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

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 


FORM 10-Q

 


(Mark One)

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

For the quarterly period ended March 31, 2007

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

 


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 whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer  x    Accelerated Filer  ¨    Non-Accelerated Filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)     Yes  ¨    No  x

As of April 30, 2007, there were 52,144,543 shares of the registrant’s common stock outstanding, par value $2.00 per share.

 



Table of Contents

SUSQUEHANNA BANCSHARES, INC.

TAB LE OF CONTENTS

 

          Page
PART I.    FINANCIAL INFORMATION   
    Item 1    Financial Statements   
   Consolidated Balance Sheets – as of March 31, 2007 and 2006 (unaudited), and December 31, 2006    3
   Consolidated Statements of Income – for the three months ended March 31, 2007 and 2006 (unaudited)    4
   Consolidated Statements of Cash Flows - for the three months ended March 31, 2007 and 2006 (unaudited)    5
   Consolidated Statements of Changes in Shareholders’ Equity for the three months ended March 31, 2007 and 2006 (unaudited)    7
   Notes to the Consolidated Financial Statements (unaudited)    8
    Item 2    Management’s Discussion and Analysis of Financial Condition and Results of Operations    16
    Item 3    Quantitative and Qualitative Disclosures About Market Risk    26
    Item 4    Controls and Procedures    28
PART II.    OTHER INFORMATION   
    Item 1    Legal Proceedings    29
    Item 1A    Risk Factors    29
    Item 2    Unregistered Sales of Equity Securities and Use of Proceeds    29
    Item 3    Defaults Upon Senior Securities    29
    Item 4    Submission of Matters to a Vote of Security Holders    29
    Item 5    Other Information    29
    Item 6    Exhibits    29
SIGNATURES    30
EXHIBIT INDEX    31


Table of Contents

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements.

Susquehanna Bancshares, Inc. and Subsidiaries

CONSOLIDATED BALANCE SHEETS

 

     March 31
2007
(unaudited)
    December 31
2006
    March 31
2006
(unaudited)
 
     (in thousands, except share data)  

Assets

      

Cash and due from banks

   $ 181,780     $ 194,785     $ 175,838  

Unrestricted short-term investments

     112,055       70,996       64,517  
                        

Cash and cash equivalents

     293,835       265,781       240,355  

Restricted short-term investments

     213       33,533       27,979  

Securities available for sale

     1,435,862       1,397,420       1,204,698  

Securities held to maturity (fair values approximate $4,933; $6,146; and $6,330)

     4,933       6,146       6,330  

Loans and leases, net of unearned income

     5,393,665       5,560,997       5,042,755  

Less: Allowance for loan and lease losses

     61,789       62,643       53,999  
                        

Net loans and leases

     5,331,876       5,498,354       4,988,756  
                        

Premises and equipment, net

     106,012       106,305       88,862  

Foreclosed assets

     3,962       1,544       2,596  

Accrued income receivable

     30,266       31,044       25,491  

Bank-owned life insurance

     265,971       264,398       259,326  

Goodwill

     338,284       335,005       242,976  

Intangible assets with finite lives

     18,469       19,092       11,135  

Investment in and receivables from unconsolidated entities

     166,811       121,663       153,546  

Other assets

     162,687       144,849       126,017  
                        

Total Assets

   $ 8,159,181     $ 8,225,134     $ 7,378,067  
                        

Liabilities and Shareholders’ Equity

      

Deposits:

      

Demand

   $ 905,382     $ 959,654     $ 902,816  

Interest-bearing demand

     2,151,530       2,004,596       1,755,688  

Savings

     470,497       477,447       449,310  

Time

     1,563,477       1,528,298       1,473,661  

Time of $100 or more

     934,621       907,594       774,141  
                        

Total deposits

     6,025,507       5,877,589       5,355,616  

Short-term borrowings

     256,299       401,964       193,825  

FHLB borrowings

     451,961       528,688       622,674  

Long-term debt

     150,033       150,036       150,000  

Junior subordinated debentures

     72,106       72,244       22,647  

Accrued interest, taxes, and expenses payable

     43,682       54,800       56,033  

Deferred taxes

     148,630       145,825       129,123  

Other liabilities

     60,263       57,702       63,536  
                        

Total Liabilities

     7,208,481       7,288,848       6,593,454  
                        

Shareholders’ equity:

      

Common stock, $2.00 par value, 100,000,000 shares authorized; Issued: 52,139,989 at March 31, 2007; 52,080,419 at December 31, 2006; and 46,927,699 at March 31, 2006

     104,219       104,161       93,855  

Additional paid-in capital

     347,471       345,840       232,215  

Retained earnings

     513,563       505,861       477,740  

Accumulated other comprehensive loss, net of taxes of $(7,836); $(10,541); and $(10,361), respectively

     (14,553 )     (19,576 )     (19,197 )
                        

Total Shareholders’ Equity

     950,700       936,286       784,613  
                        

Total Liabilities and Shareholders’ Equity

   $ 8,159,181     $ 8,225,134     $ 7,378,067  
                        

The accompanying notes are an integral part of these consolidated financial statements.


Table of Contents

Susquehanna Bancshares, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

 

     Three Months Ended
March 31
 
     2007    2006  
     (in thousands, except per share data)  

Interest Income:

     

Loans and leases, including fees

   $ 102,445    $ 91,364  

Securities:

     

Taxable

     15,465      10,847  

Tax-exempt

     387      176  

Dividends

     1,106      837  

Short-term investments

     1,124      738  
               

Total interest income

     120,527      103,962  
               

Interest Expense:

     

Deposits:

     

Interest-bearing demand

     16,398      10,617  

Savings

     1,113      622  

Time

     27,739      20,341  

Short-term borrowings

     3,782      2,718  

FHLB borrowings

     5,170      7,453  

Long-term debt

     3,277      2,474  
               

Total interest expense

     57,479      44,225  
               

Net interest income

     63,048      59,737  

Provision for loan and lease losses

     2,000      2,675  
               

Net interest income, after provision for loan and lease losses

     61,048      57,062  
               

Noninterest Income:

     

Service charges on deposit accounts

     6,475      5,055  

Vehicle origination, servicing, and securitization fees

     4,018      4,005  

Asset management fees

     4,611      4,768  

Income from fiduciary-related activities

     1,588      1,494  

Commissions on brokerage, life insurance, and annuity sales

     1,111      1,100  

Commissions on property and casualty insurance sales

     4,092      4,348  

Income from bank-owned life insurance

     2,659      2,168  

Net gain on sale of loans and leases

     4,051      3,292  

Net gain (loss) on securities

     61      (64 )

Other

     5,614      3,684  
               

Total noninterest income

     34,280      29,850  
               

Noninterest Expenses:

     

Salaries and employee benefits

     34,276      29,974  

Occupancy

     6,070      5,149  

Furniture and equipment

     2,897      2,485  

Advertising and marketing

     1,825      2,058  

Amortization of intangible assets

     623      425  

Vehicle lease disposal

     3,345      3,391  

Other

     15,811      17,475  
               

Total noninterest expenses

     64,847      60,957  
               

Income before income taxes

     30,481      25,955  

Provision for income taxes

     9,754      8,254  
               

Net Income

   $ 20,727    $ 17,701  
               

Earnings per share:

     

Basic

   $ 0.40    $ 0.38  

Diluted

   $ 0.40    $ 0.38  

Cash dividends

   $ 0.25    $ 0.24  

Average shares outstanding:

     

Basic

     52,097      46,874  

Diluted

     52,201      47,029  

The accompanying notes are an integral part of these consolidated financial statements.


Table of Contents

Susquehanna Bancshares, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

 

(Dollars in thousands)

Three months ended March 31,

   2007     2006  

Cash Flows from Operating Activities:

    

Net income

   $ 20,727     $ 17,701  

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation, amortization, and accretion

     4,000       3,681  

Provision for loan and lease losses

     2,000       2,675  

Realized (gain) loss on available-for-sale securities, net

     (61 )     64  

Deferred income taxes

     81       (735 )

Gain on sale of loans and leases

     (4,051 )     (3,292 )

Gain on sale of other real estate owned

     (43 )     (108 )

Mortgage loans originated for sale

     (27,123 )     (17,934 )

Proceeds from sale of mortgage loans originated for sale

     26,721       18,695  

Loans and leases originated/acquired for sale, net of payments received

     (144,341 )     (74,667 )

Net proceeds from sale of loans and leases originated/acquired for sale

     252,493       302,887  

Increase in cash surrender value of bank-owned life insurance

     (2,510 )     (2,272 )

Decrease (increase) in accrued interest receivable

     778       (1,268 )

Increase in accrued interest payable

     2,502       1,225  

(Decrease) increase in accrued expenses and taxes payable

     (13,620 )     4,972  

Other, net

     (18,920 )     10,106  
                

Net cash provided by operating activities

     98,633       261,730  
                

Cash Flows from Investing Activities:

    

Net decrease (increase) in restricted short-term investments

     33,320       (1,643 )

Activity in available-for-sale securities:

    

Sales

     81,279       38,675  

Maturities, repayments, and calls

     89,682       7,747  

Purchases

     (201,123 )     (108,336 )

Net decrease (increase) in loans and leases

     10,484       (103,403 )

Cash flows received from retained interests

     2,990       5,061  

Proceeds from bank-owned life insurance

     937       0  

Purchase of bank-owned life insurance

     0       235  

Additions to premises and equipment

     (2,335 )     (2,983 )
                

Net cash provided by (used in) investing activities

     15,234       (164,647 )
                

Cash Flows from Financing Activities:

    

Net increase in deposits

     147,918       46,429  

Net decrease in short-term borrowings

     (145,665 )     (113,698 )

Net decrease in FHLB borrowings

     (76,727 )     (45,992 )

Repayment of long-term debt

     (3 )     0  

Proceeds from issuance of common stock

     1,584       1,042  

Tax benefit from exercise of stock options

     105       237  

Cash dividends paid

     (13,025 )     (11,251 )
                

Net cash used in financing activities

     (85,813 )     (123,233 )
                


Table of Contents

Susquehanna Bancshares, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)

 

Net change in cash and cash equivalents

     28,054      (26,150 )

Cash and cash equivalents at January 1

     265,781      266,505  
               

Cash and cash equivalents at March 31

   $ 293,835    $ 240,355  
               

Supplemental Disclosure of Cash Flow Information

     

Cash paid for interest on deposits and borrowings

   $ 54,977    $ 43,000  

Income tax payments

   $ 8,809    $ 3,594  

Supplemental Schedule of Noncash Investing Activities

     

Real estate acquired in settlement of loans

   $ 3,507    $ 624  

Interests retained in securitizations

   $ 47,920    $ 53,253  

Securities purchased, not settled

   $ 11,225    $ 0  

Securities sold, not settled

   $ 10,060    $ 0  

The accompanying notes are an integral part of these consolidated financial statements.


Table of Contents

Susquehanna Bancshares, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (UNAUDITED)

(In thousands, except share data)

 

     Shares of
Common
Stock
   Common
Stock
   Additional
Paid-in
Capital
   Retained
Earnings
    Accumulated
Other
Comprehensive
Income (Loss)
    Total  

Balance at January 1, 2006

   46,853,193    $ 93,706    $ 231,085    $ 471,290     $ (15,611 )   $ 780,470  
                     

Comprehensive income:

               

Net income

              17,701         17,701  

Change in unrealized loss on securities available for sale, net of tax effect and reclassification adjustment

                (2,831 )     (2,831 )

Change in unrealized loss on recorded interests in securitized assets, net of tax effect

                (139 )     (139 )

Change in unrealized gain on cash flow hedges, net of tax effect and reclassification adjustment of $940

                (616 )     (616 )
                     

Total comprehensive income

                  14,115  
                     

Common stock issued under employee benefit plans (including related tax benefit of $237)

   74,506      149      1,130          1,279  

Cash dividends declared ($0.24 per share)

              (11,251 )       (11,251 )
                                           

Balance at March 31, 2006

   46,927,699    $ 93,855    $ 232,215    $ 477,740     $ (19,197 )   $ 784,613  
                                           

Balance at January 1, 2007

   52,080,419    $ 104,161    $ 345,840    $ 505,861     $ (19,576 )   $ 936,286  
                     

Comprehensive income:

               

Net income

              20,727         20,727  

Change in unrealized loss on securities available for sale, net of tax effect and reclassification adjustment of $21

                4,022       4,022  

Change in unrealized gain on recorded interests in securitized assets, net of tax effect

                981       981  

Change in unrealized gain on cash flow hedges, net of tax effect and reclassification adjustment of $(202)

                20       20  
                     

Total comprehensive income

                  25,750  
                     

Common stock issued under employee benefit plans (including related tax benefit of $105)

   59,570      58      1,631          1,689  

Cash dividends declared ($0.25 per share)

              (13,025 )       (13,025 )
                                           

Balance at March 31, 2007

   52,139,989    $ 104,219    $ 347,471    $ 513,563     $ (14,553 )   $ 950,700  
                                           

The accompanying notes are an integral part of these consolidated financial statements.


Table of Contents

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Amounts in thousands, except as noted and per share data)

NOTE 1. Accounting Policies

The information contained in this report is unaudited and is subject to year-end adjustments. Certain prior year amounts have been reclassified to conform with current period classifications. The adjustments had no effect on gross revenues, gross expenses or net income. In the opinion of management, the information reflects all adjustments necessary for a fair statement of results for the periods ended March 31, 2007 and 2006.

The accounting policies of Susquehanna Bancshares, Inc. and Subsidiaries, as applied in the consolidated interim financial statements presented herein, are substantially the same as those followed on an annual basis as presented on pages 76 through 86 of the Annual Report on Form 10-K for the fiscal year ended December 31, 2006.

Recent Accounting Pronouncements.

In February 2007, the Financial Accounting Standards Board issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” Statement 159 provides companies with an option to report selected financial assets and liabilities at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. Statement 159 is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. Early adoption is permitted as of the beginning of the previous fiscal year provided that the entity makes that choice in the first 120 days of that fiscal year and also elects to apply the provisions of Statement 157. Susquehanna is evaluating the impact of Statement 159 on its results of operations and financial condition.

In September 2006, the Financial Accounting Standards Board issued Statement No. 157, “Fair Value Measurements.” Statement 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. While Statement 157 does not require any new fair value measurements, the application of this Statement will change current practice for some entities. Statement 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Earlier application is encouraged, provided that the entity has not yet issued financial statements for an interim period within that fiscal year. Susquehanna is evaluating the impact of Statement 157 on its results of operations and financial condition.

In July 2006, the Financial Accounting Standards Board issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Tax Positions.” This interpretation clarifies the application of FAS No. 109, “Accounting for Income Taxes,” by establishing a threshold condition that a tax position must meet for any part of the benefit of that position to be recognized in the financial statements. FASB Interpretation No. 48 also provides guidance concerning measurement, derecognition, classification, and disclosure of tax positions and is effective for fiscal years beginning after December 15, 2006. Adoption of this interpretation has not had a material impact on results of operations or financial condition. Disclosures required by this Statement are presented in Footnote 10.

In March 2006, the Financial Accounting Standards Board issued Statement No. 156, “Accounting for Servicing of Financial Assets.” Statement 156, which is an amendment to FAS No. 140, simplifies the accounting for servicing assets and liabilities, such as those common with mortgage securitization activities. The new Standard clarifies when an obligation to service financial assets should be separately recognized as a servicing asset or a servicing liability; requires that a separately recognized servicing asset or servicing liability be initially measured at fair value, if practicable; and permits an entity with a separately recognized servicing asset or servicing liability to choose either the Amortization Method or Fair Value Method for subsequent measurement. Statement No. 156 is effective for separately recognized servicing assets and liabilities acquired or issued after the beginning of an entity’s fiscal year that begins after September 15, 2006. Adoption of this statement has not had a material effect on results of operations or financial condition.


Table of Contents

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Amounts in thousands, except as noted and per share data)

In February 2006, the Financial Accounting Standards Board issued Statement No. 155, “Accounting for Certain Hybrid Instruments,” which is an amendment of Statements No. 133 and 140. Statement No. 155 allows financial instruments that have embedded derivatives to be accounted for as a whole (eliminating the need to bifurcate the derivative from its host) if the holder elects to account for the whole instrument on a fair value basis. The statement also clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement No. 133; establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends Statement No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. Statement No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. Adoption of this statement has not had a material effect on results of operations or financial condition with regard to the recently created interest-only strip.

NOTE 2. Acquisitions

Community Banks, Inc.

On May 1, 2007, Susquehanna announced the signing of a definitive merger agreement pursuant to which Susquehanna will acquire Community Banks, Inc. in a stock and cash transaction valued at approximately $860,000. Under the terms of the merger agreement, shareholders of Community will be entitled to elect to receive for each share of Community common stock that they own, either $34.00 in cash or 1.48 shares of Susquehanna common stock. It is anticipated that the transaction will be completed during the fourth quarter of 2007, pending regulatory approvals, the approval of the shareholders of both Community and Susquehanna, and the satisfaction of other closing conditions.

Widmann, Siff & Co., Inc.

On April 23, 2007, Susquehanna announced that it had entered into an agreement to acquire the outstanding stock of Widmann, Siff & Co., Inc., an investment advisory firm in Radnor, Pa. Widmann, Siff has more that $300,000 in assets under management, including accounts serving individuals, pension and profit-sharing plans, corporations, and family trusts. Under the agreement, the firm will become a subsidiary of Valley Forge Asset Management Corp. The acquisition is expected to be completed by the end of the second quarter, subject to regulatory approval and other closing conditions.

Minotola National Bank

On April 21, 2006, Susquehanna acquired Minotola National Bank in a stock and cash transaction valued at approximately $172,000. The acquisition of Minotola, with total assets of $607,000 and fourteen branch locations, has provided Susquehanna with an opportunity to expand its franchise into high-growth markets in southern New Jersey. The acquisition was accounted for under the purchase method, and all transactions since that date are included in Susquehanna’s consolidated financial statements.

As part of the Minotola acquisition, Susquehanna recorded a $5,514 addition to the allowance for loan and lease losses. Susquehanna evaluated Minotola’s loan portfolio at the time of acquisition and did not identify any impaired loans as defined in Statement of Position 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer” and FAS No. 114, “Accounting by Creditors for Impairment of a Loan.” Therefore, as required by FAS No. 141, “Business Combinations,” Susquehanna recorded Minotola’s loan portfolio at present value, determined at the then current interest rates, net of the allowance for loan and lease losses in accordance with management’s evaluation of FAS No. 5, “Accounting for Contingencies.”

The acquisition of Minotola was considered immaterial for purposes of the disclosures required by FAS No. 141, “Business Combinations.”


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Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Amounts in thousands, except as noted and per share data)

NOTE 3. Investment Securities

The amortized costs and fair values of securities were as follows:

 

     March 31, 2007    December 31, 2006
     Amortized cost    Fair value    Amortized cost    Fair value

Available-for-sale:

           

U.S. Treasury

   $ 499    $ 498    $ 0    $ 0

U.S. Government agencies

     463,245      462,428      512,192      509,872

State & municipal

     36,274      36,055      27,369      27,141

Mortgage-backed

     807,392      795,807      730,873      714,747

Other debt securities

     72,306      72,309      72,368      72,282

Equities

     68,733      68,765      73,393      73,378
                           
     1,448,449      1,435,862      1,416,195      1,397,420

Held-to-maturity:

           

State & municipal

     4,933      4,933      6,146      6,146
                           

Total investment securities

   $ 1,453,382    $ 1,440,795    $ 1,422,341    $ 1,403,566
                           

NOTE 4. Loans and Leases

Loans and leases, net of unearned income, were as follows:

 

     March 31,
2007
    December 31,
2006
 

Commercial, financial, and agricultural

   $ 1,028,770     $ 978,522  

Real estate - construction

     1,062,629       1,064,452  

Real estate secured - residential

     1,152,495       1,147,741  

Real estate secured - commercial

     1,553,882       1,577,534  

Consumer

     302,870       313,848  

Leases

     293,019       478,900  
                

Total loans and leases

   $ 5,393,665     $ 5,560,997  
                

Leases held for sale (included in “Leases,” above)

   $ 59,884     $ 226,637  

Home equity line of credit loans held for sale (included in “Real estate secured - residential,” above)

   $ 28,153     $ 17,473  

The net investment in direct financing leases was as follows:

    

Minimum lease payments receivable

   $ 291,533     $ 369,732  

Estimated residual value of leases

     45,822       172,477  

Unearned income under lease contracts

     (44,336 )     (63,309 )
                

Total leases

   $ 293,019     $ 478,900  
                

An analysis of impaired loans, as of March 31, 2007 and December 31, 2006, is as follows:

    

Impaired loans without a related reserve

   $ 10,077     $ 11,468  

Impaired loans with a reserve

     8,001       8,620  
                

Total impaired loans

   $ 18,078     $ 20,088  
                

Reserve for impaired loans

   $ 2,212     $ 1,877  
                

An analysis of impaired loans, for the three months ended March 31, 2007 and 2006, is as follows:

    
    

Three Months Ended

March 31,

 
     2007     2006  

Average balance of impaired loans

   $ 18,102     $ 3,692  

Interest income on impaired loans (cash-basis)

     2       35  


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Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Amounts in thousands, except as noted and per share data)

NOTE 5. Borrowings

Short-term borrowings were as follows:

 

     March 31,
2007
   December 31,
2006

Securities sold under repurchase agreements

   $ 256,279    $ 249,728

Federal funds purchased

     0      150,000

Treasury tax and loan notes

     20      2,236
             

Total short-term borrowings

   $ 256,299    $ 401,964
             

Long-term debt was as follows:

     

Subordinated notes due November, 2012

   $ 75,000    $ 75,000

Subordinated notes due May, 2014

     75,000      75,000

Other

     33      36

Junior subordinated notes callable 2007

     22,106      22,244

Junior subordinated notes callable 2011

     50,000      50,000
             

Total long-term debt

   $ 222,139    $ 222,280
             

NOTE 6. Earnings per Share

The following tables set forth the calculation of basic and diluted earnings per share for the three-month periods ended March 31, 2007 and 2006.

 

     For the three months ended March 31
     2007    2006
     Income    Shares    Per Share
Amount
   Income    Shares    Per Share
Amount

Basic Earnings per Share:

                 

Income available to common shareholders

   $ 20,727    52,097    $ 0.40    $ 17,701    46,874    $ 0.38

Effect of Diluted Securities:

                 

Stock options and restricted shares outstanding

      104          155   
                                     

Diluted Earnings per Share:

                 

Income available to common shareholders and assuming conversion

   $ 20,727    52,201    $ 0.40    $ 17,701    47,029    $ 0.38
                                     

For the three months ended March 31, 2007 and 2006, average options to purchase 1,342 and 1,033 shares, respectively, were outstanding but were not included in the computation of diluted EPS because the options’ common stock equivalents under FAS No. 123(R) were antidilutive.

NOTE 7. Share-Based Compensation

On February 28, 2007, Susquehanna’s Compensation Committee granted to directors and certain employees nonqualified stock options to purchase an aggregate of 589 shares of common stock with an exercise price of $24.26. In addition, the Committee awarded to certain employees 25 restricted shares with a grant-date fair value of $24.26.

The fair value of $4.08 for each of the 2007 options was estimated on the date of grant using the Black-Scholes-Merton model, with the assumptions noted in the following table:

 

     2007  

Volatility

   20.59 %

Expected dividend yield

   4.00 %

Expected term (in years)

   6.5  

Risk-free rate

   4.44 %


Table of Contents

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Amounts in thousands, except as noted and per share data)

NOTE 8. Pension and Other Postretirement Benefits

Components of Net Periodic Benefit Cost

 

     Three months ended March 31
     Pension Benefits     Supplemental Executive
Retirement Plan
   Other Postretirement Benefits
     2007     2006     2007    2006    2007    2006

Service cost

   $ 1,082     $ 917     $ 26    $ 16    $ 138    $ 96

Interest cost

     1,148       999       54      55      148      105

Expected return on plan assets

     (1,759 )     (1,468 )     0      0      0      0

Amortization of prior service cost

     7       (10 )     31      31      28      12

Amortization of transition obligation (asset)

     0       (17 )     0      0      28      28

Amortization of net actuarial (gain) or loss

     34       217       11      22      33      11
                                           

Net periodic benefit cost

   $ 512     $ 638     $ 122    $ 124    $ 375    $ 252
                                           

Employer Contributions

Susquehanna previously disclosed in its financial statements for the year ended December 31, 2006, that it expected to contribute $122 to its pension plan and $328 to its other postretirement benefit plan in 2007. As of March 31, 2007, $31 of contributions have been made to its pension plans, and $62 of contributions have been made to its other postretirement benefit plan. Susquehanna anticipates contributing an additional $91 to fund its pension plan in 2007 for a total of $122, and $266 to its other postretirement benefit plan for a total of $328.

NOTE 9. Derivative Financial Instruments and Hedging Activities

Beginning in February 2007, Susquehanna entered into amortizing interest rate swaps with an aggregate notional amount of $28,199. For purposes of Susquehanna’s consolidated financial statements, the entire notional amount of the swaps is designated as a cash flow hedge of expected future cash flows associated with a forecasted sale of auto leases. These transactions are subject to FAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” At March 31, 2007, the unrealized loss, net of taxes, recorded in other comprehensive income was insignificant.

Beginning in April 2006, Susquehanna entered into amortizing interest rate swaps with an aggregate notional amount of $266,866. For purposes of Susquehanna’s consolidated financial statements, the entire notional amount of the swaps was designated as a cash flow hedge of expected future cash flows associated with a forecasted sale of auto leases. These transactions were subject to FAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” On February 8, 2007, the swaps were terminated. On February 14, 2007, the forecasted sales of auto leases occurred, and the $202 loss reported in accumulated other comprehensive income at December 31, 2006, was reclassified to gain on sale of loans and leases.

In June 2005, Susquehanna entered into two $25,000 interest rate swaps to hedge the interest rate risk exposure on $50,000 of variable-rate debt. The risk management objective with respect to these interest rate swaps is to hedge the risk of changes in cash flow attributable to changes in the LIBOR swap rate. At March 31, 2007, the unrealized gain, net of taxes, recorded in other comprehensive income was $584.

The following table summarizes our derivative financial instruments at March 31, 2007:

 

Notional

Amount

   Fair
Value
  

Variable Rate

  

Fixed

Rate

$28,199    $ (41)    One-month LIBOR    4.651% to 4.895%
25,000      326    Three-month LIBOR    3.935%
25,000      573    Three-month LIBOR    4.083%
              
$78,199    $ 858      
              

NOTE 10. Uncertainty in Income Taxes

Susquehanna adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” on January 1, 2007. There was no impact on Susquehanna’s financial position or results of operations as a result of the implementation of Interpretation No. 48. At the time of adoption, Susquehanna had $1,421 of unrecognized tax benefits, of which $1,208, if recognized, would affect the effective tax rate. The company does not anticipate a significant change to the total amount of unrecognized tax benefits within the next twelve months.

Susquehanna recognizes interest and penalties related to unrecognized tax benefits in income tax expense. Susquehanna had approximately $183 for the payment of interest and penalties accrued at January 1, 2007.

Susquehanna and its subsidiaries file income tax returns in the U.S. federal jurisdiction and various state jurisdictions. With few exceptions, Susquehanna is no longer subject to U.S. federal, state, and local examinations by tax authorities for years before 2003. There is currently one state examination of Susquehanna’s tax returns in progress.


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Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Amounts in thousands, except as noted and per share data)

Note 11. Securitization Activity

Automobile Leases

2007 Transaction

In February 2007, Susquehanna securitized $300,414 of closed-end motor vehicle leases and recorded a pre-tax gain of $2,709 (which includes a loss recognized on the associated cash-flow hedge) in noninterest income. Retained interests in the securitization totaled $51,930 and included $7,774 in subordinated notes, $40,147 in equity certificates of the securitization trust, and a $4,009 interest-only strip. The initial carrying values of these retained interests were determined by allocating the carrying value among the assets sold and retained based on their relative fair values at the date of sale. The initial carrying value of the interest-only strip was estimated at the date of sale by discounting projected future cash flows. Susquehanna has retained the right to service the leases; however, no servicing asset or liability was recognized because expected servicing costs are approximately equal to expected servicing fee income, which approximates market value. Transaction costs associated with this securitization were included as a component of gain on sale. The subordinated notes retained in the transaction, which do not bear interest, have been rated by independent rating agencies. Their final maturity date is January 14, 2013.

2006 Transaction

In March 2006, Susquehanna securitized $356,140 of closed-end motor vehicle leases and recorded a pre-tax gain of $1,937 (which includes a gain recognized on the associated cash-flow hedge) in noninterest income. Retained interests in the securitization totaled $53,953 and included $10,482 in subordinated notes, $42,812 in equity certificates of the securitization trust, and a $659 interest-only strip. The initial carrying values of these retained interests were determined by allocating the carrying value among the assets sold and retained based on their relative fair values at the date of sale. The initial carrying value of the interest-only strip was estimated at the date of sale by discounting projected future cash flows. Susquehanna has retained the right to service the leases; however, no servicing asset or liability was recognized because expected servicing costs are approximately equal to expected servicing fee income, which approximates market value. Transaction costs associated with this securitization were included as a component of gain on sale. The subordinated notes retained in the transaction, which do not bear interest, have been rated by independent rating agencies. Their final maturity date is February 14, 2012.

Home Equity Loans

2006 Transaction

In September 2006, Susquehanna securitized $349,403 of fixed-rate home mortgage loans and variable-rate line of credit loans and recorded a pre-tax gain of $8,225 in noninterest income. Retained interests in the securitization totaled $21,244 and included $2,745 in subordinated notes, and $18,499 in interest-only strips. The initial carrying value of the interest-only strips was estimated at the date of sale by discounting projected future cash flows. Susquehanna has retained the right to service the loans and recorded a servicing asset of $2,334. Transaction costs associated with this securitization were included as a component of gain on sale. The subordinated notes retained in the transaction, which bear interest at one-month LIBOR plus .75%, were rated by independent rating agencies and have a final maturity date of August 2036.

In this securitization, approximately 70.5% of the variable-rate loans as of the cut-off date included a feature that permits the obligor to convert all or a portion of the loan from a variable interest rate to a fixed interest rate. If the total principal balance of the converted loans is greater than 10% of the total outstanding balance of the portfolio, Susquehanna is required to repurchase the converted loans in excess of the 10% threshold until the total principal balance of the loans repurchased by Susquehanna is equal to 10% of the original principal balance of the loans. Based upon Susquehanna’s experience with this product, Susquehanna has concluded that the event requiring the repurchase of converted loans would be remote. The maximum dollar amount of this repurchase obligation at the cut-off date was $11,140, and its related fair value was considered to be de minimis.

Key economic assumptions used in measuring certain retained interests at the date of securitization were as follows:

 

     Gain
Recognized
   Weighted-
average Life
(in months)
   Prepayment
Speed
    Expected Credit
Losses
   Annual
Discount
Rate
   Annual
Coupon Rate to
Investors

Automobile Leases

                

2007 transaction

   $ 2,709    19    2.00%-4.00%     0.05%    5.18%    5.25%-5.61%

2006 transaction

     1,937    22    2.00%-4.00%     0.05%    5.28%    4.99%-5.58%

Home Equity Loans

                

2006 transaction

   $ 8,225              

Fixed-rate portion

      56    10.00 *   0.10%    6.60%    30-day LIBOR+
0.17% - 1.25%

Variable-rate portion

      20    45.00 *   0.06    6.60    30-day LIBOR+
0.15%

*Constant Prepayment Rate

                


Table of Contents

Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Amounts in thousands, except as noted and per share data)

The following table presents quantitative information about delinquencies, net credit losses, and components of loan and lease sales serviced by Susquehanna, including securitization transactions.

 

               Loans and Leases Past Due    For the Three Months
Ended March 31
 
     Principal Balance    30 Days or More    Net Credit Losses (Recoveries)  
     March 31, 2007    December 31, 2006    March 31, 2007    December 31, 2006    2007     2006  

Loans and leases held in portfolio

   $ 5,393,665    $ 5,560,997    $ 91,416    $ 98,242    $ 2,854     $ 2,390  

Leases securitized

     827,852      618,902      1,115      1,023      156       73  

Home equity loans securitized

     426,863      463,266      1,912      2,620      26       6  

Leases serviced for others (1)

     105,636      210,386      936      1,054      (9 )     (17 )
                                            

Total loans and leases serviced

   $ 6,754,016    $ 6,853,551    $ 95,379    $ 102,939    $ 3,027     $ 2,452  
                                            

(1) Amounts at March 31, 2007 include agency arrangements. Amounts at December 31, 2006 include the sale/leaseback transaction and agency arrangements.

Certain cash flows received from or conveyed to the structured entities associated with the securitizations are as follows:

 

Automobile Leases

   Three Months Ended March 31
     2007    2006

Proceeds from securitizations

   $ 252,493    $ 302,887

Amounts derecognized

     300,414      356,140

Servicing fees received

     2,164      1,741

Other cash flows received from retained interests

     2,990      5,061

Home Equity Loans

   Three Months Ended March 31
     2007    2006

Additional draws conveyed to the trusts

   $ 15,937    $ 13,437

Servicing fees received

     462      271

There were no proceeds from securitizations, amounts derecognized, or cash flows received from retained interests for the three-month periods ended March 31, 2007, and March 31, 2006, relating to home equity loans.

The following table sets forth a summary of the fair values of the interest-only strips, key economic assumptions used to arrive at the fair values, and the sensitivity of the March 31, 2007 fair values to immediate 10% and 20% adverse changes in those assumptions. The sensitivities are hypothetical and should be used with caution. Changes in fair value based on a 10% variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, the effect of a variation in a particular assumption on the fair value of the retained interest is calculated without changing any other assumption; in reality, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower prepayments and increased credit losses), which might magnify or counteract the sensitivities.

Susquehanna’s analysis of the information presented below indicates that any adverse change of 20% in the key economic assumptions would not have a significant effect on the fair value of the Company’s interest-only strips.

As of March 31, 2007

 

Automobile Leases

   Fair Value    Weighted-
average Life
(in months)
   Monthly
Prepayment
Speed
    Expected
Cumulative
Credit
Losses
    Annual
Discount
Rate (1)
 

2007 transaction - Interest-Only Strip

   $ 3,875    19      3.19 %     0.05 %     5.18 %

Decline in fair value of 10% adverse change

         $ 20     $ 21     $ 25  

Decline in fair value of 20% adverse change

           42       42       49  

2006 transaction - Interest-Only Strip

   $ 1,558    10      4.00 %     0.05 %     5.22 %

Decline in fair value of 10% adverse change

         $ 15     $ 12     $ 7  

Decline in fair value of 20% adverse change

           22       25       14  

2005 transaction - Interest-Only Strip

   $ 1,373    7      3.00 %     0.05 %     4.19 %

Decline in fair value of 10% adverse change

         $ 46     $ 3     $ 5  

Decline in fair value of 20% adverse change

           37       7       9  

2004 revolving transaction - Interest-Only Strip

   $ 193    12      3.00 %     0.00 %     5.22 %

Decline in fair value of 10% adverse change

         $ 0     $ 0     $ 1  

Decline in fair value of 20% adverse change

           1       0       2  


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Susquehanna Bancshares, Inc. and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Amounts in thousands, except as noted and per share data)

 

Home Equity Loans

   Fair Value    Weighted-
average Life
(in months)
   Constant
Prepayment
Rate
   Expected
Cumulative
Credit
Losses
    Annual
Discount
Rate (2)
 

2006 transaction - Interest-Only Strips

             

Fixed-rate portion

   $ 11,812    44      10.00      0.04 %     6.60 %

Decline in fair value of 10% adverse change

         $ 311    $ 33     $ 280  

Decline in fair value of 20% adverse change

           608      65       545  

Variable-rate portion

   $ 3,732    21      45.00      0.06 %     6.60 %

Decline in fair value of 10% adverse change

         $ 300    $ 9     $ 64  

Decline in fair value of 20% adverse change

           560      18       126  

2005 transaction - Interest-Only Strips

   $ 8,027    20      45.00      0.06 %     6.50 %

Decline in fair value of 10% adverse change

         $ 485    $ 13     $ 137  

Decline in fair value of 20% adverse change

           908      26       269  

(1) The annual discount rate used is derived from the interpolated swap rate based on the Treasury curve as of the settlement date.
(2) The annual discount rate is based upon a cost estimate for issuing Tier 1 Capital.


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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Management’s discussion and analysis of the significant changes in the consolidated results of operations, financial condition, and cash flows of Susquehanna Bancshares, Inc. and its subsidiaries is set forth below for the periods indicated. 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 and 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 Liquidation Center, Inc. (“Auto Lenders”) on residual loss exposure; the unlikelihood that more than 10% of the home equity line of credit loans in securitization transactions will convert from variable interest rates to fixed interest rates; expectations regarding the future performance of Hann; and our ability to achieve our 2007 financial goals. 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.


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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.

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, Susquehanna Patriot Bank and subsidiaries, (“Susquehanna Patriot”), Susquehanna Bank and subsidiaries, Valley Forge Asset Management Corp. and subsidiaries (“VFAM”), and The Addis Group, LLC (“Addis”).

Availability of Information

Our web-site address is www.susquehanna.net. 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 Quarterly Report on Form 10-Q as an inactive textual reference only.

Subsequent Events

Acquisitions

Community Banks, Inc.

On May 1, 2007, we announced the signing of a definitive merger agreement pursuant to which we will acquire Community Banks, Inc. in a stock and cash transaction valued at approximately $860.0 million. Under the terms of the merger agreement, shareholders of Community will be entitled to elect to receive for each share of Community common stock that they own, either $34.00 in cash or 1.48 shares of Susquehanna common stock. It is anticipated that the transaction will be completed during the fourth quarter of 2007, pending regulatory approvals, the approval of the shareholders of both Community and Susquehanna, and the satisfaction of other closing conditions.

Widmann, Siff & Co., Inc.

On April 23, 2007, we announced that we had entered into an agreement to acquire the outstanding stock of Widmann, Siff & Co., Inc., an investment advisory firm in Radnor, Pa. Widmann, Siff has more than $300.0 million in assets under management, including accounts serving individuals, pension and profit-sharing plans, corporations, and family trusts. Under the agreement, the firm will become a subsidiary of Valley Forge Asset Management Corp. The acquisition is expected to be completed by the end of the second quarter, subject to regulatory approval and other closing conditions.


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Executive Commentary

Sub-Prime Mortgage Lending

We have noted that there has been significant turmoil in the sub-prime mortgage market. Susquehanna Mortgage Corporation, a subsidiary of Susquehanna Bank, has originated only a small volume of sub-prime mortgages for sale in the secondary market. Each loan sold was processed in strict conformance with investor guidelines and underwritten by the purchasing investor. Our contract was structured as “no recourse,” thus avoiding buy-back requests for underwriting conformity or loan performance. Accordingly, we believe, based on our contract structure, that our sub-prime exposure is immaterial. Going forward, we will not be originating sub-prime mortgages for sale in the secondary market. We will, however, continue to offer expanded-criteria loans with “no recourse” through our normal secondary market channels.

Updated Financial Goals for 2007

As a result of better than expected financial results at Hann for the first quarter of 2007, positive results during the first quarter of 2007 relating to our efforts to grow our deposit base, and continued consumer sensitivity to interest rates that has impacted our deposit mix, we are updating our previously published financial goals for 2007 as follows:

 

     Previously
Published
Goal
    Updated
Goal
 

Net interest margin

   3.75 %   3.67 %

Loan growth (adjusted for securitizations)

   10.0 %   10.0 %

Deposit growth

   7.0 %   8.0 %

Noninterest income growth

   3.0 %   3.0 %

Noninterest expense growth

   3.0 %   2.0 %

Tax rate

   32.0 %   32.0 %

These financial goals include $7.7 million of securitization gains. The timing and amount of gain associated with these events is difficult to predict; consequently, quarterly earnings will fluctuate.

Acquisitions

Minotola National Bank

On April 21, 2006, we acquired Minotola National Bank in a stock and cash transaction valued at approximately $172 million. The acquisition of Minotola, with total assets of $607 million and fourteen branch locations, significantly enhances our presence in the high-growth markets in southern New Jersey. The acquisition was accounted for under the purchase method, and all transactions since that date are included in our consolidated financial statements.

The acquisition of Minotola was considered immaterial for purposes of the disclosures required by FAS No. 141, “Business Combinations.”

Results of Operations

Summary of 2007 Compared to 2006

Net income for the first quarter of 2007 was $20.7 million, an increase of $3.0 million, or 17.1%, over net income of $17.7 million for the first quarter of 2006. Net interest income increased 5.5%, to $63.0 million for the first quarter of 2007, from $59.7 million for the first quarter of 2006. Noninterest income increased 14.8%, to $34.3 million for the first quarter of 2007, from $29.9 million for the first quarter of 2006. Noninterest expenses increased 6.4%, to $64.8 million for the first quarter of 2007, from $61.0 million for the first quarter of 2006.


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Additional information is as follows:

 

     Three Months Ended
March 31,
 
     2007     2006  

Diluted Earnings per Share

   $ 0.40     $ 0.38  

Return on Average Assets

     1.03 %     0.96 %

Return on Average Equity

     8.95 %     9.19 %

Return on Average Tangible Equity (1)

     14.71 %     13.83 %

Efficiency Ratio

     66.11 %     67.67 %

Efficiency Ratio excluding Hann (1)

     63.66 %     61.88 %

Net Interest Margin

     3.67 %     3.76 %

(1) Supplemental Reporting of Non-GAAP-based Financial Measures

Return on average tangible equity is a non-GAAP-based financial measure calculated using non-GAAP amounts. The most directly comparable GAAP-based measure is return on average equity. We calculate return on average tangible equity by excluding the balance of intangible assets and their related amortization expense from our calculation of return on average equity. Management uses the return on average tangible equity in order to review our core operating results. Management believes that this is a better measure of our performance. In addition, 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 equity to return on average tangible equity is set forth below.

 

     Three Months Ended
March 31,
 
     2007     2006  

Return on average equity (GAAP basis)

   8.95 %   9.19 %

Effect of excluding average intangible assets and related amortization

   5.76 %   4.64 %

Return on average tangible equity

   14.71 %   13.83 %

Efficiency ratio excluding Hann is a non-GAAP-based financial measure calculated using non-GAAP amounts. The most directly comparable GAAP-based measure is 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 measure because it excludes the volatility of vehicle residual values and vehicle delivery and preparation expense of Hann and provides better visibility into our core business activities. A reconciliation of efficiency ratio to efficiency ratio excluding Hann is set forth below.

 

     Three Months Ended
March 31,
 
     2007     2006  

Efficiency ratio (GAAP basis)

   66.11 %   67.67 %

Effect of excluding Hann

   2.45 %   5.79 %

Efficiency ratio excluding Hann

   63.66 %   61.88 %


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Susquehanna Bancshares, Inc. and Subsidiaries

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

(dollars in thousands)

Interest rates and interest differential—taxable equivalent basis

 

     For the Three-Month Period Ended
March 31, 2007
   For the Three-Month Period Ended
March 31, 2006
     Average
Balance
    Interest    Rate (%)    Average
Balance
    Interest    Rate (%)

Assets

               

Short-term investments

   $ 82,594     $ 1,124    5.52    $ 72,452     $ 738    4.13

Investment securities:

               

Taxable

     1,428,770       16,571    4.70      1,174,068       11,685    4.04

Tax-advantaged

     37,780       596    6.40      17,744       269    6.15
                                   

Total investment securities

     1,466,550       17,167    4.75      1,191,812       11,954    4.07
                                   

Loans and leases, (net):

               

Taxable

     5,412,903       101,406    7.60      5,168,004       90,616    7.11

Tax-advantaged

     85,133       1,598    7.61      69,022       1,151    6.76
                                   

Total loans and leases

     5,498,036       103,004    7.60      5,237,026       91,767    7.11
                                   

Total interest-earning assets

     7,047,180     $ 121,295    6.98      6,501,290     $ 104,459    6.52
                       

Allowance for loan and lease losses

     (62,691 )           (54,388 )     

Other non-earning assets

     1,209,677             996,407       
                           

Total assets

   $ 8,194,166           $ 7,443,309       
                           

Liabilities

               

Deposits:

               

Interest-bearing demand

   $ 2,076,371     $ 16,398    3.20    $ 1,745,682     $ 10,617    2.47

Savings

     472,418       1,113    0.96      450,149       622    0.56

Time

     2,460,477       27,739    4.57      2,209,693       20,341    3.73

Short-term borrowings

     340,827       3,782    4.50      307,122       2,718    3.59

FHLB borrowings

     542,568       5,170    3.86      692,962       7,453    4.36

Long-term debt

     222,229       3,277    5.98      172,732       2,474    5.81
                                   

Total interest-bearing liabilities

     6,114,890     $ 57,479    3.81      5,578,340     $ 44,225    3.22
                       

Demand deposits

     906,701             869,721       

Other liabilities

     233,642             214,100       
                           

Total liabilities

     7,255,233             6,662,161       

Equity

     938,933             781,148       
                           

Total liabilities and shareholders’ equity

   $ 8,194,166           $ 7,443,309       
                           

Net interest income / yield on average earning assets

     $ 63,816    3.67      $ 60,234    3.76
                       

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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Net Interest Income — Taxable Equivalent Basis

Our major source of operating revenues is net interest income, which increased to $63.0 million for the first quarter of 2007, as compared to $59.7 million for the same period in 2006. Net interest income as a percentage of net interest income plus noninterest income was 64.8% for the quarter ended March 31, 2007, and 66.7% for the quarter ended March 31, 2006.

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.

The $3.3 million increase in our net interest income for the first quarter of 2007, as compared to the first quarter of 2006, was primarily the result of the net contribution from interest-earning assets and interest-bearing liabilities acquired from Minotola National Bank on April 21, 2006. Our net interest margin, however, declined from 3.76% for the first quarter of 2006, to 3.67% for the first quarter of 2007. This decrease in net interest margin was primarily due to a 59 basis point increase in rates paid on average interest-bearing liabilities, as businesses and consumers have become more rate-driven on the deposit side in the higher interest-rate environment. The 59 basis point increase was partially offset by a 46 basis point increase in yields on average interest-earning assets.

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 Item 3, “Quantitative and Qualitative Disclosures About Market Risk.”

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.

As illustrated in Table 2, the provision for loan and lease losses was $2.0 million for the first quarter of 2007, and $2.7 million for the first quarter of 2006. Among other factors, this $0.7 million decrease in the provision was due to the reduction in the loan and lease portfolio resulting in lower loan and leases balances at March 31, 2007.

The allowance for loan and lease losses was 1.15% of period-end loans and leases, or $61.8 million at March 31, 2007; 1.13% of period-end loans and leases, or $62.6 million, at December 31, 2006; and 1.07% of period-end loans and leases, or $54.0 million, at March 31, 2006.

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 March 31, 2007. 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 March 31, 2007.


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Susquehanna Bancshares, Inc. and Subsidiaries

(dollars in thousands)

TABLE 2 - Allowance for Loan and Lease Losses

 

           Three Months Ended
March 31,
 
           2007     2006  

Balance - Beginning of period

     $ 62,643     $ 53,714  

Additions charged to operating expenses

       2,000       2,675  
                  
       64,643       56,389  
                  

Charge-offs

       (3,604 )     (3,525 )

Recoveries

       750       1,135  
                  

Net charge-offs

       (2,854 )     (2,390 )
                  

Balance - Period end

     $ 61,789     $ 53,999  
                  

Net charge-offs as a percent of average loans and leases (annualized)

       0.21 %     0.19 %

Allowance as a percent of period-end loans and leases

       1.15 %     1.07 %

Average loans and leases

     $ 5,498,036     $ 5,237,026  

Period-end loans and leases

       5,393,665       5,042,755  

TABLE 3 - Risk Assets

      
     March 31,
2007
    December 31,
2006
    March 31,
2006
 

Nonperforming assets:

      

Nonaccrual loans and leases

   $ 29,372     $ 30,325     $ 16,355  

Restructured loans

     2,117       5,376       2,393  

Other real estate owned

     3,962       1,544       2,596  
                        

Total nonperforming assets

   $ 35,451     $ 37,245     $ 21,344  
                        

As a percent of period-end loans and leases plus other real estate owned

     0.66 %     0.67 %     0.42 %

Coverage ratio

     196.22 %     175.47 %     288.03 %

Loans and leases contractually past due 90 days and still accruing

   $ 6,877     $ 9,364     $ 6,100  


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Noninterest Income

First Quarter 2007 Compared to First Quarter 2006

Noninterest income, as a percentage of net interest income plus noninterest income, was 35.2% for the first quarter of 2007, and 33.3% for the first quarter of 2006.

Noninterest income increased $4.4 million, or 14.8%, for the first quarter of 2007, over the first quarter of 2006. This net increase was composed primarily of the following:

 

   

Increased service charges on deposit accounts of $1.4 million;

 

   

Increased gains on the sales of loans and leases of $0.8 million; and

 

   

Increased other income of $1.9 million.

Service charges on deposit accounts. The 28.1% increase was the result of improvements initiated in the second quarter of 2006 relating to the processing of customer overdrafts and the inclusion of Minotola operations for the first quarter of 2007.

Gains on sales of loans and leases. The increase primarily was due to a larger gain being recognized in the 2007 lease securitization transaction than in the 2006 lease securitization transaction as a result of increased spreads between the yield on the leases securitized and the rates paid to investors in the 2007 transaction.

Other income. The 52.4% increase was primarily the result of the inclusion of Minotola operations for the first quarter of 2007, most notably the merchant services division which contributed $0.5 million to other income. Furthermore, approximately $0.8 million can be attributed to increased net servicing fees related to our two home-equity-loan securitizations.

Noninterest Expenses

First Quarter 2007 Compared to First Quarter 2006

Noninterest expenses increased $3.8 million, or 6.4%, from $61.0 million for the first quarter of 2006, to $64.8 million for the first quarter of 2007. This net increase was composed primarily of the following:

 

   

Increased salaries and employee benefits of $4.3 million;

 

   

Increased occupancy expense of $0.9 million; and

 

   

Decreased other expenses of $1.7 million.

Salaries and employee benefits. The largest component of noninterest expense is salaries and employee benefits, which increased 14.4% for the first quarter of 2007, as compared to the first quarter of 2006. This increase was primarily the result of the inclusion of Minotola operations for the first quarter of 2007, normal annual salary increases, and higher benefit costs.

In addition, compensation expense relating to grants of options and restricted stock was $1.0 million for the first quarter of 2007, and $0.1 million for the first quarter of 2006. This increase is mainly due to an increase in the number of grants in 2007. Stock option grants for 2007 totaled 0.6 million, and for 2006 stock option grants totaled 0.3 million. Also, share-based compensation expense of $0.3 million relating to grants in 2006 to retirement eligible individuals was not recorded until the second quarter of 2006. For the first quarter of 2007, the $1.0 million in share-based compensation expense includes $0.8 million relating to grants in 2007 to retirement eligible individuals.


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Occupancy. The 17.9% increase primarily was the result of the inclusion of Minotola operations for the first quarter of 2007.

Other expense. The 9.5% decrease primarily was due to the elimination of monthly rental expense as a result of a termination of the sale-leaseback transaction on January 12, 2007, which is described below under the heading “Financial Condition – Loans and Leases.”

Income Taxes

Our effective tax rate for the first quarter of 2007 was 32.0%. Our effective tax rate for the first quarter of 2006 was 31.8%.

Financial Condition

Summary of March 31, 2007 Compared to December 31, 2006

Total assets at March 31, 2007 were $8.2 billion, a slight decrease of 0.8%, as compared to total assets at December 31, 2006. Loans and leases decreased to $5.4 billion at March 31, 2007, from $5.6 billion at December 31, 2006. Total deposits increased to $6.0 billion at March 31, 2007, from $5.9 billion at December 31, 2006. Equity capital was $950.7 million at March 31, 2007, or $18.23 per share, compared to $936.3 million, or $17.98 per share, at December 31, 2006.

Loans and Leases

On January 12, 2007, we exercised an early buyout option associated with Hann’s sale-leaseback transaction. As a result, Hann acquired approximately $78.4 million of beneficial interests in automobile leases and related vehicles. A significant portion of these automobile leases and related vehicles were sold to our banking subsidiaries and subsequently included in the February 2007 vehicle lease securitization transaction.

Risk Assets

Table 3 shows a decrease in non-accrual loans and leases, from $30.3 million at December 31, 2006, to $29.4 million at March 31, 2007. Restructured loans decreased from $5.4 million at December 31, 2006, to $2.1 million at March 31, 2007. As a result, the percentage of loan and lease loss reserves to non-performing loans and leases (coverage ratio) increased from 175% at December 31, 2006, to 196% at March 31, 2007. Loans and leases past due 90-days and still accruing also decreased, from $9.4 million at December 31, 2006, to $6.9 million at March 31, 2007.

The decrease in non-accrual and past-due-90-days loans and leases reflects a net change in the loan and lease portfolio that occurred during the normal course of business. Also, during the first quarter of 2007, a loan included in restructured debt at December 31, 2006, was reclassified to performing status since it was current and expected to perform in accordance with the modified terms.

Investment in and Receivables from Unconsolidated Entities

Concurrent with the lease securitization transaction in February 2007, our banking subsidiaries recorded investments in and receivables from unconsolidated entities of $47.9 million, representing notes and equity certificates of the issuer.

Deposits

While total deposits increased 2.5%, from $5.9 billion at December 31, 2006, to $6.0 billion at March 31, 2007, noninterest-bearing deposits decreased 5.7%, from $959.7 million at December 31, 2006, to $905.4 million at March 31, 2007. Interest-bearing demand deposits increased by 7.3%, from $2.0 billion at December 31, 2006, to $2.2 billion at March 31, 2007. If this trend continues in 2007, we anticipate that our net interest margin will be negatively impacted in future quarters.


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Borrowings

Federal funds purchased decreased $145.7 million, from December 31, 2006 to March 31, 2007, and FHLB borrowings decreased $76.7 million for the same time period. These decreases are the result of our using some of the proceeds from the February 2007 securitization transaction to pay down debt.

Capital Adequacy

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 and the allowance for credit losses on off-balance-sheet credit exposures 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 minimum Tier 1 capital ratio is 4%; our ratio at March 31, 2007, was 9.53%. The minimum total capital (Tiers 1and 2) ratio is 8%; our ratio at March 31, 2007, was 12.50%. The minimum leverage ratio is 4%; our leverage ratio at March 31, 2007, was 8.67%. 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.

Securitizations and Off-Balance-Sheet Financings

The following table summarizes the components of loans and leases serviced:

 

     As of March 31, 2007    As of March 31, 2006
     (dollars in thousands)

Lease Securitization Transactions*

   $ 827,852    $ 867,626

Home Equity Loan Securitization Transactions*

     426,863      203,265

Agency Arrangements and Lease Sales*

     105,636      391,926

Sale-Leaseback Transaction*

     0      90,307

Leases and Loans Held in Portfolio

     5,393,665      5,042,755
             

Total Leases and Loans Serviced

   $ 6,754,016    $ 6,595,879
             

* Off-balance-sheet

Securitization Transactions

We use the securitization of financial assets as a source of funding and a means to manage capital. Hann and the banking subsidiaries sell beneficial interests in automobile leases and related vehicles and home equity loans to qualified special purpose entities (each a “QSPE”). These transactions are accounted for as sales under the guidelines of FAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (a replacement of FASB Statement No. 125),” and a net gain or loss is recognized at the time of the initial sale.

For additional information concerning the accounting policies for initially measuring interest-only strips, the characteristics of securitization transactions, including the gain or loss from sale, the key assumptions used in measuring the fair value of the interest-only strips, and descriptions of prior years’ securitization transactions, see the following sections of our Annual Report on Form 10-K for the year ended December 31, 2006:

 

   

“Securitizations and Off-Balance-Sheet Financings” on pages 52 through 59;


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“Note 1. Summary of Significant Accounting Policies” under the captions Asset Securitizations and Servicing Fees under Securitization Transactions, the Sale-Leaseback Transaction, Agency Agreements and Lease Sales on pages 79 and 80; and

 

   

“Note 20. Securitization Activity” on pages 108 through 113.

Also see “Note 11. Securitization Activity” to the financial statements appearing in Part I, Item 1 of this Quarterly Report on Form 10-Q.

Summary of the 2007 Securitization Transaction

In February 2007, each of our wholly owned commercial and retail banking subsidiaries (each, a “Sponsor Subsidiary”) entered into a term securitization transaction (the “2007 transaction”). In connection with the 2007 transaction, each Sponsor Subsidiary sold and contributed the beneficial interest in a portfolio of automobile leases and related vehicles to a separate wholly owned QSPE (each QSPE, a “Transferor” and collectively, the “Transferors”). Collectively, the Sponsor Subsidiaries sold and contributed the beneficial interest in $300.4 million in automobile leases and the related vehicles to the Transferors. However, the transaction documents for the 2007 transaction provide, among other things, that any assets that failed to meet the eligibility requirements when transferred by the applicable Sponsor Subsidiary must be repurchased by such Sponsor Subsidiary. Each Transferor sold and contributed the portfolio acquired from the related Sponsor Subsidiary to a newly formed statutory trust (the “Issuer”). The equity interests of the Issuer are owned pro rata by the Transferors (based on the value of the portfolio conveyed by each Transferor to the Issuer). The Transferors financed the purchases of the beneficial interests from the Sponsor Subsidiaries primarily through the issuance by the Issuer of $260.3 million of fixed-rate asset-backed notes to third-party investors. The Issuer also issued an additional $7.8 million of notes, which have been retained pro rata by the Transferors in the same ratio as the Transferors retain the equity interests of the Issuer.

The gain recognized in this transaction was $2.7 million. The initial interest-only strip recognized in this transaction was $4.0 million.

Sale-Leaseback Transaction

In December 2000, Hann sold and contributed the beneficial interest in $190 million of automobiles and related auto leases owned by the Origination Trust to a wholly owned special purpose subsidiary (the “Lessee”). The Lessee sold such beneficial interests to a lessor (the “Lessor”), and the Lessor in turn leased the beneficial interests in the automobiles and auto leases back to the Lessee under a Master Lease Agreement that had an eight-year term. For accounting purposes, the sale-leaseback transaction between the Lessee and the Lessor was treated as a sale and an operating lease and qualified as a sale and leaseback under FAS No. 13.

During the third quarter of 2006, we notified the Lessor of our intention to exercise the early buyout option, and the transaction was terminated January 12, 2007. The early buyout option price was $93.7 million and was comprised of $78.4 million of beneficial interests in automobile leases and related vehicles and payment of $15.3 million in cash, which had been recognized in other operating expense in prior years. A significant portion of the automobile leases and related vehicles that Hann acquired in conjunction with the early buyout option were sold to our banking subsidiaries and included in the vehicle lease securitization transaction that closed February 14, 2007.

 

Item 3. Quantitative a nd Qualitative Disclosures About Market Risk.

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.


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Due to the nature of our operations, foreign currency and commodity price risk are not significant to us. However, in addition to general banking risks, we have other risks that are related to vehicle leasing, asset securitizations, and off-balance sheet financing that are also discussed above.

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 March 31, 2007, our bank subsidiaries had approximately $736.2 million available to them under collateralized lines of credit with various FHLBs; and approximately $503.9 million more would have been 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 totaled $112.1 million at March 31, 2007 and represented additional sources of liquidity.

As an additional source of liquidity, we periodically enter into securitization transactions in which we sell the beneficial interests in loans and leases to qualified special purpose entities (QSPEs). In February 2007, we entered into a term securitization transaction of leases and related vehicles. The purchase of these assets by the QSPEs was financed through the issuance of asset-backed notes to third-party investors. Net proceeds from this transaction totaled $252.5 million.

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 policy, as approved by our Board of Directors, is designed so that we experience no more than a 15% decline in net interest income and no more than a 30% decline in the economic value of equity for a 300 basis point shock (immediate change) in interest rates. The assumptions used for the interest rate shock analysis are reviewed and updated at least quarterly. Based upon the most recent interest rate shock analysis, we were within the Board’s approved guidelines at a down 300 basis point shock and an up 300 basis point shock.

Derivative Financial Instruments and Hedging Activities

Beginning in April 2006, we entered into amortizing interest rate swaps with an aggregate total of $266.9 million. For purposes of our consolidated financial statements, the entire notional amount of the swaps was


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designated as a cash flow hedge of expected future cash flows associated with a forecasted sale of auto leases. This transaction is subject to FAS No. 133 (as amended), “Accounting for Derivative Instruments and Hedging Activities.” On February 8, 2007, the swaps were terminated. On February 14, 2007, the forecasted sale of auto leases occurred, and the $0.2 million loss reported in other comprehensive income at December 31, 2006, was reclassified to gain on sale of loans and leases.

In June 2005, we entered into two $25.0 million interest rate swaps to hedge the interest rate risk exposure on $50.0 million of variable-rate debt. The risk management objective with respect to these interest rate swaps is to hedge the risk of changes in our cash flow attributable to changes in the LIBOR swap rate. At March 31, 2007, the unrealized gain, net of taxes, recorded in other comprehensive income totaled $0.6 million.

Beginning in February 2007, we entered into amortizing interest rate swaps with an aggregate notional amount of $28.2 million. For purposes of our consolidated financial statements, the entire notional amount of the swaps is designated as a cash flow hedge of expected future cash flows associated with a forecasted sale of auto leases. These transactions are subject to FAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” At March 31, 2007, the unrealized loss, net of taxes, recorded in other comprehensive income was insignificant.

The following table summarizes our derivative financial instruments as of March 31, 2007:

 

Notional Amount    Fair Value    

Variable Rate

   Fixed Rate
     (dollars in thousands)     
$ 28,199    $ (41 )   One-month LIBOR    4.651% to 4.895%
  25,000      326     Three-month LIBOR    3.935%
  25,000      573     Three-month LIBOR    4.083%
                 
$ 78,199    $ 858       
                 

Vehicle Leasing Residual Value Risk

In an effort to manage the vehicle residual value risk arising from the auto leasing business of Hann and our affiliate banks, Hann and the banks have entered into arrangements with Auto Lenders pursuant to which Hann or a bank, as applicable, effectively transferred to Auto Lenders all residual value risk of its respective auto lease portfolio, and all residual value risk on any new leases originated over the term of the applicable agreement. Auto Lenders, which was formed in 1990, is a used-vehicle remarketer with four retail locations in New Jersey and has access to various wholesale facilities throughout the country. Under these arrangements, Auto Lenders agrees to purchase the beneficial interest in all vehicles returned by the obligors at the scheduled expiration of the related leases for a purchase price equal to the stated residual value of such vehicles. Stated residual values of new leases are set in accordance with the standards approved in advance by Auto Lenders. Under a servicing agreement with Auto Lenders, Hann also agrees to make monthly guaranty payments to Auto Lenders based upon a negotiated schedule covering a three-year period. At the end of each year, the servicing agreement may be renewed by the mutual agreement of the parties for an additional one-year term, beyond the current three-year term, subject to renegotiation of the payments for the additional year. During the renewal process, we periodically obtain competitive quotes from third parties to determine the best remarketing and/or residual guarantee alternatives for Hann and our bank affiliates.

 

Item 4. Controls a nd Procedures.

 

(a) Evaluation of Disclosure Controls and Procedures

Susquehanna’s management, with the participation of Susquehanna’s Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of Susquehanna’s disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer


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concluded that our disclosure controls and procedures as of the end of the period covered by this report have been designed and are functioning effectively to provide reasonable assurance that the information required to be disclosed by us in reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Susquehanna believes that a control system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the control system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.

 

(b) Change in Internal Control Over Financial Reporting

No change in Susquehanna’s internal control over financial reporting occurred during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, Susquehanna’s internal control over financial reporting.

P ART II—OTHER INFORMATION

 

Item 1. 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 1A. Risk Factors.

There have been no material changes in our risk factors from those disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

None

 

Item 3. Defaults Upon Senior Securities

None

 

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

None

 

Item 5. Other Information.

None

 

Item 6. Exhibits.

The Exhibits filed as part of this report are as follows:

 

10.1    Second Amendment to Employment Agreement, dated February 26, 2007, by and among Susquehanna Bancshares, Inc., Valley Forge Asset Management Corp. and Bernard A. Francis, Jr. is attached hereto as Exhibit 10.1.
31.1    Rule 13a-14(a)/15d-14(a) Certification by Chief Executive Officer
31.2    Rule 13a-14(a)/15d-14(a) Certification by Chief Financial Officer
32    Section 1350 Certifications


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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

    SUSQUEHANNA BANCSHARES, INC.    
May 9, 2007  

/s/ William J. Reuter

 
  William J. Reuter  
  Chairman, President and Chief Executive Officer  
May 9, 2007  

/s/ Drew K. Hostetter

 
  Drew K. Hostetter  
  Executive Vice President, Treasurer, and Chief Financial Officer  


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EXHIBIT INDEX

 

Exhibit
Numbers
 

Description and Method of Filing

10.1   Second Amendment to Employment Agreement, dated February 26, 2007, by and among Susquehanna Bancshares, Inc., Valley Forge Asset Management Corp. and Bernard A. Francis, Jr. is attached hereto as Exhibit 10.1.
31.1   Rule 13a-14(a)/15d-14(a) Certification by Chief Executive Officer
31.2   Rule 13a-14(a)/15d-14(a) Certification by Chief Financial Officer
32   Section 1350 Certifications