10-Q 1 berkshire10q11-04.txt 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 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 September 30, 2004 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________________ to _________________ Commission File Number 1-15781 BERKSHIRE HILLS BANCORP, INC. -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Delaware 04-3510455 -------------------------------------------------------------------------------- (State or other jurisdiction of incorporation (I.R.S. Employer or organization) Identification No.) 24 North Street, Pittsfield, Massachusetts 01201 -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (413) 443-5601 -------------------------------------------------------------------------------- (Registrant telephone number, including area code) Not Applicable -------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) 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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ] The Registrant had 5,873,563 shares of common stock, par value $0.01 per share, outstanding as of November 3, 2004. 2 BERKSHIRE HILLS BANCORP, INC. FORM 10-Q INDEX Page ---- PART I. FINANCIAL INFORMATION Item 1. Consolidated Financial Statements (unaudited) Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003 1 Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2004 and 2003 2 Consolidated Statements of Changes in Stockholders' Equity for the Nine Months Ended September 30, 2004 and 2003 3 Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2004 and 2003 4 Notes to Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 9 Item 3. Qualitative and Quantitative Disclosures About Market Risk 16 Item 4. Controls and Procedures 18 PART II: OTHER INFORMATION Item 1. Legal Proceedings 19 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 19 Item 3. Defaults Upon Senior Securities 19 Item 4. Submission of Matters to a Vote of Security Holders 19 Item 5. Other Information 19 Item 6. Exhibits 19 Signatures 21 3 PART 1. FINANCIAL INFORMATION ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS.
BERKSHIRE HILLS BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS Unaudited September 30, December 31, 2004 2003 ----------------- ---------------- (In thousands) Assets: Cash and due from banks $ 15,908 $ 15,583 Short-term investments 6,689 1,859 ----------------- ---------------- Total cash and cash equivalents 22,597 17,442 Securities available-for-sale, at fair value 387,950 307,425 Securities held-to-maturity, at amortized cost 26,255 36,903 Federal Home Loan Bank stock, at cost 16,898 12,923 Savings Bank Life Insurance stock, at cost 2,043 2,043 Loans held for sale 571 - Loans 817,805 792,227 Allowance for loan losses (9,392) (8,969) ----------------- ---------------- Net loans 808,413 783,258 Premises and equipment, net 13,389 12,626 Accrued interest receivable 5,400 5,080 Goodwill and other intangibles 5,763 10,233 Net deferred tax assets 1,505 1,725 Bank owned life insurance 8,004 7,721 Due from broker 378 7,089 Other assets 11,343 14,080 ----------------- ---------------- Total assets $ 1,310,509 $ 1,218,548 ================= ================ Liabilities: Deposits $ 853,115 $ 830,244 Federal Home Loan Bank advances 324,831 251,465 Loans sold with recourse - 473 Due to broker - 5,646 Accrued expenses and other liabilities 4,075 5,293 ----------------- ---------------- Total Liabilities 1,182,021 1,093,121 ----------------- ---------------- Minority Interests - 2,252 Stockholders' equity: Preferred stock ($.01 par value: 1,000,000 shares authorized; no shares issued and outstanding) - - Common stock ( $.01 par value: 26,000,000 shares authorized; 7,673,761 shares issued at September 30, 2004 and December 31, 2003; 5,873,563 shares outstanding at September 30, 2004; and 5,903,082 shares outstanding at December 31, 2003) 77 77 Additional paid-in capital 77,154 75,764 Unearned compensation (7,832) (8,507) Retained earnings 92,469 86,276 Accumulated other comprehensive income 4,345 5,559 Treasury stock at cost (1,800,198 shares at September 30, 2004 and 1,770,679 shares at December 31, 2003) (37,725) (35,994) ----------------- ---------------- Total stockholders' equity 128,488 123,175 ----------------- ---------------- Total liabilities and stockholders' equity $ 1,310,509 $ 1,218,548 ================= ================
See accompanying notes to unaudited consolidated financial statements. 1 4
BERKSHIRE HILLS BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME Unaudited Three Months Ended Nine Months Ended September 30, September 30, ------------------------------- ------------------------------- 2004 2003 2004 2003 -------------- -------------- -------------- -------------- (In thousands, except per share data) Interest and dividend income: Bond interest $ 4,130 $ 1,676 $ 12,116 $ 4,799 Stock dividends 279 269 887 747 Short-term investment interest 6 5 24 103 Loan interest 11,131 11,908 32,247 36,249 -------------- -------------- -------------- -------------- Total interest and dividend income 15,546 13,858 45,274 41,898 -------------- -------------- -------------- -------------- Interest expense: Interest on deposits 3,097 3,343 9,209 10,714 Interest on FHLB advances and other borrowings 2,207 1,206 5,906 3,362 -------------- -------------- -------------- -------------- Total interest expense 5,304 4,549 15,115 14,076 -------------- -------------- -------------- -------------- Net interest income 10,242 9,309 30,159 27,822 Provision for loan losses 365 575 1,140 1,685 -------------- -------------- -------------- -------------- Net interest income, after provision for loan losses 9,877 8,734 29,019 26,137 Noninterest income: Customer service fees 580 568 1,738 1,743 Trust department fees 611 573 1,835 1,563 Loan fees 63 142 245 337 Gain on sale of securities, net 310 356 1,013 1,513 Gain on sale of loans, net - 102 84 240 Other income 162 171 651 352 -------------- -------------- -------------- -------------- Total noninterest income 1,726 1,912 5,566 5,748 -------------- -------------- -------------- -------------- Operating expenses: Salaries and benefits 4,195 3,877 12,687 12,577 Occupancy and equipment 997 895 3,030 2,858 Marketing and advertising 207 137 634 379 Data processing 305 375 1,030 920 Professional services 442 260 1,226 742 Office supplies 126 146 387 473 Foreclosed real estate and other loans, net 150 333 404 740 Other general and administrative expenses 759 850 2,279 2,648 -------------- -------------- -------------- -------------- Total operating expenses 7,181 6,873 21,677 21,337 -------------- -------------- -------------- -------------- Income from continuing operations before taxes 4,422 3,773 12,908 10,548 Provision for income taxes 1,415 1,358 4,144 4,037 -------------- -------------- -------------- -------------- Income from continuing operations 3,007 2,415 8,764 6,511 -------------- -------------- -------------- -------------- Loss from discontinued operations (including loss on sale of $75,000) - (1) (653) (208) Income tax benefit - - (222) (71) -------------- -------------- -------------- -------------- Net loss from discontinued operations - (1) (431) (137) -------------- -------------- -------------- -------------- Net income $ 3,007 $ 2,414 $ 8,333 $ 6,374 ============== ============== ============== ============== Earnings per share: Basic $ 0.57 $ 0.46 $ 1.58 $ 1.20 Diluted $ 0.53 $ 0.43 $ 1.45 $ 1.12 Weighted average shares outstanding: Basic 5,270 5,196 5,284 5,301 Diluted 5,721 5,655 5,735 5,711
See accompanying notes to unaudited consolidated financial statements. 2 5
BERKSHIRE HILLS BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003 Unaudited Accumulated Additional Other Common Paid-in Unearned Retained Comprehensive Treasury Stock Capital Compensation Earnings Income Stock Total ---------- ---------- -------------- ---------- --------------- ---------- ----------- (In thousands) Balance at December 31, 2003 $ 77 $ 75,764 $ (8,507) $ 86,276 $ 5,559 $ (35,994) $ 123,175 ---------- Comprehensive income : Net Income - - - 8,333 - - 8,333 Change in net unrealized gain on securities available-for-sale, net of reclassification adjustment and tax effects - - - - (1,214) - (1,214) ---------- Total comprehensive income 7,119 ---------- Reversals from discontinued operations - 142 - (142) - - - Cash dividends declared ($0.36 per share) - - - (1,965) - - (1,965) Treasury stock purchased - - - - - (2,545) (2,545) Treasury stock released - 358 - - - 238 596 Reissuance of Treasury stock under Stock Option Plan (32,415 shares) - - - (33) - 576 543 Change in unearned compensation - MRP - 219 319 - - - 538 Change in unearned compensation - ESOP - 671 356 - - - 1,027 ---------- ---------- ------------ ----------- ------------ ----------- ---------- Balance at September 30, 2004 $ 77 $ 77,154 $ (7,832) $ 92,469 $ 4,345 $ (37,725) $ 128,488 ========== ========== ============ =========== ============ ========== ========== Balance at December 31, 2002 $ 77 $ 74,632 $ (9,535) $ 80,010 $ 5,542 $ (30,158) $ 120,568 ---------- Comprehensive income : Net Income - - - 6,374 - - 6,374 Change in net unrealized gain on securities available-for-sale, net of reclassification adjustment and tax effects - - - - (115) - (115) ---------- Total comprehensive income 6,259 ---------- Cash dividends declared ($0.36 per share) - - - (1,981) - - (1,981) Treasury stock purchased - - - - - (6,885) (6,885) Treasury stock released - - - (41) - 721 680 Change in unearned compensation - MRP - 570 287 - - - 857 Change in unearned compensation - ESOP - 403 356 - - - 759 ---------- ---------- ------------ ----------- ------------ ----------- ---------- Balance at September 30, 2003 $ 77 $ 75,605 $ (8,892) $ 84,362 $ 5,427 $ (36,322) $ 120,257 ========== ========== ============ =========== ============ =========== ==========
See accompanying notes to unaudited consolidated financial statements. 3 6
BERKSHIRE HILLS BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Unaudited Nine Months Ended September 30, --------------------------------------- 2004 2003 ----------------- ----------------- (In thousands) Cash flows from operating activities: Continuing operations: Net income $ 8,764 $ 6,583 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 1,140 1,685 Net amortization of securities 954 1,500 Depreciation and amortization expense 1,252 1,226 Management Awards Plan Expense 920 857 Employee Stock Ownership Plan Expense 1,027 759 Increase in cash surrender value of Bank Owned Life Insurance (283) (126) Gain on sales and dispositions of securities, net (1,013) (1,513) Gain on sale of loans, net (84) (240) Loss on sale/write-down of foreclosed real estate, net 2 44 Deferred tax provision 294 239 Changes in operating assets and liabilities: Accrued interest receivable and other assets 2,417 (126) Accrued expenses and other liabilities (778) (214) ----------------- ----------------- Net cash provided by continuing operations 14,612 10,674 Discontinued operations: Net loss (431) (209) Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization expense 188 377 Amortization of goodwill and other intangibles 94 151 Minority interests - (138) Proceeds from the sale of discontinued operations 2,049 - Loss on sale of discontinued operations 75 - ----------------- ----------------- Net cash provided by discontinued operations 1,975 181 Total net cash provided by operating activities 16,587 10,855 ----------------- ----------------- Cash flows from investing activities: Continuing operations: Activity in available-for-sale securities: Sales 4,159 10,430 Maturities 25,501 106,800 Principal payments 45,153 23,823 Purchases (155,768) (192,064) Activity in held-to-maturity securities: Maturities 13,616 12,016 Principal payments 10,655 35,368 Purchases (13,797) (44,981) Purchase of Federal Home Loan Bank stock (3,975) (3,976) Purchase of Bank Owned Life Insurance - (7,500) (continued)
4 7
BERKSHIRE HILLS BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (concluded) Unaudited Nine Months Ended September 30, --------------------------------------- 2004 2003 ----------------- ----------------- (In thousands) Loan originations, net of pricipal payments and purchases $ (79,103) $ (124,527) Proceeds from sale of loans from portfolio 52,296 45,613 Additions to banking premises and equipment (2,748) (1,110) Proceeds from sale of foreclosed real estate 23 - Proceeds from sale of real estate - 1,456 Purchase of common stock in connection with stock awards plan 214 - ----------------- ----------------- Net cash used by continuing operating investing activities (103,774) (138,652) Discontinued operations: Additions to banking premises and equipment (76) (42) Proceeds from sale of equipment 621 - ----------------- ----------------- Net cash provided (used) by discontinued investing activities 545 (42) Total net cash used by investing operations (103,229) (138,694) ----------------- ----------------- Cash flows from financing activities: Net increase in deposits 22,871 45,422 Net decrease in securities sold under agreements to repurchase - (700) Proceeds from Federal Home Loan Bank advances with maturities in excess of three months 254,000 92,000 Repayment of Federal Home Loan Bank advances with maturities in excess of three months (170,634) (71,684) Proceeds of borrowings with maturities of three months or less, net of repayments (10,000) 38,000 Net decrease in loans sold with recourse (473) (603) Treasury stock purchased (2,545) (6,886) Exercise of officer stock options and non-employee director benefit programs 543 681 Dividends (1,965) (1,981) ----------------- ----------------- Net cash provided by financing activities 91,797 94,249 ----------------- ----------------- Net change in cash and cash equivalents 5,155 (33,590) Cash and cash equivalents at beginning of period 17,442 60,655 ----------------- ----------------- Cash and cash equivalents at end of period $ 22,597 $ 27,065 ================= ================= Supplemental cash flow information: Interest paid on deposits 9,203 10,732 Interest paid on borrowed funds 5,742 3,318 Income taxes paid 1,627 1,111 Due to broker - 20,019 Due from broker 378 - Transfer from loans to foreclosed real estate 25 -
See accompanying notes to unaudited consolidated financial statements. 5 8 BERKSHIRE HILLS BANCORP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2004 and 2003 (Unaudited) Note 1. Basis of Presentation ------------------------------- The consolidated interim financial statements of Berkshire Hills Bancorp, Inc. ("Berkshire Hills" or the "Company") and its wholly owned subsidiaries, Berkshire Bank (the "Bank"), Berkshire Hills Funding Corp. and Berkshire Hills Technology, Inc. herein presented are intended to be read in conjunction with the consolidated financial statements presented in the Company's most recent Securities and Exchange Commission Form 10-K and accompanying notes to the Consolidated Financial Statements filed by the Company for the year ended December 31, 2003. The consolidated financial information at September 30, 2004 and for the three- and nine-month periods ended September 30, 2004 and 2003 are derived from unaudited consolidated financial statements but, in the opinion of management, reflect all adjustments necessary to present fairly the results for these interim periods in accordance with accounting principles generally accepted in the United States of America. These adjustments consist only of normal recurring adjustments. The interim results are not necessarily indicative of the results of operations that may be expected for the entire year. On June 18, 2004, the Company announced the sale of the business assets of EastPoint Technologies, LLC ("EastPoint"), a software and data processing provider for financial institutions, to a subsidiary of Open Solutions Inc. (NASDAQ: OPEN). The Company owned 60.3 percent of EastPoint and recognized approximately $2.8 million on the sale. The transaction resulted in a net loss of $75,000 to the Company ($49,500 net of taxes). This loss, included in a current year net operating loss of $653,000 ($431,000 net of taxes) from EastPoint through June 18, 2004, was recorded as a loss from discontinued operations. The Company also has the potential to receive up to an additional $625,000 in two years. Prior periods presented have been adjusted to reflect the sale of EastPoint and the discontinued operations. Note 2. Commitments --------------------- At September 30, 2004, the Company had outstanding commitments to originate new residential and commercial loans totaling $44.1 million, which are not reflected on the consolidated balance sheet. In addition, unadvanced funds on home equity lines totaled $53.8 million and unadvanced commercial lines, including unadvanced construction loan funds, totaled $66.4 million. The Company anticipates it will have sufficient funds to meet these commitments. 6 9 Note 3. Earnings Per Share ---------------------------- Basic earnings per share represent net income divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if potential dilutive shares, such as stock options, had been issued. Unallocated shares of common stock held by the Bank's employee stock ownership plan are not included in the weighted average number of common shares outstanding for either basic or diluted earnings per share calculations. Earnings per share data is presented for the three and nine months ended September 30, 2004 and 2003.
Three Months Ended Nine Months Ended September 30, September 30, ----------------------------- ---------------------------- 2004 2003 2004 2003 -------------- ------------- ------------- ------------- (In thousands, except per share amounts) Net income from continuing operations $ 3,007 $ 2,415 $ 8,764 $ 6,511 Net loss from discontinued operations - (1) (431) (137) -------------- ------------- ------------- ------------- Net income $ 3,007 $ 2,414 $ 8,333 $ 6,374 ============== ============= ============= ============= Weighted average common shares 5,270 5,196 5,284 5,301 Dilutive effect of potential common shares related to stock compensation plans 451 459 451 410 -------------- ------------- ------------- ------------- Weighted average common shares including potential dilution 5,721 5,655 5,735 5,711 ============== ============= ============= ============= Continuing operations: Basic earnings per share $ 0.57 $ 0.46 $ 1.66 $ 1.23 Diluted earnings per share $ 0.53 $ 0.43 $ 1.53 $ 1.14 Discontinued operations: Basic loss per share $ - $ - $ (0.09) $ (0.03) Diluted loss per share $ - $ - $ (0.08) $ (0.02) Net income: Basic earnings per share $ 0.57 $ 0.46 $ 1.58 $ 1.20 Diluted earnings per share $ 0.53 $ 0.43 $ 1.45 $ 1.12
Note 4. Tangible Book Value ----------------------------- The tangible book value per share of Berkshire Hills' common stock at September 30, 2004 was $20.89, based on tangible stockholders' equity of $122.7 million and outstanding shares of 5,873,563. The tangible book value per share at December 31, 2003 was $19.13 based on tangible stockholders' equity of $112.9 million and total outstanding shares of 5,903,082. Note 5. Dividend ------------------ On July 22, 2004, the Company's Board of Directors declared a cash dividend of $0.12 per share, which was paid on August 20, 2004, to stockholders of record on August 5, 2004. Note 6. Goodwill and Other Intangibles ---------------------------------------- Goodwill and other intangibles include goodwill associated with the acquisition by Berkshire Hills Technology of a majority interest in EastPoint, as well as the Company's purchase of two branches from another financial institution in 1991 and three branches in 1998, which are evaluated for impairment on an annual basis. Intangible assets refer to customer relationships acquired in association with the EastPoint purchase, which were included in the sale of business assets of EastPoint on June 18, 2004. The carrying amount of goodwill and other intangibles as of September 30, 2004 was $5.8 million and $10.2 million on December 31, 2003. As of December 31, 2003, the gross carrying amount and accumulated amortization of these customer relationships were $101,000 and $507,000, respectively. The amortization expense and other intangible assets amounted to $94,000 for the nine-month period ended September 30, 2004 and $153,000 for the nine-month period ending September 30, 2003. 7 10 Note 7. Stock Compensation Plans ---------------------------------- Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation," encourages all entities to adopt a fair value based method of accounting for employee stock compensation plans, whereby compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. However, it also allows an entity to continue to measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by Accounting Principals Board Opinion No. 25, "Accounting for Stock Issued to Employees," whereby compensation cost is the excess, if any, of the quoted market price of the stock at the grant date (or other measurement date) over the amount an employee must pay to acquire the stock. Stock options issued under the Company's stock plans have no intrinsic value at the grant date, and under Opinion No. 25, no compensation cost is recognized for them. At September 30, 2004 and December 31, 2003, the Company had stock option plans and has elected to continue with the accounting methodology in Opinion No. 25, and as a result, has provided pro forma disclosures of net income and earnings per share, as if the fair value based method of accounting has been applied. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation.
Three Months Ended Nine Months Ended September 30, September 30, ----------------------------------- ---------------------------------- 2004 2003 2004 2003 ---------------- ---------------- --------------- ---------------- (In thousands, except per share amounts) Net income as reported $ 3,007 $ 2,414 $ 8,333 $ 6,374 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects 133 104 399 312 ---------------- ---------------- --------------- ---------------- Proforma net income $ 2,874 $ 2,310 $ 7,934 $ 6,062 ================ ================ =============== ================ Earnings per share Basic - as reported $ 0.57 $ 0.46 $ 1.58 $ 1.20 ================ ================ =============== ================ Basic - proforma $ 0.55 $ 0.44 $ 1.50 $ 1.14 ================ ================ =============== ================ Diluted - as reported $ 0.53 $ 0.43 $ 1.45 $ 1.12 ================ ================ =============== ================ Diluted - proforma $ 0.50 $ 0.41 $ 1.38 $ 1.06 ================ ================ =============== ================
8 11 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following analysis discusses changes in the financial condition and results of operations at and for the three and nine months ended September 30, 2004 and 2003, and should be read in conjunction with Berkshire Hills Bancorp, Inc.'s Consolidated Financial Statements and the notes thereto, appearing in Part I, Item 1 of this document. FORWARD-LOOKING STATEMENTS This report contains forward-looking statements that are based on assumptions and may describe future plans, strategies and expectations of Berkshire Hills and Berkshire Bank. These forward-looking statements are generally identified by use of the words "believe," "expect," "intend," "anticipate," "estimate," "project" or similar expressions. Berkshire Hills' and Berkshire Bank's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations of Berkshire Hills and its subsidiaries include, but are not limited to, changes in interest rates, national and regional economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in Berkshire Hills' and Berkshire Bank's market area, changes in real estate market values in Berkshire Hills' and Berkshire Bank's market area, and changes in relevant accounting principles and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, Berkshire Hills does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions which may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events. GENERAL Berkshire Hills is a Delaware corporation and the holding company for Berkshire Bank, a state-chartered savings bank headquartered in Pittsfield, Massachusetts. Established in 1846, Berkshire Bank is one of Massachusetts' oldest and largest independent banks. With eleven full-service branch offices serving communities throughout Berkshire County, Massachusetts as well as a full-service branch office in Oriskany Falls, New York and a representative office in Albany, New York, Berkshire Bank is the largest banking institution based in western Massachusetts. The Bank is a community-based financial institution that originates a variety of loan products including real estate loans, commercial loans and consumer loans primarily in Berkshire County and its surrounding areas. The Bank offers a wide variety of deposit products and other investment products and financial services, including asset management and trust services and municipal finance. COMPARISON OF FINANCIAL CONDITION AT SEPTEMBER 30, 2004 AND DECEMBER 31, 2003 Total assets at September 30, 2004 were $1.31 billion, an increase of $92.0 million, or 7.6%, from December 31, 2003. The increase in assets was primarily due to an increase of $73.9 million, or 20.6%, in securities and $25.6 million, or 3.2%, in loans. This increase was largely funded by a $73.4 million increase in Federal Home Loan Bank advances, and an increase of $22.9 million in deposits. LOANS Loans increased $25.6 million from December 31, 2003. Residential real estate loans decreased $36.7 million during the first nine months of 2004 primarily due to the securitization of $38.7 million of one- to four-family longer-term fixed rate mortgages, as the Bank continued to reduce its exposure to loans and investments with longer maturities. Commercial real estate loans increased $48.1 million, as the Bank has been successful in soliciting new relationships and due to an improving commercial real estate market in Berkshire County. However, commercial loans decreased $7.1 million as our market experienced weak demand for commercial and industrial financing during the first nine months of 2004. The automobile loan portfolio increased $16.1 million during the first nine months of 2004, as increased marketing efforts aimed at generating high quality loans with FICO scores above 700 continued to gain momentum. Home equity loans increased $5.7 million, or 12.4%, due equally to draw-downs on existing equity lines of credit and new loan originations. 9 12
At September 30, 2004 At December 31, 2003 ----------------------------- ----------------------------- Percent Percent Balance of total Balance of total ------------- ------------- -------------- ------------- (Dollars in thousands) Real estate loans: Residential one- to four-family $ 214,100 26.18% $ 254,939 32.18% Residential land development and construction 14,754 1.80% 10,583 1.33% Commercial real estate 217,373 26.58% 166,796 21.05% Commercial land development and construction 20,560 2.51% 24,136 3.05% Multi-family 16,616 2.03% 15,514 1.96% ----------- ------------ ----------- Total real estate loans 483,403 59.11% 471,968 59.57% Commercial loans 159,156 19.46% 166,296 20.99% Consumer loans: Automobile 119,787 14.65% 103,674 13.09% Home equity loans 51,465 6.29% 45,783 5.78% Other 3,994 0.49% 4,506 0.57% ----------- ------------ ----------- Total consumer loans 175,246 21.43% 153,963 19.44% Total loans 817,805 100.00% 792,227 100.00% ========== =========== Less: Allowance for loan losses (9,392) 1.15% (8,969) 1.13% ----------- ------------ Loans, net $ 808,413 $ 783,258 =========== ============
ALLOWANCE FOR LOAN LOSSES All banks that manage loan portfolios will experience losses to varying degrees. The allowance for loan losses is the amount available to absorb these losses and represents management's evaluation of the risks inherent in the portfolio based on the collectibility of the loans, changing collateral values, past loan loss history, specific borrower situations and general economic conditions. Management continually assesses the adequacy of the allowance for loan losses and makes monthly provisions to maintain the allowance at a level considered adequate to cover losses in the loan portfolio. Because future events affecting the loan portfolio cannot be predicted with complete accuracy, there can be no assurances that management's estimates are correct and that the existing allowance for loan losses is adequate. However, management believes that, based on the information available on September 30, 2004, the Company's allowance for loan losses is sufficient to cover losses inherent in the Company's loan portfolio as of such date. The allowance consists of allocated, general and unallocated components. The allocated component relates to loans that are classified as either doubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors such as the credit history and credit quality of the borrower, the type and geographic concentration of loans in the portfolio, and the local economic environment. An unallocated component is maintained to cover uncertainties that could affect management's estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating losses in the portfolio. At September 30, 2004, the allowance for loan losses totaled $9.4 million, or 1.15%, of total loans outstanding and 346.06% of nonperforming loans, as compared to $9.0 million, or 1.13%, of total loans outstanding and 280.37% of nonperforming loans at December 31, 2003. Charged-off loans totaled $1.5 million during the first nine months of this year as compared to $3.3 million for the same nine-month period last year. The improvement was almost exclusively from indirect automobile loans, as the Bank's credit risk profile for these loans has improved greatly since the Bank sold $9.9 million, of nearly all of its sub-prime automobile loans, in December 2003. 10 13 The following table sets forth information regarding the allowance for loan losses for the nine-month periods ended September 30, 2004 and 2003.
Nine Months Ended ----------------------------------------------- September 30, 2004 September 30, 2003 ---------------------- --------------------- (Dollars in thousands) Allowance for loan losses, beginning of period $ 8,969 $ 10,308 Charge-offs: Residential one- to four-family - - Residential land development and construction - - Commercial real estate 34 - Commercial land development and construction - - Multi-family - - Commercial 12 43 Consumer (1) 1,419 3,247 -------------------- ------------------- Total charge-offs 1,465 3,290 -------------------- ------------------- Recoveries: Residential one- to four-family - - Residential land development and construction - - Commercial real estate - - Commercial land development and construction - - Multi-family - - Commercial 158 437 Consumer (1) 590 957 -------------------- ------------------- Total recoveries 748 1,394 -------------------- ------------------- Net charge-offs 717 1,896 Provision for loan losses 1,140 1,685 -------------------- ------------------- Allowance for loan losses, end of period $ 9,392 $ 10,097 ==================== =================== Net loans charged-off to total loans 0.09% 0.24% Allowance for loan losses to total loans 1.15% 1.26% Allowance for loan losses to nonperforming loans 346.06% 276.55% Recoveries to charge-offs 51.06% 42.37%
------------------------------------------------------- (1) Consists primarily of automobile loans. 11 14 NONPERFORMING ASSETS The following table sets forth information regarding nonperforming assets as of September 30, 2004 and December 31, 2003.
At September 30, 2004 At December 31, 2003 -------------------------- -------------------------- (Dollars in thousands) Nonaccruing loans: Residential one- to four-family $ 332 $ 348 Residential land development and construction - - Commercial real estate 614 496 Commercial land development and construction - - Multi-family - - Commercial 1,463 1,887 Automobile 297 451 Home equity - - Other consumer 8 17 ------------------------ ------------------------ Total 2,714 3,199 ------------------------ ------------------------ Other real estate owned - - ------------------------ ------------------------ Total nonperforming assets $ 2,714 $ 3,199 ======================== ======================== Total nonperforming loans to total loans 0.33% 0.40% Total nonperforming assets to total assets 0.21% 0.26%
Generally, the Company ceases accruing interest on all loans, except automobile loans, when principal or interest payments are 90 days or more past due, unless management determines the principal and interest to be fully secured and in the process of collection. Once management determines that interest is uncollectible and ceases accruing interest on a loan, all previously accrued interest is reversed against current interest income. With regard to automobile loans, all delinquent automobile loans remain on accrual status until they are 120 days past due, at which time they are charged off, except for loans to customers in bankruptcy proceedings, which are transferred to nonaccrual status. At September 30, 2004, the Company had $40,000 in automobile loans that were 90 days past due and still accruing as compared to $306,000 at December 31, 2003. Nonaccruing loans totaled $2.7 million at September 30, 2004, a decrease of $485,000 from December 31, 2003. Commercial real estate nonaccruing loans increased $118,000 from December 31, 2003, primarily due to the addition of two adequately reserved loans which are current with their payments. Offsetting the increase was a decrease of $424,000 in commercial loans and a decrease of $154,000 in automobile loans due to improved credit quality, as well as, collections and loan amortizations received. INVESTMENT SECURITIES Securities, including Federal Home Loan Bank stock and Savings Bank Life Insurance stock, totaled $433.1 million at September 30, 2004, an increase of $73.9 million, or 20.6%, from December 31, 2003. The increase was primarily due to the securitization of $38.7 million of the Bank's one- to four-family fixed rate mortgages and the purchase of pass-through mortgage-backed securities with average maturities of 3.5 years, which have limited risk of average life extension. These securities were purchased to leverage the Bank's capital and reduce interest rate risk exposure to longer-term investments while taking advantage of a steep yield curve. The Bank sold securities totaling $378,000 in the third quarter for a net gain of $310,000. The net unrealized gain in the securities portfolio, net of taxes, decreased $1.2 million to $4.3 million at September 30, 2004, primarily due to a decline in the market value of the debt portfolio, which was recognized in accumulated other comprehensive income on the consolidated statement of changes in stockholders' equity. 12 15 BANK OWNED LIFE INSURANCE ("BOLI") The single premium BOLI contract executed in May 2003 totaled $8.0 million at September 30, 2004, an increase of $283,000 from December 31, 2003. The income earned on BOLI is recorded as an increase in the asset and noninterest income. DEPOSITS Customers' deposits are the primary funding vehicle for the Company's asset base. The following table sets forth the Company's deposit stratification as of September 30, 2004 and December 31, 2003.
At September 30, 2004 At December 31, 2003 ----------------------------- ------------------------------ Percent Percent Balance of deposits Balance of deposits ------------- ------------- ------------- ------------- (Dollars in thousands) Demand deposits $ 104,204 12.21% $ 102,788 12.38% NOW accounts 96,945 11.36% 94,606 11.39% Savings accounts 166,720 19.54% 171,603 20.67% Money Market accounts 160,423 18.82% 139,897 16.85% ------------- ------------- ------------- ------------- Total Core Accounts 528,292 61.93% 508,894 61.29% Certificates of Deposit 324,823 38.07% 321,350 38.71% ------------- ------------- Total deposits $ 853,115 $ 830,244 ============= =============
Core deposits increased $19.4 million, or 3.8%, from December 31, 2003 and certificates of deposit increased $3.5 million, or 1.1%, from December 31, 2003, as the Bank continued to actively pursue relationships through its TRUSTED SOLUTIONS SM brand campaign initiated in early 2004. BORROWINGS Borrowings from the Federal Home Loan Bank of Boston totaled $324.8 million at September 30, 2004, a $73.4 million, or 29.2%, increase from $251.5 million at December 31, 2003, as the Bank took advantage of the lower cost of borrowings relative to the cost of deposits to fund earning asset growth. This increase represented new borrowings with terms ranging from one month to four years. The Company had additional borrowing capacity of $49.7 million at the Federal Home Loan Bank of Boston at September 30, 2004. STOCKHOLDERS' EQUITY At September 30, 2004, the Company had $128.5 million in stockholders' equity compared to $123.2 million at December 31, 2003, an increase of $5.3 million. The increase was primarily due to net income of $8.3 million and increases to additional paid-in capital of $1.4 million. Partially offsetting these increases in stockholders' equity were decreases of $1.2 million in net unrealized gain on securities, net of taxes, due to a decline in the market value of the debt portfolio, which was recognized in accumulated other comprehensive income, the payment of cash dividends of $0.36 per common share amounting to $2.0 million and net increases in treasury stock transactions of $1.7 million. COMPARISON OF OPERATING RESULTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003 NET INTEREST INCOME. Net interest income is the largest component of the Company's revenue stream and is the difference between the interest and dividends earned on the loan and investment portfolios and the interest paid on the Company's funding sources, primarily customer deposits and advances from the Federal Home Loan Bank of Boston. Net interest income increased $933,000, or 10.0%, for the three months ended September 30, 2004, and increased $2.3 million, or 8.4%, for the nine months ended September 30, 2004, primarily due to an increase in average earning assets and a lower cost of funds offset by a decrease in the yield on average interest-earning assets. The yield on average earning assets declined to 4.99% for the three months ended September 30, 2004 compared to 5.22% for the three months ended September 30, 2003 and declined to 4.96% for the nine-month period ended September 30, 2004, from 5.49% for the 13 16 nine-month period ended September 30, 2003, due primarily to the lower interest rate environment and the Company's strategy to shorten the duration of its earning assets. The Company's net interest margin was 3.29% for the three-month period and 3.30% for the nine-month period ended September 30, 2004, compared to 3.51% for the three months ended September 30, 2003 and 3.64% for the nine months ended September 30, 2003. The decreases in net interest margin were attributable to the low interest rate environment, as maturing loans and securities were reinvested at lower yields with shorter durations. The Company expects the net interest margin to remain stable over the next twelve months under a flat to gradual decline of 100 basis points in general market interest rates and respond positively to a gradual rise of 200 basis points. Total interest and dividend income increased $1.7 million, or 12.2%, for the three months ended September 30, 2004 and $3.4 million, or 8.1%, for the nine months ended September 30, 2004, compared to the same periods last year. The increases occurred primarily due to an increase of $184.2 million in average earning assets for the three months ended September 30, 2004 and an increase of $198.8 million in average earning assets for the nine-month period ended September 30, 2004. Interest earned on the Company's investment portfolio increased $2.5 million for the three months ended September 30, 2004, and $7.4 million for the nine months ended September 30, 2004, as higher average balances were able to offset lower average rates earned. Loan interest declined $777,000, or 6.5%, for the three months ended September 30, 2004 and declined $4.0 million, or 11.0%, for the nine months ended September 30, 2004 as compared to the same periods last year. The decline was due to the sale of higher rate sub-prime automobile loans in December 2003, the securitization of $55.0 million of one- to four- family fixed-rate mortgages and the impact of lower market interest rates. An increase in average funding liabilities of $173.0 million for the three months ended September 30, 2004, and $328.3 million for the nine months ended September 30, 2004, resulted in increases in interest expense of $755,000 for the three-month period and $1.0 million for the nine months ended September 30, 2004, compared to the same periods last year. Interest expense on deposits fell by $246,000 for the three-month period and $1.5 million for the nine-month period ended September 30, 2004 compared to the same periods last year, as higher average balances were offset by lower interest rates and increases in lower cost core deposits. Interest paid on Federal Home Loan Bank of Boston advances and other borrowings increased $1.0 million for the three months ended September 30, 2004 and $2.5 million for the nine months ended September 30, 2004 compared to the same period last year, consistent with the average increase of $154.0 million in borrowings for the three and nine month periods ended September 30, 2003. PROVISION FOR LOAN LOSSES. The Company's provision for loan losses was $365,000 for the three months ended September 30, 2004 and $1.1 million for the nine months ended September 30, 2004, as compared to $575,000 and $1.7 million for the same periods last year. The decrease in the provision for the three and nine months ended September 30, 2004 was largely attributed to a $13.0 million decrease in sub-prime automobile loans from September 30, 2003. The Company also considered net loan charge-offs, which decreased $1.2 million to $717,000 for the first nine months of this year compared to the same period last year. Foremost in this decrease were consumer loan net charge-offs which decreased $1.5 million, consisting mainly of sub-prime automobile loans. Additional factors management considered were the level of delinquent loans, which declined from 0.98% of total loans at September 30, 2003, to 0.73% at September 30, 2004, and nonaccrual loans which declined $937,000, or 25.7%, from September 30, 2003. NONINTEREST INCOME. For the three and nine months ended September 30, 2004, noninterest income decreased $186,000 and $182,000, respectively, as compared to the same periods last year. Included in these decreases were decreases of $79,000 and $92,000 in loan fees during the three and nine months ended September 30, 2004. Gain on sale of securities decreased $46,000 and $500,000 for the three and nine months ended September 30, 2004, as compared to the same periods last year. Gain on the sale of loans decreased $102,000 and $156,000 for the three and nine months ended September 30, 2004 as compared to the same periods last year, as the Company did not sell as many loans during 2004 as in 2003 and due to heavy refinancing activity in 2003, as the Company did not originate as many loans for sale in 2004. These decreases were partially offset by increases of $38,000 and $272,000 in trust department fees for the three and nine months ended September 30, 2004, compared to the same period last year. The increase in trust department fees was due to an increase of $43.5 million, or 15.4%, in assets under management from September 30, 2003. An increase of $299,000 in other income during the nine months ended September 30, 2004 resulted primarily from increases in the cash surrender value on life insurance policies due to a $7.5 million BOLI contract executed in May 2003. OPERATING EXPENSES. Operating (noninterest) expenses increased $308,000, or 4.5%, and $340,000, or 1.6%, respectively, for the three- and nine-month periods ended September 30, 2004, compared to the same periods last year. Salaries and benefits increased $318,000, or 8.2%, and $110,000, or 0.9%, for the three- and nine-month periods ended September 30, 2004, respectively, compared to the same periods last year. The increase in salaries and benefits 14 17 for the three-month period was attributed to increases in retirement benefit expense, the timing of payments to directors and an increase in incentive compensation. The implementation of the TRUSTED SOLUTIONS SM advertising campaign increased marketing expenses $70,000 and $255,000 for the three and nine months ended September 30, 2004, respectively. Professional services fees increased $182,000 and $484,000 for the three and nine months ended September 30, 2004, respectively, primarily due to the implementation of Six Sigma, a productivity improvement program, and due to the additional costs of complying with the additional corporate government requirements contained in the Sarbanes-Oxley Act. Occupancy expenses increased $172,000 during the nine-month period. These increases were partially offset by a reduction in foreclosed real estate and other loan expenses, which were primarily driven by repossessed automobile expenses, which declined $183,000 and $336,000 for the three and nine months ended September 30, 2004, respectively, due to the reduction in lower quality automobile loans. Also, decreases in FDIC insurance premiums of $91,000 and $369,000 for the three and nine months ended September 30, 2004, resulted from efforts made by management to improve the Bank's risk and earnings profile. INCOME TAXES. The Company's effective tax rate was 32.0% for the three and nine months ended September 30, 2004. Excluding the income tax and associated charges relating to the Bank's REIT disallowance in March 2003 and subsequent settlement in June 2003, the Company's effective tax rate would have been 36.0% for the three and nine months ended September 30, 2003. The lower effective tax rate in 2004 was due in part to an increase in securities purchased in the Bank's subsidiary securities corporations, which are taxed at a lower rate. The Company expects its effective tax rate will be approximately 32.0% for the remainder of 2004. REGULATORY CAPITAL The Company's capital to assets ratios for September 30, 2004 and December 31, 2003 were 9.81% and 10.11%, respectively. The various regulatory capital ratios for the Bank at September 30, 2004 and December 31, 2003 were as follows:
FDIC Minimums At September 30, 2004 At December 31, 2003 to be Well Capitalized ------------------------ ----------------------- ------------------------ Total capital to risk weighted assets: 12.67% 12.57% 10.00% Tier 1 capital to risk weighted assets: 11.29 11.07 6.00 Tier 1 capital to average assets: 7.98 7.87 5.00
As of September 30, 2004, Berkshire Bank met the conditions to be classified as "well capitalized" under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios. As part of management's revised strategy to address the overall credit risk to the Bank, management has determined to maintain capital levels in an amount in excess of the regulatory requirements. LIQUIDITY Liquidity is the ability to meet current and future financial obligations of a short-term nature. The Bank further defines its liquidity requirements as the ability to respond to the needs of depositors and borrowers, as well as maintaining the flexibility to take advantage of investment opportunities. The Bank's primary sources of funds consist of deposit inflows, loan repayments, maturities, loan sales, paydowns of mortgage-backed securities, sales/calls of investments and borrowings from the Federal Home Loan Bank of Boston. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit outflows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition. Berkshire Bank's primary investing activities are: (1) originating residential one- to four-family mortgage loans, commercial business and real estate loans, multi-family loans, home equity loans and lines of credit and consumer loans; and (2) investing in mortgage- and asset-backed securities, U.S. government and agency obligations, and debt obligations. These activities are funded primarily by principal and interest payments on loans, maturities and sales of securities, deposits and Federal Home Loan Bank of Boston advances. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by interest rates, economic conditions and competition. Berkshire Bank closely monitors its liquidity position on a daily basis. If the Bank requires funds beyond its ability to generate them internally, additional sources of funds are available 15 18 through advances or a line of credit with the Federal Home Loan Bank and through repurchase agreements with the Depositors Insurance Fund, the Bank's excess deposit insurer, and Lehman Brothers. Outstanding commitments for all loans and unadvanced construction loans and lines of credit totaled $164.3 million at September 30, 2004. Management of Berkshire Bank anticipates that it will have sufficient funds available to meet its current loan commitments. Certificates of deposit scheduled to mature in one year or less from September 30, 2004 were approximately $187.5 million. Berkshire Bank relies primarily on competitive rates, customer service and long-standing relationships with customers to retain deposits. Occasionally, the Bank will also offer special competitive promotions to its customers to increase retention and promote deposit growth. Based upon the Bank's historical experience with deposit retention, management believes that, although it is not possible to predict future terms and conditions upon renewal, a significant portion of such deposits will remain with the Bank. Funding for the Company is provided by dividend payments from the Bank. These dividend payments have primarily been used to pay holding company obligations, including the payment of dividends and the funding of stock repurchase programs. The Bank's ability to pay dividends and other capital distributions to the Company is generally limited by the Massachusetts banking regulations and the regulations of the Federal Deposit Insurance Corporation. Additionally, the Massachusetts Banking Commissioner and Federal Deposit Insurance Corporation may prohibit the payment of dividends which are otherwise permissible by regulation for safety and soundness reasons. OFF-BALANCE SHEET ARRANGEMENTS In the normal course of operations, the Company engages in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in the Company's financial instruments. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are used primarily to manage customers' requests for funding and take the form of loan commitments and lines of credit. A further presentation of the Company's off-balance sheet arrangements is presented in the Company's Form 10-K for the year ended December 31, 2003. For the nine months ended September 30, 2004, the Company did not engage in any off-balance sheet transactions reasonably likely to have a material effect on the Company's financial condition, results of operation or cash flows. ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK. QUALITATIVE ASPECTS OF MARKET RISK. The Bank's most significant form of market risk is interest rate risk. The principal objectives of the Bank's interest rate risk management are to evaluate the interest rate risk inherent in certain balance sheet accounts, determine the level of risk appropriate given its business strategy, operating environment, capital and liquidity requirements and performance objectives, and manage the risk consistent with its established policies. The Bank maintains an Asset/Liability Committee consisting of nine members of senior management and the Senior Financial Analyst, who are responsible for reviewing the Bank's asset/liability policies and interest rate risk position. The Asset/Liability Committee meets quarterly and reports to the Loan and Investment Committee of the Bank and the Board of Directors. The extent of the movement of interest rates is an uncertainty that could have a negative impact on the earnings of the Bank. The Bank manages interest rate risk by: o emphasizing the origination of adjustable rate loans and, from time to time, selling a portion of its longer-term fixed rate loans as market interest rate conditions dictate; o securitizing a portion of the Bank's long-term, fixed rate mortgages; o originating shorter-term commercial and consumer loans; o investing in high quality liquid investment securities that provide adequate liquidity and flexibility to take advantage of opportunities that may arise from fluctuations in market interest rates, the overall maturity and duration of which is monitored in relation to the repricing of its loan and funding portfolios; o promoting lower cost liability accounts such as core deposits; and o using Federal Home Loan Bank advances to better structure maturities of its interest rate sensitive liabilities. 16 19 For the Bank, market risk also includes price risk, primarily security price risk. The securities portfolio had unrealized gains before taxes of $6.8 million at September 30, 2004. Changes in this figure are reflected, net of taxes, in accumulated other comprehensive income as a separate component of Berkshire Hills' stockholders' equity. Since December 31, 2003, this component has decreased by $1.7 million. It is not possible to predict with complete accuracy the direction and magnitude of market value changes in the securities portfolio. Unfavorable market conditions or other factors could cause price declines in the securities portfolio. QUANTITATIVE ASPECTS OF MARKET RISK. Berkshire Bank uses a simulation model to measure the potential change in net interest income, incorporating various assumptions regarding the shape of the yield curve, the pricing characteristics of loans, deposits and borrowings, prepayments on loans and securities and changes in the balance sheet mix. The model assumes the yield curve is derived from the interpolated Treasury yield curve and that an instantaneous increase or decrease of market interest rates would cause a simultaneous parallel shift along the entire yield curve. Loans, deposits and borrowings are expected to reprice at the new market rate on the contractual review or maturity date. The Bank closely monitors its loan prepayment trends and uses prepayment guidelines set forth by Freddie Mac, Fannie Mae and other market sources, as well as Bank generated figures where applicable. All prepayments and maturities are assumed to roll over into the types of loans with the maturity or repricing characteristics that management believes will be generated going forward. Berkshire Bank further assumes that its securities' cash flows, especially its mortgage-backed securities cash flows, are such that they will generally follow industry standards and that prepayments will be reinvested in the same category at the prevailing market rate. Finally, the model assumes that the balance sheet size and mix will remain relatively unchanged throughout the next calendar year. The table below sets forth, as of September 30, 2004 and December 31, 2003, estimated net interest income and the estimated changes in the Company's net interest income for the next twelve-month period, which may result in instantaneous increases or decreases in market interest rates of 100 and 200 basis points.
Increase/ (decrease) in market interest rates At September 30, 2004 At December 31, 2003 -------------------------------------------- -------------------------------------------- in basis points Dollar Percent Dollar Percent (rate shock) Amount Change change Amount Change change ----------------- ------------- ------------- ------------- ------------- -------------- ------------- (Dollars in thousands) 200 $ 41,780 $ 932 2.28 % $ 37,144 $ (1,757) (4.52)% 100 41,127 279 0.68 38,162 (739) (1.90) Static 40,848 - - 38,901 - - (100) 40,848 - - 39,478 577 1.48 (200) 38,946 (1,902) (4.66) 37,116 (1,785) (4.59)
In the event of a sudden and sustained decrease in prevailing market interest rates of 100 basis points, the September 30, 2004 table indicates no significant dollar change in net interest, while the December 31, 2003 table indicates an increase of $577,000. The primary reason for no change in net interest income under a declining interest rate environment of 100 basis points are the actions that the Bank has taken to mitigate the impact of relatively smaller changes in market interest rates while becoming better positioned for more significant increases in market interest rates. These steps include the origination of short-term adjustable rate commercial and residential mortgage loans, the origination of home equity lines of credit and the sale of longer-term, fixed rate mortgages. In the event of a sudden and sustained 200 basis point decline in market interest rates, the September 30, 2004 table indicates a decrease of $1.9 million, slightly greater than the decrease of $1.8 million indicated by the December 31, 2003 table, reflecting the fact that the Bank's core deposits would reach rate floors while assets would continue to price lower. In the event of a sudden and sustained increase in prevailing market interest rates of 100 and 200 basis points, the September 30, 2004 table indicates that net interest income would increase by $279,000 and $932,000, respectively. The December 31, 2003 table indicates that a sudden and sustained increase of 100 and 200 basis points would decrease net interest income by $739,000 and $1.8 million, respectively. The primary reason for this change in the Bank's interest rate risk sensitivity is management's desire to better position the Bank's balance sheet for the eventual rise in market interest rates. This goal was achieved through the continued strategy of selling longer-term, fixed rate residential mortgages, emphasizing the origination of adjustable rate commercial and residential loans and by extending the average maturity of FHLB borrowings. 17 20 Computation of prospective effects of hypothetical interest rate changes are based on a number of assumptions, including the level of market interest rates, the degree to which certain assets and liabilities with similar maturities or periods to repricing react to changes in market interest rates, the expected prepayment rates on loans and investments, the degree to which early withdrawals occur on certificates of deposit, and other deposit flows. As a result, these computations should not be relied upon as indicative of actual results. Further, the computations do not reflect any actions that management may undertake in response to changes in interest rates. 18 21 ITEM 4. CONTROLS AND PROCEDURES. The Company's management, including the Company's principal executive officer and principal financial officer, have evaluated the effectiveness of the Company's "disclosure controls and procedures," as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Based upon their evaluation, the principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company's disclosure controls and procedures were effective for the purpose of ensuring that the information required to be disclosed in the reports that the Company files or submits under the Exchange Act with the Securities and Exchange Commission (the "SEC") (1) is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and (2) is accumulated and communicated to the Company's management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. There has been no change in the Company's internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15 that occurred during the Company's last fiscal quarter that has materially affected or is reasonably likely to materially affect, the Company's internal control over financial reporting. 19 22 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS. The Company is not involved in any legal proceedings other than routine legal proceedings occurring in the normal course of business. Such routine proceedings, in the aggregate, are believed by management to be immaterial to the Company's financial condition or results of operations. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS The Company did not repurchase any shares in the third quarter of 2004. On June 3, 2003, the Company authorized the purchase of up to 298,886 shares, from time to time, subject to market conditions. The repurchase plan will continue until it is completed or terminated by the Board of Directors. As of September 30, 2004, 110,841 shares remain available for purchase under the plan. No plans expired during the three months ended September 30, 2004. The Company has no plans that it has elected to terminate prior to expiration or under which it does not intend to make further purchases. 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 3.1 Certificate of Incorporation of Berkshire Hills Bancorp, Inc. (1) 3.2 Bylaws of Berkshire Hills Bancorp, Inc. (2) 4.0 Stock Certificate of Berkshire Hills Bancorp, Inc. (1) 31.1 Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer 31.2 Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer 32.1 Section 1350 Certification of Chief Executive Officer 32.2 Section 1350 Certification of Chief Financial Officer ----------------------------- (1) Incorporated herein by reference into this document from the Exhibits filed with the Securities and Exchange Commission on the Registration Statement on Form S-1 on March 11, 2000, and any amendments thereto, Registration No. 333-32146. (2) Incorporated herein by reference into this document from the Exhibits to the Form 10-K as filed with the Securities and Exchange Commission on March 11, 2004. 20 23 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. BERKSHIRE HILLS BANCORP, INC. Dated: November 5, 2004 By: /s/ Michael P. Daly ----------------------------------- Michael P. Daly President, Chief Executive Officer and Director (principal executive officer) Dated: November 5, 2004 By: /s/ Wayne F. Patenaude ------------------------------------- Wayne F. Patenaude Senior Vice President, Chief Financial Officer and Treasurer (principal financial and accounting officer) 21