
Balance


    Interest

  Rate
(%)


    (Dollars in thousands)

Assets

                                                     

Short - term investments

  $ 72,405     $ 815   1.13   $ 77,505     $ 705   0.91   $ 73,157     $ 1,351   1.85

Investment securities:

                                                     

Taxable

    1,159,860       42,513   3.67     1,104,863       37,893   3.43     966,156       52,497   5.43

Tax - advantaged

    33,141       2,411   7.27     30,842       2,217   7.19     53,174       3,762   7.07
   


 

     


 

     


 

   

Total investment securities

    1,193,001       44,924   3.77     1,135,705       40,110   3.53     1,019,330       56,259   5.52
   


 

     


 

     


 

   

Loans and leases, (net):

                                                     

Taxable

    4,668,299       273,781   5.86     3,910,353       243,236   6.22     3,657,342       257,977   7.05

Tax - advantaged

    75,565       4,743   6.28     59,179       4,222   7.13     48,230       3,758   7.79
   


 

     


 

     


 

   

Total loans and leases

    4,743,864       278,524   5.87     3,969,532       247,458   6.23     3,705,572       261,735   7.06
   


 

     


 

     


 

   

Total interest - earning assets

    6,009,270     $ 324,263   5.40     5,182,742     $ 288,273   5.56     4,798,059     $ 319,345   6.66
           

             

             

   

Allowance for loan and lease losses

    (49,012 )               (40,868 )               (39,193 )          

Other non - earning assets

    816,524                 582,652                 514,147            
   


           


           


         

Total assets

  $ 6,776,782               $ 5,724,526               $ 5,273,013            
   


           


           


         

Liabilities

                                                     

Deposits:

                                                     

Interest - bearing demand

  $ 1,640,525     $ 16,803   1.02   $ 1,195,656     $ 9,473   0.79   $ 991,096     $ 12,429   1.25

Savings

    552,950       2,115   0.38     498,157       1,999   0.40     461,947       4,036   0.87

Time

    1,776,623       49,484   2.79     1,601,495       51,419   3.21     1,643,785       66,034   4.02

Short - term borrowings

    358,348       4,261   1.19     352,271       3,582   1.02     338,903       10,130   2.99

FHLB borrowings

    640,397       22,529   3.52     587,305       22,420   3.82     544,176       28,108   5.17

Long - term debt

    190,649       12,550   6.58     141,425       10,120   7.16     116,910       8,736   7.47
   


 

     


 

     


 

   

Total interest - bearing liabilities

    5,159,492     $ 107,742   2.09     4,376,309     $ 99,013   2.26     4,096,817     $ 129,473   3.16
           

             

             

   

Demand deposits

    783,551                 646,971                 545,971            

Other liabilities

    179,584                 162,828                 116,926            
   


           


           


         

Total liabilities

    6,122,627                 5,186,108                 4,759,714            

Equity

    654,155                 538,418                 513,299            
   


           


           


         

Total liabilities & shareholders' equity

  $ 6,776,782               $ 5,724,526               $ 5,273,013            
   


           


           


         

Net interest income / yield on average earning assets

          $ 216,521   3.60           $ 189,260   3.65           $ 189,872   3.96
           

             

             

   

 

Additional Information

Average loan balances include non accrual loans.

Tax-exempt income has been adjusted to a tax-equivalent basis using a marginal rate of 35%.

For presentation in this table, average balances and the corresponding average rates for investment securities are based upon historical cost, adjusted for amortization of premiums and accretion of discounts.

 

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TABLE 2 - Changes in Net Interest Income - Tax Equivalent Basis

 

    

2004 Versus 2003

Increase (Decrease)

Due to Change in


   

2003 Versus 2002

Increase (Decrease)

Due to Change in


 
     Average
Volume


    Average
Rate


    Total

    Average
Volume


    Average
Rate


    Total

 
     (Dollars in thousands)  

Interest Income

                                                

Other short-term investments

   $ (48 )   $ 158     $ 110     $ 76     $ (722 )   $ (646 )

Investment securities:

                                                

Taxable

     1,941       2,679       4,620       6,758       (21,362 )     (14,604 )

Tax-advantaged

     167       27       194       (1,604 )     59       (1,545 )
    


 


 


 


 


 


Total investment securities

     2,108       2,706       4,814       5,154       (21,303 )     (16,149 )

Loans (net of unearned income):

                                                

Taxable

     45,065       (14,520 )     30,545       17,068       (31,809 )     (14,741 )

Tax-advantaged

     1,071       (550 )     521       801       (337 )     464  
    


 


 


 


 


 


Total loans

     46,136       (15,070 )     31,066       17,869       (32,146 )     (14,277 )
    


 


 


 


 


 


Total interest-earning assets

   $ 48,196     $ (12,206 )   $ 35,990     $ 23,099     $ (54,171 )   $ (31,072 )
    


 


 


 


 


 


Interest Expense

                                                

Deposits:

                                                

Interest-bearing demand

   $ 4,103     $ 3,227     $ 7,330     $ 2,226     $ (5,182 )   $ (2,956 )

Savings

     213       (97 )     116       294       (2,331 )     (2,037 )

Time

     5,284       (7,219 )     (1,935 )     (1,660 )     (12,955 )     (14,615 )

Short-term borrowings

     64       615       679       (2,409 )     (4,139 )     (6,548 )

FHLB borrowings

     1,942       (1,833 )     109       2,092       (7,780 )     (5,688 )

Long - term debt

     3,293       (863 )     2,430       1,767       (383 )     1,384  
    


 


 


 


 


 


Total interest-bearing liabilities

     14,899       (6,170 )     8,729       2,310       (32,770 )     (30,460 )
    


 


 


 


 


 


Net Interest Income

   $ 33,297     $ (6,036 )   $ 27,261     $ 20,789     $ (21,401 )   $ (612 )
    


 


 


 


 


 


 

Changes which are due in part to volume and in part to rate are allocated in proportion to their relationship to the amounts of changes attributed directly to volume and rate.

 

Provision and Allowance for Loan and Lease Losses

 

The provision for loan and lease losses is the expense necessary to maintain the allowance for loan and lease losses at a level adequate to absorb management’s estimate of probable losses in the loan and lease portfolio. Our provision for loan and lease losses is based upon management’s quarterly review of the loan portfolio. The purpose of the review is to assess loan quality, identify impaired loans and leases, analyze delinquencies, ascertain loan and lease growth, evaluate potential charge-offs and recoveries, and assess general economic conditions in the markets we serve.

 

Commercial and commercial real estate loans are internally risk rated, using a standard rating system, by our loan officers and periodically reviewed by loan quality personnel. Consumer loans, residential real estate loans, and leases are generally analyzed in the aggregate as they are of relatively small dollar size and homogeneous in nature.

 

In 2002, we changed the methodology for calculating the allowance for loan and lease losses. Under this new methodology, loss rates for the last three years on a rolling quarter-to-quarter basis are determined for: (a) commercial credits (including agriculture, commercial, commercial real estate, land acquisition, development and construction) and (b) consumer credits (including residential real estate, consumer direct, consumer indirect, consumer revolving, and leases). The loss rates are calculated for each affiliate bank, and they are applied to loan balances of the portfolio segments described above.

 

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In addition to using loss rates, non-accrual loans of $0.25 million or greater are reviewed for impairment as required under FAS No. 114. Those loans that have specific loss allocations are identified and included in the reserve allocation. Risk-rated loans that are not reviewed for impairment are segregated into homogeneous pools with loss allocation rates that reflect the severity of risk. Loss rates are adjusted by applying other factors to the calculations. These factors include adjustment for current economic trends, delinquency and risk trends, credit concentrations, credit administration and other special allocations for unusual events or changes in products.

 

The methodology provides a more in-depth analysis of the portfolios of our banks and better reflects the estimated losses within the various portfolios. Reserve allocations are then reviewed and consolidated. This process is performed on a quarterly basis, including a risk-rated review of commercial credit relationships at the banking affiliates.

 

Prior to 2002, we did not have a standard risk rating system for affiliate banks. The banks used their own methodology for calculating the allowance, and loss data was not broken out in as many categories, particularly real estate loans, because the data was not available. Table 10, “Allocation of Allowance for Loan and Lease Losses,” reflects comparative data for 2004, 2003 and 2002 using the revised methodology. The prior years’ allocations for real estate in total are consistent. If data were available, and we could retroactively apply our current methodology to prior years, we believe the allocation between the categories of real estate – construction and real estate - mortgage would be consistent with 2004, 2003, and 2002 allocations.

 

Determining the level of the allowance for possible loan and lease losses at any given point in time is difficult, particularly during uncertain economic periods. We must make estimates using assumptions and information that is often subjective and changing rapidly. The review of the loan and lease portfolios is a continuing event in light of a changing economy and the dynamics of the banking and regulatory environment. In our opinion, the allowance for loan and lease losses is adequate to meet probable loan and lease losses at December 31, 2004. There can be no assurance, however, that we will not sustain losses in future periods that could be greater than the size of the allowance at December 31, 2004.

 

As illustrated in Table 3, the provision for loan and lease losses was $10.0 million for 2004 and $10.2 million in 2003. This $0.2 million decrease in the provision is the result of the continuing strength of our asset quality as evidenced by the decrease in total non-performing assets as a percentage of period-end loans and leases plus other real estate owned, from 0.65% at December 31, 2003, to 0.41% at December 31, 2004. The allowance for loan and lease losses at December 31, 2004 was 1.03% of period-end loans and leases, or $54.1 million, compared with 1.00% or $42.7 million at December 31, 2003.

 

Should the economic climate deteriorate, borrowers may experience increasing difficulty in meeting their payment obligations, and the level of non-performing loans and assets, charge-offs, and delinquencies could rise and require further increases in the provision. In addition, regulatory authorities, as an integral part of their examinations, periodically review the level of the allowance for loan and lease losses. They may require additions to allowances based upon their judgments about information available to them at the time of examination.

 

It is our policy not to renegotiate the terms of a commercial loan simply because of a delinquency status. Rather, a commercial loan is typically transferred to non-accrual status if it is not well secured and in the process of collection, and is considered delinquent in payment if either principal or interest is past due 90 days or more. Interest income received on impaired commercial loans in 2004 and 2003 was $0.10 million and $0.06 million, respectively. Interest income that would have been recorded on these loans under the original terms was $1.0 million and $0.7 million for 2004 and 2003, respectively. At December 31, 2004, we had no outstanding commitments to advance additional funds with respect to these impaired loans.

 

Consumer loans are typically charged-off at 120 days past due unless they are secured by real estate. Loans secured by real estate are evaluated on the basis of collateral value. Loans that are well secured may continue to accrue interest while other loans are charged down to net realizable value or placed on non-accrual depending upon their loan to value ratio.

 

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Table 3 is an analysis of the provision levels as well as the activity in the allowance for loan and lease losses for the past five years. Table 4 reflects the five-year history of non-performing assets and loans and leases contractually past due 90 days and not placed on non-accrual. At December 31, 2004, non-performing assets totaled $21.7 million and included $1.3 million in other real estate acquired through foreclosure. At December 31, 2003, non-performing assets totaled $27.8 million, and included $2.9 million in other real estate acquired through foreclosure and a $5.8 million restructured loan.

 

At December 31, 2003, we had a restructured loan totaling $5.8 million with a long-time borrower. However, in accordance with FAS No.114, information about a restructured loan involving a modification of terms need not be included in disclosures in years after the restructuring if the restructuring agreement has market terms, including a market rate of interest, and the restructured loan is current and is expected to perform in accordance with the modified terms. The removal of this restructured loan from nonperforming assets in January 2004, contributed to the ratio changes noted above.

 

TABLE 3 - Provision and Allowance for Loan and Lease Losses

 

     2004

    2003

    2002

    2001

    2000

 
     (Dollars in thousands)  

Allowance for loan and lease losses, January 1

   $ 42,672     $ 39,671     $ 37,698     $ 37,187     $ 44,465  

Allowance acquired in business combination

     9,149       0       0       539       0  

Allowance transferred to third-party guarantor

     0       0       0       0       3,057  

Additions to provision for loan and lease losses charged to operations

     10,020       10,222       10,664       7,310       3,726  

Loans and leases charged-off during the year:

                                        

Commercial, financial, and agricultural

     2,211       2,340       3,261       2,563       3,314  

Real estate - construction

     0       0       3       69       415  

Real estate secured - residential

     948       956       1,271       451       862  

Real estate secured - commercial

     1,845       1,413       1,143       750       270  

Consumer

     3,607       3,561       3,657       3,178       4,186  

Leases

     2,248       1,840       1,697       2,413       653  
    


 


 


 


 


Total charge-offs

     10,859       10,110       11,032       9,424       9,700  
    


 


 


 


 


Recoveries of loans and leases previously charged-off:

                                        

Commercial, financial, and agricultural

     611       614       283       271       211  

Real estate - construction

     0       0       16       115       145  

Real estate secured - residential

     298       289       66       185       217  

Real estate secured - commercial

     96       128       0       63       7  

Consumer

     1,493       1,421       1,852       1,326       1,109  

Leases

     613       437       124       126       64  
    


 


 


 


 


Total recoveries

     3,111       2,889       2,341       2,086       1,753  
    


 


 


 


 


Net charge-offs

     7,748       7,221       8,691       7,338       7,947  
    


 


 


 


 


Allowance for loan and lease losses, December 31,

   $ 54,093     $ 42,672     $ 39,671     $ 37,698     $ 37,187  
    


 


 


 


 


Average loans and leases outstanding

   $ 4,743,864     $ 3,969,532     $ 3,705,572     $ 3,537,316     $ 3,449,145  

Period-end loans and leases

     5,253,008       4,263,272       3,830,953       3,519,498       3,433,610  

Net charge-offs as a percentage of average loans and leases

     0.16 %     0.18 %     0.23 %     0.21 %     0.23 %

Allowance as a percentage of period-end loans and leases

     1.03 %     1.00 %     1.04 %     1.07 %     1.08 %

 

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TABLE 4 - Non-Performing Assets

 

At December 31,


   2004

    2003

    2002

    2001

    2000

 
     (Dollars in thousands)  

Loans contractually past due 90 days and still accruing

   $ 10,217     $ 6,538     $ 8,208     $ 11,498     $ 13,798  
    


 


 


 


 


Non-performing assets:

                                        

Nonaccrual loans:

                                        

Commercial, financial, and agricultural

   $ 1,866     $ 1,735     $ 3,252     $ 1,588     $ 1,858  

Real estate - construction

     0       128       1,148       1,536       1,374  

Real estate secured - residential

     5,801       4,157       3,819       2,557       5,371  

Real estate secured - commercial

     10,611       12,963       9,192       6,702       5,823  

Consumer

     146       54       245       41       117  

Leases

     1,983       0       534       3,092       1,998  

Restructured loans

     0       5,823       0       0       0  

Other real estate owned

     1,340       2,893       3,151       3,761       4,039  
    


 


 


 


 


Total non-performing assets

   $ 21,747     $ 27,753     $ 21,341     $ 19,277     $ 20,580  
    


 


 


 


 


Total non-performing assets as a percentage of period-end loans and leases and other real estate owned

     0.41 %     0.65 %     0.56 %     0.55 %     0.60 %

Allowance for loan and lease losses as a percentage of non-performing loans and leases

     265 %     172 %     218 %     243 %     225 %

 

Real estate acquired through foreclosure is carried at its fair value, which is calculated as the lower of the recorded amount of the loan for which the foreclosed property served as collateral, or the fair market value of the property as determined by a current appraisal less estimated costs to sell. Prior to foreclosure, the recorded amount of the loan is written-down, if necessary, to fair value by charging the allowance for loan and lease losses. Subsequent to foreclosure, gains or losses on the sale of real estate acquired through foreclosure are recorded in operating income, and any losses determined as a result of periodic valuations are charged to other operating expense.

 

Loans with principal and/or interest delinquent 90 days or more and still accruing interest were $10.2 million at December 31, 2004, an increase from the $6.5 million at December 31, 2003. A softening of certain segments of the economy may adversely affect certain borrowers and may cause additional loans to become past due beyond 90 days or be placed on non-accrual status because of uncertainty of receiving full payment of either principal or interest on these loans.

 

Potential problem loans consist of loans that are performing under contract but for which potential credit problems have caused us to place them on our internally monitored loan list. These loans, which are not included in Table 4, totaled $30.1 million at December 31, 2004, and $22.5 at December 31, 2003. We do not consider this increase to be indicative of any particular trends, as changes to risk ratings occur in the normal course of business. Depending upon the state of the economy and the impact thereon to these borrowers, as well as future events, such as regulatory examination assessments, these loans and others not currently so identified could be classified as non-performing assets in the future.

 

Noninterest Income

 

Noninterest income consists of the following:

 

    service charges on deposit accounts;

 

    asset management fees;

 

    fees for trust services;

 

    vehicle origination, servicing, and securitization fees;

 

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    income generated from bank-owned life insurance and reinsurance activities;

 

    commissions and fees on casualty and property insurance;

 

    commissions on brokerage, life insurance, and annuity sales;

 

    net gains on security transactions;

 

    net gains on sales of loans; and

 

    other miscellaneous income, such as fees for sales of travelers’ checks and money orders, safe deposit box rents, and net gains on the sale of other real estate and branch offices.

 

Noninterest income, as a percentage of net interest income plus noninterest income, was 35%, 35% and 33% for 2004, 2003, and 2002, respectively.

 

Noninterest income increased $12.8 million, or 12.6%, in 2004, over 2003. This net increase is composed primarily of the following:

 

    Increased service charges on deposit accounts of $2.1 million;

 

    Increased asset management fees of $4.1 million;

 

    Increased commissions on brokerage, life insurance, and annuity sales of $1.9 million;

 

    Increased income from bank-owned life insurance of $2.1 million;

 

    Increased net gains on sales of securities of $2.6 million;

 

    Net gains on the sales of branch deposits of $3.2 million (included in other); and

 

    Decreased vehicle origination, servicing, and securitization fees of $6.3 million.

 

Service charges on deposit accounts. The 10.7% increase in service charges on deposit accounts is directly related to the acquisition of Patriot and to the increase in demand deposits, from $724.5 million at December 31, 2003, to $853.4 million at December 31, 2004.

 

Asset management fees and commissions on brokerage, life insurance, and annuity sales. As part of our strategy to increase other fee-based income, we continued to focus on enhancing the wealth management aspect of our business. As a result, asset management fees increased 40.3%, as assets under management at VFAM increased 27.3%, to $3.6 billion at December 31, 2004, from $2.8 billion at December 31, 2003. The Patriot acquisition contributed $354.6 million to the increase in assets under management. Commissions on brokerage, life insurance, and annuity sales increased 94.9%, to $4.0 million for 2004, from $2.1 million for 2003.

 

Income from bank-owned life insurance. The 30.8% increase in income from bank-owned life insurance for 2004 can be attributed to the purchase of $50.0 million of life insurance in the third quarter of 2003, $4.9 million in the first quarter of 2004, and $25.0 million in the third quarter of 2004. In addition, we acquired $19.0 million of bank-owned life insurance through the Patriot acquisition.

 

Net gains on sales of securities. In July and August of 2004, as part of a restructuring of our investment portfolio in response to the Patriot acquisition and EITF 03-01, “The Meaning of Other-than-Temporary Impairment and Its Application to Certain Investments,” we sold approximately $107.0 million in securities and realized a net, pre-tax gain of approximately $3.8 million.

 

Net gains on the sales of branch deposits. In the third and fourth quarters of 2004, we sold four branch locations of several banking subsidiaries. We realized an aggregate net pre-tax gain of $3.2 million on the sale of their deposits, totaling $44.2 million, to other financial institutions. These sales were part of our effort to enhance the efficiency of our branch network through our previously announced plans to consolidate and/or sell several locations.

 

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For 2005, we plan to sell seven more branches with aggregate deposits of approximately $96.0 million with an estimated pre-tax gain on the sales of $5.7 million. We expect to incur costs associated with the sales and other branch consolidations of approximately $0.4 million with resultant cost savings, from both sales and consolidations, of approximately $3.0 million in 2005.

 

Vehicle origination, securitization, and servicing fees. The 24.3% decrease in vehicle origination, servicing, and securitization fees was primarily due to a reduction in securitization fees as a result of the roll-off of earlier securitizations and lower lease origination volumes.

 

Noninterest Expenses

 

Non-interest expenses are categorized into the following groupings:

 

    employee-related expenses, which includes salaries, benefits, and employment taxes;

 

    occupancy expenses, which includes depreciation, rents, maintenance, utilities, and insurance;

 

    furniture and equipment expenses, which includes depreciation, rents, and maintenance;

 

    amortization of intangible assets;

 

    vehicle residual value expense;

 

    vehicle delivery and preparation expense; and

 

    other expenses (detailed in Table 5) incurred in the operation of our business.

 

TABLE 5 - Analysis of Other Expenses

 

Year ended December 31,


   2004

   2003

   2002

     (Dollars in thousands)

Advertising, marketing, and public relations

   $ 6,948    $ 5,874    $ 6,005

Communications

     3,720      3,822      4,084

FDIC and other insurance

     5,048      3,146      3,191

Legal and consulting

     4,552      3,528      3,918

Postage and delivery

     5,983      5,461      4,994

All other

     40,612      35,348      32,958
    

  

  

Total

   $ 66,863    $ 57,179    $ 55,150
    

  

  

 

Noninterest expenses increased $29.6 million, or 15.6%, in 2004, over 2003. Salaries and employee benefits, the largest component of noninterest expense, increased $15.0 million, or 16.4%, from 2003 to 2004. The increase in salaries and benefits was primarily the result of the Patriot acquisition, normal annual salary increases, new revenue producing positions, and higher benefit costs.

 

Charges for occupancy increased $1.9 million, or 13.8%, in 2004, from 2003. The increase can be attributed to the Patriot acquisition and general increases in the costs of doing business, predominantly in the categories of rent expense and real estate taxes.

 

Vehicle delivery and preparation expense for 2004 increased $3.0 million over the prior year’s expense due to an increase in the number of vehicles that were turned in at the end of the lease and needed to be prepared for sale, as opposed to being purchased by the lessee. We believe that the increase in the number of vehicles that were turned in at the end of the lease was caused by new-car manufacturers continuing to offer attractive financing incentives. For 2005, Auto Lenders, Hann’s third party residual value guarantor, will open a new central vehicle reconditioning center which, along with fewer vehicle leases scheduled to mature in 2005, is expected to decrease our vehicle delivery and preparation expense by approximately $2.3 million in 2005. Offsetting this improvement will be an estimated $4.5 million increase in vehicle residual value expense for 2005. However, based upon servicing agreements with Auto Lenders, our vehicle residual value guarantee expense will decline by $5.5 million in 2006 and by another $2.7 million in 2007.

 

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All other expenses increased $9.7 million, net (see Table 5). The inclusion of Patriot operations since June 10, 2004, contributed to a general increase in all expense categories. In addition, we incurred expenses relating to our branding initiative of $1.3 million and expenses relating to our bank realignment project of $0.6 million.

 

For 2005, we anticipate incurring branding-initiative costs of approximately $2.6 million. We estimate that bank-realignment-related costs in 2005 will be $0.9 million and concomitant savings will be $3.8 million.

 

Income Taxes

 

Our effective tax rates for 2004 and 2003 were 29.5% and 30.0%, respectively. The reduction in the effective tax rate for 2004 was primarily related to increased tax-advantaged income as a result of the Patriot acquisition and additional purchases of bank-owned life insurance.

 

Financial Condition

 

Summary of 2004 Compared to 2003

 

Total assets at December 31, 2004 were $7.5 billion, an increase of 25.6%, as compared to total assets of $6.0 billion at December 31, 2003. Loans and leases increased to $5.3 billion at December 31, 2004, from $4.3 billion at December 31, 2003; while deposits increased to $5.1 billion from $4.1 billion during the same time period. Equity capital was $751.7 million at December 31, 2004, or $16.13 per share, compared to $547.4 million, or $13.73 per share, at December 31, 2003.

 

Acquisition of Patriot Bank Corp on June 10, 2004

 

The following is a summary of the fair value of assets acquired and liabilities assumed through the purchase of Patriot (in thousands):

 

Assets

      

Cash and cash equivalents

   $ 13,804

Securities

     303,625

Loans and leases, net of allowance of 9,149

     642,255

Premises and other equipment

     11,776

Goodwill and other intangibles

     190,570

Deferred taxes

     11,655

Other assets

     35,034
    

Total assets acquired

   $ 1,208,719
    

Liabilities

      

Deposits

   $ 648,797

Borrowings

     341,271

Other liabilities

     9,685
    

Total liabilities assumed

     999,753
    

Net assets acquired

   $ 208,966
    

 

Investment Securities

 

We follow FAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” This accounting pronouncement requires the segregation of investment securities into three categories, each having a distinct accounting treatment:

 

    held-to-maturity;

 

    trading; or

 

    available-for-sale.

 

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Securities identified as “held-to-maturity” continue to be carried at their amortized cost and, except for limited circumstances, may not be sold prior to maturity. Securities identified as “available-for-sale” must be reported at their market or “fair” value, and the difference between that value and their amortized cost is recorded in the equity section, net of taxes, as a component of other comprehensive income. As a result, our total equity was negatively impacted by $0.1 million as the unrealized losses, net of taxes, on available-for-sale securities increased slightly, from a loss of $2.2 million at December 31, 2003, to a loss of $2.3 million at December 31, 2004. This increased loss was due to the interest-rate environment.

 

Investment securities available for sale increased $257.1 million from December 31, 2003, to December 31, 2004. As part of the Patriot acquisition, we acquired $303.6 million in available-for-sale securities; however, in July and August of 2004, as part of a restructuring of our investment portfolio in anticipation of the ramifications of EITF 03-01, we sold approximately $107.0 million of these securities.

 

Securities identified as “trading account securities” are marked-to-market with the change recorded in the income statement. Presently, we do not engage in trading activity, but we do engage in active portfolio management, that requires the majority of our security portfolios to be identified as “available-for-sale.” While FAS 115 requires segregation into “held-to-maturity” and “available-for-sale” categories (see Table 6), it does not change our policy concerning the purchase of only high quality securities. Strategies employed address liquidity, capital adequacy and net interest margin considerations, which then determine the assignment of purchases into these two categories. Table 7 illustrates the maturities of these security portfolios and the weighted average yields based upon amortized costs. Yields are shown on a tax equivalent basis assuming a 35% federal income tax rate.

 

At December 31, 2004, we held no securities of one issuer, other than U. S. Government obligations, where the aggregate book value exceeded ten percent of shareholders’ equity. Furthermore, there were no investment securities whose ratings were less than investment grade at December 31, 2004 and 2003.

 

TABLE 6 - Carrying Value of Investment Securities

 

Year ended December 31,


   2004

   2003

   2002

    

Available-

for-Sale


  

Held-to-

Maturity


  

Available-

for-Sale


  

Held-to-

Maturity


  

Available-

for-Sale


  

Held-to-

Maturity


     (Dollars in thousands)

U.S. Treasury

   $ 0    $ 0    $ 202    $ 0    $ 1,304    $ 0

U.S. Government agencies

     262,340      0      84,679      0      67,003      0

State and municipal

     38,219      4,469      18,793      4,340      42,365      4,177

Other securities

     7,365      0      7,409      0      0      0

Mortgage-backed securities

     868,266      0      832,248      0      978,861      0

Equity securities

     64,755      0      40,551      0      32,697      0
    

  

  

  

  

  

Total investment securities

   $ 1,240,945    $ 4,469    $ 983,882    $ 4,340    $ 1,122,230    $ 4,177
    

  

  

  

  

  

 

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TABLE 7 - Maturities of Investment Securities

 

At December 31, 2004


  

Within

1 Year


   

After 1 Year but

Within 5 Years


   

After 5 Years but

Within 10 Years


   

After

10 Years


    Total

 
     (Dollars in thousands)  

Available-for-Sale

                                        

U.S. Government agencies

                                        

Fair value

   $ 2,497     $ 258,339     $ 827     $ 677     $ 262,340  

Amortized cost

     2,496       259,881       816       642       263,835  

Yield

     3.54 %     3.28 %     4.73 %     5.80 %     3.29 %

Corporate debt securities

                                        

Fair value

   $ 0     $ 7,365     $ 0     $ 0     $ 7,365  

Amortized cost

     0       7,376       0       0       7,376  

Yield

     0.00 %     3.79 %     0.00 %     0.00 %     3.79 %

Mortgage-backed securities

                                        

Fair value

   $ 0     $ 126,913     $ 443,275     $ 298,078     $ 868,266  

Amortized cost

     0       127,840       448,162       296,322       872,324  

Yield

     0.00 %     3.77 %     3.63 %     4.73 %     4.02 %

State and municipal securities

                                        

Fair value

   $ 1,617     $ 9,918     $ 2,824     $ 23,860     $ 38,219  

Amortized cost

     1,597       9,763       2,779       22,911       37,050  

Yield

     5.30 %     3.49 %     6.03 %     4.97 %     4.67 %

Equity securities

                                        

Fair value

                                   $ 64,755  

Amortized cost

                                     63,840  

Yield

                                     3.16 %

Held-to-Maturity

                                        

Mortgage-backed securities

                                        

Fair value

   $ 0     $ 0     $ 0     $ 4,469     $ 4,469  

Amortized cost

     0       0       0       4,469       4,469  

Yield

     0.00 %     0.00 %     0.00 %     4.03 %     4.03 %

Total Securities

                                        

Fair value

   $ 4,114     $ 402,535     $ 446,926     $ 327,084     $ 1,245,414  

Amortized cost

     4,093       404,860       451,757       324,344       1,248,894  

Yield

     4.23 %     3.45 %     3.64 %     4.74 %     3.84 %

Weighted-average yields are based on amortized cost. For presentation in this table, yields on tax-exempt securities have not been calculated on a tax-equivalent basis.

 

Information included in this table regarding mortgage-backed securities is based on final maturities.

 

Loans and Leases

 

Loans and leases increased $989.7 million, from December 31, 2003, to December 31, 2004. Of this increase, Patriot accounted for $651.4 million, resulting in internal core growth of $338.3 million. In general, we believe that the internal growth that occurred in our loan portfolio in 2004 was accomplished through our sales and marketing efforts. We remain committed, however, to maintaining credit quality and doing business in our market area with customers we know.

 

Table 8 presents loans outstanding, by type of loan, in our portfolio for the past five years. In general, the composition of our loan portfolio, by percentage of total loans, has remained relatively unchanged from December 31, 2003, to December 31, 2004. The greatest percentage changes were between real estate construction loans, which increased by 1.2% of total loans and leases, and consumer loans, which decreased by 1.2% of total loans and leases.

 

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TABLE 8 - Loan and Lease Portfolio

 

At December 31,


  2004

    2003

    2002

    2001

    2000

 
    Amount

 

Percentage

of Loans

to Total

Loans

and Leases


    Amount

 

Percentage

of Loans

to Total

Loans

and Leases


    Amount

 

Percentage

of Loans

to Total

Loans

and Leases


    Amount

 

Percentage

of Loans

to Total

Loans

and Leases


    Amount

 

Percentage

of Loans

to Total

Loans

and Leases


 
    (Dollars in thousands)  

Commercial, financial, and agricultural

  $ 760,106   14.5 %   $ 621,438   14.6 %   $ 478,181   12.5 %   $ 434,780   12.4 %   $ 371,320   10.8 %

Real estate:

                                                           

construction

    741,660   14.1       549,672   12.9       456,663   11.9       359,445   10.2       264,182   7.7  

residential

    1,611,999   30.7       1,306,371   30.6       1,246,939   32.5       1,140,678   32.4       1,257,383   36.6  

commercial

    1,252,753   23.8       1,016,360   23.8       988,633   25.8       822,416   23.4       676,389   19.7  

Consumer

    351,846   6.7       337,989   7.9       343,537   9.0       325,170   9.2       350,707   10.2  

Leases

    534,644   10.2       431,442   10.2       317,000   8.3       437,009   12.4       513,629   15.0  
   

 

 

 

 

 

 

 

 

 

Total

  $ 5,253,008   100.0 %   $ 4,263,272   100.0 %   $ 3,830,953   100.0 %   $ 3,519,498   100.0 %   $ 3,433,610   100.0 %
   

 

 

 

 

 

 

 

 

 

 

Our bank subsidiaries have historically reported a significant amount of loans secured by real estate, as depicted in Table 8. Many of these loans have real estate collateral taken as additional security not related to the acquisition of the real estate pledged. Open-end home equity loans totaled $371.4 million at December 31, 2004, and an additional $137.6 million was lent against junior liens on residential properties at December 31, 2004. Senior liens on 1 - 4 family residential properties totaled $990.0 million at December 31, 2004, and much of the $1.2 billion in loans secured by non-farm, non-residential properties represented collateralization of operating lines, or term loans that finance equipment, inventory, or receivables. Loans secured by farmland totaled $46.2 million, while loans secured by multi-family residential properties totaled $113.0 million at December 31, 2004.

 

Table 9 represents the maturity of commercial, financial, and agricultural loans, as well as real estate construction loans. Table 10 presents the allocation of the allowance for loan and lease losses by type of loan.

 

TABLE 9 - Loan Maturity and Interest Sensitivity

 

At December 31, 2004


                   

Maturity


  

Under One

Year


  

One to Five

Years


  

Over

Five

Years


   Total

     (Dollars in thousands)

Commercial, financial, and agricultural

   $ 277,413    $ 364,332    $ 118,361    $ 760,106

Real estate - construction

     402,331      269,197      70,132      741,660
    

  

  

  

     $ 679,744    $ 633,529    $ 188,493    $ 1,501,766
    

  

  

  

Rate sensitivity of loans with maturities greater than 1 year


                   

Variable rate

          $ 325,758    $ 150,750    $ 476,508

Fixed rate

            307,771      37,743      345,514
           

  

  

            $ 633,529    $ 188,493    $ 822,022
           

  

  

 

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Table of Contents

TABLE 10 - Allocation of Allowance for Loan and Lease Losses

 

At December 31,


   2004

   2003

   2002

   2001

   2000

     (Dollars in thousands)

Commercial, financial, and agricultural

   $ 14,066    $ 9,772    $ 10,317    $ 8,783    $ 7,518

Real estate - construction (1)

     3,339      3,095      2,721      10,388      7,632

Real estate secured - residential (1)

     9,275      7,448      7,412      N/A      N/A

Real estate secured - commercial (1)

     13,760      12,764      10,488      N/A      N/A

Real estate - mortgage (1)

     N/A      N/A      N/A      8,545      8,064

Consumer

     5,779      5,704      5,077      6,423      6,187

Leases

     6,050      2,566      2,414      1,923      2,276

Unused commitments

     1,345      1,060      1,094      1,110      2,211

Unallocated

     479      263      148      526      3,299
    

  

  

  

  

Total

   $ 54,093    $ 42,672    $ 39,671    $ 37,698    $ 37,187
    

  

  

  

  


(1) In 2002, the methodology used for calculating the allowance for loan and lease losses was changed. Prior years' information is not available in this format. We believe that, if we could retroactively apply the current methodology to prior years, the allocation between real estate construction and real estate mortgage would be consistent with 2004, 2003, and 2002.

 

Substantially all of our loans and leases are to enterprises and individuals in our market area. As shown in Table 11, there is no concentration of loans to borrowers in any one industry, or related industries, which exceeds 10% of total loans.

 

TABLE 11 - Loan Concentrations

 

At December 31, 2004, Susquehanna's portfolio included the following industry concentrations:

 

     Permanent

   Construction

   All
Other


   Total
Amount


   % Nonperforming
in Each Category


     (Dollars in thousands)     

Residential construction

   $ 48,192    $ 216,353    $ 10,081    $ 274,626    0.14

Land development (site work) construction

     42,243      205,060      6,077      253,380    0.00

Real estate - residential

     227,535      16,680      4,797      249,012    0.31

Motor vehicles

     181,841      4,068      31,117      217,026    0.07

Lessors of professional offices

     105,134      30,975      0      136,109    0.09

Manufacturing

     44,236      447      82,700      127,383    1.55

Commercial and industrial construction

     52,592      54,017      4,685      111,294    0.02

Retail consumer goods

     50,569      501      40,501      91,571    1.81

Public services

     24,055      2,211      55,366      81,632    0.24

Hotels / motels

     70,295      5,333      1,154      76,782    1.76

Medical services

     32,344      3,196      32,133      67,673    0.04

Contractors

     23,234      2,817      40,925      66,976    0.29

Agriculture

     36,063      666      16,628      53,357    0.72

Restaurants/Bars

     43,714      1,069      7,730      52,513    1.89

 

Goodwill and Other Identifiable Intangible Assets

 

As a result of the Patriot acquisition, we recognized goodwill of $181.5 million, a core deposit intangible of $8.0 million, that will be amortized over ten years, and customer lists of $1.1 million, that will be amortized over five and ten years.

 

During the third quarter of 2003, cash payments of $4.2 million resulting from the attainment of certain earnings targets were recorded as additional goodwill relating to the Addis acquisition of 2002.

 

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Table of Contents

Deposits

 

Our deposit base is consumer-oriented, consisting of time deposits, primarily certificates of deposit with various terms, interest-bearing demand accounts, savings accounts, and demand deposits. Average deposit balances by type and the associated average rate paid are summarized in Table 12.

 

TABLE 12 - Average Deposit Balances

 

Year ended December 31,


  2004

    2003

    2002

 
    Average
Balance


 

Average

Rate Paid


    Average
Balance


 

Average

Rate Paid


    Average
Balance


 

Average

Rate Paid


 
    (Dollars in thousands)  

Demand deposits

  $ 783,551   0.00 %   $ 646,971   0.00 %   $ 545,971   0.00 %

Interest-bearing demand deposits

    1,640,525   1.02       1,195,656   0.79       991,096   1.25  

Savings deposits

    552,950   0.38       498,157   0.40       461,947   0.87  

Time deposits

    1,776,623   2.79       1,601,495   3.21       1,643,785   4.02  
   

       

       

     

Total

  $ 4,753,649         $ 3,942,279         $ 3,642,799      
   

       

       

     

 

Total deposits increased $996.2 million, from December 31, 2003 to December 31, 2004. Of this increase, Patriot accounted for $648.8 million. Also, in the third and fourth quarters of 2004, as part of our realignment project, we sold branch deposits totaling approximately $44.2 million. The net result of these transactions was an increase in total deposits of $391.6 million. Of this net increase, $169.3 million was in brokered certificates of deposit, which are being utilized as an alternative funding source to support the increase in our loan portfolio. We believe that the remainder of the net increase is a direct result of the continuing success of our bank subsidiaries in carrying out our retail and corporate sales initiatives.

 

We do not rely upon time deposits of $0.1million or more as a principal source of funds, as they represent only 11.4% of total deposits. Table 13 presents a breakdown by maturity of time deposits of $0.1million or more as of December 31, 2004.

 

TABLE 13 - Deposit Maturity

 

The maturities of time deposits of $0.1 million or more at December 31, 2004 were as follows:

 

(Dollars in thousands)


    

Three months or less

   $ 193,391

Over three months through six months

     91,452

Over six months through twelve months

     81,516

Over twelve months

     219,023
    

Total

   $ 585,382
    

 

Short-term Borrowings

 

Short-term borrowings, which include securities sold under repurchase agreements, federal funds purchased, and Treasury tax and loan notes, increased by $65.3 million, or 18.4%, from December 31, 2003 to December 31, 2004. The greatest increase within this category occurred in Federal funds purchased, which increased from $55.3 million at December 31, 2003 to $108.6 million at December 31, 2004.

 

Federal Home Loan Bank Borrowings and Long-term Debt

 

Federal Home Loan Bank (“FHLB”) borrowings increased $137.4 million and long-term debt increased $93.3 million from December 31, 2003, to December 31, 2004. Of the increase in FHLB borrowings, the fair value of debt assumed through the Patriot acquisition accounted for $275.6 million, resulting in a net decrease of $138.2 million. The net increase in long-term debt was the result of the fair value of junior subordinated

 

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Table of Contents

debentures, $23.6 million, assumed through the Patriot acquisition, the issuance of $75.0 million in subordinated notes in May 2004, and the repayment of a subsidiary’s $5.0 million term note in July 2004.

 

On May 3, 2004, we completed the private placement of $75.0 million aggregate principal amount of 4.75% fixed rate/floating rate subordinated notes due May 1, 2014. We used the net proceeds from the offering to fund the cash portion of the Patriot acquisition and the remaining balance to increase our liquidity and capital position in anticipation of future growth and for general corporate purposes. The notes qualify as Tier 2 Capital under the capital guidelines established by the Federal Reserve Board.

 

The notes bear interest at a fixed rate of 4.75% per annum through and including May 1, 2009 and convert to a floating rate thereafter until maturity, based on the US dollar three-month LIBOR plus 1.82%. Beginning May 1, 2009, we, upon consultation with the Federal Reserve Board, have the right to redeem the notes at a redemption price of 100% of the principal amount of the notes plus any accrued interest. We issued and sold the notes to Keefe, Bruyette & Woods, Inc., Sandler O’Neill & Partners, L.P., Legg Mason Wood Walker, Incorporated and Ferris, Baker Watts, Incorporated, the initial purchasers, in transactions exempt from the registration requirements of the Securities Act of 1933, as amended, because the sale did not involve a public offering. The initial purchasers resold the notes to persons they reasonably believed to be “qualified institutional buyers” as defined in Rule 144A of the Securities Act of 1933 or pursuant to Regulation S. Under the registration rights agreement relating to the notes, we filed a registration statement with the Securities and Exchange Commission to register an identical form of notes which could be exchanged for the privately placed notes that were not registered for sale; and on October 28, 2004, we completed the exchange offer pursuant to which we exchanged all of the outstanding $75 million notes for the form of notes registered for resale.

 

In addition, as part of the Patriot acquisition, we assumed $20.5 million in junior subordinated debt issued to Patriot Capital Trust I and Patriot Capital Trust II. The aggregate fair value of this debt at the date of acquisition was $23.6 million. The $15.5 million in debentures issued to Patriot Capital Trust I bear interest at 10.30% and are callable on or after July 1, 2007. If these debentures are not called, they must be redeemed upon maturity in 2027. The $5.0 million in debentures issued to Patriot Capital Trust II bear interest at the 180-day LIBOR plus 3.70%; the rate at December 31, 2004 was 5.31%. The debentures are callable on any April 22 or October 22 after April 22, 2007. If these debentures are not called, they must be redeemed upon maturity in 2032.

 

Contractual Obligations and Commercial Commitments

 

Table 14 presents certain of our contractual obligations and commercial commitments, including Susquehanna’s guarantees on behalf of its subsidiaries, and their expected year of payment or expiration.

 

Table 14 - Contractual Obligations and Commercial Commitments

 

 

     Payments Due by Period

Contractual Obligations


   Total

   Less than 1
Year


   1 - 3 Years

   4 - 5 Years

   Over 5
Years


     (Dollars in thousands)

Certificates of deposit

   $ 1,952,664    $ 1,014,839    $ 677,067    $ 256,004    $ 4,754

Federal Home Loan Bank borrowings

     751,220      240,000      102,286      155,214      253,720

Long-term debt

     223,277      50,000      0      0      173,277

Operating leases

     47,511      6,316      9,829      7,444      23,922

Contingent cash collateral

     35,075      0      0      35,075      0
     Commitment Expiration by Period

Other Commercial Commitments


   Total

   Less than 1
Year


   1 - 3 Years

   4 - 5 Years

   Over 5
Years


     (Dollars in thousands)

Stand-by letters of credit

   $ 124,840    $ 108,128    $ 16,712    $ 0    $ 0

Guarantees

     14,688      0      6,688      8,000      0

Commercial commitments

     416,295      318,247      98,048      0      0

Real estate commitments

     644,320      264,588      379,732      0      0

 

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Table of Contents

Capital Adequacy

 

Risk-based capital ratios, based upon guidelines adopted by bank regulators in 1989, focus upon credit risk. Assets and certain off-balance sheet items are segmented into one of four broad risk categories and weighted according to the relative percentage of credit risk assigned by the regulatory authorities. Off-balance sheet instruments are converted into a balance sheet credit equivalent before being assigned to one of the four risk-weighted categories. To supplement the risk-based capital ratios, the regulators issued a minimum leverage ratio guideline (Tier 1 capital as a percentage of average assets less excludable intangibles).

 

Capital elements are segmented into two tiers. Tier 1 capital represents shareholders’ equity plus junior subordinated debentures reduced by excludable intangibles. Tier 2 capital represents certain allowable long-term debt, the portion of the allowance for loan and lease losses equal to 1.25% of risk-adjusted assets, and 45% of the unrealized gain on equity securities. The sum of Tier 1 capital and Tier 2 capital is “total risk-based capital.”

 

The maintenance of a strong capital base at both the parent company level as well as at each bank affiliate is an important aspect of our philosophy. We, and each of our bank subsidiaries, have leverage and risk-weighted ratios well in excess of regulatory minimums, and each entity is considered “well capitalized” under regulatory guidelines.

 

Market Risks

 

The types of market risk exposures generally faced by banking entities include:

 

    equity market price risk;

 

    liquidity risk;

 

    interest rate risk;

 

    foreign currency risk; and

 

    commodity price risk.

 

Due to the nature of our operations, foreign currency and commodity price risk are not significant to us.

 

Equity Market Price Risk

 

Equity market price risk is the risk related to market fluctuations of equity prices in the securities markets. While we do not have significant risk in our investment portfolio, market price fluctuations may affect fee income generated through our asset management operations. Generally, our fee structure is based on the market value of assets being managed at specific time frames. If market values decline, our fee income may also decline.

 

Liquidity Risk

 

The maintenance of adequate liquidity — the ability to meet the cash requirements of our customers and other financial commitments — is a fundamental aspect of our asset/liability management strategy. Our policy of diversifying our funding sources — purchased funds, repurchase agreements, and deposit accounts — allows us to avoid undue concentration in any single financial market and also to avoid heavy funding requirements within short periods of time. At December 31, 2004, our bank subsidiaries had approximately $515.3 million available to them under collateralized lines of credit with various FHLBs; and $185.5 million more was available provided that additional collateral had been pledged.

 

Liquidity is not entirely dependent on increasing our liability balances. Liquidity is also evaluated by taking into consideration maturing or readily marketable assets. Unrestricted short-term investments amounted to $31.5 million for the year ended December 31, 2004 and represented additional sources of liquidity.

 

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Table of Contents

Interest Rate Risk

 

The management of interest rate risk focuses on controlling the risk to net interest income and the associated net interest margin as the result of changing market rates and spreads. Interest rate sensitivity is the matching or mismatching of the repricing and rate structure of the interest-bearing assets and liabilities. Our goal is to control risk exposure to changing rates within management’s accepted guidelines to maintain an acceptable level of risk exposure in support of consistent earnings.

 

We employ a variety of methods to monitor interest rate risk. These methods include basic gap analysis, which points to directional exposure; routine rate shocks simulation; and evaluation of the change in economic value of equity. Board directed guidelines have been adopted for both the rate shock simulations and economic value of equity exposure limits. By dividing the assets and liabilities into three groups, fixed rate, floating rate and those which reprice only at our discretion, strategies are developed to control the exposure to interest rate fluctuations.

 

Our interest rate risk using the static gap analysis is presented in Table 15. This method reports the difference between interest-rate sensitive assets and liabilities at a specific point in time. Management uses the static gap methodology to identify our directional interest-rate risk. Table 15 also illustrates our estimated interest rate sensitivity (periodic and cumulative) gap positions as calculated as of December 31, 2004 and 2003. These estimates include anticipated prepayments on commercial and residential loans, mortgage-backed securities, in addition to certain repricing assumptions relative to our core deposits. Traditionally, an institution with more assets repricing than liabilities over a given time frame is considered asset sensitive, and one with more liabilities repricing than assets is considered liability sensitive. An asset sensitive institution will generally benefit from rising rates, and a liability sensitive institution will generally benefit from declining rates. Static gap analysis is widely accepted because of its simplicity in identifying interest rate risk exposure; but it ignores market spread adjustments, the changing mix of the balance sheet, planned balance sheet management strategies, and the change in prepayment assumptions.

 

TABLE 15 - Balance Sheet Gap Analysis

 

At December 31, 2004


 

1-3

months


   

3-12

months


   

1-3

years


   

Over 3

years


    Total

    (Dollars in thousands)

Assets

                                     

Short-term investments

  $ 58,372     $ 0     $ 0     $ 362     $ 58,734

Investments

    139,716       222,272       501,504       381,922       1,245,414

Loans and leases, net of unearned income

    2,072,313       727,635       1,274,575       1,178,485       5,253,008
   


 


 


 


 

Total

  $ 2,270,401     $ 949,907     $ 1,776,079     $ 1,560,769     $ 6,557,156
   


 


 


 


 

Liabilities

                                     

Interest-bearing demand

  $ 291,079     $ 366,940     $ 829,026     $ 278,032     $ 1,765,077

Savings

    34,359       102,924       316,686       105,561       559,530

Time

    197,689       452,771       506,804       210,018       1,367,282

Time in denominations of $100 or more

    194,830       171,667       167,301       51,584       585,382

Total borrowings

    770,931       35,193       47,346       541,895       1,395,365
   


 


 


 


 

Total

  $ 1,488,888     $ 1,129,495     $ 1,867,163     $ 1,187,090     $ 5,672,636
   


 


 


 


 

Impact of other assets, other liabilities, capital, and noninterest-bearing deposits:

  $ 0     $ (213,352 )   $ (480,041 )   $ (191,127 )      

Interest Sensitivity Gap:

                                     

Periodic

  $ 781,513     $ (392,940 )   $ (571,125 )   $ 182,552        

Cumulative

            388,573       (182,552 )     0        

Cumulative gap as a percentage of total assets

    10 %     5 %     -2 %     0 %      

 

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Table of Contents

TABLE 15 - Balance Sheet Gap Analysis (continued)

 

At December 31, 2003


 

1-3

months


   

3-12

months


   

1-3

years


   

Over 3

years


    Total

    (Dollars in thousands)

Assets

                                     

Short-term investments

  $ 78,400     $ 0     $ 0     $ 562     $ 78,962

Investments

    110,235       208,389       372,953       296,645       988,222

Loans and leases, net of unearned income

    1,664,830       666,930       949,667       981,845       4,263,272
   


 


 


 


 

Total

  $ 1,853,465     $ 875,319     $ 1,322,620     $ 1,279,052     $ 5,330,456
   


 


 


 


 

Liabilities

                                     

Interest-bearing demand

  $ 173,178     $ 250,067     $ 653,416     $ 218,932     $ 1,295,593

Savings

    31,805       95,414       286,253       95,417       508,889

Time

    241,966       414,466       395,770       198,856       1,251,058

Time in denominations of $100 or more

    115,316       125,159       63,948       50,030       354,453

Total borrowings

    614,927       143,727       80,600       260,149       1,099,403
   


 


 


 


 

Total

  $ 1,177,192     $ 1,028,833     $ 1,479,987     $ 823,384     $ 4,509,396
   


 


 


 


 

Impact of other assets, other liabilities, capital and noninterest-bearing deposits:

  $ 180,651     $ (179,473 )   $ (403,813 )   $ (418,425 )      

Interest Sensitivity Gap:

                                     

Periodic

  $ 856,924     $ (332,987 )   $ (561,180 )   $ 37,243        

Cumulative

            523,937       (37,243 )     0        

Cumulative gap as a percentage of total assets

    15 %     9 %     -1 %     0 %      

 

In addition to static gap reports comparing the sensitivity of interest-earning assets and interest-bearing liabilities to changes in interest rates, we also utilize simulation analysis that measures our exposure to interest rate risk. The financial simulation model calculates the income effect and the economic value of assets, liabilities and equity at current and forecasted interest rates, and at hypothetical higher and lower interest rates at one percent intervals. The income effect and economic value of defined categories of financial instruments is calculated by the model using estimated cash flows based on embedded options, prepayments, early withdrawals, and weighted average contractual rates and terms. For economic value calculations, the model also considers discount rates for similar financial instruments. The economic values of longer-term fixed-rate financial instruments are generally more sensitive to changes in interest rates. Adjustable-rate and variable-rate financial instruments largely reflect only a change in economic value representing the difference between the contractual and discounted rates until the next contractual interest rate repricing date, unless subject to rate caps and floors.

 

A portion of our loan portfolio consists of commercial and residential mortgage loans containing embedded options, which permit the borrower to repay the principal balance of the loan prior to maturity (“prepayments”) without penalty. A loan’s susceptibility for prepayment is dependent upon a number of factors, including the current interest rate versus the contractual interest rate of the loan, the financial ability of the borrower to refinance, the economic benefit, and the availability of refinancing at attractive terms in addition to general changes in customers needs. Refinancing may also depend upon economic and other factors in specific geographic areas that affect the sales and price levels of residential property. In a changing interest rate environment, prepayments may increase or decrease depending on the current relative levels and expectations of future short-term and long-term interest rates.

 

Changes in market rates and general economic conditions will have an impact on an organization’s mortgage-backed security portfolio. This will have an associated change on our sensitivity position in changing economic times. Savings and checking deposits generally may be withdrawn upon the customer’s request without prior notice. A continuing relationship with customers resulting in future deposits and withdrawals is generally predictable, resulting in a dependable source of funds. Time deposits generally have early withdrawal penalties,

 

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while term FHLB borrowings and subordinated notes have prepayment penalties, which discourage customer withdrawal of time deposits and prepayment of FHLB borrowings and subordinated notes prior to maturity.

 

Our floating-rate loan portfolio is primarily indexed to national interest rate indices. The portfolio is funded by interest-bearing liabilities which are determined by other indices, primarily deposits and FHLB borrowings. A changing interest rate environment may result in different levels of changes to the different indices resulting in disproportionate changes in the value of, and the net earnings generated from such financial instruments. Basis risk is the result of this inconsistent change in the indices, with historical relationships not always being a good indicator.

 

Tables 16 and 17 reflect the estimated income effect and economic value of assets, liabilities and equity calculated using certain assumptions we determined as of December 31, 2004, and 2003, at then current interest rates and at hypothetical higher and lower interest rates in 1% and 2% increments. As noted in Table 16, the economic value of equity at risk as of December 31, 2004 is -4%, at an interest rate change of positive 2%, while Table 17 discloses that net interest income at risk as of December 31, 2004 is 3%, at an interest rate change of positive 2%. The positive rate scenarios are considered more likely, as we and most economists believe that the Federal Reserve will continue to increase short-term interest rates throughout 2005, putting upward pressure on the long-term interest rates, as well.

 

At December 31, 2004, we were an asset-sensitive institution and should benefit from a continued rise in interest rates in 2005, if that should occur.

 

TABLE 16 - Balance Sheet Shock Analysis

 

At December 31, 2004


  -2%

    -1%

   

Base

Present

Value


    1%

    2%

 
    (Dollars in thousands)  

Assets

                                       

Cash and due from banks

  $ 160,574     $ 160,574     $ 160,574     $ 160,574     $ 160,574  

Short-term investments

    59,248       59,248       59,248       59,248       59,248  

Investment securities:

                                       

Held-to-maturity

    4,652       4,555       4,461       4,370       4,281  

Available-for-sale

    1,272,163       1,262,941       1,250,260       1,217,944       1,177,465  

Loans and leases, net of unearned income

    5,358,087       5,285,541       5,212,443       5,135,232       5,056,609  

Other assets

    802,187       802,187       802,187       802,187       802,187  
   


 


 


 


 


Total assets

  $ 7,656,911     $ 7,575,046     $ 7,489,173     $ 7,379,555     $ 7,260,364  
   


 


 


 


 


Liabilities

                                       

Deposits:

                                       

Non-interest bearing

    807,724       788,528       770,010       752,140       734,889  

Interest-bearing

    4,263,365       4,203,808       4,148,725       4,091,392       4,037,260  

Total borrowings

    1,524,990       1,491,500       1,459,134       1,430,274       1,406,956  

Other liabilities

    197,332       197,332       197,332       197,332       197,332  
   


 


 


 


 


Total liabilities

    6,793,411       6,681,168       6,575,201       6,471,138       6,376,437  

Total economic equity

    867,309       895,474       913,431       905,814       879,334  

Off balance sheet

    3,809       1,596       (541 )     (2,603 )     (4,593 )
   


 


 


 


 


Total liabilities and equity

  $ 7,656,911     $ 7,575,046     $ 7,489,173     $ 7,379,555     $ 7,260,364  
   


 


 


 


 


Economic equity ratio

    11 %     12 %     12 %     12 %     12 %

Value at risk

  $ (46,122 )   $ (17,957 )   $ 0     $ (7,617 )   $ (34,097 )

% Value at risk

    -5 %     -2 %     0 %     -1 %     -4 %

 

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TABLE 16 - Balance Sheet Shock Analysis (continued)

 

At December 31, 2003


  -2%

    -1%

   

Base

Present

Value


    1%

    2%

 
    (Dollars in thousands)  

Assets

                                       

Cash and due from banks

  $ 176,240     $ 176,240     $ 176,240     $ 176,240     $ 176,240  

Short-term investments

    78,962       78,962       78,962       78,962       78,962  

Investment securities:

                                       

Held-to-maturity

    4,339       4,339       4,339       4,339       4,339  

Available-for-sale

    1,009,641       1,003,183       999,708       978,861       949,636  

Loans and leases, net of unearned income

    4,373,682       4,314,894       4,253,003       4,189,281       4,125,281  

Other assets

    489,183       488,384       489,168       489,159       489,152  
   


 


 


 


 


Total assets

  $ 6,132,047     $ 6,066,002     $ 6,001,420     $ 5,916,842     $ 5,823,610  
   


 


 


 


 


Liabilities

                                       

Deposits:

                                       

Non-interest bearing

    697,492       682,613       666,849       651,640       636,962  

Interest-bearing

    3,423,357       3,377,211       3,331,401       3,284,929       3,241,324  

Total borrowings

    1,173,986       1,162,709       1,143,355       1,125,969       1,110,468  

Other liabilities

    172,028       172,028       172,028       172,028       172,028  
   


 


 


 


 


Total liabilities

    5,466,863       5,394,561       5,313,633       5,234,566       5,160,782  

Total economic equity

    665,086       671,455       687,864       682,408       663,014  

Off balance sheet

    (98 )     14       77       132       186  
   


 


 


 


 


Total liabilities and equity

  $ 6,132,047     $ 6,066,002     $ 6,001,420     $ 5,916,842     $ 5,823,610  
   


 


 


 


 


Economic equity ratio

    11 %     11 %     11 %     12 %     11 %

Value at risk

  $ (22,778 )   $ (16,409 )   $ 0     $ (5,456 )   $ (24,850 )

% Value at risk

    -3 %     -2 %     0 %     -1 %     -4 %

 

TABLE 17 - Net Interest Income Shock Analysis

 

At December 31, 2004


  -2%

    -1%

    Base
Scenario


    1%

    2%

 
    (Dollars in thousands)  

Interest income:

                                       

Short-term investments

  $ 169     $ 944     $ 1,894     $ 2,875     $ 3,870  

Investments

    34,005       41,118       49,046       52,272       53,756  

Loans and leases

    273,287       296,675       319,644       341,804       363,311  
   


 


 


 


 


Total interest income

    307,461       338,737       370,584       396,951       420,937  
   


 


 


 


 


Interest expense:

                                       

Interest-bearing demand and savings

    8,858       15,113       24,198       31,327       39,002  

Time

    43,484       48,119       53,844       60,004       66,234  

Total borrowings

    34,653       40,629       47,846       55,610       63,369  
   


 


 


 


 


Total interest expense

    86,995       103,861       125,888       146,941       168,605  
   


 


 


 


 


Net interest income

  $ 220,466