10-K 1 tenk.htm Converted by EDGARwiz


UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

Annual Report Pursuant to Section 13 or 15(d) of

The Securities Exchange Act of 1934

For the Fiscal Year Ended December 31, 2009

Commission File Number: 0-12507

ARROW FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

New York

 

22-2448962

(State or other jurisdiction of

 

(IRS Employer Identification

incorporation or organization)

        

Number)

 

250 GLEN STREET, GLENS FALLS, NEW YORK 12801

(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code:   (518) 745-1000

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT - NONE

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT

Common Stock, Par Value $1.00

(Title of Class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

 

     Yes      x   No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

 

     Yes      x   No

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.

 x   Yes          No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during

the preceding 12 months (or for shorter period that the registrant was required to submit and post such files).

    Yes          No

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

of this Form 10-K or any amendment to this Form 10-K:   

     

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer     

Accelerated filer   x 

Non-accelerated filer     

Smaller reporting company     

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

     Yes      x   No

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter:    $233,441,000

Indicate the number of shares outstanding of each of the registrant’s classes of common stock.

Class

 

 

 

Outstanding as of February 22, 2010

Common Stock, par value $1.00 per share

 

 

 

10,924,856

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s Proxy Statement for the Annual Meeting of Stockholders to be held April 28, 2010 (Part III)




ARROW FINANCIAL CORPORATION

FORM 10-K – TABLE OF CONTENTS


 

Page

Note on Terminology

3

Forward-Looking Statements

3

Use of Non-GAAP Financial Measures

4

PART I

 

Item 1.

Business

4

A.

General

4

B.

Lending Activities

5

C.

Supervision and Regulation

6

D.

Recent Legislative Developments

7

E.

Statistical Disclosure (Guide 3)

8

F.

Competition

8

G.

Executive Officers of the Registrant

9

H.

Available Information

9

Item 1A.

Risk Factors

9

Item 1B.

Unresolved Staff Comments

11

Item 2.

Properties

11

Item 3.

Legal Proceedings

11

Item 4.

Submission of Matters to a Vote of Security Holders

11

PART II

 

Item 5.

Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of

Equity Securities

11

Item 6.

Selected Financial Data

16

Item 7.

Management's Discussion and Analysis of Financial Condition and Results of Operations

17

 

Critical Accounting Policies

19

A.

Overview

19

B.

Results of Operations

22

I.

Net Interest Income

22

II.

Provision for Loan Losses and Allowance for Loan Losses

26

III.

Noninterest Income

29

IV.

Noninterest Expense

30

V.

Income Taxes

31

C.

Financial Condition

31

I.

Investment Portfolio

31

II.

Loan Portfolio

33

a. Types of Loans

33

b. Maturities and Sensitivities of Loans to Changes in Interest Rates

36

c. Risk Elements

36

III.

Summary of Loan Loss Experience

38

IV.

Deposits

38

V.

Time Deposits of $100,000 or More

39

D.

Liquidity

40

E.

Capital Resources and Dividends

40

F.

Off-Balance Sheet Arrangements

41

G.

Contractual Obligations

41

H.

Fourth Quarter Results

42

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

43

Item 8.

Financial Statements and Supplementary Data

44

Item 9.

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

80

Item 9A. Controls and Procedures

80

Item 9B. Other Information

80

PART III

 

Item 10. Directors, Executive Officers and Corporate Governance*

81

Item 11. Executive Compensation*

81

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters *

81

Item 13. Certain Relationships and Related Transactions, and Director Independence*

81

Item 14. Principal Accounting Fees and Services*

81

PART IV

 

Item 15. Exhibits, Financial Statement Schedules

81

Signatures

82

Exhibit Index

83


*These items are incorporated by reference to the Corporation’s Proxy Statement for the Annual Meeting of Stockholders to be held April 28, 2010.



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NOTE ON TERMINOLOGY

In this Annual Report on Form 10-K, the terms “Arrow,” “the registrant,” “the company,” “we,” “us,” and “our” generally refer to Arrow Financial Corporation and its subsidiaries as a group, except where the context indicates otherwise.  Arrow is a two-bank holding company headquartered in Glens Falls, New York.  Our banking subsidiaries are Glens Falls National Bank and Trust Company (Glens Falls National) whose main office is located in Glens Falls, New York, and Saratoga National Bank and Trust Company (Saratoga National) whose main office is located in Saratoga Springs, New York.  Subsidiaries of Glens Falls National include Capital Financial Group, Inc. (an insurance agency specializing in selling and servicing group health care policies), North Country Investment Advisers, Inc. (a registered investment adviser that provides investment advice to our proprietary mutual funds), U.S. Benefits, Inc. (a provider of administrative and recordkeeping services for more complex retirement plans) and Arrow Properties, Inc., a real estate investment trust (REIT).

At certain points in this Report, our performance is compared with that of our “peer group” of financial institutions.  Unless otherwise specifically stated, this peer group is comprised of the group of 296 domestic bank holding companies with $1 to $3 billion in total consolidated assets as identified in the Federal Reserve Board’s “Bank Holding Company Performance Report” for December 31, 2009, and peer group data has been derived from such Report.  This peer group is not, however, identical to either of the peer groups comprising the two bank indices included in the stock performance graphs on pages 13 and 14 of this Report.


FORWARD-LOOKING STATEMENTS

The information contained in this Annual Report on Form 10-K contains statements that are not historical in nature but rather are based on our beliefs, assumptions, expectations, estimates and projections about the future.  These statements are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and involve a degree of uncertainty and attendant risk.  Words such as “expects,” “believes,” “anticipates,” “estimates” and variations of such words and similar expressions often identify such forward-looking statements.  Some of these statements, such as those included in the interest rate sensitivity analysis in Item 7A of this Report, entitled “Quantitative and Qualitative Disclosures About Market Risk,” are merely presentations of what future performance or changes in future performance would look like based on hypothetical assumptions and on simulation models.  Other forward-looking statements are based on our general perceptions of market conditions and trends in activity, both locally and nationally, as well as current management strategies for future operations and development.  


Examples of forward-looking statements in this Report are referenced in the table below:

Topic

Section

Page

Location

Impact of Legislative Developments

Part I,

Item 1.D.

8

Last paragraph in Section D

Impact of Changing Interest Rates on

      Earnings

Part II,

Item 7.B.I.

24

Last paragraph

 

Part II,  

Item 7.C.II.a.

25

3rd paragraph

 

Part II,

Item 7.C.II.a.

34

Last paragraph under “Indirect Loans”

 

Part II,

Item 7.C.II.a.

35

1st paragraph under table

 

Part II,

Item 7.C.IV.

39

1st paragraph

 

Part II,

Item 7A.

43

Last three paragraphs

Adequacy of the Allowance for Loan

      Losses

Part II,

Item 7.B.II.

26

1st and 2nd paragraphs under “II. Provision

  For Loan Losses and Allowance For

  Loan Losses”

Expected Level of Real Estate Loans

Part II,  

Item 7.C.II.a.

34

1st paragraph under “Residential

  Real Estate Loans”

Liquidity

Part II,

Item 7.D.

40

3rd to Last paragraph in Section D

  “Liquidity”

Dividend Capacity

Part I,

Item 1.C.

6

3rd to last paragraph under Section C

  “Supervision and Regulation”

 

Part II,

Item 7.E.

41

Next to last paragraph in Section E

Pension Plan

Part  IV,

Item 15

68

Next to last paragraph

 

 

72

Paragraph in “Cash Flows”  

Commitments to Extend Credit

Part IV,

Item 15

76

1st paragraph


These statements are not guarantees of future performance and involve certain risks and uncertainties that are difficult to quantify or, in some cases, to identify.  In the case of all forward-looking statements, actual outcomes and results may differ materially from what the statements predict or forecast.  

Factors that could cause or contribute to such differences include, but are not limited to; unexpected changes in economic and market conditions, including unanticipated fluctuations in interest rates and changes in the values of real estate and motor vehicles; severe changes in credit markets, including credit insurance markets; unforeseen developments in state and federal regulation of financial institutions; enhanced competition from unexpected sources, including governmental operation of previously private large banking organizations; new emerging technologies; unexpected loss of key personnel; and similar risks of major upheavals in financial operations and markets.  Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof.  We undertake no obligation to revise or update these forward-looking statements to reflect the occurrence of unanticipated events.

 




3



USE OF NON-GAAP FINANCIAL MEASURES

The Securities and Exchange Commission (SEC) has adopted Regulation G, which applies to all public disclosures, including earnings releases, made by registered companies that contain “non-GAAP financial measures.”  GAAP is generally accepted accounting principles in the United States of America.  Under Regulation G, companies making public disclosures containing non-GAAP financial measures must also disclose, along with each non-GAAP financial measure, certain additional information, including a reconciliation of the non-GAAP financial measure to the closest comparable GAAP financial measure and a statement of the company’s reasons for utilizing the non-GAAP financial measure as part of its financial disclosures.  As a parallel measure with Regulation G, the SEC has provided in Item 10 of its Regulation S-K, that public companies must make the same types of supplemental disclosures whenever they include non-GAAP financial measures in their filings with the SEC.  The SEC has exempted from the definition of “non-GAAP financial measures” certain commonly used financial measures that are not based on GAAP.  When these exempted measures are included in public disclosures or SEC filings, supplemental information is not required.  The following measures used in this Report, which although commonly utilized by financial institutions have not been specifically exempted by the SEC, may constitute "non-GAAP financial measures" within the meaning of the SEC's rules, although we are unable to state with certainty that the SEC would so regard them.


Tax-Equivalent Net Interest Income and Net Interest Margin: Net interest income, as a component of the tabular presentation by financial institutions of Selected Financial Information regarding their recently completed operations, is commonly presented on a tax-equivalent basis.  That is, to the extent that some component of the institution's net interest income which is presented on a before-tax basis, is exempt from taxation (e.g., is received by the institution as a result of its holdings of state or municipal obligations), an amount equal to the tax benefit derived from that component is added back to the net interest income total.    This adjustment is considered helpful in comparing one financial institution's net interest income to that of another institution, to correct any distortion that might otherwise arise from the fact that the two institutions typically will have different proportions of tax-exempt items in their portfolios.  Moreover, net interest income is itself a component of a second financial measure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average earning assets.  For purposes of this measure as well, tax-equivalent net interest income is generally used by financial institutions, again to provide a better basis of comparison from institution to institution.  We follow these practices.


The Efficiency Ratio: Financial institutions often use an "efficiency ratio" as a measure of expense control.  The efficiency ratio typically is defined as the ratio of noninterest expense to net interest income and noninterest income.  Net interest income as utilized in calculating the efficiency ratio is typically expressed on a tax-equivalent basis.  Moreover, most financial institutions, in calculating the efficiency ratio, also adjust both noninterest expense and noninterest income to exclude from these items (as calculated under GAAP) certain component elements, such as intangible asset amortization (deducted from noninterest expense) and securities gains or losses, including other-than-temporary impairment, (excluded from noninterest income).  We follow these practices.


Tangible Book Value per Share:  Tangible equity is total stockholders’ equity (as calculated under GAAP) less intangible assets.  Tangible book value per share is tangible equity divided by total shares issued and outstanding.  Tangible book value per share is often regarded as a more meaningful comparative ratio than book value per share as calculated under GAAP, that is, total stockholders’ equity including intangible assets divided by total shares issued and outstanding.  Intangible assets, as a category of assets, includes many items, such as goodwill.



PART I

Item 1.  Business

A. GENERAL

Our holding company, Arrow Financial Corporation, a New York corporation, was incorporated on March 21, 1983 and is registered as a bank holding company within the meaning of the Bank Holding Company Act of 1956.  Arrow owns (directly or indirectly) two nationally chartered banks in New York (Glens Falls National and Saratoga National), an insurance agency (Capital Financial Group, Inc.), a registered investment adviser that advises our proprietary mutual funds (North Country Investment Advisers, Inc.), a Real Estate Investment Trust (Arrow Properties, Inc.) and four other non-bank subsidiaries whose operations are insignificant.


Subsidiary Banks (dollars in thousands)

 

 

Glens Falls National

Saratoga National

Total Assets at Year-End

$1,571,797

$279,649

Trust Assets Under Administration and

   Investment Management at Year-End

   (Not Included in Total Assets)

$829,599

$37,555

Date Organized

1851

1988

Employees (full-time equivalent)

432

41

Offices

28

6

Counties of Operation

Warren, Washington,

Saratoga, Essex &

Clinton

Saratoga


Main Office

250 Glen Street

Glens Falls, NY

171 So. Broadway

Saratoga Springs, NY


The holding company’s business consists primarily of the ownership, supervision and control of our two banks.  The holding company provides various advisory and administrative services and coordinates the general policies and operation of the banks.  There were 473 full-time equivalent employees at December 31, 2009.



4



We offer a full range of commercial and consumer banking and financial products.  Our deposit base consists of deposits derived principally from the communities we serve.  We target our lending activities to consumers and small and mid-sized companies in our immediate geographic areas.  Through our banks' trust operations, we provide retirement planning, trust and estate administration services for individuals, and pension, profit-sharing and employee benefit plan administration for corporations.

In July 2008, we acquired the key operating assets, two employees and the trade name from U.S. Benefits, Inc., a provider of administrative and recordkeeping services for more complex retirement plans.  This acquisition allows the Company to offer enhanced and broadened services to retirement plan clients and will complement the fiduciary services currently offered by the Company through its trust administrative and investment management activities.  

In April 2005, we acquired from HSBC Bank USA, N.A. (“HSBC”) three bank branches located within our service area.  Our subsidiary Glens Falls National acquired two HSBC branches located in Argyle and Salem, New York, and our subsidiary Saratoga National acquired a branch located in Corinth, New York.  The banks acquired substantially all deposit liabilities, the physical facilities and certain loans related to the branches.  At the closing of the acquisitions, total deposits of the three branches were approximately $62 million and the related loans were approximately $8 million.  The acquisition resulted in total intangible assets, including goodwill, of approximately $5.9 million.

In November 2004, we acquired all of the outstanding shares of common stock of Capital Financial Group, Inc. (“CFG”), an insurance agency headquartered in South Glens Falls, New York, which specializes in group health and life insurance products.  The acquisition was structured as a tax-free exchange of Arrow’s common stock for CFG’s common stock.  CFG’s president and staff continued with CFG after the acquisition.  As adjusted for cumulative contingent payments, we recorded the following intangible assets as a result of the acquisition (none of which are deductible for income tax purposes): goodwill ($1.735 million), covenant not to compete ($117 thousand) and portfolio expirations ($686 thousand).   The value of the covenant is being amortized over five years and the value of the expirations is being amortized over twenty years.  Under the acquisition agreement, we issued 68,629 shares of Arrow’s common stock at the closing.  The agreement also provided for annual contingent post-closing payments of Arrow common stock, based upon earnings of CFG, adjusted as provided in the agreement, over the five-year period following the closing.  We concluded that these contingent payments would be recorded as additional goodwill at the time of payment.  Total contingent payments, for the now completed five-year period, amounted to $898 thousand (35,120 shares).

In 2000, we formed a subsidiary, North Country Investment Advisers, Inc. (“NCIA”), which is an investment adviser registered with the U. S. Securities and Exchange Commission. NCIA advises two SEC-registered mutual funds, the North Country Intermediate Bond Fund™ and the North Country Equity Growth Fund™.  Currently, the investors in these funds consist primarily of individual, corporate and institutional trust customers of our Banks.  However, the funds are also offered on a retail basis at most of the branch locations of our banks.


B. LENDING ACTIVITIES

Arrow engages in a wide range of lending activities, including commercial and industrial lending primarily to small and mid-sized companies; mortgage lending for residential and commercial properties; and consumer installment and home equity financing.  We also maintain an active indirect lending program through our sponsorship of automobile dealer programs under which we purchase dealer paper, primarily from dealers that meet pre-established specifications.  From time-to-time we sell a portion of our residential real estate loan originations into the secondary market, primarily to the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and state housing agencies, while normally retaining the servicing rights.  

In addition to sales of loans into the secondary market, we have periodically securitized some of the mortgage loans in our portfolio.  In the securitized transactions, we have sold mortgage loans into a newly-formed trust and concurrently have purchased an equivalent amount of mortgage-backed securities issued by the trust that are guaranteed by Freddie Mac, with the sold loans representing the underlying collateral for the trust securities.  We have no contingent liability to unrelated parties under these securitization arrangements.  At December 31, 2009, the balance of these securitized loans remaining in our securities portfolio was approximately $2.1 million.  In addition to interest earned on loans, we receive facility fees for various types of commercial and industrial credits, and commitment fees for extensions of letters of credit and certain types of loans.

Generally, we continue to implement lending strategies and policies that are intended to protect the quality of the loan portfolio, including strong underwriting and collateral control procedures and credit review systems.  It is our policy to discontinue the accrual of interest on loans when the payment of interest and/or principal is due and unpaid for a designated period (generally 90 days) or when the likelihood of repayment is, in the opinion of management, uncertain (see Part II, Item 7.C.II.c. “Risk Elements”). Subsequent cash payments on loans classified as nonaccrual may be applied all to principal, although income in some cases may be recognized on a cash basis.

We lend almost exclusively to borrowers within our geographic area, with the exception of our indirect consumer lending line of business where we acquire retail paper on primarily automobile loans.  We have an extensive network of automobile dealers, all of whom are located in New York State, that operate in a geographic area larger than our footprint primarily in the eastern region of upstate New York.  The loan portfolio does not include any foreign loans or any other significant risk concentrations.  We do not participate in loan syndications, either as originator or as a participant.  Most of the portfolio, in general, is fully collateralized, and many commercial loans are further secured by personal guarantees.

We do not engage in subprime mortgage lending as a business line and we do not extend or purchase so-called “Alt A,” “negative amortization,” “option ARM’s” or “negative equity” mortgage loans.



5



C. SUPERVISION AND REGULATION

The following generally describes the laws and regulations to which we are subject.  Bank holding companies, banks and their affiliates are extensively regulated under both federal and state law.  To the extent that the following information summarizes statutory or regulatory law, it is qualified in its entirety by reference to the particular provisions of the various statutes and regulations.  Any change in applicable law may have a material effect on our business and prospects.

Currently, as a result of the financial crisis that has affected the United States and most of the world’s advanced nations, there has been much discussion in legal and regulatory circles about the need for fundamental financial reform in order to prevent a recurrence of the economic and financial collapse.  Among the areas of banking law and regulation most commonly identified as necessitating reform are inadequate capital standards, over-reliance on securitization of loans, inconsistency or inadequacy of bank regulatory oversight, lax underwriting standards, and expansion of permitted bank activities into inappropriate non-banking business.  It is impossible to predict at present what new banking laws or regulations ultimately will be enacted or promulgated or the impact thereof on our banks and our banking business, except to note that any such changes are likely to impose added restrictions on U.S. banks and banking activity generally, which may reduce profitability.

Arrow is a registered bank holding company within the meaning of the Bank Holding Company Act of 1956 (“BHC Act”) and is subject to regulation by the Board of Governors of the Federal Reserve System (“FRB”).  Arrow is not a so-called “financial holding company” under federal banking law.  Additionally, as a “bank holding company” under New York State law, Arrow is subject to a limited amount of regulation by the New York State Banking Department.  Our two subsidiary banks are both nationally chartered banks and are subject to supervision and examination by the Office of the Comptroller of the Currency (“OCC”). The banks are members of the Federal Reserve System and the deposits of each bank are insured by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation (“FDIC”).  The BHC Act generally prohibits Arrow from engaging, directly or indirectly, in activities other than banking, activities closely related to banking, and certain other financial activities.  Under the BHC Act, a bank holding company must obtain FRB approval before acquiring, directly or indirectly, 5% or more of the voting shares of another bank or bank holding company (unless it already owns a majority of such shares).  Bank holding companies are able to acquire banks or other bank holding companies located in all 50 states.  The Gramm-Leach-Bliley Act, enacted in 1999, authorized bank holding companies to affiliate with a much broader array of other financial institutions than was previously permitted, including insurance companies, investment banks and merchant banks.  See Item 1.D., “Recent Legislative Developments.”

An important area of banking regulation is the federal banking system’s promulgation and enforcement of minimum capitalization standards for banks and bank holding companies.  The FRB has adopted various "capital adequacy guidelines" for its use in the examination and supervision of bank holding companies.  The FRB’s risk-based capital guidelines assign risk weightings to all assets and certain off-balance sheet items and establish an 8% minimum ratio of qualified total capital to the aggregate dollar amount of risk-weighted assets (which is almost always less than the dollar amount of such assets without risk weighting).  Under the risk-based guidelines, at least half of total capital must consist of "Tier 1" capital, which comprises common equity, retained earnings and a limited amount of permanent preferred stock, less goodwill.  Under the FRB’s guidelines, trust preferred securities may also qualify as Tier 1 capital, in an amount not to exceed 25% of Tier 1 capital.  The final rule limits restricted core capital elements to a percentage of the sum of core capital elements, net of goodwill less any associated deferred tax liability.  We issued trust preferred securities in 2003 and 2004 to serve as part of our core capital.  Up to half of total capital may consist of so-called "Tier 2" capital, comprising a limited amount of subordinated debt, preferred stock not qualifying as Tier 1 capital, certain other instruments and a limited amount of the allowance for loan losses. The FRB’s other important guideline for measuring a bank holding company’s capital is the leverage ratio standard, which establishes minimum limits on the ratio of a bank holding company's "Tier 1" capital to total tangible assets (not risk-weighted).  For top-rated holding companies, the minimum leverage ratio is 3%, but lower-rated companies may be required to meet substantially greater minimum ratios.  Our subsidiary banks are subject to capital requirements similar to the capital requirements applicable at the holding company level described above.  Our banks’ capital requirements have been promulgated by their primary federal regulator, the OCC.  It is widely anticipated that prevailing capital guidelines will be strengthened by the regulatory authorities in upcoming years.

Under applicable law, federal banking regulators are required to take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements.  The regulators have established five capital classifications for banking institutions, the highest being "well-capitalized."  Our holding company and both of our subsidiary banks currently qualify as “well-capitalized.”  Under regulations adopted by the federal bank regulators, a banking institution is considered "well-capitalized" if it has a total risk-adjusted capital ratio of 10% or greater, a Tier 1 risk-adjusted capital ratio of 6% or greater and a leverage ratio of 5% or greater and is not subject to any regulatory order or written directive regarding capital maintenance.  The year-end 2009 capital ratios of our holding company and our banks are set forth in Part II, Item 7.E. "Capital Resources and Dividends" and in Note 15 “Regulatory Matters” to the audited financial statements under Part II, Item 8 of this Report.  

A holding company's ability to pay dividends or repurchase its outstanding stock, as well as its ability to expand its business through acquisitions of additional banking organizations or permitted non-bank companies, may be restricted if its capital falls below these minimum capitalization ratios or fails to meet other informal capital guidelines that the regulators may apply from time to time to specific banking organizations.  In addition to these potential regulatory limitations on payment of dividends, our holding company’s ability to pay dividends to our stockholders, and our subsidiary banks’ ability to pay dividends to our holding company are also subject to various restrictions under applicable corporate laws, including banking laws (affecting our subsidiary banks) and the New York Business Corporation Law (affecting our holding company).  The ability of our holding company and banks to pay dividends in the future is, and is expected to continue to be, influenced by regulatory policies, capital guidelines and applicable law.

In cases where banking regulators have significant concerns regarding the financial condition, assets or operations of a bank or bank holding company, the regulators may take enforcement action or impose enforcement orders, formal or informal, against the organization.  If the leverage ratio/Tier 1 risk-adjusted capital ratio of a bank falls below 2%, the bank may be closed and placed in receivership, with the FDIC as receiver.

The Emergency Economic Stabilization Act of 2008 (EESA), which includes the Troubled Asset Relief Program (TARP), and the American Recovery and Reinvestment Act of 2008 (the ARRA) were enacted in response to the financial crises affecting the banking system and financial markets.  The EESA, the ARRA and related government programs include a variety of regulatory initiatives aimed at providing stability to the financial services industry and financial markets; however, many of these laws and programs are and will continue to impact the supervision and regulation of the banking industry.  The impact of certain of these laws and programs are addressed in the following section regarding Recent Legislative Developments.



6



D. RECENT LEGISLATIVE DEVELOPMENTS


The recently enacted federal laws addressing the financial crisis, including EESA and ARRA, and the related, recently established governmental programs, such as the FDIC’s Temporary Liquidity Guarantee Program (TLGP) and the U.S. Treasury’s Capital Purchase Program (CPP), a component of TARP, are discussed at the end of this section.  

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 became effective October 17, 2005. The Act addressed many areas of bankruptcy practice, including consumer bankruptcy, general and small business bankruptcy, treatment of tax claims in bankruptcy, ancillary and cross-border cases, financial contract protection amendments to Chapter 12 governing family farmer reorganization, and special protection for patients of a health care business filing for bankruptcy.  This Act did not have a significant impact on our earnings or on our efforts to recover collateral on secured loans.  In January of 2008, Congress began to consider a bill that would give bankruptcy judges the power to alter rates, terms, balances and maturities of home mortgage loans.

The Sarbanes-Oxley Act, signed into law on July 30, 2002, adopted a number of measures having a significant impact on all publicly-traded companies, including Arrow.  Generally, the Act sought to improve the quality of financial reporting of these companies by compelling them to adopt good corporate governance practices and by strengthening the independence of their auditors.  The Act placed substantial additional duties on directors, officers, auditors and attorneys of public companies.  Among other specific measures, the Act required that chief executive officers and chief financial officers certify to the SEC in the holding company’s annual and quarterly reports filed with the SEC regarding the accuracy of its financial statements contained therein and the integrity of its internal controls.  The Act also accelerated insiders' reporting requirements for transactions in company securities, restricts certain executive officer and director transactions, imposed obligations on corporate audit committees, and provided for enhanced review of company filings by the SEC.  As part of the general effort to improve public company auditing, the Act places limits on consulting services that may be performed by a company's independent auditors by requiring that the company’s Audit Committee of the Board of Directors evaluate amounts to determine independence.  The Act created a federal public company accounting oversight board (the PCAOB) to set auditing standards, inspect registered public accounting firms, and exercise enforcement powers, subject to oversight by the SEC.  

In the wake of the Sarbanes-Oxley Act, the nation’s stock exchanges, including the exchange on which Arrow’s stock is listed, the National Association of Securities Dealers, Inc. (“NASD”), promulgated a wide array of governance standards that must be followed by listed companies.  The NASD standards include having a Board of Directors the majority of whose members are independent of management, and having audit, compensation and nomination committees of the Board consisting exclusively of independent directors.  We have implemented a variety of corporate governance measures and procedures to comply with Sarbanes-Oxley and the amended NASD listing requirements, although we have always relied on a Board of Directors a majority of whose members are independent and independent Board committees to make important decisions regarding the company.

The USA Patriot Act initially adopted in 2001 and re-adopted by the U.S. Congress in 2006 with certain changes (the “Patriot Act”), imposes substantial new record-keeping and due diligence obligations on banks and other financial institutions, with a particular focus on detecting and reporting money-laundering transactions involving domestic or international customers.  The U.S. Treasury Department has issued and will continue to issue regulations clarifying the Patriot Act's requirements.  The Patriot Act requires all financial institutions, including banks, to establish certain anti-money laundering compliance and due diligence programs.  The provisions of the Act impose substantial additional costs on all financial institutions, including ours.

In November 1999, Congress enacted the Gramm-Leach-Bliley Act (“GLBA”), which permitted bank holding companies to engage in a wider range of financial activities.  For example, under GLBA bank holding companies may underwrite all types of insurance and annuity products and all types of securities products and mutual funds, and may engage in merchant banking activities.  Bank holding companies that wish to engage in these or other financial activities generally must do so through separate “financial” subsidiaries and may themselves be required to register (and qualify to register) as so-called “financial holding companies.”  A bank holding company that does not register as a financial holding company remains a bank holding company subject to substantially the same regulatory restrictions and permitted activities as applied to bank holding companies prior to GLBA (See Item I.C., “Supervision and Regulation,” above).  We have not as yet elected to become a “financial holding company”.  Also under GLBA, financial institutions have become subject to stringent customer privacy regulations, in addition to the privacy provisions under the Fair Credit Reporting Act Amendment of 2003.

The FDIC collects both insurance premiums on insured deposits and an assessment for the Financing Corporation (FICO) bonds.

The FICO was established by the Competitive Equality Banking Act of 1987, and is a mixed-ownership government corporation whose sole purpose was to issue bonds to insure thrift institutions. Outstanding FICO bonds, which are 30-year noncallable bonds with a principal amount of approximately $8.1 billion, mature in 2017 through 2019.  FICO has assessment authority, separate from the FDIC's authority to assess risk-based premiums for deposit insurance, to collect funds from all FDIC-insured institutions sufficient to pay interest on FICO bonds. The FDIC acts as collection agent for the FICO.  Since the first quarter of 2000, all FDIC-insured deposits have been assessed at the same rate by FICO.  For 2009, our FICO assessment was $141 thousand.

In 2007 the FDIC resumed charging financial institutions a premium under the new “risk-based assessment system.”  Under this system, institutions in Risk Category I (the lowest of four risk categories) will pay a rate (based on a formula) of 5 to 7 cents per $100 of assessable deposits.  Both of our banks qualified for the 5 cent per $100 assessment rate during 2008.

 

The Federal Deposit Insurance Reform Act of 2005 allowed "eligible insured depository institutions" to share a one-time assessment credit pool of approximately $4.7 billion.  Our credit amounted to $747 thousand.  The credit was available to offset FDIC insurance premiums beginning in 2007, but not to offset the FICO bond assessment, which will continue through 2019.  The one-time credit fully offset our FDIC insurance premiums for 2008 and offset approximately $134 thousand of our $637 thousand 2008 FDIC premiums.

In 2008, in response to the level of claims against the Bank Insurance Fund, the FDIC announced that it would raise the lowest rate from 5 cents to 12 cents per $100 of assessable deposits beginning with the first quarter of 2008, which remained in effect throughout 2008 and 2009.  In addition, beginning with the second quarter of 2009, the FDIC added four new factors to the assessment rate calculation, including factors for brokered deposits, secured liabilities and unsecured liabilities (see Note 19 to the consolidated financial statements).




7



In 2009 the FDIC imposed a special assessment on all insured institutions, including our banks, at .05% of total assets as adjusted for Tier 1 capital.  We charged $787 thousand to earnings in the second quarter of 2009 for this assessment, which was paid on September 30, 2009.  In the fourth quarter of 2009, the FDIC collected prepaid assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012.  Based on the current rate of 12 cents per $100 in 2009 and 2010 and 15 cents per $100 for 2011 and 2012, our prepaid assessment amounted to $6.8 million.  The expense will be ratably recorded over the respective periods as directed by the FDIC.  We are unable to predict whether or to what extent the FDIC may elect to impose additional special assessments on insured institutions in upcoming years, although it is commonly understood that the FDIC insurance fund may not be adequate if bank failures continue at their present rate for any significant period of time and/or the cost to the FDIC of the bank failures recently resolved by it should prove even greater than was initially anticipated.

In late 2008, the FDIC adopted the TLGP to boost consumer confidence in funds deposited with insured institutions.  The TLGP allowed insured institutions to participate in two areas of additional insurance: 1) full coverage of noninterest-bearing accounts through December 31, 2009 at a cost of an additional 10 cents per $100 of additional insured deposits, and 2) a guarantee of certain newly-issued unsecured short-term senior debt issued by a bank holding company or bank on or before June 30, 2009, at a cost ranging from 50 to 100 basis points.  We elected to participate in both components of the TLGP, but did not issue any FDIC-guaranteed unsecured short-term debt before expiration of the program.  The cost for the additional deposit insurance was $18 thousand for 2009.

Arrow was preliminarily approved by the U.S. Treasury Department to participate in the CPP; however, in January 2009, we announced that we would not participate in the CPP due to our strong financial and liquidity positions.  See Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, page 17.  Under the CPP, the U.S. Treasury purchased preferred stock in participating publicly traded financial institutions.  The dividend rate on the stock was 5%, increasing to 9% in year 6 and later years.  The purchase also included the issuance of stock warrants at 15% of the amount of the investment.

The EESA, the ARRA, and the related governmental programs include a variety of initiatives that could have a significant impact on the banking industry and on Arrow; however, the actual impact that these new laws and programs will have on the financial markets, the financial services industry and Arrow cannot be determined at this time.  In addition, various federal bills that would significantly affect banks have been introduced in Congress, including laws that would reform the regulatory agencies.  We cannot estimate the likelihood of any currently proposed banking bills being enacted into law, or the ultimate effect that any such potential legislation, if enacted, would have upon our financial condition or operations.  


E. STATISTICAL DISCLOSURE – (GUIDE 3)

Set forth below is an index identifying the location in this Report of various items of statistical information required to be included in this Report by the SEC’s industry guide for Bank Holding Companies.


Required Information

Location in Report

Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and Interest Differential

Part II, Item 7.B.I.

Investment Portfolio

Part II, Item 7.C.I.

Loan Portfolio

Part II, Item 7.C.II.

Summary of Loan Loss Experience

Part II, Item 7.C.III.

Deposits

Part II, Item 7.C.IV.

Return on Equity and Assets

Part II, Item 6.

Short-Term Borrowings

Part II, Item 8. Note 10.


F. COMPETITION

We face intense competition in all markets we serve.  Traditional competitors are other local commercial banks, savings banks, savings and loan institutions and credit unions, as well as local offices of major regional and money center banks.  Like all banks, we encounter strong competition in mortgage lending from the very large and growing government sponsored entities “Fannie Mae” and “Freddie Mac,” who guarantee government-subsidized mortgage loans, that in 2009 accounted for a large majority of the total amount of mortgage loans extended in the U.S.  Additionally, non-banking financial organizations, such as consumer finance companies, insurance companies, securities firms, money market and mutual funds and credit card companies offer substantive equivalents of the various loan and financial products and transactional accounts that we offer, even though these non-banking organizations are not subject to the same regulatory restrictions and capital requirements that apply to us.  Under federal banking laws, such non-banking financial organizations not only may offer products comparable to those offered by commercial banks, but also may establish or acquire their own commercial banks.




8



G. EXECUTIVE OFFICERS OF THE REGISTRANT

The names and ages of the executive officers of Arrow and positions held by each are presented in the following table.  Officers are elected annually by the Board of Directors.

Name

Age

Positions Held and Years from Which Held

Thomas L. Hoy

61

Chairman, President and CEO since 2004.  Prior to 2004, Mr. Hoy served as President and CEO.  Mr. Hoy has been with the company since 1974.

Terry R. Goodemote

46

Senior Vice President, Treasurer and CFO since January 1, 2007.  Prior to 2007, Mr. Goodemote was Senior Vice President and head of the Accounting Division.  Mr. Goodemote has been with the company since 1992.

David S. DeMarco

48

Senior Vice President since May 1, 2009.  Mr. DeMarco has been with the company since 1987.

Thomas J. Murphy

51

Vice President and Corporate Secretary since May 1, 2009.  Prior to that, Mr. Murphy served as Assistant Corporate Secretary.  Mr. Murphy has been with the company since 2004.

Raymond F. O’Conor

54

Senior Vice President since May 1, 2009.  Mr. O’Conor has been with the company since 1985.


H. AVAILABLE INFORMATION

Our Internet address is www.arrowfinancial.com.  We make available free of charge on or through our Internet website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports as soon as practicable after we file or furnish them with the SEC pursuant to the Exchange Act.  We also make available on the internet website various other documents related to corporate operations, including our Corporate Governance Guidelines, the charters of our principal board committees, and our codes of ethics.  We have adopted a financial code of ethics that applies to Arrow’s chief executive officer, chief financial officer and principal accounting officer and a business code of ethics that applies to all directors, officers and employees.


Item 1A. Risk Factors

Our financial results and the market price of our stock in future periods are subject to risks arising from many factors, including the following:  (Please note that the discussions below regarding potential impact on Arrow of certain of these factors that may develop in the future are not meant to provide predictions by Arrow's management that such factors will develop, but to acknowledge the possible impact that could occur if the factors do develop.)


Difficult market conditions have adversely affected the financial services industry.  For many financial institutions, dramatic declines in the U.S. housing market over the past three years, with falling home prices and increasing foreclosures and unemployment, have negatively impacted the credit performance of real estate related loans and resulted in significant write-downs of asset values.   To date, the impact of these adverse market conditions has been less significant on Arrow than it has been on many other U.S. financial institutions.  Write-downs at many of these other institutions, initially of asset-backed securities but spreading to other securities and loans, have caused a number of those institutions to seek additional capital, to reduce or eliminate dividends, to merge with larger and stronger institutions and, in some cases, to fail.  Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have reduced or ceased providing funding to borrowers, including to other financial institutions.  Generally, in the financial services sector, this market turmoil and tightening of credit have led to an increased level of commercial and consumer delinquencies at many institutions, lack of consumer confidence, increased market volatility and widespread reduction of business activity.  Although this turmoil has affected Arrow and our local markets less than certain other institutions and markets so far, the resulting economic pressure on consumers and lack of confidence in the financial markets has already, to some extent, adversely affected our business, financial condition and results of operations. Market developments may continue to affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates, which may impact our charge-offs and provision for credit losses.  A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on Arrow and others in the financial institutions industry.  

If economic conditions continue to deteriorate and the U.S. experiences a prolonged nationwide recession, the company’s allowance for loan losses may not be adequate to cover actual losses.  Like all financial institutions, we maintain an allowance for loan losses to provide for probable loan losses at the balance sheet date.  Our allowance for loan losses is based on our historical loss experience as well as an evaluation of the risks associated with our loan portfolio, including the size and composition of the portfolio, current economic conditions and geographic concentrations within the portfolio and other factors.  If the economy in our geographic market area, Northeastern New York State, should deteriorate or enter into a prolonged state of recession, this may have an additional adverse impact on our loan portfolio.  If the quality of our portfolio should weaken due to this impact, our allowance for loan losses may not be adequate to cover actual loan losses, and future provisions for loan losses could materially and adversely affect financial results.  Moreover, loan portfolio difficulties often accompany difficulties in other areas of our business, including growth of our business generally, thereby compounding the negative effects on earnings.



9



The domestic interest rate environment could negatively affect the company’s net interest income.  An institution’s net interest income is significantly affected by market rates of interest, including short-term and long-term rates and the relationship between the two.  Interest rates are highly sensitive to many factors, which are beyond our control, including general economic conditions, policies of various governmental and regulatory agencies such as the Federal Reserve Board, and actions taken by foreign central banks.  Like all financial institutions, the Company’s balance sheet is affected by fluctuations in interest rates. Many commentators believe that the Federal Reserve and other central banks will begin to increase prevailing rates within the next 12 months or soon thereafter, and that this development may negatively affect banks’ profitability.  See the discussion under “Changes in Net Interest Income Due to Rate,” on page 24 of this Report.

If economic conditions worsen and the U.S. financial markets continue to experience difficulties, the company may experience limited access to credit markets.  As discussed under Part I, Item 7.D. “Liquidity,” the company has relationships with various third parties to provide overnight and longer-term credit arrangements.  As these third parties themselves have difficulty in accessing their own credit markets then we may, in turn, experience a decrease in our capacity to borrow funds from them or other third parties traditionally relied upon by banks for liquidity.

  

If the value of real estate in our market area were to decline materially, a significant portion of our loan portfolio could become under-collateralized, which might have a material adverse effect on us.  In addition to considering the financial strength and cash flow characteristics of borrowers, we often secure loans with real estate collateral, which in each case provides an alternate source of repayment in the event of default by the borrower.  This real property may deteriorate in value during the time the credit is outstanding.  If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected.  Furthermore, the possibility of legislative changes at the Federal or State level, related to foreclosure proceedings, may result in negative impacts to financial institutions.  

If securities prices should significantly decline in upcoming periods, we likely will experience a continuing reduction in income from fiduciary activities.  The most significant portion of the income we earn from managing assets in our fiduciary capacity is tied to the market value of those assets, i.e., investment securities.    

We are subject to the local economies where we operate, and unfavorable economic conditions in these areas could have a material adverse effect on our financial condition and results of operations.  Our success depends upon the growth in population, income levels and deposits in our geographic market area.  Unpredictable and unfavorable economic conditions unique to our market area may have an adverse effect on the quality of our loan portfolio and financial performance.  As a community bank, we are less able than our larger regional competitors to spread the risk of unfavorable local economic conditions over a larger market area.  Moreover, we cannot give any assurances that we will benefit from any unique and favorable economic conditions in our market area, even if they do occur.  

Current levels of market volatility.  The market for certain investment securities, including mortgage-backed securities, has been highly volatile or inactive, and may not stabilize or resume in the near future.  This volatility can result in significant fluctuation in the prices of those securities, which could affect the results of our operations.  

Changes in accounting standards may materially impact the company’s financial statements.  From time-to-time, the Financial Accounting Standards Board (“FASB”) changes the financial accounting and reporting standards that govern the preparation of our financial statements.  These changes can be hard to predict and can materially impact how we record and report our financial condition and results of operations.  In some cases, we may be required to apply a new or revised standard retroactively, resulting in changes to previously reported financial statements.

The company’s business could suffer if it loses key personnel unexpectedly or fails to provide for an orderly management succession.  Our success depends, in large part, on our ability to retain our key personnel for the duration of their expected terms of service, and to arrange for an orderly succession of other, equally skilled personnel.  Competition for the best people in our business can be intense.  While our Board of Directors actively reviews succession plans, any sudden change at the senior management level may adversely affect our business.

The company relies on other companies to provide key components of the company’s business infrastructure.  Third-party vendors provide key components of our business infrastructure such as internet connections, network access and mutual fund distribution.  These parties are beyond our control, and any problems caused or experienced by these third parties, including their not providing us their services or performing such services poorly, or not being able to continue to perform such services, could adversely affect our ability to deliver products and services to our customers and conduct our business.  

The soundness of other financial institutions could adversely affect Arrow.  Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions.  Financial services institutions are interrelated as a result of trading, clearing, counterparty and other relationships.  Arrow has exposure to many different counterparties, and we routinely execute transactions with counterparties in the financial industry, including brokers and dealers, commercial banks, investment banks, mutual and hedge funds, and other financial institutions.  As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, could lead to market-wide liquidity problems and to losses or defaults by Arrow or by other institutions and organizations.  Many of these transactions expose Arrow to credit risk in the event of default of our counterparty or client.  In addition, Arrow’s credit risk may be exacerbated when the collateral held by Arrow cannot be liquidated or is liquidated at prices not sufficient to recover the full amount of the financial instrument exposure due Arrow.  There is no assurance that any such losses would not materially and adversely affect our results of operations.  

The company faces continuing and growing security risks to its own information base and to information on its customers.  The computer systems and network infrastructure that we use are always vulnerable to unforeseen problems, including theft of confidential customer information (“identity theft”) and interruption of service as a result of fire, natural disasters, explosion or general infrastructure failure.  These problems may arise in both our internally developed systems and the systems of our third-party service providers.  We constantly assess and attempt to improve our security systems and disaster preparedness, including back-up systems, but the risks in these areas are substantially escalating.




10



The company’s stock price may begin to reflect market volatility.  Our stock price can fluctuate widely in response to a variety of factors, including:  actual or anticipated variations in our operating results; recommendations by securities analysts; significant acquisitions or business combinations; operating and stock price performance of other companies that investors deem comparable to us; new technology used or services offered by our competitors; news reports relating to trends, concerns and other issues in the financial services industry; and changes in government regulations.  Many of these factors that may adversely affect our stock price do not directly pertain to our operating results, including general market fluctuations, industry-wide factors and economic and general political conditions and events, including terrorist attacks, economic slowdowns or recessions, interest rate changes, credit loss trends or currency fluctuations.

We may be adversely affected by government regulation.  We are subject to extensive federal and state banking regulations and supervision.  Banking regulations are intended primarily to protect our depositors’ funds and the federal deposit insurance funds, not the company’s stockholders.  Regulatory requirements affect our lending practices, capital structure, investment practices, dividend policy and growth.  Failure to meet minimum capital requirements could result in the imposition of limitations on our operations that would adversely impact our operations and could, if capital levels dropped significantly, result in our being required to cease or scale back our operations.  Changes in governing law, regulations or regulatory practices could impose additional costs on us or adversely affect our ability to obtain deposits or make loans and thereby hurt our revenues and profitability.

 


Item 1.B.  Unresolved Staff Comments - None


Item 2.  Properties

Our main office is at 250 Glen Street, Glens Falls, New York.  The building is owned by us and serves as the main office for Glens Falls National Bank, our principal subsidiary.  We own twenty-eight branch offices and lease six others at market rates.

In the opinion of management, the physical properties of our holding company and our subsidiary banks are suitable and adequate.  For more information on our properties, see Notes 1, 6 and 21 to the Consolidated Financial Statements contained in Part II, Item 8 of this Report.


Item 3.  Legal Proceedings

We are not the subject of any material pending legal proceedings, other than ordinary routine litigation occurring in the normal course of our business.  On an ongoing basis, we are the subject of or a party to various legal claims, which arise in the normal course of our business.  The various pending legal claims against us will not, in the opinion of management based upon consultation with counsel, result in any material liability.


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

None in the fourth quarter of 2009.


PART II


Item 5.  Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity

    Securities


The common stock of Arrow Financial Corporation is traded on The Nasdaq Stock MarketSM under the symbol AROW.

The high and low prices listed below represent actual sales transactions, as reported by Nasdaq.  All stock prices and cash dividends per share have been restated to reflect subsequent stock dividends.  On September 28, 2009, we distributed a 3% stock dividend on our outstanding shares of common stock.

 

2009

2008

 

Sales Price

Cash Dividends

Sales Price

Cash Dividends

 

Low

High

Declared

Low

High

Declared

First Quarter

$18.93

$25.23

$.243

$17.96

$23.00

$.233

Second Quarter

22.35

26.89

.243

17.48

23.64

.233

Third Quarter

24.68

29.74

.243

17.27

31.77

.243

Fourth Quarter

24.06

27.77

.250

20.87

29.11

.243

 

 

 

 

 

 

 

The payment of cash dividends by Arrow is at the discretion of its Board of Directors and is dependent upon, among other things, our earnings, financial condition and other factors, including applicable legal and regulatory restrictions.  See "Capital Resources and Dividends" in Part II, Item 7.E. of this report.

There were approximately 6,227 holders of record of Arrow’s common stock at December 31, 2009. Arrow has no other class of stock outstanding.




11



Equity Compensation Plan Information

The following table sets forth certain information regarding Arrow's equity compensation plans as of December 31, 2009.  These equity compensation plans were our 2009 Long Term Incentive Plan ("Stock Plan"), our 2000 Director, Officer and Employee Stock Purchase Plan ("ESPP") and our Directors' Stock Plan.  Consistent with applicable law and regulation, the Stock Plan was approved by Arrow's shareholders, while the ESPP and the Directors' Stock Plan were not shareholder approved when they were adopted.  However, shareholders approved the Directors’ Stock Plan at their 2009 annual meeting when the plan was amended to add shares.





Plan Category

(a)

Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights        

(b)

Weighted-Average

Exercise Price of Outstanding Options, Warrants and Rights     

(c)

Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Securities Reflected in Column (a))        

Equity Compensation Plans Approved by Security Holders

439,322 (1)

$22.35

270,743 (2)

Equity Compensation Plans Not Approved by Security Holders

           0

0

537,128 (3)

Total

439,322

$22.35

807,871


(1) Includes 439,222 shares of common stock issuable pursuant to outstanding stock options granted under the Stock Plan and predecessor stock plans.  

(2) Includes 247,700 shares of common stock issuable under the Stock Plan and 23,043 shares of common stock available for future issuance under the Directors’ Stock Plan.

(3) All 537,128 shares of common stock are available for future issuance under the ESPP.  


Description of Non-Stockholder Approved Plans.


Director, Officer and Employee Stock Purchase Plan.  The Director, Officer and Employee Stock Purchase Plan was adopted by the Board of Directors in 2000.  Under the plan, eligible participants (currently directors, officers, full-time employees and certain retirees) are permitted to acquire shares of common stock at a price that represents a small discount from the current market price of the stock by authorizing regular withholding from their paychecks or, in the case of directors or retirees, regular withdrawals from their bank deposit accounts.  Participants may also purchase shares on an ad hoc basis through optional cash contributions.  The maximum discount on shares acquired through regular withholdings or withdrawals is 5% (also the current discount).  The discounted price only applies to the first $1,000 of a participant's monthly contribution; after that threshold is reached, shares are purchased at 100% of market price.  The total number of shares originally authorized for purchase under the Plan, as adjusted, was 798,812 shares.  There are maximum and minimum levels for participant contributions, which the Board of Directors may change from time to time.


Directors' Stock Plan.   The Directors' Stock Plan was originally adopted by the Board of Directors in 1999, and amended in 2009 with the approval of the shareholders.  It provides for the automatic issuance of shares of Common Stock to directors of Arrow and its subsidiary banks in lieu of cash director fees otherwise payable to them.  The portion of directors’ fees payable in stock (as opposed to in cash) is fixed each year in advance by the Board of Directors.  The total number of shares authorized for issuance under the Plan, as adjusted through December 31, 2009, is 64,619 shares.


 



12



STOCK PERFORMANCE GRAPHS


The following two graphs provide a comparison of the total cumulative return (assuming reinvestment of dividends) for the common stock of Arrow as compared to the Russell 2000 Index, the NASDAQ Banks Index and the Zacks $1B-$5B Bank Assets Index.


The historical information set forth below may not be indicative of the future results. The first graph presents the five-year period from December 31, 2004 to December 31, 2009 and the second graph presents the ten-year period from December 31, 1999 to December 31, 2009.


[tenk002.gif]



 

TOTAL RETURN PERFORMANCE

 

Period Ending

Index

12/31/04

12/31/05

12/31/06

12/31/07

12/31/08

12/31/09

Arrow Financial Corporation

100.00

89.91

90.96

84.89

103.40

110.07

Russell 2000 Index

100.00

104.56

123.75

121.83

80.66

102.59

NASDAQ Banks Index

100.00

97.69

109.63

86.90

63.36

53.09

Zacks $1B - $5B Bank Assets Index

100.00

109.32

118.20

105.20

63.16

73.32










Source:  Zacks Investment Research, Inc., Chicago, IL. Copyright 2010. All rights reserved. Used with permission.





13



[tenk004.gif]


 

TOTAL RETURN PERFORMANCE

 

Period Ending

Index

12/31/99

12/31/00

12/31/01

12/31/02

12/31/03

12/31/04

12/31/05

12/31/06

12/31/07

12/31/08

12/31/09

Arrow Financial

  Corporation

100.00

104.65

171.39

195.91

228.30

270.52

243.22

246.06

229.64

279.71

297.75

Russell 2000 Index

100.00

96.98

99.39

79.03

116.38

137.71

143.99

170.41

167.78

111.08

141.27

NASDAQ Banks

   Index

100.00

114.23

123.68

126.61

162.88

186.40

182.09

204.36

161.99

118.11

98.96

Zacks $1B - $5B Bank

  Assets Index

100.00

126.35

126.91

117.43

160.20

191.54

209.38

226.40

201.49

120.98

140.43


Source: Zacks Investment Research, Inc., Chicago, IL. Copyright 2010. All rights reserved. Used with permission.


The preceding stock performance graphs shall not be deemed incorporated by reference by virtue of any general statement incorporating by reference this Annual Report on Form 10-K into any filing under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, except to the extent the company specifically incorporates this information by reference, and shall not otherwise be deemed filed as part of such other filings.


Unregistered Sales of Equity Securities

In connection with Arrow’s acquisition in 2004 of Capital Financial Group, Inc. (CFG), an insurance agency specializing in the sale of group health and life insurance products, Arrow issued 68,629 shares, as adjusted, of its common stock to the former sole stockholder of CFG, in exchange for his CFG shares.  The terms of the acquisition included a post-closing purchase price adjustment provision, under which Arrow would also pay to the sole stockholder, over the 5-year period following closing, additional consideration in the form of additional shares of Arrow’s common stock, depending on the financial performance of CFG as a subsidiary of Arrow during such period.  Under this provision, Arrow issued an additional 35,120 shares to the sole stockholder over the now completed five year period.  All shares issued to the sole stockholder at the original closing and in post-closing adjustments have been issued without registration under the Securities Act of 1933, as amended, in reliance upon the exemption for such registration set forth in Section 3(a)(11) of the Act and Rule 147 promulgated by the Securities and Exchange Commission thereunder.  This exemption was available because the sole stockholder was a New York resident and CFG was a New York corporation having substantially all of its assets and business operations in the State of New York.



14



Issuer Purchases of Equity Securities

The following table presents information about repurchases by us during the three months ended December 31, 2009 of our common stock (our only class of equity securities registered pursuant to Section 12 of the Securities Exchange Act of 1934):


Fourth Quarter

Calendar Month

Total Number of

Shares Purchased1

Average Price

Paid Per Share1

Total Number of

Shares Purchased as

Part of Publicly

Announced

Plans or Programs2

Maximum

Approximate Dollar

Value of Shares that

May Yet be

Purchased Under the

Plans or Programs2

October

15,706

$25.73

15,000

$3,444,819

November

32,394

25.19

  30,100

2,686,944

December

27,000

25.45

       ---

2,686,944

Total

75,100

25.40

45,100

 


1The total number of shares purchased and the average price paid per share include shares purchased in open market transactions under the Arrow Financial Corporation Automatic Dividend Reinvestment Plan (the “DRIP”) by the administrator of the DRIP and shares surrendered or deemed surrendered to Arrow by holders of options to acquire Arrow common stock in connection with the exercise of such options.  In the months indicated, the listed number of shares purchased included the following numbers of shares purchased through such methods:  October 2009 - DRIP purchases (706 shares); November 2009 – DRIP purchases (2,294 shares) December 2009 – DRIP purchases (17,607 shares), stock options (9,393 shares).  DRIP purchases do not reflect so-called “netting” transactions, that is, purchases effected within the DRIP itself by the DRIP administrator consisting of monthly acquisitions of shares on behalf of purchasing participants who are investing funds in the plan from selling participants who are withdrawing funds from the plan.

2Includes those shares acquired by Arrow pursuant to its publicly-announced stock repurchase programs, but does not include shares purchased or subject to purchase under the DRIP or shares surrendered to Arrow upon exercise of options granted under any compensatory stock plans.  Our only current publicly-announced stock repurchase program is the program approved by the Board of Directors and announced in April 2009 under which the Board authorized a twelve-month maximum cumulative purchase of $5 million in stock.




15




Item 6.  Selected Financial Data

FIVE YEAR SUMMARY OF SELECTED DATA

Arrow Financial Corporation and Subsidiaries

(Dollars In Thousands, Except Per Share Data)



Consolidated Statements of Income Data:

2009

2008

2007

2006

2005

Interest and Dividend Income

$86,857 

$89,508 

$86,577 

$80,611 

$72,127 

Interest Expense

  26,492 

  32,277 

  40,283 

  34,743 

  24,114 

Net Interest Income

60,365 

57,231 

46,294 

45,868 

48,013 

Provision for Loan Losses

    1,783 

    1,671 

       513 

       826 

    1,030 

Net Interest Income After Provision

 for Loan Losses

58,582 

55,560 

45,781 

45,042 

46,983 

Noninterest Income

19,235 

15,886 

16,288 

15,883 

14,584 

Net (Losses) Gains on Securities Transactions

357 

383 

--- 

(102)

364 

Noninterest Expense

  46,592 

  42,393 

  37,930 

  36,807 

  35,189 

Income Before Provision for Income Taxes

31,582 

29,436 

24,139 

24,016 

26,742 

Provision for Income Taxes

    9,790 

    8,999 

    6,807 

    7,124 

    8,103 

Net Income

$21,792 

$20,437 

$17,332 

$16,892 

$18,639 

 

 

 

 

 

 

Per Common Share: 1

 

 

 

 

 

Basic Earnings

$ 2.00

$ 1.88

$ 1.57

$ 1.50

$ 1.64

Diluted Earnings

1.99

1.87

1.56

1.48

1.61

 

 

 

 

 

 

Per Common Share: 1

 

 

 

 

 

Cash Dividends

$    .98

$    .95

$    .91

$    .89

$    .84

Book Value

12.90

11.58

11.17

10.52

10.37

Tangible Book Value 2

11.37

10.07

9.65

9.01

8.84

 

 

 

 

 

 

Consolidated Year-End Balance Sheet Data:

 

 

 

 

 

Total Assets

$1,841,627

$1,665,086

$1,584,846

$1,520,217

$1,519,603

Securities Available-for-Sale

437,706

315,414

328,496

307,902

317,061

Securities Held-to-Maturity

168,931

133,976

114,611

108,498

118,123

Loans

1,112,150

1,109,812

1,038,844

1,008,999

996,545

Nonperforming Assets

4,772

4,971

2,336

3,169

2,372

Deposits

1,443,566

1,275,063

1,204,200

1,186,397

1,165,763

Federal Home Loan Bank Advances

140,000

160,000

160,000

125,000

157,000

Other Borrowed Funds

93,908

79,956

73,719

68,324

63,054

Stockholders’ Equity

140,818

125,802

122,256

118,130

117,421

 

 

 

 

 

 

Selected Key Ratios:

 

 

 

 

 

Return on Average Assets

1.24%

1.24%

1.11%

1.11%

1.28%

Return on Average Equity

16.16    

16.26    

14.68    

14.38    

15.94    

Dividend Payout  3

49.25    

51.04    

58.39    

59.87    

52.27    


1Share and per share amounts have been adjusted for subsequent stock splits and dividends, including the most recent September

    2009 3% stock dividend.

2Tangible book value excludes intangible assets from total equity.

3Dividend Payout Ratio – cash dividends per share to fully diluted earnings per share.



16



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


The following table presents selected quarterly information for the fourth quarter of 2009 and the preceding four quarters:


Selected Quarterly Information:

(Dollars In Thousands, Except Per Share Amounts)

(Share and per share amounts have been adjusted for the September 2009 3% stock dividend.)


 

Dec 2009

Sep 2009

Jun 2009

Mar 2009

Dec 2008

Net Income

$5,117

$5,062

$4,931

$6,682

$5,012

 

 

 

 

 

 

Transactions Recorded in Net Income (Net of Tax):

 

 

 

 

 

Other-Than-Temporary Impairment (OTTI) (see page 21)

$(227)

$--- 

$ --- 

$    --- 

$(242)

Net Securities Gains

17

29 

2 

167 

249

Net Gains on Sales of Loans

56

10 

141 

46 

31

Net Gain on Sale of

   Merchant Bank Card Processing (see page 20)

--- 

--- 

161

1,630 

       --- 

Income from Restitution Payment (see page 29)

--- 

--- 

272 

---

---

FDIC Special Assessment (see page 20)

--- 

--- 

(475)

---

---

 

 

 

 

 

 

Period End Shares Outstanding

10,917

10,916

10,909

10,901

10,863

Basic Average Shares Outstanding

10,910

10,912

10,901

10,892

10,840

Diluted Average Shares Outstanding

10,959

10,982

10,948

10,922

10,906

Basic Earnings Per Share

$.47

$.46

$.45

$.61

$.42

Diluted Earnings Per Share

.47

.46

.45

.61

.42

Cash Dividends Per Share

.25

.24

.24

.24

.24

 

 

 

 

 

 

Average Assets

$1,856,176

$1,778,893

$1,725,739

$1,681,096

$1,687,366

Average Equity

140,786

136,397

133,718

128,507

127,136

Return on Average Assets

1.09%

1.13%

1.15%

1.61%

1.18%

Return on Average Equity  

     14.42

14.72

14.79

21.09

     15.68

 

 

 

 

 

 

Average Earning Assets

$1,781,464

$1,706,626

$1,653,637

$1,610,007

$1,615,240

Average Paying Liabilities

1,492,326

1,417,218

1,382,451

1,346,413

1,345,344

Interest Income, Tax-Equivalent 1

23,032

22,499

22,245

22,262

23,446

Interest Expense

6,522

6,462

6,716

6,792

7,541

Net Interest Income, Tax-Equivalent 1

16,510

16,037

15,529

15,470

15,905

Tax-Equivalent Adjustment

863

835

744

739

727

Net Interest Margin 1

3.68%

3.73%

3.77%

3.90%

3.92%


Efficiency Ratio Calculation:1

 

 

 

 

 

Noninterest Expense

$11,699 

$11,401 

$12,119 

$11,373 

$11,273 

Less: Intangible Asset Amortization

       (77)

       (79)

       (79)

       (89)

       (89)

   Net Noninterest Expense

$11,622 

$11,322 

$12,040 

$11,284 

$11,184 

Net Interest Income, Tax-Equivalent 1

$16,510 

$16,037 

$15,529 

$15,470 

$15,905 

Noninterest Income

3,805 

3,976 

4,844 

6,967 

4,152 

Less: Net Securities Losses (Gains) & OTTI

       347 

       (48)

         (4)

     (277)

       (12)

   Net Gross Income

$20,662 

$19,965 

$20,369 

$22,160 

$20,045 

Efficiency Ratio 1

56.25%

56.71%

59.11%

50.92%

55.79%


Period-End Capital Information:

 

 

 

 

 

Tier 1 Leverage Ratio

8.43%

8.37%

8.77%

8.64%

8.39%

Total Stockholders’ Equity (i.e. Book Value)

$140,818

$139,304

$134,586

$132,539

$125,802

Book Value per Share

12.90

12.76

12.71

12.52

11.58

Intangible Assets

16,712

16,353

16,440

16,450

16,378

Tangible Book Value per Share

11.37

11.26

11.15

10.97

10.07

 

 

 

 

 

 

Net Loans Charged-off as a

  Percentage of Average Loans, Annualized

.09%

.08%

.09%

.12%

.14%

Provision for Loan Losses as a

  Percentage of Average Loans, Annualized

 .16   

 .15   

 .15   

 .18   

 .32   

Allowance for Loan Losses as a

  Percentage of Loans, Period-end

1.26   

1.25   

1.25   

1.22   

1.20   

Allowance for Loan Losses as a

  Percentage of Nonperforming Loans, Period-end

300.73   

299.07   

383.40   

352.65   

338.05   

Nonperforming Loans as a

  Percentage of Loans, Period-end

 .42   

 .42   

 .32   

 .35   

 .35   

Nonperforming Assets as a

  Percentage of Total Assets, Period-end

 .26   

 .26   

 .23   

 .27   

 .30   

 

 

 

 

 

 

 1 See “Use of Non-GAAP Financial Measures” on page 4.





17



Selected Twelve-Month Information:

(Dollars In Thousands, Except Per Share Amounts)

Share and per share amounts have been adjusted for the September 2009 3% stock dividend.

 

 

 

Dec 2009

Dec 2008

Dec 2007

Net Income

 

 

$21,792

$20,437

$17,332

 

 

 

 

 

 

Transactions Recorded in Net Income (Net of Tax):

 

 

 

 

 

Other-Than-Temporary Impairment (OTTI) (see page 21)

 

 

$(227)

$(971)

$---

Net Securities Gains

 

 

   216

   231

   ---

Net Gains on Sales of Loans

 

 

252

64

25

Income from Restitution Payment (see page 29)

 

 

272 

--- 

--- 

Net Gains (Losses) on the Sale of Other Real Estate Owned

 

 

--- 

18 

(2)

Net Gain on the Sale of Premises (see page 29)

 

 

---

69

---

Visa Litigation (see page 21)

 

 

--- 

185 

(362)

Gain on Redemption of Visa Inc. Class B Shares (see page 21)

 

 

---

452

   ---

 

 

 

 

 

 

Period End Shares Outstanding

 

 

10,917

10,863

10,946

Basic Average Shares Outstanding

 

 

10,904

10,882

11,036

Diluted Average Shares Outstanding

 

 

10,953

10,941

11,109

Basic Earnings Per Share

 

 

$2.00  

$1.88  

$1.57  

Diluted Earnings Per Share

 

 

1.99  

1.87  

1.56  

Cash Dividends Per Share

 

 

.98  

.95

.91

 

 

 

 

 

 

Average Assets

 

 

$1,761,006

$1,644,210

$1,558,251

Average Equity

 

 

134,890

125,653

118,082

Return on Average Assets

 

 

1.24%

1.24%

1.11%

Return on Average Equity

 

 

16.16   

16.26   

14.68   

 

 

 

 

 

 

Average Earning Assets

 

 

$1,688,454

$1,568,677

$1,486,707

Average Paying Liabilities

 

 

1,410,022

1,303,740

1,229,882

Interest Income, Tax-Equivalent 1

 

 

90,038

92,441

89,498

Interest Expense

 

 

26,492

32,277

40,283

Net Interest Income, Tax-Equivalent 1

 

 

63,546

60,164

49,215

Tax-Equivalent Adjustment

 

 

3,181

2,933

2,921

Net Interest Margin 1

 

 

3.76%

3.84%

3.31%


Efficiency Ratio Calculation 1

 

 

 

 

 

Noninterest Expense

 

 

$46,592 

$42,393 

$37,930 

Less: Intangible Asset Amortization

 

 

     (324)

     (360)

     (394)

   Net Noninterest Expense

 

 

$46,268 

$42,033 

$37,536 

Net Interest Income, Tax-Equivalent 1

 

 

$63,546 

$60,164 

$49,215 

Noninterest Income

 

 

19,592 

16,269 

16,288 

Less: Net Securities Losses & OTTI

 

 

         18 

    478 

          --- 

   Net Gross Income

 

 

$83,156 

$76,911 

$65,503 

Efficiency Ratio 1

 

 

55.64%

54.65%

57.30%


Period-End Capital Information:

 

 

 

 

 

Tier 1 Leverage Ratio (Period-end)

 

 

8.43%

8.39%

8.37%

Total Stockholders’ Equity (i.e. Book Value)

 

 

$140,818

$125,802

$122,256

Book Value per Share

 

 

12.90

11.58

11.17

Intangible Assets

 

 

16,712

16,378

16,590

Tangible Book Value per Share

 

 

11.37

10.07

9.65

 

 

 

 

 

 

Net Loans Charged-off as a

  Percentage of Average Loans

 

 

.09%

.07%

.04%

Provision for Loan Losses as a

  Percentage of Average Loans

 

 

 .16   

 .16   

 .05   

Allowance for Loan Losses as a

  Percentage of Loans, Period-end

 

 

1.26   

1.20   

1.19   

Allowance for Loan Losses as a

  Percentage of Nonperforming Loans, Period-end

 

 

300.73   

338.05   

567.81   

Nonperforming Loans as a

  Percentage of Loans, Period-end

 

 

 .42   

 .35   

 .21   

Nonperforming Assets as a

  Percentage of Total Assets, Period-end

 

 

 .26   

 .30   

 .15   


1 See “Use of Non-GAAP Financial Measures” on page 4.



18



CRITICAL ACCOUNTING POLICIES

In order to prepare our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America, we were required to make estimates and assumptions that affected the amounts reported in these statements.  There are uncertainties inherent in making these estimates and assumptions, which could materially affect our results of operations and financial position.  We consider the following to be critical accounting policies:


The allowance for loan losses:  The adequacy of the allowance for loan losses is sensitive to changes in current economic conditions that may make it difficult for borrowers to meet their contractual obligations.  Any downward trend in the economy, regional or national, may require us to increase the allowance for loan losses resulting in a negative impact on our results of operations and financial condition at the same time that other areas of our operations, including new loan originations and assets under administration in our trust department may also be experiencing negative pressures from the same underlying negative economic conditions.

Liabilities for retirement plans:  We have a variety of pension and retirement plans.  Liabilities under these plans rely on estimates of future salary increases, numbers of employees and employee retention, discount rates and long-term rates of return on plan investments. Changes in these assumptions due to changes in the financial markets, the economy, our own operations or applicable law and regulation may result in material changes to our liability for postretirement expense, with consequent impact on our results of operations and financial condition.

Valuation allowance for deferred tax assets:  Accounting standards require a reduction in the carrying amount of deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50 percent) that some portion or all of the deferred tax assets will not be realized.  The valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized.  Our analysis of the need for a valuation allowance for deferred tax assets is, in part, based on an estimate of future taxable income.

Goodwill:  Accounting standards require that goodwill be tested for impairment at a level of reporting referred to as a reporting unit.  Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value.  The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill.  The second step of the goodwill impairment test, used to measure the amount of impairment loss, compares the implied fair value of a reporting unit’s goodwill with the carrying amount of that goodwill.

Other than temporary decline in the value of debt and equity securities:  Accounting standards require that, for individual securities classified as either available-for-sale or held-to-maturity, an enterprise shall determine whether a decline in fair value below the amortized cost basis is other than temporary.  When an other-than-temporary impairment has occurred, the amount of the other-than-temporary impairment recognized in earnings depends on whether we intend to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss.  If we intend to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the other-than-temporary impairment is recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date.  If we do not intend to sell the security and it is not more likely than not that we will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the other-than-temporary impairment is separated into the amount representing the credit loss and the amount related to all other factors.  The amount of the total other-than-temporary impairment related to the credit loss is recognized in earnings.  Any significant economic downturn might result, and historically have on occasion resulted, in an other-than-temporary impairment in securities held in our portfolio.

Valuation methods for securities available-for-sale measured at fair value on a recurring basis:  Most of the available-for-sale portfolio, which includes U.S. Treasury and agency securities, mortgage-backed securities, collateralized mortgage obligations, municipal securities, corporate debt and equity securities are priced using industry-standard models that consider various assumptions that include time value, yield curves, volatility factors, prepayment speeds, default rates, loss severity, current market and contractual prices for the underlying financial instruments, as well as other relevant economic measures.  Substantially all of these assumptions are either observable in the marketplace, derived from observable data or are supported by observable levels at which transactions are executed in the marketplace.   Municipal and corporate securities are valued using a type of matrix, or grid, pricing in which securities are benchmarked against the treasury rate based on credit rating.  These model and matrix measurements are classified as Level 2 in the fair value hierarchy.  

The following discussion and analysis focuses on and reviews our results of operations for each of the years in the three-year period ended December 31, 2009 and our financial condition as of December 31, 2009 and 2008.  The discussion below should be read in conjunction with the selected quarterly and annual information set forth above and the consolidated financial statements and other financial data presented elsewhere in this Report.  When necessary, prior-year financial information has been reclassified to conform to the current-year presentation.


A. OVERVIEW


Summary of 2009 Financial Results


We reported net income of $21.8 million for 2009, an increase of $1.4 million, or 6.6%, compared to 2008.  Diluted earnings per share of $1.99 represented an increase of $.12, or 6.4%, from 2008.  During 2008, both our net interest margin and net interest income increased due to a combination of falling short-term interest rates (which has a proportionately larger impact on the cost of our deposits than on our earnings from our assets), a market-wide return of a positively-sloped yield curve (which has a proportionately larger impact on our earning assets than on our liabilities) and a 5.5% increase in average earning assets.  However, during 2009, we experienced a small decrease in our net interest margin as rates remained very low, and our increase in income reflected asset growth almost exclusively.  Most of our deposits were already at such low rates going into 2009 that it was not possible to effect significant additional downward repricing, while our loan cash-flows continued to reprice downward during the year.

Importantly, we still did not experience significant deterioration in our loan and asset quality during 2009 despite the continuing worldwide economic recession and severe disruption in the financial markets generally, which began in 2008.  

Although earnings in 2009 and 2008 were impacted by certain significant transactions, discussed below and later in this report, net income for 2009 was a record high for us.  



19



Financial Market Turmoil:  Over the past fifteen months, the Dow Jones Industrial Average (Dow Jones) lurched from a high of over 14,000 to a low of under 8,000, and then rebounded to 10,000, demonstrating a degree of volatility not seen in many decades, with the most dramatic change occurring during the fourth quarter of 2009.  The financial sector and particularly banks have been severely affected, suffering major losses on mortgages and other credit portfolios and an industry-wide loss of short-term liquidity.  In addition, bank failures have continued to occur with regularity, through 2009 and into 2010, and are expected to persist for the foreseeable future.  Many community banks, like our company, have not experienced significant losses in their loan or investment portfolios or the liquidity concerns that many of our larger contemporaries have experienced, but expanding problems in commercial real estate portfolios throughout the U.S. now threaten many of these community banks.  However, the magnitude of turmoil in the markets did have an impact on our operations during 2009 and may continue to influence our financial condition and results of operations in forthcoming periods.


Decision Not to Participate in U.S. Treasury TARP CCP:  As previously disclosed in our Current Report in Form 8-K filed with the SEC on January 27, 2009, our Board of Directors determined in late January 2009, after we had applied for participation by the Company in the U.S. Government’s Capital Purchase Plan (an element of the larger Troubled Assets Relief Program), and after we had been preliminarily approved by the Department of Treasury for participation, that we would not proceed ahead and sell shares of our preferred stock to the Treasury Department but would decline to participate.  The basic reason for the Board’s decision, as discussed in the Form 8-K, was that the Company’s financial and liquidity positions remained sufficiently strong at year-end such that the potential loss of Board and management flexibility entailed in participation in the program was deemed too high a cost to warrant participation.  


Sale of Merchant Bank Card Processing to TransFirst:  As we previously reported on March 2, 2009, our bank subsidiaries, Glens Falls National Bank and Trust Company and Saratoga National Bank and Trust Company, sold their merchant bank card processing business for an initial cash payment at closing of $3 million to TransFirst LLC (TransFirst) and a bank designated by TransFirst.  In connection with the sale, we entered into a relationship with TransFirst under which TransFirst will provide merchant bank card processing to merchant customers of our subsidiary banks.  The gain was offset, in part, by an estimated $300 thousand cost to terminate certain pre-existing agreements for a net gain of $2.7 million, which we recognized in the first quarter of 2009.  In the second quarter of 2009, a post-closing adjustment to the purchase price substantially eliminated the termination fees related to the pre-existing agreements such that our net gain on the sale of the business as adjusted increased $266 thousand to approximately $2.97 million.


FDIC Special Assessment & Prepayment:  The FDIC announced during the second quarter of 2009 that they would levy a special assessment on all FDIC insured financial institutions to rebuild the FDIC’s insurance fund which has recently been depleted by bank failures.  The special assessment was set at 0.05% of an institution’s total assets less Tier 1 capital.  Institutions were instructed to estimate and accrue the expense in the second quarter of 2009.  We determined that our expense was $787 thousand, which we accrued on June 30, 2009.  During the third quarter of 2009 the FDIC announced that they would not impose any additional special assessments in the remainder of 2009, but would generate additional much-needed cash for the insurance fund by requiring insured institutions to prepay in the fourth quarter of 2009 their projected assessments for the fourth quarter of 2009 and all of 2010, 2011 and 2012.  Our prepayment amount of $6.8 million, will be amortized, as required by bank regulatory guidance, into expense during the relevant periods to which such assessment relates.  


Economic recession and loan quality:  As the economic recession got underway in late 2008, our market area of northeastern New York was relatively sheltered from falling real estate values and increasing unemployment.  As the recession became stronger and deeper in late 2009, even northeastern New York began to feel the impact of the worsening national economy reflected in a slow-down in real estate sales and increasing unemployment rates.   By year-end 2009, we had experienced a decline in the credit quality of our loan portfolio, although by standard measures our portfolio continued to appear stronger than the average for our peer group.  Nonperforming loans amounted to $4.7 million at December 31, 2009, an increase of $734 thousand from the prior year-end.  The ratio of nonperforming loans to period-end loans was .42% at December 31, 2009, an increase from .35% one year earlier.  By way of comparison, this ratio for our peer group increased during the same period by 107 basis points, from 2.39% at December 31, 2008 to 3.46% at December 31, 2009.  Our loans charged-off (net of recoveries) against our allowance for loan losses were $1.0 million for 2009, as compared to $800 thousand for the prior year.  At year-end 2009, the allowance for loan losses was $14.0 million, representing 1.26% of total loans, essentially the same as at the prior year-end. To date, we have not experienced significant deterioration in any of our three major loan portfolio segments:

o

Commercial Loans:  We lend to small and medium size businesses, which typically do not encounter liquidity problems, since we often also provide support for their supplementary liquidity needs.  However, current unemployment rates in our region are higher than in the past few years and the number of total jobs has decreased, although these trends are largely attributable to a few changes in the local operations of a small number of larger corporations.  Commercial property values have not shown significant deterioration and we update the appraisals on our nonperforming and watched commercial properties as deemed necessary, usually when the loan is downgraded or when we perceive significant market deterioration since our last appraisal.

o

Residential Real Estate Loans:  We have not experienced a notable increase in our foreclosure rates, primarily due to the fact that we did not originate or participate in underwriting subprime or other high-risk mortgage loans, such as so called “Alt A,” “negative amortization,” “option ARM’s” or “negative equity” loans.

o

Indirect Automobile Loans:  These loans comprise over 30% of our loan portfolio.  We have not experienced any significant change in our delinquency rate or level of charge-offs, although both delinquencies and charge-offs did increase modestly during 2009.





20



Investment securities and other-than-temporary impairment:  Prior to Lehman’s bankruptcy in September 2008, we held a $2.0 million par value senior unsecured bond issued by Lehman.  Immediately after the bankruptcy, the fair value of the bond decreased significantly.  We deemed the decline to be other-than-temporary in the third quarter 2008, and, accordingly, recognized a non-cash other-than-temporary impairment charge to earnings of $731 thousand net of tax (a $.07 reduction in diluted earnings per share). After further deterioration in the bond, we recognized an additional charge to earnings of $241 thousand net of tax (a $.02 reduction in diluted earnings per share) in the fourth quarter of 2008.  The remaining estimated value of our Lehman bond of $400 thousand was included in non-performing assets as of December 31, 2008.  During 2009, we sold the bond at an additional loss of $60 thousand.  Also during 2009, we recognized a $375 thousand impairment charge on one inactively-traded common stock held in our available-for-sale portfolio.  We did not hold any preferred or common stock of Fannie Mae or Freddie Mac.   As of year-end, we had not experienced any impairment issues with our holdings of mortgage-backed securities or CMO’s.  Mortgage-backed securities held by the company are comprised of pass-through securities backed by conventional residential mortgages and guaranteed by government agencies or government sponsored entities. We do not hold any private-label mortgage-backed securities or securities backed by subprime or other high risk non-traditional mortgage loans.


Liquidity and access to credit markets:  We have not experienced any liquidity issues during 2009 and through the date of this report.  The terms of our lines of credit with our correspondent banks, the FHLBNY and the Federal Reserve Bank have not changed, except for some increases in the maximum borrowing capacity (see our general liquidity discussion on page 40).  In general, we rely on asset-based liquidity (i.e. funds in overnight investments and cash flow from maturing investments and loans) with liability-based liquidity as a secondary source (overnight lending arrangements with our correspondent banks, FHLBNY overnight and term advances and the Federal Reserve Bank discount window, as our main sources).  During the recent period of bank failures, some institutions experienced a run on deposits, even though there was no reasonable expectation that depositors would lose any of their insured deposits.  We maintain, and periodically test, a contingent liquidity plan whose purpose is to ensure that we can generate an adequate amount of cash to meet a wide variety of potential liquidity crises.     


VISA Transactions in 2008 and 2009:  On March 28, 2008, VISA Inc. distributed to its member banks, including Glens Falls National Bank and Trust Company, by way of a mandatory redemption of 38.7% of the Visa Class B shares held by the member banks, some of the proceeds realized by Visa from the initial public offering and sale of its Class A shares just then completed.  With another portion of the IPO proceeds, Visa established a $3 billion escrow fund to cover certain, but not all, of its continuing litigation liabilities under various antitrust claims, which its member banks are otherwise required to bear.  Accordingly, during the first quarter of 2008, we recorded the following transactions:

•

 A gain of $749 thousand from the mandatory redemption by Visa from us of 38.7% of our Class B Visa Inc. shares, reflected as an increase in noninterest income, and

•

 A reversal of $306 thousand of the $600 thousand accrual previously recorded by us at December 31, 2007, representing our then estimated proportional share of Visa litigation costs, which reversal was reflected as a reduction in 2008 other operating expense.


In October 2008, Visa announced that it had settled a lawsuit with Discover Financial Services, which was part of the covered litigation for which the Visa member banks remained contingently liable. In December 2008, Visa deposited an additional $1.1 billion into the escrow fund for covered litigation. On July 16, 2009, Visa announced that it had deposited an additional $700 million into the escrow fund.  These developments reduced the Company’s proportionate exposure for covered litigation but also reduced the ultimate value of its remaining Class B Visa shares.  However, the Company had not previously recognized the value of its remaining Class B shares in accordance with SEC guidance, thus the Company did not recognize any income or expense in any of the periods presented as a result of the reduced value of those shares upon Visa’s settlement of the litigation. The estimation of the Company’s proportionate share of any potential losses related to the covered litigation is extremely difficult and involves a high degree of uncertainty. Management has determined that the remaining $294 thousand liability included in “Other Liabilities” on our year-end 2008 consolidated balance sheet remained the fair value of our proportionate share of the remaining covered Visa litigation obligation as of December 31, 2009, but this value is subject to change depending upon future developments in the covered litigation.


Change in Stockholders’ Equity:  At December 31, 2009, our tangible book value per share (calculated based on stockholders’ equity reduced by intangible assets including goodwill and other intangible assets) amounted to $11.37, an increase of $1.30, or 12.9%, from year-end 2008.  Our total stockholders’ equity at year-end 2009 increased 11.9% over the year-end 2008 level.  Major changes to stockholders’ equity included: i) $21.8 million of net income for the year; ii) a $707 thousand net unrealized gain in securities available-for-sale; iii) gains on our pension plan (reflected as other comprehensive income) of $1.5 million; offset by iv) cash dividends of $10.6 million; and by (v) repurchases of our own common stock of $3.8 million.  As of the last trading day of 2009, our closing stock price was $25.00, resulting in a trading multiple of 2.20 to our tangible book value.  The Company and each of its subsidiary banks also continue to remain classified as “well-capitalized” under regulatory guidelines.  As mentioned above, due to our strong capital, financial and liquidity positions, we did not participate in the U.S. Treasury’s Capital Purchase Program (a component of TARP).

The Board of Directors declared a quarterly cash dividend of $.25 per share for the fourth quarter of 2009.  For the year, total cash dividends (as adjusted for stock dividends) were $.98 compared to $.95 for 2008, an increase of $.03, or 3.2%.





21



B. RESULTS OF OPERATIONS

The following analysis of net interest income, the provision for loan losses, noninterest income, noninterest expense and income taxes, highlights the factors that had the greatest impact on our results of operations for 2009 and the prior two years.


I. NET INTEREST INCOME (Tax-equivalent Basis)

Net interest income represents the difference between interest, dividends and fees earned on loans, securities and other earning assets and interest paid on deposits and other sources of funds.  Changes in net interest income result from changes in the level and mix of earning assets and sources of funds (volume) and changes in the yields earned and interest rates paid (rate).  Net interest margin is the ratio of net interest income to average earning assets.  Net interest income may also be described as the product of average earning assets and the net interest margin.  As described in the section entitled “Use of Non-GAAP Financial Measures” on page 4 of this Report we calculate net interest income on a tax-equivalent basis using a marginal tax rate of 35%.


CHANGE IN NET INTEREST INCOME

 (Dollars In Thousands) (Tax-equivalent Basis)

 

 

Years Ended December 31,

Change From Prior Year

 

 

 

 

 

2008 to 2009

2007 to 2008

 

 

2009

2008

2007

Amount

%

Amount

%

Interest and Dividend Income

 

$90,038

$92,441

$89,498

$(2,403)

(2.6)%

$  2,943 

3.3 %

Interest Expense

 

  26,492

  32,277

  40,283

  (5,785)

(17.9)

   (8,006)

(19.9)

Net Interest Income

 

$63,546

$60,164

$49,215

$ 3,382 

5.6 

$10,949 

22.3 



On a tax-equivalent basis, net interest income was $63.5 million in 2009, an increase of $3.4 million, or 5.6%, from $60.2 million in 2008.  This compared to an increase of $10.9 million, or 22.3%, from 2007 to 2008.  Factors contributing to the increase in net interest income over the three-year period are discussed in the following portions of this Section B.I.

In the following table, net interest income components are presented on a tax-equivalent basis.  Changes between periods are attributed to movement in either the average daily balances or average rates for both earning assets and interest-bearing liabilities.  Changes attributable to both volume and rate have been allocated proportionately between the categories.


 

 

2009 Compared to 2008

2008 Compared to 2007

 

 

Change in Net Interest Income Due to:

Change in Net Interest Income Due to:

Interest and Dividend Income:

 

Volume

Rate

Total

Volume

Rate

Total

Federal Funds Sold

 

$ (464)

$      --- 

$    (464)

$ (195)

$  (439)

$    (634)

Interest-Bearing Bank Balances

 

160 

(68)

92 

57 

--- 

57 

Investment Securities:

 

 

 

 

 

 

 

  Taxable

 

1,353 

(2,779)

(1,426)

1,152 

665 

1,817 

  Non-Taxable

 

  1,373 

  (738)

 635 

  324 

  (328)

 (4)

Loans

 

 1,892 

(3,132)

  (1,240)

 3,229 

(1,522)

   1,707 

Total Interest and Dividend Income

 

 4,314 

(6,717)

  (2,403)

 4,567 

(1,624)

   2,943 

Interest Expense:

 

 

 

 

 

 

 

Deposits:

 

 

 

 

 

 

 

  NOW Accounts

 

1,159 

(1,160)

(1)

1,001 

(2,696)

(1,695)

  Savings Deposits

 

   290 

(1,587)

(1,297)

   217 

(792)

(575)

  Time Deposits of $100,000 or More

 

(504)

(1,369)

(1,873)

(392)

(2,645)

(3,037)

  Other Time Deposits

 

   220 

 (1,517)

  (1,297)

   (625)

 (2,140)

  (2,765)

Total Deposits

 

1,165 

(5,633)

(4,468)

201 

(8,273)

(8,072)

 

 

 

 

 

 

 

 

Short-Term Borrowings

 

 14 

(674)

(660)

 221 

(821)

(600)

Long-Term Debt

 

  (147)

    (510)

     (657)

  1,025 

    (359)

       666 

Total Interest Expense

 

 1,032 

 (6,817)

  (5,785)

 1,447 

 (9,453)

  (8,006)

Net Interest Income

 

$3,282 

$    100 

$ 3,382 

$3,120 

$7,829 

$10,949 


The following table reflects the components of our net interest income, setting forth, for years ended December 31, 2009, 2008 and 2007 (i) average balances of assets, liabilities and stockholders' equity, (ii) interest and dividend income earned on earning assets and interest expense incurred on interest-bearing liabilities, (iii) average yields earned on earning assets and average rates paid on interest-bearing liabilities, (iv) the net interest spread (average yield less average cost) and (v) the net interest margin (yield) on earning assets.  Interest income and interest rate information is presented on a tax-equivalent basis (see the discussion under “Use of Non-GAAP Financial Measures“ on page 4 of this Report).  The yield on securities available-for-sale is based on the amortized cost of the securities.  Nonaccrual loans are included in average loans.  



22





Average Consolidated Balance Sheets and Net Interest Income Analysis

(Tax-equivalent basis using a marginal tax rate of 35%)

(Dollars in Thousands)

Years Ended:

                          2009                       

                          2008                       

                          2007                       

 

 

Interest

 

 

Interest

 

 

Interest

 

 

Average

Income or

Rate Earned

Average

Income or

Rate Earned

Average

Income

 or

Rate Earned

 

Balance

Expense

or Paid

Balance

Expense

or Paid

Balance

Expense

or Paid

Federal Funds Sold

$           --- 

$       --- 

---%

$     17,472 

$   464 

2.66%

$     22,022 

$   1,098 

4.99%

Interest-Bearing Deposits at

   Banks

56,920 

149 

0.26

5,997 

57 

0.95

--- 

--- 

---

Investment Securities:

 

 

 

 

 

 

 

 

 

    Taxable

362,059 

14,739 

4.07

332,530 

16,182 

4.87

308,482 

14,365 

4.66

    Non-Taxable

167,716 

8,453 

5.04

141,294 

7,801 

5.52

135,347 

7,805 

5.77

Loans

 1,101,759 

  66,697 

6.05

 1,071,384 

  67,937 

6.34

 1,020,856 

  66,230 

6.49

  Total Earning Assets

 1,688,454 

  90,038 

5.33

 1,568,677 

  92,441 

5.89

 1,486,707 

  89,498 

6.02

Allowance for Loan Losses

(13,626)

 

 

(12,658)

 

 

(12,323)

 

 

Cash and Due From Banks

28,096 

 

 

32,505 

 

 

33,180 

 

 

Other Assets

      58,082 

 

 

      55,686 

 

 

      50,687 

 

 

  Total Assets

$1,761,006 

 

 

$1,644,210 

 

 

$1,558,251 

 

 

Deposits:

 

 

 

 

 

 

 

 

 

  NOW Accounts

$   460,096 

5,172 

1.12

$   367,351 

5,173 

1.41

$   315,614 

6,868 

2.18

  Savings Deposits

307,133 

2,101 

0.68

281,208 

3,398 

1.21

266,007 

3,973 

1.49

  Time Deposits of $100,000

    Or More

155,378 

3,718 

2.39

172,055 

5,591 

3.25

180,606 

8,628 

4.78

  Other Time Deposits

    249,575 

  7,331 

2.94

    243,247 

  8,628 

3.55

    258,042 

  11,393 

4.42

    Total Interest-

      Bearing Deposits

1,172,182 

18,322 

1.56

1,063,861 

22,790 

2.14

1,020,269 

30,862 

3.02

Short-Term Borrowings

59,566 

129 

0.22

58,473 

789 

1.35

49,355 

1,389 

2.81

FHLBNY Advances  and

   Long-Term Debt

    178,274 

   8,041 

4.51

    181,406 

   8,698 

4.79

    160,258 

   8,032 

5.01

    Total Interest-

      Bearing Funds

1,410,022 

 26,492 

1.88

1,303,740 

 32,277 

2.48

1,229,882 

 40,283 

3.28

Demand Deposits

191,504 

 

 

189,999 

 

 

186,474 

 

 

Other Liabilities

      24,590 

 

 

      24,818 

 

 

      23,813 

 

 

    Total Liabilities

1,626,116 

 

 

1,518,557 

 

 

1,440,169 

 

 

Stockholders’ Equity

    134,890 

 

 

    125,653 

 

 

    118,082 

 

 

    Total Liabilities and

      Stockholders’ Equity

$1,761,006 

 

 

$1,644,210 

 

 

$1,558,251 

 

 

Net Interest Income

  (Tax-equivalent Basis)

 

63,546 

 

 

60,164 

 

 

49,215 

 

Reversal of Tax

  Equivalent Adjustment

 

  (3,181)

.19%

 

  (2,933)

.19%

 

  (2,921)

.20%

Net Interest Income

 

$60,365 

 

 

$57,231 

 

 

$46,294 

 

Net Interest Spread

 

 

3.45%

 

 

3.41%

 

 

2.74%

Net Interest Margin

 

 

3.76%

 

 

3.84%

 

 

3.31%




23



CHANGES IN NET INTEREST INCOME DUE TO RATE

YIELD ANALYSIS (Tax-equivalent basis)

 

December 31,

 

 

2009

2008

2007

Yield on Earning Assets

 

5.33%

5.89%

6.02%

Cost of Interest-Bearing Liabilities

 

1.88

2.48

3.28

Net Interest Spread

 

3.45%

3.41%

2.74%

Net Interest Margin

 

3.76%

3.84%

3.31%


Following two years of decreases in net interest income in 2006 and 2005 (during a period of rising interest rates), we experienced a modest increase in net interest income in 2007, a significant increase in 2008 followed by another strong increase in 2009.   In all periods, we experienced a benefit from an increase in average earning assets, but the substantial increase in 2008 was largely attributable to a period of falling interest rates and the benefit we experience from paying liabilities repricing downwards more quickly than our earning assets.  

The increase in net interest income was $3.4 million, or 5.6%, from 2008 to 2009.  Net interest income increased $10.9 million, or 22.3%, from 2007 to 2008.  In 2009, an increase in average earning assets, net of a smaller increase in average paying liabilities (i.e., changes in volume) had a $3.3 million positive impact on net interest income, while changes in rates only provided a $100 thousand positive impact on our net interest income for the year, reflecting the fact that the prevailing federal funds rates stayed in the range of 0 to .25% for all the year.

Generally, the following items have a major impact on changes in net interest income due to rate:  general interest rate changes, the ratio of our rate sensitive assets to rate sensitive liabilities (interest rate sensitivity gap) during periods of interest rate changes, and changes in the level of nonperforming loans.  


Impact of Interest Rate Changes 2003 – 2009

Our profitability is affected by the prevailing interest rate environment, both short-term rates and long-term rates, by changes in those rates, and by the relationship between short- and long-term rates (i.e., the yield curve).


Changes in Rates 2003 – 2009.  In mid-2003, due to actions by the Federal Reserve Bank (Fed), the target rate on federal funds (funds which banks loan to one another on an overnight basis) decreased to a (then) almost unprecedented low of 1.00%, and rates paid by banks on short-term deposits similarly decreased to historically low levels.  The resulting lower rates on credit provoked a substantial expansion of lending across all sectors of the U.S. economy, especially mortgage and consumer lending.  In mid-2005, following this period of prolonged and, at that time, historically low interest rates, the Fed began to increase short-term rates with a series of 25 basis point increases in the targeted federal funds rate, reaching 5.25% by mid-2007.  Rates paid by banks on short-term deposits similarly increased during this period, although rates paid on long-term deposits (and yields earned on long-term loans and assets) did not increase proportionately, as lending, particularly mortgage lending, continued to expand nationwide at a rapid rate.  

From mid-2007 to fall 2008, the Fed did not take any actions to change short-term rates.  In September 2008, however, in response to a weakening economy and a loss of liquidity in the short-term credit market, precipitated in large part by the collapse in the housing market and resulting problems in subprime residential real estate lending, the Fed began lowering the federal funds target rate, rapidly and by significant amounts.  

By the December 2008 meeting of the Board of Governors, the rate had decreased 100 basis points, to 4.25%, and throughout 2009, the Fed, in response to continuing liquidity concerns in the credit markets, further lowered the targeted federal funds rate by an additional 400 basis points, to an unprecedented low range of 0% to .25% where it remained for all of 2009 and continues at present.  We began to see an immediate impact in the reduced cost of our deposits when rates began to fall in 2008 and continued falling in 2009.  Yields on our earning assets also began to fall, but lagged significantly behind the deposit repricing.   


Changes in the Yield Curve 2005 – 2009.  An important development with regard to the effect of rate changes on our profitability in the mid-2005 to mid-2007 period was the “flattening” of the yield curve, especially during 2006 and the first half of 2007.  After the Fed began increasing short-term interest rates in June 2004, the yield curve did not maintain its traditional upward slope but flattened; that is, as short-term rates increased, longer-term rates stayed unchanged or even decreased.  Therefore, the traditional spread between short-term rates and long-term rates (the upward yield curve) essentially disappeared, i.e., the curve flattened.  In late 2006 and in early 2007, the yield curve actually inverted, with short-term rates exceeding long-term rates.  The flattening of the yield curve was the most significant factor in reducing our net interest income from 2005 through 2007.  We, like many banks, typically fund longer-duration assets with shorter-maturity liabilities, and the flattening of the yield curve directly diminishes the benefit of this strategy.  

At the end of the second quarter of 2007, however, the yield on longer-term securities began to increase compared to short-term investments.  This increase in rate spread was further enhanced when long-term rates held steady after the Fed began lowering short-term rates in September 2007.  Because market perceptions and expectations have changed regarding the need to price more risk into certain long-term debt instruments, long-term rates may be expected to remain steady or rise, even though short-term rates dropped sharply in 2008 and remained low in 2009.  The yield curve may continue to reflect its more traditional shape for some time.  However, even lending institutions such as ours that have avoided subprime lending problems and have enjoyed continued high credit quality have nevertheless experienced some increasing pressure on credit quality in recent periods, and this may continue  especially if the national or regional economy continues to weaken.  Any credit or asset quality erosion will reduce or possibly outweigh the benefit we may experience from the return of a positively-sloped yield curve.  Thus, no assurances can be given on future improvements in our net interest margins, net interest income or net income generally, particularly as consumer mortgage related borrowings have diminished across the economy and the redeployment of funds by bankers from maturing loans and assets into other high-quality assets has become progressively more difficult.




24



Effect of Rate Changes on Our Margin; Changes in Our Margins 2002 – Late 2007.  In addition to the shape of the yield curve, our net interest margin has traditionally been sensitive to and impacted by changes in prevailing market interest rates.  Generally, there has been a negative correlation between changes in prevailing interest rates and our net interest margin, especially when rates begin to move in a different direction.  Typically, when prevailing rates begin to decline, our net interest margin generally increases in immediately ensuing periods, and conversely, when prevailing rates begin to increase, our net interest margin generally decreases, as in each case earning assets reprice more slowly than interest-bearing sources of funds.  This was the case for our net interest margin during the 2002 to mid-2003 period, when prevailing short-term market rates began to decline and our margin increased, and also during the mid-2003 to 2004 period, when rates began to increase and our margins experienced a negative effect.  Similarly, in 2005 through mid-2007, as the Fed increased short-term rates, not only did our net interest margin suffer initially, as usual, but it continued to narrow as rates on assets, especially longer-maturity assets, never rose and the yield curve flattened.  Our margin reached a low point in the fourth quarter of 2006, at 3.24%, and then increased slightly to 3.32% for each of the first two quarters of 2007.  In the third quarter of 2007 the margin decreased once again, to 3.29%.


Improvement in Our Margins Late 2007 – 2009.  From the third quarter of 2007 through mid-2008 our margin steadily improved, principally due to the fact the rates we paid on our interest-bearing liabilities began to reprice downward rapidly.  The dramatic reduction in short-term interest rates after September 2007 had a significant positive impact on our net interest income and net interest margins through mid-2009.  Our net interest margin held steady at around 3.90% for four successive quarters, but began to narrow in the last three quarters of 2009 as the downward repricing of paying liabilities neared its completion while interest earning assets continued to reprice downwards.


We expect that our margin may contract a bit more in future periods as the volume of downward repricing in our investment and loan portfolios exceeds the volume of downward repricing in our deposit and wholesale funding portfolios.  

Moreover, our ability to reduce the rates paid on many of our nonmaturity deposit products, even if longer-term funding rates should decline in upcoming periods, is limited due to the already low levels for those products, whereas rates earned on our earning assets will likely index downwards to the full extent of the decrease in prevailing rates.  A discussion of the models we use in projecting the impact on net interest income resulting from possible changes in interest rates vis-à-vis the repricing patterns of our earning assets and interest-bearing liabilities is included later in this report under Item 7.A., “Quantitative and Qualitative Disclosures About Market Risk.”


CHANGES IN NET INTEREST INCOME DUE TO VOLUME

AVERAGE BALANCES

(Dollars In Thousands)

 

Years Ended December 31,

Change From Prior Year

 

 

 

 

2008 to 2009

2007 to 2008

 

2009

2008

2007

Amount

%

Amount

%

Earning Assets

$1,688,454

$1,568,677

$1,486,707

$119,777

 7.6%

$81,970

 5.5%

Interest-Bearing Liabilities

1,410,022

1,303,740

1,229,882

106,282

 8.2   

73,858

 6.0   

Demand Deposits

191,504

189,999

186,474

 1,505

0.8   

 3,525

1.9   

Total Assets

1,761,006

1,644,210

1,558,251

116,796

 7.1   

85,959

 5.5   

Earning Assets to Total Assets

95.88%

95.41%

95.41%

 

 

 

 


2008 to 2009:

In general, an increase in average earning assets has a positive impact on net interest income.  For 2009, average earning assets increased $119.8 million or 7.6% over 2008, while average interest-bearing liabilities increased $106.3 million or 8.2%.  This combination led to a $3.3 million increase in net interest income, even though our net interest margin decreased by 8 basis points (from 3.84% to 3.76%) between the two years.  (This positive effect was in addition to the $100 thousand positive impact on net interest income resulting from the changes in rates during the year, discussed above.)

The $119.8 million increase in average earning assets from 2008 to 2009 reflected an increase in average loans of $30.4 million, or 2.8%, an increase of $56.0 million, or 11.8%, in investment securities and a $33.5 increase in the level of overnight funds. Although the balance of indirect loans (which represented the second largest segment of the loan portfolio) began to decrease in the second half of 2009, the average balances increased $9.1 million, or 3.0%, in our commercial and commercial real estate loans and increased $24.2 million, or 7.0%, in our residential real estate loans.

The $106.3 million increase in average interest-bearing liabilities was primarily attributable to increases in municipal deposit balances.  The fact that our average earning assets increased more than our average paying liabilities, was attributable to both an increase in non-interest bearing demand deposits together with additions to stockholders’ equity.


2007 to 2008:

For 2008, average earning assets increased $82.0 million or 5.5% over 2007, while average interest-bearing liabilities increased $73.9 million or 6.0%.  This combination led to a $3.1 million increase in net interest income.    The $82.0 million increase in average earning assets from 2007 to 2008 reflected an increase in average loans of $50.5 million, or 5.0%, and an increase of $30.0 million, or 6.8%, in investment securities, while the level of overnight funds purchased remained relatively unchanged.  We experienced increases in all major categories within the loan portfolio during 2008, although the average balance of indirect loans (which represented the second largest segment of the loan portfolio) increased only 1.3% from 2007.  Increases in the average balances of our other two large segments were $29.5 million, or 10.0%, in our commercial and commercial real estate loans and an increase of $18.2 million, or 5.5%, in our residential real estate loans.

The $73.9 million increase in average interest-bearing liabilities resulted from a $47.1 million increase in average deposit balances and a $30.3 million increase in the average balance of other borrowed funds.  

Increases in the volume of loans and deposits, as well as yields and costs by type, are discussed later in this Report under Item 7.C. “Financial Condition.”




25



I. PROVISION FOR LOAN LOSSES AND ALLOWANCE FOR LOAN LOSSES


We consider our accounting policy relating to the allowance for loan losses to be a critical accounting policy, given the uncertainty involved in evaluating the level of the allowance required to cover credit losses inherent in the loan portfolio, and the material effect that such judgments may have on our results of operations.  In addition to the following discussion, see Notes 1 and 5 to the consolidated financial statements, included in Item 8 of this Report.

Through the provision for loan losses, an allowance is maintained that reflects our best estimate of probable incurred loan losses related to specifically identified loans and losses for categories of loans in the remaining portfolio.  Actual loan losses are charged against this allowance when loans are deemed uncollectible.

We use a two-step process to determine the provision for loans losses and the amount of the allowance for loan losses.  We evaluate impaired commercial and commercial real estate loans over $250,000 individually, while we evaluate the remainder of the portfolio on a pooled basis as described below.

At December 31, 2009, we had three loans, over $250,000, considered impaired.  Those loans had sufficient collateral and required no specific reserve.  See Note 5 to the consolidated financial statements, included in Item 8 of this Report.  


Homogenous Loan Pools:  Under our pooled analysis, we group homogeneous loans as follows, each with its own estimated loss-rate:

i)

Secured and unsecured commercial loans,

ii)

Secured construction and development loans,

iii)

Secured commercial loans – non-owner occupied,

iv)

Secured commercial loans – owner occupied,

v)

One to four family residential real estate loans,

vi)

Home equity loans,

vii)

Indirect loans – low risk tiers (based on credit scores),

viii)

Indirect loans – high risk tiers, and

ix)

Other consumer loans.


Within the group of other commercial and commercial real estate loans, we sub-group loans based on our internal system of risk-rating, which is applied to all commercial and commercial real estate loans.  We establish loss rates for each of these pools.  

Estimated losses reflect consideration of all significant factors that affect the collectibility of the portfolio as of December 31, 2009.  In our evaluation, we do both a quantitative and qualitative analysis of the homogeneous pools.


Quantitative Analysis:  Quantitatively, we determine the historical loss rate for each homogeneous loan pool.  

During the past five years we have had little charge-off activity on loans secured by residential real estate.  Indirect consumer lending (principally automobile loans) represents a significant component of our total loan portfolio and is the only category of loans that has a history of losses that lends itself to a trend analysis.  We have had two losses on commercial real estate loans in the past five years.  Losses on commercial loans (other than those secured by real estate) are also historically low, but can vary widely from year-to-year; this is the most complex category of loans in our loss analysis.

Our net charge-offs for the past five years have been at or near historical lows for our company, although charge-offs increased in 2008 and 2009, (see the table on page 28).  Annualized net charge-offs have ranged from .04% to .09% of average loans during this period.   In prior years this ratio was significantly higher.  For example, in the mid-to-late 1990’s, the charge-off ratio ranged from .16% to .32% for our company.   The ratio for bank holding companies in our peer group was 1.32% and .70% for the years ended December 31, 2009 and 2008, respectively.  The change in this peer group ratio represents a significant increase from the prior five years when the peer ratio ranged from .13% to .25%.


Qualitative Analysis:  While historical loss experience provides a reasonable starting point for our analysis, historical losses, or even recent trends in losses, do not by themselves form a sufficient basis to determine the appropriate level for the allowance.  Therefore, we have also considered and adjusted historical loss factors for qualitative and environmental factors that are likely to cause credit losses associated with our existing portfolio.  These included:

·

Changes in the volume and severity of past due, nonaccrual and adversely classified loans

·

Changes in the nature and volume of the portfolio and in the terms of loans

·

Changes in the value of the underlying collateral for collateral dependent loans

·

Changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere in estimating credit losses

·

Changes in the quality of the loan review system

·

Changes in the experience, ability, and depth of lending management and other relevant staff

·

Changes in international, national, regional, and local economic and business conditions and developments that affect the collectibility of the portfolio

·

The existence and effect of any concentrations of credit, and changes in the level of such concentrations

·

The effect of other external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the  existing portfolio or pool



26




For each homogeneous loan pool, we estimate a loss factor expressed in basis points for each of the qualitative factors above, and for historical credit losses.  We update and change, if necessary, the loss-rates assigned to various pools based on the analysis of loss trends and the change in qualitative and environmental factors.  

From June 2004 to June 2006, the Federal Reserve Bank increased prevailing short-term rates in an effort to slow down national economic growth and check potential increases in the inflation rate.  However, from August 2007 through December 2008, the Federal Reserve Bank began to cut rates in response to the growing financial crisis in credit markets and evidence of a significant economic recession.  In our market area there was little impact from these developments in credit markets and the national economy on unemployment rates, job growth and business failures until the last quarter of 2008; overall, our market area has not experienced in the past five quarters the degree of negative impact on lending, credit and property values that the U.S. as a whole has experienced, although this may change in upcoming periods.

Due to the imprecise nature of the loan loss estimation process and ever changing economic conditions, the risk attributes of our portfolio may not be adequately captured in data related to the formula-based loan loss components used to determine allocations in our analysis of the adequacy of the allowance for loan losses. Management, therefore, has established and held an unallocated portion within the allowance for loan losses reflecting the uncertainty of future economic conditions within our market area.  This unallocated portion of the allowance was $855 thousand, or 6.1% of the total allowance for loan losses, at December 31, 2009.




27




SUMMARY OF THE ALLOWANCE AND PROVISION FOR LOAN LOSSES

(Dollars In Thousands) (Loans, Net of Unearned Income)


Years-Ended December 31,

2009

2008

2007

2006

2005

Loans at End of Period

$1,112,150 

$1,109,812 

$1,038,844 

$1,008,999 

$  996,545 

Average Loans

1,101,759 

1,071,384 

1,020,856 

996,611 

942,286 

Total Assets at End of Period

1,841,627 

1,665,086 

1,584,846 

1,520,217 

1,519,603 

 

 

 

 

 

 

Nonperforming Assets:

 

 

 

 

 

  Nonaccrual Loans:

 

 

 

 

 

  Commercial Real Estate

  $2,235 

  $2,263 

  $  758 

  $    708 

  $    597 

  Commercial Loans

309 

 50 

 73 

 56 

 26 

  Residential Real Estate Loans

901 

100 

253 

452 

59 

  Consumer Loans

     945 

  1,056 

    855 

    822 

  1,193 

    Total Nonaccrual Loans

4,390 

3,469 

1,939 

2,038 

1,875 

 

 

 

 

 

 

Loans Past Due 90 or More Days and

 

 

 

 

 

  Still Accruing Interest

     270 

     457 

     245 

     739 

      373 

    Total Nonperforming Loans

4,660 

3,926 

2,184 

2,777 

2,248 

Repossessed Assets

59 

64 

63 

144 

124 

Other Real Estate Owned

53 

581 

89 

248 

--- 

Nonaccrual Investments

        --- 

      400 

        --- 

        --- 

        --- 

    Total Nonperforming Assets

$4,772 

$4,971 

$2,336 

$3,169 

$2,372 

 

 

 

 

 

 

Allowance for Loan Losses:

 

 

 

 

 

Balance at Beginning of Period

$13,272 

$12,401 

$12,278 

$12,241 

$12,046 

Loans Charged-off:

 

 

 

 

 

  Commercial, Financial

 

 

 

 

 

    and Agricultural

(88)

(83)

(27)

(32)

(134)

  Real Estate - Commercial

--- 

--- 

(6)

--- 

--- 

  Real Estate - Residential

(25)

(25)

 --- 

 --- 

 (30)

  Installment Loans to Individuals

(1,317)

(1,184)

 (797)

 (1,105)

   (964)

    Total Loans Charged-off

   (1,430)

   (1,292)

   (830)

   (1,137)

   (1,128)

                                      

 

 

 

 

 

Recoveries of Loans Previously Charged-off:

 

 

 

 

 

  Commercial, Financial

 

 

 

 

 

    and Agricultural

14 

38 

13 

27 

18 

  Real Estate - Commercial

--- 

197 

17 

17 

17 

  Real Estate - Residential

 6 

 2 

 2 

 2 

 2 

  Installment Loans to Individuals

      369 

      255 

      408 

      302 

      256 

    Total Recoveries of Loans

     Previously Charged-off

      389 

      492 

      440 

      348 

      293 

    Net Loans Charged-off

(1,041)

(800)

(390)

(789)

(835)

Provision for Loan Losses

 

 

 

 

 

  Charged to Expense

    1,783 

     1,671 

       513 

       826 

   1,030 

                                      

 

 

 

 

 

Balance at End of Period

$14,014 

$13,272 

$12,401 

$12,278 

$12,241 

 

 

 

 

 

 

Nonperforming Asset Ratio Analysis:

 

 

 

 

 

Net Loans Charged-off as a Percentage of

  Average Loans

.09%

.07%

.04%

.08%

.09%

Provision for Loan Losses as a

  Percentage of Average Loans

 .16   

 .16   

 .05   

 .08   

 .11   

Allowance for Loan Losses as a

  Percentage of Loans, Period-end

1.26   

1.20   

1.19   

1.22   

1.23   

Allowance for Loan Losses as a

  Percentage of Nonperforming Loans

300.73   

338.05   

567.81   

442.12   

544.55   

Nonperforming Loans as a

  Percentage  of Loans, Period-end

 .42   

 .35   

 .21   

 .28   

 .23   

Nonperforming Assets as a Percentage of

  Total Assets, Period-end

 .26   

 .30   

 .15   

 .21   

 .16   

 

 

 

 

 

 


ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES

(Dollars in Thousands)


 

2009

2008

2007

2006

2005

Commercial, Financial  and Agricultural

$ 1,304

$  1,735

$  1,634

$  1,691

$  1,574

Real Estate-Commercial

4,000

3,568

3,247

3,348

3,160

Real Estate-Residential Mortgage

2,954

2,610

2,320

1,714

1,569

Indirect and Other Installment Loans to Individuals

4,901

4,859

4,369

4,517

5,294

Unallocated

       855

       500

       831

    1,008

      644

Total

$14,014

$13,272

$12,401

$12,278

$12,241




28



III. NONINTEREST INCOME

The majority of our noninterest income constitutes fee income from services, principally fees and commissions from fiduciary services, deposit account service charges, insurance commissions, and other recurring fee income.  Net gains or losses on the sale of securities available-for-sale is another category of noninterest income.


ANALYSIS OF NONINTEREST INCOME

(Dollars In Thousands)

 

Years Ended December 31,

Change From Prior Year

 

 

 

2008 to 2009

2007 to 2008

2009 

2008 

2007

Amount 

%

Amount 

%

Income from Fiduciary Activities

$  5,009 

$  5,463 

$  5,572 

$  (454)

(8.3)%

$  (109)

(2.0)%

Fees for Other Services to Customers

8,051 

8,562 

8,130 

 (511)

(6.0)   

 432 

5.3    

Net Gains (Losses) on Securities Transactions

 357 

 383 

 --- 

(26)

(6.8) 

383 

---   

Other-Than-Temporary Impairment

(375)

(1,610)

--- 

1,235 

76.7    

(1,610)

---     

Net Gain on Sale of Merchant Bank Card Processing

2,966 

--- 

--- 

2,966 

---     

---  

---     

Gain on Visa Stock Redemption

--- 

749 

--- 

(749)

---     

749 

---     

Gain on the Sale of Premises

--- 

115 

--- 

(115)

---     

115 

---     

Income from Restitution Payment

450 

--- 

--- 

450 

---     

--- 

---     

Insurance Commissions

2,412 

2,066 

1,869 

346 

16.7    

197 

10.5    

Other Operating Income

       722 

       541 

       717 

    181 

33.5    

   (176)

(24.5)   

  Total Noninterest Income

$19,592 

$16,269 

$16,288 

$3,323 

20.4    

$   (19)

(0.1)   


2009 compared to 2008:  Without regard to certain transactions (securities gains, OTTI, sale of the merchant bank card processing, VISA transactions, sale of premises and the restitution payment) total noninterest income was down $438 thousand, or 2.6%, from 2008 to 2009.  The most significant transactions involving non-interest income occurring during 2008 and 2009 were discussed in the Overview beginning on page 19: 1) the net gain on the sale of our merchant bank card processing to TransFirst in the first quarter of 2009, 2) the write-down of our Lehman bond in 2008 and of our holdings in an inactively-traded common stock in 2009 and, 3) the 2008 gain from the Visa stock redemption.  

For 2009, income from fiduciary activities decreased $454 thousand, or 8.3%, from 2008.  The decrease mirrored (and resulted from) a similar and significant decrease in the fair value of assets under administration and management following the severe decline in the stock markets during 2008 to the early 2009 period.  

At December 31, 2009, the fair value of assets under trust administration and investment management amounted to $867.2 million, an increase of $111.8 million, or 14.8%, from December 31, 2008.  A significant portion of our fiduciary fees are indexed to the average dollar amount of assets under administration and we normally expect (and experience) a change in our fiduciary fee income proportionate to our change in average dollar assets under administration.  An increase in stock market prices was not sufficient to achieve an overall increase in income from fiduciary activities for 2009 as compared to 2008, since the average balance in 2009 was still well below the average balance for 2008.  

Income from fiduciary activities includes fee income from the investment advisory services performed by our affiliated investment advisor for our proprietary mutual funds.  These mutual funds are the North Country Funds, which include the North Country Equity Growth Fund (NCEGX) and the North Country Intermediate Bond Fund (NCBDX).  The combined funds represented a market value of $213.5 million at December 31, 2009, compared to $180.0 million at December 31, 2008.  

Fees for other services to customers (primarily service charges on deposit accounts, credit card merchant fees, debit card interchange fees, revenues related to the sale of mutual funds to our customers by third party providers and servicing income on sold loans) were $8.1 million for 2009, a decrease of $511 thousand, or 6.0%, from the 2008 period.  The decrease was primarily attributable to a decrease in fees we received from the merchant bank card processing business following our sale of that business in the first quarter of 2009.  That decrease was offset, in part, by an increase in fees on debit cards and other fee income.

During the first quarter of 2008, Visa successfully completed an initial public offering (IPO) and used a portion of the proceeds from the IPO to fund a $3 billion litigation escrow account.  As a result, in the first quarter of 2008, our subsidiary, Glens Falls National Bank and Trust Company, a Visa member bank that is contingently liable with other member banks for certain covered Visa litigation expenses, reversed litigation-related accruals of $306 thousand out of the total of $600 thousand in pre-tax charges which we had previously recognized in the fourth quarter of 2007 for such expenses. Visa used another portion of the IPO proceeds to redeem 38.7% of the Visa Class B common stock held by each of its member banks.  As a result, we also recognized in the first quarter a pre-tax gain of $749 thousand representing the proceeds received by us from this partial redemption.

In 2009, we sold many of our newly originated residential real estate loans to Freddie Mac, resulting in net gains of $418 thousand, compared to $106 thousand in gains for the 2008 period which is reflected in other operating income above.  Other operating income also includes net gains on the sale of other real estate owned, repossessed vehicles, fixed assets, as well as other miscellaneous revenues.

2008 compared to 2007:  Although total noninterest income was relatively unchanged from 2007 to 2008 there were several significant transactions involving non-interest income occurring during 2007 and 2008, most notably the two items discussed in the Overview beginning on page 19: 1) the write-down of our Lehman bond, and 2) the gain from the Visa stock redemption.  

For 2008, income from fiduciary activities decreased $109 thousand, or 2.0%, from 2007.  The decrease followed the significant decrease in assets under administration and management following the severe decline in the stock markets principally in the last three months of 2008.  At year-end 2008, the market value of assets under trust administration and investment management amounted to $755.4 million, a decrease of $205.8 million, or 21.4%, from year-end 2007.  By comparison, the Dow Jones Industrial Average was 8,776 at December 31, 2008 – a 33.8% decrease from 13,264 at December 31, 2007.   With a significant portion of our fiduciary fees indexed to assets under administration we would normally expect this income to decrease proportionately.  However, since the market decline occurred primarily in the second half of the year our total income from fiduciary activities did not fall to the full extent of the decrease in the market value of assets under administration.





29



Income from fiduciary activities includes income from funds under investment management in The North Country Funds, specifically the North Country Equity Growth Fund (“NCEGX”) and the North Country Intermediate Bond Fund (“NCBDX”), both of which are advised by our registered investment adviser subsidiary, North Country Investment Advisers, Inc.  On a combined basis, these funds had a market value of $180.0 million and $207.1 million at December 31, 2008 and 2007, respectively.  The funds were introduced in March 2001.  Most of the dollars invested in these funds are derived from retirement and pension plan accounts of which our banks serve as trustee, but our North Country Funds also are offered on a retail basis through an arrangement with UVEST Financial Services Group, Inc., a third-party registered broker/dealer that provides securities brokerage services to our customers from several of our bank branches.  Our company’s pension plan is included as an investor in the North Country Funds, and owned shares in the funds with a market value of approximately $14.5 million at December 31, 2008 and $17.5 million at 2007.

Fees for other services to customers include deposit account service charges, debit card processing fees, merchant bankcard processing fees, safe deposit box fees and loan servicing fees.  These fees amounted to $8.6 million in 2008, an increase of $432 thousand, or 5.3%, from 2007.  The increase was primarily attributable to debit card activity fee income and increases in income from our third-party provider of securities brokerage services.

During 2008, we recognized a net gain of $383 thousand on the sale of $29.1 million of investment securities available-for-sale, whereas no securities were sold during 2007.

During 2008, we sold a building which we were using for storage and administrative purposes to a developer.  After renovation, we agreed to lease back office space which amounted to less than 10 percent of the total building space.  We recognized a gain of $115 thousand in 2008 on this sale.  

In November 2004, we acquired Capital Financial Group, Inc., a local insurance agency specializing in the sale of group health and life insurance.  See the more detailed discussion of the acquisition on page 5 of this Report.  Insurance commission income increased from $1.9 million in 2007 to $2.1 million in 2008.

Other operating income includes net gains on the sale of loans and other real estate owned as well as other miscellaneous revenues.  For 2008, other operating income decreased $176 thousand, or 24.5%, from 2007.  In years prior to 2008, other operating income included data processing servicing fee income received from one unaffiliated upstate New York bank.  However, this arrangement came to an end in the second quarter of 2007, following the acquisition of that institution by an unrelated company.  Termination of the arrangement resulted in a reduction in fee income of $135 thousand in 2008 compared to 2007.

 


IV. NONINTEREST EXPENSE

Noninterest expense is a means of measuring the delivery cost of services, products and business activities of a company.  The key components of noninterest expense are presented in the following table.


ANALYSIS OF NONINTEREST EXPENSE

(Dollars In Thousands)

 

Years Ended December 31,

Change From Prior Year

 

 

 

 

2008 to 2009

2007 to 2008

 

2009 

2008 

2007 

Amount

%

Amount

%

Salaries and Employee Benefits

$27,042 

$24,551 

$21,424 

$2,491 

10.1%

$3,127 

14.6%

Occupancy Expense of Premises, Net

 3,316 

 3,479 

 3,198 

 (163)

 (4.7)

 281 

  8.8  

Furniture and Equipment Expense

3,264 

3,211 

3,015 

53 

1.7  

196 

6.5  

FDIC Special Assessment

787 

--- 

--- 

787 

---  

---

---  

FDIC Regular Assessment

1,783 

644 

139 

1,139 

176.9 

505 

363.3 

VISA Related Litigation Exposure (Reversal)

--- 

(306)

600 

306 

---  

(906)

(151.0)

Amortization

324 

360 

395 

(36)

(10.0)

(35)

(8.9)

Other Operating Expense

  10,076 

  10,454 

    9,159 

   (378)

(3.6)

  1,295 

14.1 

   Total Noninterest Expense

$46,592 

$42,393 

$37,930 

$4,199 

 9.9  

$4,463 

 11.8  


2009 compared to 2008:  Noninterest expense for 2009 amounted to $46.6 million, an increase of $4.2 million, or 9.9%, from 2008.  One comparative measure of operating expenses for financial institutions is the efficiency ratio.  The efficiency ratio (a ratio where lower is better) is calculated as the ratio of noninterest expense to the sum of tax equivalent net interest income and other income.  Excluded from our calculation of the efficiency ratio is intangible asset amortization and any net securities gains or losses.    The efficiency ratio might be considered a non-GAAP financial measure but is generally utilized by banks and bank analysts to assess an institution’s performance.  See the discussion on “Use of Non-GAAP Financial Measures” on page 4 of this Report.  For 2009, the efficiency ratio for Arrow was 55.64%, an increase from the 2008 ratio of 54.65%.  A similar ratio (total overhead expense to adjusted tax equivalent operating income) is presented in the Federal Reserve Board’s “Bank Holding Company Performance Report” for December 31, 2009.  Our 2009 ratio, 56.03%, compared favorably to the ratio for our peer group of 76.40%.  For information on the calculation of our efficiency ratios on a quarterly and annual basis, see pages 17 and 18 of this Report.  

Salaries and employee benefits expense increased $2.5 million, or 10.1%, from 2008 to 2009.  Salary expense increased $746 thousand, or 4.3%, from 2008, due primarily to staff increases and to normal merit increases.  Employee benefits increased $1.7 million, or 24.5% from 2008 to 2009.  This was primarily attributable to increases in pension expenses resulting from a decrease in the investment return on the pension plan assets during 2008.  The ratio of total personnel expense (salaries and employee benefits) to average assets was 1.54% for 2009, 8 basis points higher than the annualized ratio for our peer group of 1.46% at December 31, 2009.

Occupancy expense decreased $163 thousand, or 4.7%, from 2008 to 2009.  The decrease was primarily attributable to decreased heating costs, which had increased in 2008 over 2007 when oil prices were at an all time high.  Furniture and equipment expense increased by only $53 thousand, or 1.7%, from 2008 to 2009.  The increase was primarily attributable to increases in data processing expenses.

Changes in our FDIC insurance assessment, the 2009 FDIC special assessment and the VISA related items were discussed earlier on pages 7-8.




30



Other operating expense decreased from 2008 to 2009, by $378 thousand, or 3.6%.  The decrease was primarily attributable to a decrease in the fees paid to third party computer processing expenses.


2008 compared to 2007:  Noninterest expense for 2008 amounted to $42.4 million, an increase of $4.5 million, or 11.8%, from 2007.  For 2008, the efficiency ratio for Arrow was 54.65%, a decrease from the 2007 ratio of 57.3%.  Our 2008 ratio compared favorably to the ratio for our peer group of 68.95% as of December 31, 2008.  For information on the calculation of our efficiency ratios on a quarterly and annual basis, see pages 17 and 18 of this Report.  Also see the discussion on “Use of Non-GAAP Financial Measures” on page 4 of this Report.

Salaries and employee benefits expense increased $3.1 million, or 14.6%, from 2007 to 2008.  Salary expense increased $1.13 million, or 6.9%, from 2007, due primarily to staff increases and to normal merit increases.  Employee benefits increased $2.0 million, or 39.2% from 2007 to 2008.  This was primarily attributable to increases in incentive compensation expenses.  The ratio of total personnel expense (salaries and employee benefits) to average assets was 1.49% for 2008, which was still 4 basis points less than the annualized ratio for our peer group of 1.53% at December 31, 2008.

Occupancy expense increased $281 thousand, or 8.8%, from 2007 to 2008.  The increase was primarily attributable to increased heating costs (i.e., substantially increased cost of oil in 2008), as well as maintenance and real estate taxes.  Furniture and equipment expense increased by $196 thousand, or 6.5%, from 2007 to 2008.  The increase was primarily attributable to increases in data processing expenses.

Other operating expense increased from 2007 to 2008, by $1.3 million, or 14.1%.  The increases were spread among a variety of categories, most notably legal and marketing expenses.   



V. INCOME TAXES

The following table sets forth our provision for income taxes and effective tax rates for the periods presented.


INCOME TAXES AND EFFECTIVE RATES

(Dollars In Thousands)

 

Years Ended December 31,

Change From Prior Year

 

 

 

 

2008 to 2009

2007 to 2008

 

2009

2008

2007

Amount

%

Amount

%

Provision for Income Taxes

$9,790

$8,999

$6,807

$791

8.8%

$2,192

32.2%

Effective Tax Rate

31.0%

30.6%

28.2%

0.4%

1.3

2.4%

8.5

 

 

 

 

 

 

 

 

The provisions for federal and state income taxes amounted to $9.8 million, $9.0 million and $6.8 million for 2009, 2008 and 2007, respectively.   The effective income tax rates for 2009, 2008 and 2007 were 31.0%, 30.6% and 28.2%, respectively, with the increase in the effective rate between 2008 and 2009 reflecting a decrease in the ratio of tax-exempt income to total income before taxes.



C. FINANCIAL CONDITION


I. INVESTMENT PORTFOLIO

Investment securities are classified as held-to-maturity, trading, or available-for-sale, depending on the purposes for which such securities are acquired and thereafter held.  Securities held-to-maturity are debt securities that we have both the positive intent and ability to hold to maturity; such securities are stated at amortized cost.  Debt and equity securities that are bought and held principally for the purpose of sale in the near term are classified as trading securities and are reported at fair value with unrealized gains and losses included in earnings.  Debt and equity securities not classified as either held-to-maturity or trading securities are classified as available-for-sale and are reported at fair value with unrealized gains and losses excluded from earnings and reported net of taxes in accumulated other comprehensive income or loss.  During 2009, 2008 and 2007, we held no trading securities.  Set forth below is certain information about our securities available-for-sale portfolio and securities held-to-maturity portfolio.


Securities Available-for-Sale:

The following table sets forth the carrying value of our securities available-for-sale portfolio at year-end 2009, 2008 and 2007.


SECURITIES AVAILABLE-FOR-SALE

(In Thousands)

 

December 31,

 

2009

2008

2007

U.S. Treasury and Agency Obligations

$123,331

$  11,528

$  39,497

State and Municipal Obligations

18,913

15,446

24,206

Collateralized Mortgage Obligations

199,781

185,830

138,971

Mortgage-Backed Securities - Residential

93,017

93,849

112,458

Corporate and Other Debt Securities

1,331

7,433

11,574

Mutual Funds and Equity Securities

      1,333

      1,328

      1,790

  Total

$437,706

$315,414

$328,496





31



In all periods, mortgage-backed securities – residential consisted solely of agency mortgage pass-through securities.  Pass-through securities provide to the investor monthly portions of principal and interest pursuant to the contractual obligations of the underlying mortgages.  Collateralized mortgage obligations (“CMOs”) separate the repayments on mortgage-backed securities into two or more components (tranches), where each tranche has a separate estimated life and yield.  Our practice has been to purchase only pass-through securities and CMOs that are guaranteed by federal agencies, and the tranches of CMOs that we purchase generally are those having shorter maturities.  Included in our corporate and other debt securities for each of the periods are corporate bonds that were highly rated at the time of purchase, although in some cases the securities had been downgraded before the reporting date, including our Lehman bond, which had been downgraded and partially charged off prior to December 31, 2008, and was subsequently sold in 2009.  See additional disclosure on our downgraded securities holdings, including the Lehman bond, on page 21.


The following table sets forth the maturities of our securities available-for-sale portfolio as of December 31, 2009.  CMOs and other mortgage-backed securities are included in the table based on their expected average lives.  Mutual funds and equity securities, which have no stated maturity, are included in the after 10-years category.


MATURITIES OF SECURITIES AVAILABLE-FOR-SALE

(In Thousands)

 

Within

One

Year

After

1 But

Within

5 Years

After

5 But

Within

10 Years

After

10 Years

Total  

U.S. Treasury and Agency Obligations

$86,345

$36,986

$       ---

$       ---

$123,331

State and Municipal Obligations

9,680

4,708

1,657

2,868

18,913

Collateralized Mortgage Obligations

21,021

79,599

93,315

 5,846

199,781

Mortgage-Backed Securities - Residential

4,038

39,120

13,306

36,553

93,017

Corporate and Other Debt Securities

---

80

  ---

1,251

1,331

Mutual Funds and Equity Securities

           ---

           ---

           ---

    1,333

      1,333

    Total

$121,084

$160,493

$108,278

$47,851

$437,706


The following table sets forth the tax-equivalent yields of our securities available-for-sale portfolio at December 31, 2009.


YIELDS ON SECURITIES AVAILABLE-FOR-SALE

(Fully Tax-Equivalent Basis)

 

Within

One

Year

After

1 But

Within

5 Years

After

5 But

Within

10 Years

After

10 Years

Total

U.S. Treasury and Agency Obligations

2.18%

2.08%

---%

 ---%

2.15%

State and Municipal Obligations

2.63

2.64

5.52

7.59

3.64

Collateralized Mortgage Obligations

4.31

4.65

4.83

4.01

4.68

Mortgage-Backed Securities - Residential

3.26  

4.49

5.53

4.17

4.45

Corporate and Other Debt Securities

---   

6.45

---

2.93

3.12

Mutual Funds and Equity Securities

---   

---

---

3.97

3.97

    Total

2.55

3.93

4.90

4.16

3.81


The yields on obligations of states and municipalities exempt from federal taxation were computed on a fully tax-equivalent basis using a marginal tax rate of 35%. The yields on other debt securities shown in the table above are calculated by dividing annual interest, including accretion of discounts and amortization of premiums, by the amortized cost of the securities at December 31, 2009.  Dividend earnings derived from equity securities were adjusted to reflect applicable federal income tax exclusions.

At December 31, 2009 and 2008, the weighted average maturity was 4.1 and 5.1 years, respectively, for debt securities in the available-for-sale portfolio.  

At December 31, 2009, the net unrealized gains on securities available-for-sale amounted to $5.2 million.  The net unrealized gain or loss on such securities, net of tax, is reflected in accumulated other comprehensive income/loss.  The net unrealized gains on securities available-for-sale was $4.0 million at December 31, 2008.  For both periods, the net unrealized gain was primarily attributable to a change in market rates between the date of purchase and market yields at the balance sheet date.

For further information regarding our portfolio of securities available-for-sale, see Note 3 to the Consolidated Financial Statements contained in Part II, Item 8 of this Report.




32



Securities Held-to-Maturity:

The following table sets forth the carrying value of our portfolio of securities held-to-maturity (consisting exclusively of state and municipal obligations) at December 31 of each of the last three years.


SECURITIES HELD-TO-MATURITY

(In Thousands)

 

December 31,

 

2009

2008

2007

State and Municipal Obligations

$167,931

$133,976

$114,611

Corporate and Other Debt Securities

      1,000

           ---

            ---

  Total

$168,931

$133,976

$114,611


For information regarding the fair value of our portfolio of securities held-to-maturity at December 31, 2009, see Note 3 to the Consolidated Financial Statements contained in Part II, Item 8 of this Report.


The following table sets forth the maturities of our portfolio of securities held-to-maturity as of December 31, 2009.


MATURITIES OF SECURITIES HELD-TO-MATURITY

(In Thousands)

 

Within

One Year

After 1 But

Within 5 Years

After 5 But

Within 10 Years

After

10 Years

Total

State and Municipal Obligations

 $44,391

$41,753

$68,788

$12,999

$167,931

Corporate and Other Debt Securities

         ---

         ---

         ---

    1,000

      1,000

    Total

$44,391

$41,753

$68,788

$13,999

$168,931


The following table sets forth the tax-equivalent yields of our portfolio of securities held-to-maturity at December 31, 2009.


YIELDS ON SECURITIES HELD-TO-MATURITY

(Fully Tax-Equivalent Basis)

 

Within

One Year

After 1 But

Within 5 Years

After 5 But

Within 10 Years

After

10 Years

Total

State and Municipal Obligations

3.72%

4.46%

5.25%

5.99%

4.71%

Corporate and Other Debt Securities

---

---

---

6.50

6.50

    Total

3.72

4.46

5.25

6.03

4.72


The yields shown in the table above are calculated by dividing annual interest, including accretion of discounts and amortization of premiums, by the carrying value of the securities at December 31, 2009.  Yields on obligations of states and municipalities exempt from federal taxation (which constituted the entire portfolio) were computed on a fully tax-equivalent basis using a marginal tax rate of 35%.

During 2009, 2008 and 2007, we sold no securities from the held-to-maturity portfolio.  The weighted-average maturity of the held-to-maturity portfolio was 5.3 years and 4.0 years at December 31, 2009 and 2008, respectively.


II. LOAN PORTFOLIO


The amounts and respective percentages of loans outstanding represented by each principal category on the dates indicated were as follows:

a. Types of Loans

(Dollars In Thousands)

 

December 31,

 

2009

2008

2007

2006

2005

 

Amount

%

Amount

%

Amount

%

Amount

%

Amount

%

Commercial, Financial

 and Agricultural

$     89,222 

8

$     86,872 

8

$    79,128

8

$   79,581 

8

$  79,917 

8

Real Estate -

 Commercial

185,582 

17

183,676 

17

160,787 

15

161,443 

16

152,447 

15

Real Estate -

 Construction

34,906 

3

34,428 

3

39,265 

4

31,319 

3

25,736 

3

Real Estate -

 Residential

472,605 

42

444,655 

40

417,092 

40

399,446 

40

376,820 

38

Indirect and Other Installment

  Loans to Individuals

    329,835 

      30

    360,181 

      32

    342,572 

      33

   337,210 

      33

  361,625 

     36

Total Loans

1,112,150 

100

1,109,812 

100

1,038,844 

100

1,008,999 

100

996,545 

100

Allowance for Loan

 Losses

     (14,014)

 

     (13,272)

 

     (12,401)

 

   (12,278)

 

  (12,241)

 

Total Loans, Net

$1,098,136 

 

$1,096,540 

 

$1,026,443 

 

$ 996,721 

 

$984,304 

 




33



Maintenance of High Quality in the Loan Portfolio:  During the second half of 2008 and throughout 2009, the U.S. experienced significant disruption and volatility in its financial and capital markets.  A major cause of the disruption was a significant decline in residential real estate values across much of the U.S., which in turn triggered widespread defaults on subprime mortgage loans and steep devaluations of portfolios containing these loans and securities collateralized by them.  In recent months, as real estate values have continued to fall in most areas of the U.S., problems have spread from subprime loans to better quality mortgage portfolios, and in some cases prime mortgage loans, as well as home equity and credit card loans.  Recently, commercial real estate values have begun to decline substantially and commercial real estate mortgage portfolios have begun to experience the same problems that have beset residential mortgage portfolios over the prior 18 months.  Many lending institutions have suffered sizable charge-offs and losses in their loan and investment securities portfolios in the past six quarters as a result of their origination or investment in these kinds of loans or securities.

Through December 2009, we have not experienced a significant deterioration in our loan or investment portfolios, except for the impaired securities, including the Lehman bond discussed earlier in this Report.  We have never engaged in subprime mortgage lending as a business line and we do not extend or purchase any so-called “Alt-A,” “negative amortization,” “option ARM,” or “negative equity” mortgage loans.  On occasion we have made loans to borrowers having a FICO score of 660 or below or have had extensions of credit outstanding to borrowers who have developed credit problems after origination resulting in deterioration of their FICO scores.  We also on occasion have extended community development loans to borrowers whose creditworthiness is below our normal standards as part of the community support program we have developed in fulfillment of our statutorily-mandated duty to support low- and moderate-income borrowers within our service area.  However, we are a prime lender and apply prime lending standards and this, together with the fact that the service area in which we make most of our loans has not experienced as severe a decline in property values as other parts of the U.S., are the principal reasons that we have not to date experienced significant deterioration in the real estate categories of our loan portfolio.  

If, however, the current downturn in the U.S. real estate markets should continue and the U.S. and/or our local economy should continue in its current weakened state for any substantial additional period of time, we can give no assurances about the continuing high quality of our loan portfolio.  In such event, we may experience elevated charge-offs, higher provisions to our loan loss reserve, and increasing expense related to asset maintenance and supervision.


Residential Real Estate Loans: In recent years, residential real estate and home equity loans have represented the largest segment of our loan portfolio.  Residential mortgage demand has been moderate since 2004, after a several year period when demand was high.  However, during 2004 and 2005 and the first quarter of 2006, we sold many of our 30-year, fixed-rate mortgage originations, while retaining the servicing rights.  By the end of the first quarter of 2006, as yields on longer-term residential real estate loans began to rise, we decided to stop selling our 30-year mortgage originations and instead retain them in our portfolio.  However, during the last quarter of 2008 and the first two quarters of 2009, as the government supported entities (GSEs) Fannie Mae and Freddie Mac increased their dominance of the highly stressed home mortgage market with very low-rate mortgages and we returned to our earlier practice of selling most of our mortgage originations to Freddie Mac.  During 2009, only a portion of the $91.9 million of our new residential real estate loan originations was sold to Freddie Mac (with further offsets as a result of normal principal amortization and prepayments on pre-existing loans).  However, if we continue in the current GSE-subsidized low-rate environment for newly originated residential real estate loans, we may elect to resell an even higher portion of our loan originations and may experience a decrease in our outstanding balances in this segment of our portfolio.  Moreover, if our local economy or real estate market suffers a major downturn, the demand for residential real estate loans in our service area may decrease, which also may negatively impact our real estate portfolio and our financial performance.


Indirect Loans: In the early post-2000 years, indirect consumer loans (consisting principally of automobile loans originated through dealerships located primarily in the eastern region of upstate New York), was the largest segment of our loan portfolio.  For much of this period, indirect consumer loans were the fastest growing segment of our loan portfolio, both in terms of absolute dollar amount and as a percentage of the overall portfolio.  Since 2003, however, this segment of the portfolio has basically been flat, with periods of expansion followed by contraction.  Over the period, the segment has experienced little growth in absolute terms and decreased as a percentage of the overall portfolio.  This change in indirect loan totals was largely the result of aggressive campaigns of zero rate and other subsidized financing by auto manufacturers, commencing late 2001 and recurring periodically in the years since then.  

At the end of the first quarter of 2006, we experienced an increase in indirect loans, which continued throughout the second and third quarters of 2006, for a variety of factors, including the decision by the automobile manufacturers to be less aggressive with their subsidized financing programs.  In the fourth quarter of 2006, however, indirect loan balances declined by 4.3%, measured at quarter-end (although the average balance for the fourth quarter was slightly higher than the average balance for the third quarter).

In the last quarter of 2007 and the first two quarters of 2008, we encountered enhanced rate competition on indirect (auto) loans from other lenders, including finance affiliates of the auto manufacturers who increased their offerings of heavily subsidized, low- or zero-rate loans.  This increasingly competitive environment, combined with softening demand for vehicles, especially for SUVs and light trucks, had a negative effect on our indirect originations, and we experienced decreases in indirect balances in the first two quarters of 2008.  However during the last two quarters of 2008, as some of the major lenders in the indirect market pulled back, including the auto companies’ financing affiliates, our share of the indirect loan market increased and our portfolio at December 31, 2008 exceeded the balance at December 31, 2007 by $19.5 million, or 5.7%.  However, in 2009 our outstanding balances steadily declined from month to month and our ending balance at December 31, 2009 was $28.1 million, or 7.8%, below the 2008 year-end balance.

At the time of origination, the borrowers of the indirect loans we originated had an average credit score of over 725. We have an extremely capable and experienced lending staff that not only utilize software tools but also review and evaluate each loan individually. We believe our disciplined approach to evaluating risk has contributed to maintaining our strong loan quality.  Originations of indirect loans for 2009 were approximately $  127.8 million, a decrease of $50.0 million, or 36.7%, from 2008.  At December 31, 2009, indirect loans represented the second largest category of loans in our portfolio and a significant component of our business.  However, if the recent reduction in auto demand continues, our indirect loan portfolio is likely to experience limited, if any, overall growth, either in real terms or as a percentage of the total portfolio, regardless of whether the auto company affiliates continue or resume their offering of highly-subsidized vehicle loans.  Such weakened demand for indirect loans could negatively impact our financial performance.



34



Commercial, Commercial Real Estate and Construction and Land Development Loans:  In recent years, we have experienced moderate to strong demand for commercial loans, and commercial and commercial real estate loan balances have generally increased, both in dollar amount and as a percentage of the overall loan portfolio.  This pattern continued during 2008 as the outstanding balance in this category grew $21.3 million, or 8.0%, from year-end 2007.  However, demand began to ease in 2009 and our outstanding balances at the end of 2009 were essentially unchanged from year-end 2008.  Substantially all commercial and commercial real estate loans in our portfolio are extended to businesses or borrowers located in our regional market.  Many of the loans in the commercial portfolio have variable rates tied to prime, FHLBNY or U.S. Treasury indices.  We have not experienced any significant weakening in the quality of our commercial loan portfolio in recent quarters, although during that period on a national scale the commercial real estate market has begun to give signs of significant weakness.  It is entirely possible that we may experience a reduction in the demand for such loans and/or a weakening in the quality of our commercial and commercial real estate loan portfolio in upcoming periods.


The following table indicates the changing mix in our loan portfolio by including the quarterly average balances for our significant loan products for the past five quarters.  The remaining quarter-by-quarter tables present the percentage of total loans represented by each category and the annualized tax-equivalent yield of each category.


LOAN PORTFOLIO

Quarterly Average Loan Balances

(Dollars In Thousands)

 

 

Quarter Ended

 

 

Dec 2009

Sep 2009

Jun 2009

Mar 2009

Dec 2008

Commercial and Commercial Real Estate

 

$   306,781

$   304,968

$   304,381

$  305,246

$   308,232

Residential Real Estate

 

355,292

343,948

335,572

339,597

340,486

Home Equity

 

 66,037

 61,819

 58,173

 54,857

 51,887

Indirect Consumer Loans

 

337,582

343,751

348,807

355,937

358,945

Other Consumer Loans1

 

       43,803

       45,335

       46,582

       48,534

       50,428

 Total Loans

 

$1,109,495

$1,099,821

$1,093,515

$1,104,171

$1,109,978


Percentage of Total Quarterly Average Loans

 

 

Quarter Ended

 

 

Dec 2009

Sep 2009

Jun 2009

Mar 2009

Dec 2008

Commercial and Commercial Real Estate

 

27.6%

27.7%

27.8%

27.6%

27.8%

Residential Real Estate

 

32.0

31.3   

30.7   

30.8   

30.7

Home Equity

 

6.0

5.6   

5.3   

5.0   

4.7

Indirect Consumer Loans

 

30.4

31.3   

31.9   

32.2   

32.3

Other Consumer Loans1

 

   4.0

    4.1   

    4.3   

    4.4   

   4.5

 Total Loans

 

100.0%

100.0%

100.0%

100.0%

100.0%


Quarterly Tax-Equivalent Yield on Loans

 

 

Quarter Ended

 

 

Dec 2009

Sep 2009

Jun 2009

Mar 2009

Dec 2008

Commercial and Commercial Real Estate

 

6.19%

6.23%

6.30%

6.41%

6.48%

Residential Real Estate

 

5.77

5.87   

6.01   

6.11   

6.00

Home Equity

 

3.14

3.22   

3.25   

3.33   

4.74

Indirect Consumer Loans

 

6.26

6.34   

6.27   

6.30   

6.36

Other Consumer Loans1

 

7.24

7.33   

7.28   

7.35   

7.34

 Total Loans

 

5.94

6.03   

6.08   

6.17   

6.25


1 Other Consumer Loans includes certain home improvement loans secured by mortgages.  However, these same loan balances are reported as

   Real Estate – Residential in the table of period-end balances on page 33, captioned “Types of Loans.”


In general, the yield (tax-equivalent interest income divided by average loans) on our loan portfolio and other earning assets is ultimately impacted by changes in prevailing interest rates, as previously discussed on in this Report on page 24 under the heading "Impact of Interest Rate Changes 2003 - 2009."  We expect that loan yields will continue to rise and fall with changes in prevailing market rates, although the timing and degree of responsiveness will be influenced by a variety of other factors, including the makeup of the loan portfolio, the shape of the yield curve, consumer expectations and preferences and the rate at which the portfolio expands.     

In additional to the repricing of certain outstanding loans as market rates fluctuate, there is a significant amount of cash flow from normal amortization and prepayments in all loan categories, and this cash flow reprices at current rates as new loans are generated.  

As noted in the earlier discussion, during a period of change in prevailing rates, we generally experience a time lag between the impact of the change on our deposit portfolio (which is felt relatively quickly) and the impact of the change on our loan portfolio (which occurs more slowly).  The consequence of this time lag is a positive impact on the net interest margin during the beginning of a rate decline period, and a negative impact on the margin at the beginning of a rate increase period.

As we discussed in our review of net interest income above, during the period from mid-2004 to mid-2006, the Federal Reserve Bank increased the targeted federal funds rate from 1.00% to 5.25% (and thereby increased short-term rates generally), in an effort to dampen inflationary pressures and unrestrained borrowing.  During this period of rate increase, the time-lag between repricing of our deposits and the repricing of loan balances was especially lengthy; in some sectors of the portfolio, the upward repricing of loan rates never occurred, at least not before the Fed reversed course and began decreasing rates in the last four months of 2007 and throughout all of 2008.  



35



The following table indicates the respective maturities and interest rate structure of our commercial, financial and agricultural loans and real estate - construction loans at December 31, 2009.  For purposes of determining relevant maturities, loans are assumed to mature at (but not before) their scheduled repayment dates as required by contractual terms.  Demand loans and overdrafts are included in the “Within 1 Year” maturity category.  Most of the real estate - construction loans are made with a commitment for permanent financing, whether extended by us or unrelated third parties.  The maturity distribution below reflects the final maturity of the permanent financing.


b. Maturities and Sensitivities of Loans to Changes in Interest Rates

(In Thousands)

 

 


Within

1 Year

After 1

But Within

5 Years


After

5 Years



Total

Commercial, Financial and Agricultural

 

$33,511

$33,321

$22,390

$  89,222

Real Estate - Construction

 

    3,160

  6,672

  25,074

   34,906

  Total

 

$36,671

$39,993

$47,464

$124,128

 

Fixed Interest Rates

 

$  7,804

$33,638

$20,702

$  62,144

Variable Interest Rates

 

  28,867

   6,355

  26,762

   61,984

  Total

 

$36,671

$39,993

$47,464

$124,128

 


COMMITMENTS AND LINES OF CREDIT

Stand-by letters of credit represent extensions of credit granted in the normal course of business, which are not reflected in the financial statements at a given date because the commitments are not funded at that time.  As of December 31, 2009, our total contingent liability for standby letters of credit amounted to $14.7 million.  In addition to these instruments, we also have issued lines of credit to customers, including home equity lines of credit, commitments for residential and commercial construction loans and other personal and commercial lines of credit, which also may be unfunded or only partially funded from time to time.  Commercial lines, generally issued for a period of one year, are usually extended to provide for the working capital requirements of the borrower.  At December 31, 2009, we had outstanding unfunded loan commitments in the aggregate amount of approximately $183.2 million.


c. Risk Elements


1. Nonaccrual, Past Due and Restructured Loans

The amounts of nonaccrual, past due and restructured loans for the past five years are presented in the table on page 28 under the heading “Summary of the Allowance and Provision for Loan Losses.”

We designate loans as nonaccrual when the payment of interest and/or principal is due and unpaid for a designated period (generally 90 days) or when the likelihood of the full repayment of principal and interest is, in the opinion of management, uncertain.  Under the Uniform Retail Credit Classification and Account Management Policy established by banking regulators, fixed-maturity consumer loans must generally be charged-off no later than when 120 days past due.  Loans secured with non-real estate collateral in the process of collection are charged-down to the value of the collateral, less cost to sell.  Open-end credits, residential real estate loans and commercial loans are evaluated for charge-off on a loan-by-loan basis when placed on nonaccrual status.  We had no material commitments to lend additional funds on outstanding nonaccrual loans at December 31, 2009.  Loans past due 90 days or more and still accruing interest are those loans which were contractually past due 90 days or more but because of expected repayments, were still accruing interest.  

The balance of loans 30-89 days past due totaled $11.3 million at December 31, 2009 and represented 1.01% of loans outstanding at that date, as compared to approximately $7.8 million, or 0.71% of loans at December 31, 2008.  These non-current loans at December 31, 2009 were composed of approximately $6.9 million of consumer loans, principally indirect motor vehicle loans, $2.5 million of residential real estate loans and $1.9 million of commercial loans.

All our impaired loans over $250,000 are measured based on (i) the present value of expected future cash flows discounted at the loan's effective interest rate, (ii) the loan's observable market price or (iii) the fair value of the collateral, less cost to sell, if the loan is collateral dependent.  We determine impairment for collateralized loans based on fair value of the collateral less estimated cost to sell.  For other loans, impairment is determined by comparing the recorded value of the loan to the present value of the expected cash flows, discounted at the loan’s effective interest rate.  We determine the interest income recognition method for impaired loans on a loan-by-loan basis.  Based upon the borrowers’ payment histories and cash flow projections, interest recognition methods include full accrual or cash basis.  Our method for measuring all other loans is described in detail beginning on page 26.

During 2009, three commercial loans over $250,000 were considered impaired with an average recorded investment of $2.0 million.  At year-end 2009, the balance of impaired loans consisted of three loans with a combined balance of $1.9 million which had no related reserve.

At December 31, 2009, nonperforming loans amounted to $4.7 million, an increase of $734 thousand from the balance at year-end 2008.  Total nonperforming loans at year-end 2009 represented .42% of period-end loans, an increase from .35% at year-end 2008.  By way of comparison, the ratio of nonperforming loans to average loans for our peer group at December 31, 2009 was 3.46%, up from 2.39% at December 31, 2008.

During 2009, income recognized on year-end balances of nonaccrual loans was $163 thousand.  Income that would have been recognized during that period on nonaccrual loans, if such loans had been current in accordance with their original terms and had been outstanding throughout the period (or since origination if held for part of the period) was $357 thousand.

During 2008, four commercial loans over $250,000 were considered impaired with an average recorded investment of $1.1 million.  At year-end 2008, the balance of impaired loans consisted of three loans with a combined balance of $2.2 million which had no related reserve.



36



At December 31, 2008, nonperforming loans amounted to $3.9 million, an increase of $1.7 million from the balance at year-end 2007.  Total nonperforming loans at year-end 2008 represented .35% of period-end loans, an increase from .21% at year-end 2007.  By way of comparison, the ratio of nonperforming loans to average loans for our peer group at December 31, 2008 was 2.36%, up from 1.08% at December 31, 2007.

During 2008, income recognized on year-end balances of nonaccrual loans was $208 thousand.  Income that would have been recognized during that period on nonaccrual loans, if such loans had been current in accordance with their original terms and had been outstanding throughout the period (or since origination if held for part of the period) was $295 thousand.

During 2007, one commercial loan over $250,000 was considered impaired with an average recorded investment of $733 thousand.  At year-end 2007, the balance of impaired loans consisted of that one loan with a balance of $759 thousand which had no related reserve.

At December 31, 2007, nonperforming loans amounted to $2.2 million, a decrease of $593 thousand, or 21.4%, from the balance at year-end 2006.  Total nonperforming loans at year-end 2007 represented .21% of period-end loans, a decrease from .28% at year-end 2006.  The ratio of nonperforming loans to average loans for our peer group at December 31, 2007 was 1.08%, up from .56% at December 31, 2006.

During 2007, income recognized on year-end balances of nonaccrual loans was $70 thousand.  Income that would have been recognized during that period on nonaccrual loans, if such loans had been current in accordance with their original terms and had been outstanding throughout the period (or since origination if held for part of the period) was $162 thousand.


2. Potential Problem Loans

On at least a quarterly basis, we apply an internal credit quality rating system to commercial loans that are either past due or fully performing but exhibit certain characteristics that could reflect a potential weakness.  Loans are placed on nonaccrual status when the likely amount of future principal and interest payments are expected to be less than the contractual amounts, even if such loans are not 90 days past due.  

Periodically we review the loan portfolio for evidence of potential problem loans.  Potential problem loans are loans that are currently performing in accordance with contractual terms, but where known information about possible credit problems of the borrower causes doubt about the ability of the borrower to comply with the loan payment terms and may result in disclosure of such loans as nonperforming at some time in the future.  Through our on-going credit monitoring, we consider loans which, in our internal classification system, are classified as substandard but continue to accrue interest to be potential problem loans.  At December 31, 2009, we identified 54 commercial relationships totaling $35.0 million as potential problem loans.  At December 31, 2008, we identified 46 commercial relationships totaling $34.4 million as potential problem loans.  Factors such as payment history, value of supporting collateral, and personal or government guarantees led us to conclude that the current risk exposure on these loans did not warrant accounting for the loans as nonperforming.  Although in a performing status as of year-end, these loans exhibited certain risk factors, which have the potential to cause them to become nonperforming at some point in the future.  

The overall level of our performing loans that demonstrate characteristics of potential weakness from time-to-time is for the most part dependent on economic conditions in northeastern New York State, which in turn are impacted at least in part by economic conditions in the U.S. generally.  On both the regional and national level, economic conditions are much weaker at present than was the case in the 2007 and earlier periods.  If weak economic conditions persist, potential problems loans likely will increase.


3. Foreign Outstandings - None


4. Loan Concentrations

The loan portfolio is well diversified.  There are no concentrations of credit that exceed 10% of the portfolio, other than the general categories reported in the preceding Section C.II.a. of this Item 7.  For further discussion, see Note 24 to the Consolidated Financial Statements in Part II, Item 8 of this Report.


5. Other Real Estate Owned and Repossessed Assets

Other real estate owned (“OREO”) consists of real property acquired in foreclosure.  OREO is carried at the lower of (i) fair value less estimated cost to sell or (ii) the recorded investment in the loan at the date of foreclosure, or cost.  We establish allowances for OREO losses, which are established and monitored on a property-by-property basis and reflect our ongoing estimate of the property's estimated fair value less costs to sell (when such amount is less than cost).  For all periods, all OREO was held for sale.  Repossessed assets for each of the five years in the table below consist almost entirely of motor vehicles.


Distribution of OREO and Repossessed Assets

(In Thousands)

 

December 31,

 

2009 

2008 

2007

2006 

2005 

Single Family 1 - 4 Units

$53 

$581 

$  89 

$  48 

 $  --- 

Commercial Real Estate

   --- 

    --- 

    --- 

  200 

  --- 

Other Real Estate Owned, Net

  53 

  581 

   89 

   248 

   --- 

Repossessed Assets

    59 

    64 

    63 

  144 

  124 

Total OREO and Repossessed Assets

$112 

$645 

$152 

$392 

$124 


The following table summarizes changes in the net carrying amount of OREO for each of the periods presented.


Schedule of Changes in OREO

(In Thousands)

 

2009 

2008 

2007

2006 

2005 

Balance at Beginning of Year

 

$ 581 

$  89 

$248 

$   --- 

$   --- 

Properties Acquired Through Foreclosure

 

 54 

 581 

 115 

 248 

 295 

Sales

 

  (582)

   (89)

(274)

    --- 

 (295)

Balance at End of Year

 

$   53 

$581 

$  89 

$248 

$   --- 




37



There was no allowance for OREO losses at year-end 2009, 2008 or 2007.  We started 2009 with four properties in OREO.  During the year we acquired one in 2009 and sold all four properties in inventory at the beginning of the year.  We started 2008 with one property in OREO.  During the year we acquired four more and sold one, ending the year with four properties.  We started 2007 with two properties in OREO.  During the year we acquired two more and sold three, ending the year with just one property.  We started 2006 with no properties in OREO.  During the year we acquired two properties, which remained unsold at year-end.  We started 2005 with no properties in OREO.  During the year we acquired and sold four properties, ending the year with no properties in OREO.  


III. SUMMARY OF LOAN LOSS EXPERIENCE

The information required in this section is presented in the discussion of the “Provision for Loan Losses and Allowance for Loan Losses” in Part II Item 7.B.II. beginning on page 26 of this Report, including:

·

Charge-offs and Recoveries by loan type

·

Factors that led to the amount of the Provision for Loan Losses

·

Allocation of the Allowance for Loan Losses by loan type

The percent of loans in each loan category is presented in the table of loan types in the preceding section on page 33 of this report.


IV. DEPOSITS

The following table sets forth the average balances of and average rates paid on deposits for the periods indicated.


AVERAGE DEPOSIT BALANCES

 (Dollars In Thousands)

 

 

Years Ended December 31,


 

2009

2008

2007

 

 

Average

Balance


Rate

Average

Balance


Rate

Average

Balance


Rate

Demand Deposits

 

$   191,504

---%

$   189,999

---%

$   186,474

---%

NOW Accounts

 

460,096

1.12

367,351

1.41

315,614

2.18

Savings Deposits

 

307,133

0.68

281,208

1.21

266,007

1.49

Time Deposits of $100,000 or More

 

155,378

2.39

172,055

3.25

180,606

4.78

Other Time Deposits

 

     249,575

2.94

     243,247

3.55

     258,042

4.42

  Total Deposits

 

$1,363,686

1.34

$1,253,860

1.82

$1,206,743

2.56


During 2009 average deposit balances increased by $109.8 million, or 8.8%, over the average for 2008.  The increase was generated from our pre-existing branch network.

During 2008 average deposit balances increased by $47.1 million, or 3.9%, over the average for 2007.  The increase was generated from our pre-existing branch network.

We did not sell or close any branches during the covered period, 2007-2009.  We did not hold any brokered deposits during 2009, 2008 and 2007.


The following table presents the quarterly average balance by deposit type for each of the most recent five quarters.  


DEPOSIT PORTFOLIO

Quarterly Average Deposit Balances

(Dollars In Thousands)

 

 

Quarter Ended

 

 

Dec 2009

Sep 2009

Jun 2009

Mar 2009

Dec 2008

Demand Deposits

 

$   199,116

$   199,611

$   186,033

$   180,966

$   188,638

Interest-Bearing Demand Deposits

 

520,161

443,841

451,350

424,154

406,206

Regular and Money Market Savings

 

329,400

310,991

298,180

289,481

285,986

Time Deposits of $100,000 or More

 

155,588

167,681

145,335

152,744

165,725

Other Time Deposits

 

    248,455

     253,359

     249,650

     246,777

    244,155

  Total Deposits

 

$1,452,720

$1,375,483

$1,330,548

$1,294,122

$1,290,710


Fluctuations in balances of our NOW accounts and time deposits of $100,000 or more are largely the result of municipal deposit fluctuations.  Municipal deposits on average represent 20% to 28% of our total deposits.  Municipal deposits are typically placed in NOW accounts and time deposits of short duration.  Many of our municipal deposit relationships are subject to annual renewal, by formal or informal agreements.  

In general, there is a seasonal pattern to municipal deposits starting with a low point during July and August.  Account balances tend to increase throughout the fall and into the winter months from tax deposits and receive an additional boost at the end of March from the electronic deposit of state funds.  In addition to these seasonal fluctuations within types of accounts, the overall level of municipal deposit balances fluctuates from year-to-year as some municipalities move their accounts in and out of our banks due to competitive factors.  Often, the balances of municipal deposits at the end of a quarter are not representative of the average balances for that quarter.  

For a variety of reasons, including the seasonality of municipal deposits, we typically experience little net growth or a small contraction in average deposit balances in the first quarter of each calendar year, versus significant growth in the second and subsequent quarters.  Deposit balances followed this general pattern for 2009.   Although average balances did not contract in the first quarter of 2009, the increase was minimal compared to the growth in the following three quarters of $36.4 million, $44.9 million and $77.2 million, respectively.  



38



We typically experience a shift within the mix of deposit categories during periods of significant interest rate increases or decreases.  During periods of falling rates, like the period from mid-2007 through the end of 2008, depositors tend to transfer maturing time deposits to nonmaturity interest-bearing deposit products.  This was the case for 2008 and continued for all four quarters of 2009.  At December 31, 2009 time deposits represented 27.8% of total deposits, down from 31.7% at December 31, 2008.  This compares to recent historical lows and highs for time deposits of 22.5% at June 30, 2004 and 40.8% at June 30, 2000.   We expect this shift from time deposits to nonmaturity deposit products to continue if rates remain at their current low levels.  

  

The total quarterly average balances as a percentage of total deposits are illustrated in the table below.


Percentage of Total Quarterly Average Deposits

 

Quarter Ended

 

 

Dec 2009

Sep 2009

Jun 2009

Mar 2009

Dec 2008

Demand Deposits

 

13.7%

14.5%

14.0%

14.0%

14.6%

Interest-Bearing Demand Deposits

 

35.8

32.3   

33.9   

32.8   

31.5

Regular and Money Market Savings

 

22.7

22.6   

22.4   

22.4   

22.2

Time Deposits of $100,000 or More

 

10.7

12.2   

10.9   

11.8   

12.8

Other Time Deposits

 

  17.1

  18.4   

  18.8   

  19.0   

  18.9

  Total Deposits

 

100.0%

100.0%

100.0%

100.0%

100.0%


Time deposits of $100,000 or more are to a large extent comprised of municipal deposits and are obtained on a competitive bid basis.


Quarterly Cost of Deposits

 

Quarter Ended

 

 

Dec 2009

Sep 2009

Jun 2009

Mar 2009

Dec 2008

Demand Deposits

 

---%

---%

---%

---%

---%

Interest-Bearing Demand Deposits

 

1.14

1.02

1.15

1.18

1.28

Regular and Money Market Savings

 

0.65

0.64

0.69

0.76

1.02

Time Deposits of $100,000 or More

 

2.09

2.19

2.62

2.72

2.87

Other Time Deposits

 

2.71

2.87

3.02

3.17

3.25

  Total Deposits (Including Non-Interest-Bearing)

 

1.24

1.27

1.40

1.48

1.61


In general, rates paid by us on various types of deposit accounts are influenced by the rates being offered or paid by our competitors, which in turn are influenced by prevailing interest rates in the economy as impacted from time to time by the actions of the Federal Reserve Bank.  There typically is a time lag between the Federal Reserve’s actions undertaken to influence rates and the actual repricing of our deposit liabilities, although this lag is normally shorter than the lag between Federal Reserve rate actions and the repricing of our loans and other earning assets.  

As demonstrated in the table above, we experienced a steady decrease in the cost of our deposits in each of the past 5 quarters following the period of falling interest rates from mid-2007 through the end of 2008.  Although some maturing time deposits will  continue to reprice at lower rates in forthcoming periods, the favorable reduction in the cost of deposits may not continue since most of our time deposits have already repriced to current rates and the rates on our nonmaturity deposit balances have already been reduced to (or nearly to) the lowest sustainable levels.  

We do not use brokered deposits as a regular funding source and there were not any such balances carried during 2009, 2008 or 2007.


V. TIME DEPOSITS OF $100,000 OR MORE

The maturities of time deposits of $100,000 or more at December 31, 2009 are presented below.  (In Thousands)


Maturing in:

 

Under Three Months

$ 50,730

Three to Six Months

24,956

Six to Twelve Months

20,837

2011

15,141

2012

19,906

2013

  7,124

2014

      9,817

  Total

$148,511



39



D. LIQUIDITY

Our liquidity is measured by our ability to raise cash when we need it at a reasonable cost.  We must be capable of meeting expected and unexpected obligations to our customers at any time.  Given the uncertain nature of customer demands as well as the need to maximize earnings, we must have available reasonably priced sources of funds, on- and off-balance sheet, that can be accessed quickly in time of need.

Overnight investments in federal funds sold, interest bearing bank balances at the Federal Reserve Bank, and cash flow from investment securities and loans, both from normal repayment cash-flows and the ability to quickly pledge marketable investment securities and loans to obtain funds, represent our primary sources of available liquidity.  Certain investment securities are selected at purchase as available-for-sale based on their marketability and collateral value, as well as their yield and maturity.  Our securities available-for-sale portfolio was $437.7 million at year-end 2009.  Due to the volatility in market values, we are not able to assume that large quantities of such securities could be sold at short notice at their carrying value to provide needed liquidity. But, if market conditions are favorable resulting in unrealized gains in the available-for-sale portfolio, we may pursue modest sales of such securities conducted in an orderly fashion to provide needed liquidity.

In addition to liquidity from short-term investments, investment securities and loans, we have supplemented available liquidity with additional off-balance sheet sources such as federal funds lines of credit and credit lines with the Federal Home Loan Bank of New York (“FHLBNY”).    We have established federal funds lines of credit with three correspondent banks totaling $30 million, but did not draw on those lines during 2009.  We have established overnight and 30 day term lines of credit with the FHLBNY; each of these lines provided for a maximum borrowing line of $125.7 million at December 31, 2009.  We did not borrow from our overnight line of credit with the FHLBNY during 2009.  If advanced, such lines of credit are collateralized by mortgage-backed securities, loans and FHLBNY stock.   The balance in other short-term borrowings at December 31, 2009 consisted entirely of treasury, tax and loan balances at the Federal Reserve Bank of New York.

In addition, we have identified brokered certificates of deposit as an appropriate off-balance sheet source of funding accessible in a relatively short time period.  Also, Glens Falls National has established a borrowing facility with the Federal Reserve Bank of New York, pledging certain consumer loans as collateral for potential “discount window” advances.  At December 31, 2009, the amount available under this facility was $227.4 million, but there were no advances then outstanding.  We measure and monitor our basic liquidity as a ratio of liquid assets to short-term liabilities, both with and without the availability of borrowing arrangements.  Based on the level of overnight funds investments, available liquidity from our investment securities portfolio, cash flow from our loan portfolio, our stable core deposit base and our significant borrowing capacity, we believe that our liquidity is sufficient to meet any reasonably likely events or occurrences.

During the past several quarters, Arrow’s liquidity position has been strong, as depositors and investors in the wholesale funding markets have shown no hesitations on placing or maintaining their funds with our banks.  The financial markets have been challenging for many financial institutions, and in the view of many, lack of liquidity has been as great a problem as capital shortage.  As a result, liquidity premiums have widened and many banks have experienced certain liquidity constraints, including substantially increased pricing to retain deposit balances.  Because of Arrow’s favorable credit quality and strong balance sheet, Arrow has not experienced any significant liquidity constraints through the end of 2009.  


E. CAPITAL RESOURCES AND DIVIDENDS

Stockholders' equity was $140.8 million at December 31, 2009, an increase of $15.0 million, or 11.9%, from the prior year-end.  The most significant positive changes to stockholders’ equity included (a) net income of $21.8 million, (b) net unrealized gains in the valuation allowance for available-for-sale securities ($707 thousand, net of tax), and (c) a net retirement plan gain reflected as a component of other comprehensive income ($1.5 million)  which were only partially offset by: (i) cash dividends ($10.6 million), and (ii) purchases of our own common stock ($3.8 million).  

In each of 2004 and 2003, we enhanced our regulatory capital by issuing $10 million of capital securities in private placements with institutional investors, utilizing a subsidiary Delaware business trust for that purpose.  These trust preferred securities were reflected as “Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts” on our consolidated balance sheets as of December 31, 2009 and 2008.  In the past, these securities were an attractive funding vehicle, although the current financial downturn has caused trust preferred securities to become less favored from both a market and regulatory perspective.  Under the Federal Reserve’s current regulatory capital guidelines, trust preferred securities still qualify as Tier 1 capital, in an amount not to exceed 25% of Tier 1 capital, net of goodwill less any associated deferred tax liability.  Both of our issues of trust preferred securities qualify in their entirety as Tier 1 regulatory capital.  There is no current consideration, to our knowledge, that trust preferred securities will lose their status as Tier I capital under bank regulatory guidelines.  

The maintenance of appropriate capital levels is a management priority.  Overall capital adequacy is monitored on an ongoing basis by management and reviewed regularly by the Board of Directors.  Our principal capital planning goal is to provide an adequate return to stockholders while retaining a sufficient base to provide for future expansion and comply with all regulatory standards.

Our continuing strong capital base and financial condition were key factors in our decision in January of 2009, to decline a capital investment by the U.S. Treasury under their CPP (see page 8).

One set of regulatory capital guidelines applicable to our holding company and subsidiary banks are the so-called risk-based capital measures.  Under these measures, as established by federal bank regulators, the minimum ratio of "Tier 1" capital to risk-weighted assets is 4.0% and the minimum ratio of total capital to risk-weighted assets is 8.0%.  For Arrow, Tier 1 capital is comprised of common stockholders' equity and the trust preferred securities issued by our two unconsolidated subsidiaries (see the second previous paragraph), less intangible assets.  Total capital for the risk-based capital guidelines includes Tier 1 capital plus other qualifying regulatory capital, including a portion of our allowance for loan losses.

In addition to the risk-based capital measures, the federal bank regulatory agencies require banks and bank holding companies to satisfy another capital guideline, the Tier 1 leverage ratio (Tier 1 capital to quarterly average assets less intangible assets).  The minimum Tier 1 leverage ratio is 3.0% for the most highly rated institutions.  The guidelines provide that other institutions should maintain a Tier 1 leverage ratio that is at least 1.0% to 2.0% higher than the 3.0% minimum level for top-rated institutions.




40



The table below sets forth the capital ratios of our holding company and subsidiary banks, Glens Falls National and Saratoga National, as of December 31, 2009:


Capital Ratios:

Arrow  

GFNB  

SNB  

Risk-Based Tier 1 Ratio

14.2%

14.4%

12.7%

Total Risk-Based Capital Ratio

15.4

15.7

13.9

Tier 1 Leverage Ratio

8.4

8.3

8.6


At December 31, 2009 our holding company and both banks exceeded the minimum capital ratios established by the regulatory guidelines, and qualified as "well-capitalized", the highest category, in the capital classification scheme set by federal bank regulatory agencies (see the further discussion under "Supervision and Regulation" in Part I Item 1.C. of this Report).

Although there is considerable current speculation in banking and financial circles that bank regulatory capital guidelines will likely be adjusted in forthcoming periods so as to require a greater degree of capital protection against sudden financial stress within banks, there is no consensus on what these enhanced capital standards will look like or over what period they will be imposed on the banking section.    

The source of funds for the payment of stockholder dividends by our holding company consists primarily of dividends declared and paid to the holding company by our bank subsidiaries.  In addition to regulatory constrictions on payments of dividends, there are statutory limitations applicable to the payment of dividends by our bank subsidiaries.  As of December 31, 2009, under this statutory limitation, the maximum amount that could have been paid by the bank subsidiaries to the holding company, without special regulatory approval, was approximately $20.4 million.  The ability of our holding company and our banks to pay dividends in the future is and will continue to be influenced by regulatory policies, capital guidelines and applicable laws.

See Part II, Item 5, "Market for the Registrant's Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities" for a recent history of our cash dividend payments.


F. OFF-BALANCE SHEET ARRANGEMENTS

In the normal course of operations, we may engage in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in the financial statements, or are recorded in amounts that differ from the notional amounts.  These transactions involve, to varying degrees, elements of credit, interest rate, and liquidity risk.  Such transactions may be used by us for general corporate purposes or for customer needs.  Corporate purpose transactions may be used to help manage credit, interest rate, and liquidity risk or to optimize capital.  Customer transactions may be used to manage customers' requests for funding.

We have no off-balance sheet arrangements that are reasonably likely to have a material current or future effect on our financial condition, revenues or expenses, results of operations, liquidity or capital expenditures.


G. CONTRACTUAL OBLIGATIONS (In Thousands)

 

Payments Due by Period

Contractual Obligation

Total

Less Than

 1 Year

1-3 Years

3-5 Years

More Than 5 Years

Long-Term Debt Obligations:

 

 

 

 

 

  Federal Home Loan Bank Advances1

$140,000

$20,000

$110,000

$10,000

$       ---

Junior Subordinated Obligations

    Issued to Unconsolidated

    Subsidiary Trusts2

20,000

---

---

---

20,000

Operating Lease Obligations3

      2,825

  344

      695

        712

    1,074

Obligations under Retirement Plans4

     29,352

    2,472

      5,776

    5,984

  15,120

Total

$192,177

$22,816

$116,471

$16,696

$36,194


1 See Note 11 to the Consolidated Financial Statements in Item 8 of this Report for additional information on Federal Home Loan Bank Advances, including call provisions.

2 See Note 12 to the Consolidated Financial Statements in Item 8 of this Report for additional information on Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts (trust preferred securities).

3 See Note 21 to the Consolidated Financial Statements in Item 8 of this Report for additional information on our Operating Lease Obligations.

4 See Note 16 to the Consolidated Financial Statements in Item 8 of this Report for additional information on our Retirement Plans.




41



H. FOURTH QUARTER RESULTS

We reported net income of $5.1 million for the fourth quarter of 2009, an increase of $105 thousand, or 2.1%, from the fourth quarter of 2008.  Diluted earnings per common share for the fourth quarter of 2009 were $.47, an increase of $.01, or 2.3%, from the $.46 amount for the fourth quarter of 2008.  The net change in earnings was primarily affected by the following: (a) a $605 thousand increase in tax-equivalent net interest income, (b) a $347 thousand decrease in noninterest income, (c) a $445 thousand decrease in the provision for loan losses, (d) a $426 thousand increase in noninterest expense, and (iii) a $36 thousand increase in the provision for income taxes.  The factors contributing to these quarter-to-quarter changes are included in the discussion of the year-to-year changes elsewhere in this Report.



SELECTED FOURTH QUARTER FINANCIAL INFORMATION

(Dollars In Thousands, Except Per Share Amounts)

 

 

For the Quarters Ended

 December 31,

 

 

2009 

2008 

Interest and Dividend Income

 

$22,169 

$22,719 

Interest Expense

 

   6,522 

   7,541 

Net Interest Income

 

15,647 

15,178 

Provision for Loan Losses

 

      435 

      880 

Net Interest Income after Provision for Loan Losses

 

15,212 

14,298 

Noninterest Income

 

3,805 

4,152 

Noninterest Expense

 

 11,699 

 11,273 

Income Before Provision for Income Taxes

 

7,318 

7,177 

Provision for Income Taxes

 

    2,201 

    2,165 

Net Income

 

$  5,117 

$  5,012 

 

 

 

 

SHARE AND PER SHARE DATA:

 

 

 

Weighted Average Number of Shares Outstanding:

 

 

 

  Basic

 

10,910 

10,840 

  Diluted

 

10,959 

10,906 

Basic Earnings Per Common Share

 

$.47 

$.46 

Diluted Earnings Per Common Share

 

.47 

.46 

Cash Dividends Per Common Share

 

.25 

.24 

 

 

 

 

AVERAGE BALANCES:

 

 

 

Assets

 

$1,856,176 

$1,687,366 

Earning Assets

 

1,781,464 

1,615,240 

Loans

 

1,109,496 

1,109,978 

Deposits

 

1,452,720 

1,290,710 

Stockholders’ Equity

 

140,786 

127,136 

 

 

 

 

SELECTED RATIOS (Annualized):

 

 

 

Return on Average Assets

 

1.09% 

1.18% 

Return on Average Equity

 

14.42% 

15.68% 

Net Interest Margin 1

 

 3.68% 

 3.92% 

 

 

 

 

Net Charge-offs to Average Loans

 

.09% 

.14% 

Provision for Loan Losses to Average Loans

 

.16% 

.32% 

 

 

 

 

1Net Interest Margin is the ratio of tax-equivalent net interest income to average earning assets. (See “Use of Non-GAAP Financial

   Measures” on page 4).



42



Item 7A.  Quantitative and Qualitative Disclosures About Market Risk

In addition to credit risk in our loan portfolio and liquidity risk, discussed earlier, our business activities also generate market risk.  Market risk is the possibility that changes in future market rates (interest rates) or prices (fees for products and services) will make our position less valuable.  The ongoing monitoring and management of interest rate and market risk is an important component of our asset/liability management process, which is governed by policies that are reviewed and approved annually by the Board of Directors.  The Board of Directors delegates responsibility for carrying out asset/liability oversight and control to management’s Asset/Liability Committee (“ALCO”).  In this capacity ALCO develops guidelines and strategies impacting our asset/liability profile based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends.  We have not made use of derivatives, such as interest rate swaps, in our risk management process.

Interest rate risk is the most significant market risk affecting us.  Interest rate risk is the exposure of our net interest income to changes in interest rates. Interest rate risk is directly related to the different maturities and repricing characteristics of interest-bearing assets and liabilities, as well as to the risk of prepayment of loans and early withdrawal of time deposits, and the fact that the speed and magnitude of responses to interest rate changes varies by product.

The ALCO utilizes the results of a detailed and dynamic simulation model to quantify the estimated exposure of net interest income to sustained interest rate changes.  While ALCO routinely monitors simulated net interest income sensitivity over a rolling two-year horizon, it also utilizes additional tools to monitor potential longer-term interest rate risk.

The simulation model attempts to capture the impact of changing interest rates on the interest income received and interest expense paid on all interest-sensitive assets and liabilities reflected on our consolidated balance sheet.  This sensitivity analysis is compared to ALCO policy limits which specify a maximum tolerance level for net interest income exposure over a one year horizon, assuming no balance sheet growth and a 200 basis point upward and a 100 basis point downward shift in interest rates, and a repricing of interest-bearing assets and liabilities at their earliest reasonably predictable repricing date.  We normally apply a parallel and pro rata shift in rates over a 12 month period.  However, at year-end 2009 the targeted federal funds rate was a range of 0 to .25%.  For the decreasing rate simulation we applied a 100 basis point downward shift in interest rates for the long end of the yield curve with short-term rate decreases limited at zero.

Applying the simulation model analysis as of December 31, 2009, a 200 basis point increase in interest rates demonstrated a 1.0% decrease in net interest income, and a 100 basis point decrease in interest rates demonstrated a 0.8% decrease in net interest income.  These amounts were well within our ALCO policy limits.  Historically there has existed an inverse relationship between changes in prevailing rates and our net interest income, reflecting the fact that our liabilities and sources of funds generally reprice more quickly than our earning assets.  

The preceding sensitivity analysis does not represent a forecast on our part and should not be relied upon as being indicative of expected operating results.  As noted elsewhere in this Report, the Federal Reserve Board took certain actions from September 2007 through December 2008 that resulted in a 500 basis point decrease in prevailing rates.  We believe that decreases in prevailing interest rates will generally have a short-term positive impact on our net interest margin and net interest income, which would be mitigated or perhaps reversed over the mid- to longer-term.  We believe that increases in prevailing rates will generally have a negative impact on our margin and net interest income in the short-term, which would be mitigated or perhaps reversed over the long-term.  In each case, that is, in the case of increasing or decreasing rates, the slope of the yield curve and changes in the slope of the yield curve will also affect net interest income and the net interest margin.  We are not able to predict with certainty what the magnitude of these effects would be.  

The hypothetical estimates underlying the sensitivity analysis are based upon numerous assumptions including: the nature and timing of changes in interest rates including yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cash flows, and others.  While assumptions are developed based upon current economic and local market conditions, we cannot make any assurance as to the predictive nature of these assumptions including how customer preferences or competitor influences might change.

Also, as market conditions vary from those assumed in the sensitivity analysis, actual results will differ due to: prepayment/refinancing levels likely deviating from those assumed, the varying impact of interest rate changes on caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, unanticipated shifts in the yield curve and other internal/external variables.  Furthermore, the sensitivity analysis does not reflect actions that ALCO might take in responding to or anticipating changes in interest rates.




43



Item 8.  Financial Statements and Supplementary Data


The following audited consolidated financial statements and unaudited supplementary data are submitted herewith:

Reports of Independent Registered Public Accounting Firm

Financial Statements:

Consolidated Balance Sheets

as of December 31, 2009 and 2008

Consolidated Statements of Income

for the Years Ended December 31, 2009, 2008 and 2007

Consolidated Statements of Changes in Stockholders' Equity

for the Years Ended December 31, 2009, 2008 and 2007

Consolidated Statements of Cash Flows

for the Years Ended December 31, 2009, 2008 and 2007

Notes to Consolidated Financial Statements

Supplementary Data:  (Unaudited)

Summary of Quarterly Financial Data for the Years Ended December 31, 2009 and 2008



Report of Independent Registered Public Accounting Firm


The Board of Directors and Stockholders

of Arrow Financial Corporation:


We have audited the accompanying consolidated balance sheets of Arrow Financial Corporation and subsidiaries (the “Company”) as of December 31, 2009 and 2008, and the related consolidated statements of income, changes in stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2009. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.


We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.


In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Arrow Financial Corporation and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles.


We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 4, 2010, expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.



[tenk006.gif]




Albany, New York

March 4 2010



44



Report of Independent Registered Public Accounting Firm


The Board of Directors and Stockholders

of Arrow Financial Corporation:


We have audited Arrow Financial Corporation and subsidiaries’ (the “Company”) internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.


We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.


A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.


Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.


In our opinion, Arrow Financial Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).


We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Arrow Financial Corporation and subsidiaries as of December 31, 2009 and 2008, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2009, and our report dated March 4, 2010 expressed an unqualified opinion on those consolidated financial statements.





[tenk008.gif]




Albany, New York

March 4, 2010  



45



ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands)


 

December 31,

 

2009

2008

ASSETS

 

 

Cash and Due from Banks

$    44,386 

$    37,239 

Interest-Bearing Deposits at Banks

      22,730 

      21,099 

 

 

 

Investment Securities:

 

 

Available-for-Sale

437,706 

315,414 

Held-to-Maturity  (Approximate Fair Value of $171,183 in 2009 and $134,331 in 2008)

168,931 

133,976 

Other Investments

8,935 

9,676 

            

 

 

Loans

1,112,150 

1,109,812 

  Allowance for Loan Losses

     (14,014)

     (13,272)

     Net Loans

1,098,136 

1,096,540 

Premises and Equipment, Net

 18,756 

 17,602 

Other Real Estate and Repossessed Assets, Net

 112 

 645 

Goodwill

15,269 

14,726 

Other Intangible Assets, Net

1,443 

1,652 

Accrued Interest Receivable

7,115 

6,611 

Other Assets

       18,108 

        9,906 

      Total Assets

$1,841,627 

$1,665,086 

 

 

 

LIABILITIES          

 

 

Noninterest-Bearing Deposits

$  198,025 

$  182,613 

NOW Accounts

516,269 

403,464 

Savings Deposits

336,271 

285,288 

Time Deposits of $100,000 or More

148,511 

157,187 

Other Time Deposits

     244,490 

     246,511 

    Total Deposits

  1,443,566 

  1,275,063 

 

 

 

Federal Funds Purchased and Securities Sold Under Agreements to Repurchase

72,020 

59,339 

Other Short-Term Borrowings

1,888 

 617 

Federal Home Loan Bank Advances

140,000 

160,000 

Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts

20,000 

20,000 

Accrued Interest Payable

2,257 

2,966 

Other Liabilities

      21,078 

      21,299 

    Total Liabilities

 1,700,809 

 1,539,284 

 

 

 

Commitments and Contingent Liabilities (Notes 21 and 22)  

 

 

 

 

 

STOCKHOLDERS’ EQUITY

 

 

Preferred Stock, $5 Par Value; 1,000,000 Shares Authorized

--- 

--- 

Common Stock, $1 Par Value; 20,000,000 Shares Authorized

   (15,170,399 Shares Issued at December 31, 2009 and

  14,728,543 Shares Issued at December 31, 2008)

15,170 

14,729 

Additional Paid-in Capital

178,192 

163,215 

Retained Earnings

24,100 

25,454 

Unallocated ESOP Shares (105,167 Shares at December 31, 2009

 

 

   and 122,207 Shares at December 31, 2008)

(2,204)

(2,572)

Accumulated Other Comprehensive Loss

 (6,640)

 (9,404)

Treasury Stock, at Cost (4,147,811 Shares at December 31,

 

 

  2009 and 4,060,209 Shares at December 31, 2008)

      (67,800)

     (65,620)

    Total Stockholders’ Equity

     140,818 

     125,802 

      Total Liabilities and Stockholders’ Equity

$1,841,627 

$1,665,086 

 

 

 












See Notes to Consolidated Financial Statements.



46



ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(In Thousands, Except Per Share Amounts)


 

Years Ended December 31,

 

2009 

2008 

2007 

INTEREST AND DIVIDEND INCOME

 

 

 

Interest and Fees on Loans

$66,427 

$67,638 

$65,904 

Interest on Deposits at Banks

149 

57 

--- 

Interest on Federal Funds Sold

--- 

464 

1,098 

Interest and Dividends on Investment Securities:

 

 

 

  Fully Taxable

   14,739 

   16,164 

   14,351 

  Exempt from Federal Taxes

   5,542 

   5,185 

   5,224 

Total Interest and Dividend Income

  86,857 

  89,508 

  86,577 

INTEREST EXPENSE 

 

 

 

NOW Accounts

5,172 

5,173 

6,868 

Savings Deposits

2,101 

3,398 

3,972 

Time Deposits of $100,000 or More

3,718 

5,591 

8,628 

Other Time Deposits

7,331 

8,628 

11,394 

Federal Funds Purchased and Securities Sold Under Agreements to Repurchase

129 

779 

1,367 

Other Short-Term Borrowings

--- 

 10 

 22 

Federal Home Loan Bank Advances

    7,340 

    7,462 

    6,627 

Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts

       701 

    1,236 

    1,405 

Total Interest Expense

  26,492 

  32,277 

  40,283 

NET INTEREST INCOME

60,365 

57,231 

46,294 

Provision for Loan Losses

    1,783 

    1,671 

       513 

NET INTEREST INCOME AFTER

 

 

 

  PROVISION FOR LOAN LOSSES

  58,582 

  55,560 

  45,781 

NONINTEREST INCOME 

 

 

 

Income from Fiduciary Activities

5,009 

5,463 

5,572 

Fees for Other Services to Customers

8,051 

8,562 

8,130 

Net Gains on Securities Transactions

357 

383 

 --- 

Other-Than-Temporary Impairment on Investment Securities

(375)

(1,610)

---

Net Gain on Sale of Merchant Bank Card Processing

2,966

---

---

Gain on Visa Stock Redemption

---

749

---

Gain on Sale of Premises

---

115

---

Insurance Commissions

2,412 

2,066 

1,869 

Other Operating Income

    1,172 

       541 

       717 

Total Noninterest Income

  19,592 

  16,269 

  16,288 

NONINTEREST EXPENSE 

 

 

 

Salaries and Employee Benefits

27,042 

24,551 

21,424 

Occupancy Expense of Premises, Net

3,316 

3,479 

3,198 

Furniture and Equipment Expense

3,264 

3,211 

3,015 

Other Operating Expense

  12,970 

  11,152 

  10,293 

Total Noninterest Expense

  46,592 

  42,393 

  37,930 

 

 

 

 

INCOME BEFORE PROVISION FOR INCOME TAXES

31,582 

29,436 

24,139 

Provision for Income Taxes

    9,790 

    8,999 

    6,807 

NET INCOME

 $21,792 

 $20,437 

 $17,332 

Average Shares Outstanding: 

 

 

 

  Basic

10,904 

10,882 

11,036 

  Diluted

10,953 

10,941 

11,109 

Per Common Share: 

 

 

 

  Basic Earnings

$ 2.00 

$ 1.88 

$ 1.57 

  Diluted Earnings

   1.99 

   1.87 

   1.56 

 

 

 

 






Share and Per Share Amounts have been restated for the September 2009 3% stock dividend.

See Notes to Consolidated Financial Statements.



47



ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

(In Thousands, Except Share and Per Share Amounts)




 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

Unallo-

Other Com-

 

 

 

Common

 

 

 

cated

prehensive

 

 

 

Shares

Common

 

Retained

ESOP

Income

Treasury

 

 

Issued

Stock

Surplus

Earnings

Shares

   (Loss)

Stock

Total

Balance at December 31, 2006

14,299,556 

$14,300 

$150,919 

$17,619 

$  (862)

$ (7,965)

$(55,881)

$118,130 

Comprehensive Income, Net of Tax:

 

 

 

 

 

 

 

 

 Net Income

--- 

--- 

--- 

17,332 

--- 

--- 

--- 

   17,332 

 Net Unrealized Securities Holding Gains

   Arising During the Period, Net of Tax

  (Pre-tax $6,137)

--- 

--- 

--- 

--- 

--- 

  3,691 

--- 

       3,691 

Net Retirement Plan Loss (Pre-tax $1,524)

--- 

--- 

--- 

--- 

--- 

 (939)

--- 

       (939)

Net Retirement Plan Prior Service Credit

  (Pre-tax $329)

--- 

--- 

--- 

--- 

--- 

 199 

--- 

       199 

Amortization of Net Retirement Plan

  Actuarial Loss (Pre-tax $444)

--- 

--- 

--- 

--- 

--- 

  268 

--- 

          268 

Accretion of Net Retirement Plan Prior

  Service Credit (Pre-tax $239)

--- 

--- 

--- 

--- 

--- 

  (144)

--- 

            (144)

     Other Comprehensive Income

 

 

 

 

 

 

 

         3,075 

      Comprehensive Income

 

 

 

 

 

 

 

    20,407 

3% Stock Dividend

428,987 

429 

9,148 

(9,577)

--- 

--- 

--- 

--- 

Cash Dividends Paid, $.91 per Share 1

--- 

--- 

--- 

(10,027)

--- 

--- 

--- 

(10,027)

Stock Options Exercised

  (69,236 Shares)

--- 

--- 

498 

--- 

--- 

--- 

 557 

1,055 

Shares Issued Under the Directors’ Stock

  Plan  (6,354 Shares)

--- 

--- 

90 

--- 

--- 

--- 

 50 

140 

Shares Issued Under the Employee Stock

  Purchase Plan  (22,749 Shares)

--- 

--- 

308 

--- 

--- 

--- 

181 

489 

Stock-Based Compensation Expense

--- 

--- 

70 

--- 

--- 

--- 

--- 

70 

Tax Benefit for Disposition of

  Stock Options

--- 

--- 

164 

--- 

--- 

--- 

--- 

164 

Purchase of Treasury Stock

  (327,562 Shares)

--- 

--- 

--- 

--- 

--- 

--- 

(7,303)

(7,303)

Acquisition of Subsidiary  (4,317 Shares)

--- 

--- 

79 

--- 

--- 

--- 

32

111 

Acquisition of Shares by ESOP

  (67,190 Shares)

--- 

--- 

--- 

--- 

(1,500)

 --- 

--- 

     (1,500)

Allocation of ESOP Stock  (23,317 Shares)

              --- 

         --- 

         200 

         --- 

      320 

          --- 

           --- 

         520 

Balance at December 31, 2007

14,728,543 

$14,729 

$161,476 

$15,347 

$(2,042)

$ (4,890)

$(62,364)

$122,256 


(Continued on Next Page)




















48



ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY, Continued

(In Thousands, Except Share and Per Share Amounts)




 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

Unallo-

Other Com-

 

 

 

Common

 

 

 

cated

prehensive

 

 

 

Shares

Common

 

Retained

ESOP

Income

Treasury

 

 

Issued

Stock

Surplus

Earnings

Shares

   (Loss)

Stock

Total

Balance at December 31, 2007

14,728,543 

$14,729 

$161,476 

$15,347 

$(2,042)

$(4,890)

$(62,364)

$122,256 

Comprehensive Income, Net of Tax:

 

 

 

 

 

 

 

 

 Net Income

--- 

--- 

--- 

20,437 

--- 

--- 

--- 

   20,437 

 Net Unrealized Securities Holding Gains

   Arising During the Period, Net of Tax

  (Pre-tax $2,860)

--- 

--- 

--- 

--- 

--- 

  1,727 

--- 

       1,727 

 Reclassification Adjustment for

  Net Securities Gains Included

  in Net  Income, Net of Tax

  (Pre-tax $383)

--- 

--- 

--- 

--- 

--- 

 (230)

--- 

 (230)

Reclassification Adjustment for Other-Than-  

  Temporary Impairment, Net of Tax (Pre-tax

  $1,610)

--- 

--- 

--- 

--- 

--- 

 972 

--- 

 972 

Net Retirement Plan Loss (Pre-tax $11,471)

--- 

--- 

--- 

--- 

--- 

 (6,928)

--- 

     (6,928)

Net Retirement Plan Prior Service Cost

  (Pre-tax $336)

--- 

--- 

--- 

--- 

--- 

(202)

--- 

       (202)

Amortization of Net Retirement Plan

  Actuarial Loss (Pre-tax $443)

--- 

--- 

--- 

--- 

--- 

  268 

--- 

          268 

Accretion of Net Retirement Plan Prior

  Service Credit (Pre-tax $200)

--- 

--- 

--- 

--- 

--- 

  (121)

--- 

            (121)

     Other Comprehensive Loss

 

 

 

 

 

 

 

    (4,514)

      Comprehensive Income

 

 

 

 

 

 

 

    15,923 

Cash Dividends Paid, $.95 per Share 1

--- 

--- 

--- 

(10,330)

--- 

--- 

--- 

(10,330)

Stock Options Exercised

  (79,823 Shares)

--- 

--- 

503 

--- 

--- 

--- 

 673 

1,176 

Shares Issued Under the Directors’ Stock

  Plan  (5,185 Shares)

--- 

--- 

78 

--- 

--- 

--- 

 43 

121 

Shares Issued Under the Employee Stock

  Purchase Plan  (19,286 Shares)

--- 

--- 

266 

--- 

--- 

--- 

162 

428 

Shares Issued for Dividend Reinvestment

  Plans (17,568 Shares)

--- 

--- 

282 

--- 

--- 

--- 

148 

430 

Stock-Based Compensation Expense

--- 

--- 

115 

--- 

--- 

--- 

--- 

115 

Tax Benefit for Disposition of

  Stock Options

--- 

--- 

176 

--- 

--- 

--- 

--- 

176 

Purchase of Treasury Stock

  (195,801 Shares)

--- 

--- 

--- 

--- 

--- 

--- 

(4,325)

(4,325)

Acquisition of Subsidiary  (5,129 Shares)

--- 

--- 

69 

--- 

--- 

--- 

43

112 

Acquisition of Shares by ESOP

  (43,262 Shares)

--- 

--- 

--- 

--- 

(1,000)

 --- 

--- 

      (1,000)

Allocation of ESOP Stock  (30,940 Shares)

              --- 

         --- 

         250 

         --- 

      470 

          --- 

           --- 

         720 

Balance at December 31, 2008

14,728,543 

$14,729 

$163,215 

$25,454 

$(2,572)

$(9,404)

$(65,620)

$125,802 


  (Continued on Next Page)















49



ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY, Continued

(In Thousands, Except Share and Per Share Amounts)




 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

Unallo-

Other Com-

 

 

 

Common

 

 

 

cated

prehensive

 

 

 

Shares

Common

 

Retained

ESOP

Income

Treasury

 

 

Issued

Stock

Surplus

Earnings

Shares

   (Loss)

Stock

Total

Balance at December 31, 2008

14,728,543

$14,729

$163,215

$25,454 

$(2,572)

$(9,404)

$(65,620)

$125,802 

Comprehensive Income, Net of Tax:

 

 

 

 

 

 

 

 

 Net Income

--- 

--- 

--- 

21,792 

--- 

--- 

--- 

   21,792 

 Net Unrealized Securities Holding Gains

   Arising During the Period, Net of Tax

  (Pre-tax $1,172)

--- 

--- 

--- 

--- 

--- 

  707 

--- 

       707 

 Reclassification Adjustment for

  Net Securities Gains Included

  in Net  Income, Net of Tax

  (Pre-tax $357)

--- 

--- 

--- 

--- 

--- 

(215)

--- 

 (215)

Reclassification Adjustment for Other-Than-  

  Temporary Impairment, Net of Tax (Pre-tax

  $375)

--- 

--- 

--- 

--- 

--- 

 226 

--- 

 226 

Net Retirement Plan Gain (Pre-tax $2,456)

--- 

--- 

--- 

--- 

--- 

 1,483 

--- 

     1,483 

Net Retirement Plan Prior Service Cost

  (Pre-tax $257)

--- 

--- 

--- 

--- 

--- 

(155)

--- 

       (155)

Amortization of Net Retirement Plan

  Actuarial Loss (Pre-tax $1,370)

--- 

--- 

--- 

--- 

--- 

  827 

--- 

          827 

Accretion of Net Retirement Plan Prior

  Service Credit (Pre-tax $181)

--- 

--- 

--- 

--- 

--- 

  (109)

--- 

          (109)

     Other Comprehensive Income

 

 

 

 

 

 

 

         2,764 

      Comprehensive Income

 

 

 

 

 

 

 

    24,556 

 

3% Stock Dividend 2

441,856

441

12,065

(12,506)

--- 

--- 

--- 

--- 

Cash Dividends Paid, $.98 per Share

--- 

--- 

--- 

(10,640)

--- 

--- 

--- 

(10,640)

Stock Options Exercised

  (73,797 Shares)

--- 

--- 

545 

--- 

--- 

--- 

 633 

1,178 

Shares Issued Under the Directors’ Stock

  Plan  (4,603 Shares)

--- 

--- 

76 

--- 

--- 

--- 

 40 

116 

Shares Issued Under the Employee Stock

  Purchase Plan  (19,055 Shares)

--- 

--- 

302 

--- 

--- 

--- 

164 

466 

Shares Issued for Dividend Reinvestment

  Plans (66,924 Shares)

--- 

--- 

1,083 

--- 

--- 

--- 

575 

1,658 

Stock-Based Compensation Expense

--- 

--- 

189 

--- 

--- 

--- 

--- 

189 

Tax Benefit for Disposition of

  Stock Options

--- 

--- 

193 

--- 

--- 

--- 

--- 

193 

Purchase of Treasury Stock

  (151,078 Shares)

--- 

--- 

--- 

--- 

--- 

--- 

(3,761)

(3,761)

Acquisition of Subsidiary  (19,938 Shares)

--- 

--- 

373 

--- 

--- 

--- 

169 

542 

Allocation of ESOP Stock  (20,103 Shares)

              --- 

         --- 

         151 

         --- 

      368 

          --- 

           --- 

        519 

Balance at December 31, 2009

15,170,399 

$15,170 

$178,192 

$24,100 

$(2,204)

$(6,640)

$(67,800)

$140,818 

 

 

 

 

 

 

 

 

 


1 Cash dividends paid per share have been adjusted for the September 2009 3% stock dividend.

2 Included in the shares issued for the 3% stock dividend in 2009 were treasury shares of 120,841 and unallocated ESOP shares of 3,063.













See Notes to Consolidated Financial Statements.



50



ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Thousands)

 

Years Ended December 31,

Cash Flows from Operating Activities:

2009 

2008 

2007 

Net Income

$21,792 

$20,437 

$17,332 

Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities:

  Provision for Loan Losses

    1,783 

    1,671 

      513 

  Depreciation and Amortization

    2,813 

    2,571 

    2,868 

  Compensation Expense for Allocated ESOP Shares

151 

250 

200 

  Gains on the Sale of Securities Available-for-Sale

    (550)

    (422)

    --- 

  Losses on the Sale of Securities Available-for-Sale

  193 

   39 

   --- 

  Other-Than-Temporary Impairment

375 

1,610 

   --- 

  Loans Originated and Held-for-Sale

(24,490)

(2,311)

(4,627)

  Proceeds from the Sale of Loans Held-for-Sale

 24,908 

  6,830 

  4,680 

  Net Gains on the Sale of Loans

    (418)

    (106)

    (42)

  Net (Gains) Losses on the Sale of Fixed Assets,

    Other Real Estate Owned and Repossessed Assets

  (2)

  (133)

    19 

  Contributions to Pension Plans

(2,304)

(6,810)

(2,288)

  Deferred Income Tax Expense

 705 

 2,203 

 1,021 

  Shares Issued Under the Directors’ Stock Plan

116 

121 

140 

  Stock-Based Compensation Expense

189 

115 

70 

  Net Increase in Other Assets

(5,672)

(374)

(653)

  Net (Decrease) Increase in Other Liabilities

      (625)

       (96)

    1,977 

Net Cash Provided By Operating Activities

  18,964 

  25,595 

  21,210 

 

 

 

 

Cash Flows from Investing Activities:

 

 

 

Proceeds from the Sale of Securities Available-for-Sale

 23,979 

 29,079 

  2,228 

Proceeds from the Maturities and Calls of Securities Available-for-Sale

112,401 

106,671 

63,189 

Purchases of Securities Available-for-Sale

 (258,026)

 (120,234)

 (81,970)

Proceeds from the Maturities and Calls of Securities Held-to-Maturity

  26,772 

  21,944 

  10,085 

Purchases of Securities Held-to-Maturity

 (61,965)

 (41,493)

 (16,419)

Net Increase in Loans

(4,062)

(77,333)

(30,975)

Proceeds from the Sales of Premises and Equipment, Other

  Real Estate Owned and Repossessed Assets

1,299 

1,164 

 953 

Purchase of Premises and Equipment

    (2,501)

     (2,469)

     (2,403)

Net Cash Used In Investing Activities

(162,103)

 (82,671)

 (55,312)

 

 

 

 

Cash Flows from Financing Activities:

 

 

 

Net Increase in Deposits

168,503 

70,863 

17,803 

Net Increase in Short-Term Borrowings

13,952 

6,237 

5,395 

Federal Home Loan Bank Advances

--- 

--- 

40,000 

Federal Home Loan Bank Repayments

(20,000)

--- 

(5,000)

Purchase of Treasury Stock

 (3,761)

 (4,325)

 (7,303)

Treasury Stock Issued for Stock-Based Plans

   1,644 

   1,604 

   1,544 

Tax Benefit from Exercise of Stock Options

193 

176 

164 

Treasury Stock Issued for Dividend Reinvestment Plans

1,658 

430 

--- 

Acquisition of Unallocated Common Stock by the ESOP

--- 

(1,000)

(1,500)

Allocation of Common Stock Purchased by the ESOP

368 

470 

320 

Cash Dividends Paid

 (10,640)

 (10,330)

 (10,027)

Net Cash Provided By Financing Activities

 151,917 

   64,125 

   41,396 

Net Increase in Cash and Cash Equivalents

8,778 

7,049 

7,294 

Cash and Cash Equivalents at Beginning of Year

   58,338 

   51,289 

   43,995 

Cash and Cash Equivalents at End of Year

 $ 67,116 

 $ 58,338 

 $ 51,289 

Supplemental Disclosures to Statements of Cash Flow Information:

 

 

 

  Cash Paid During the Year for:

 

 

 

    Interest on Deposits and Borrowings

 $27,201 

 $34,415 

 $38,892 

    Income Taxes

10,301 

6,235 

5,902 

  Non-cash Investing and Financing Activity:

 

 

 

    Transfer of Loans to Other Real Estate Owned and Repossessed Assets

683 

1,152 

 729 

    Change in Net Unrealized Gains on Securities Available-for-Sale, Net of Tax

718 

2,468 

3,691 

    Additional Shares Issued for Acquisition of Subsidiary

542 

112 

111 

    Change in Retirement Plans Net Loss and Prior Service Cost, Net of Tax

2,046 

(6,983)

(616) 



See Notes to Consolidated Financial Statements.



51



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 1:

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (In Thousands, Except Per Share Amounts)


Arrow Financial Corporation (“Arrow”) is a bank holding company organized in 1983 under the laws of New York and registered under the Bank Holding Company Act of 1956.  The accounting and reporting policies of Arrow Financial Corporation and its subsidiaries conform to accounting principles generally accepted in the United States of America and general practices within the banking industry in all material respects.


Principles of Consolidation - The financial statements of Arrow and its wholly owned subsidiaries are consolidated and all material inter-company transactions have been eliminated.  In the “Parent Company Only” financial statements in Note 25, the investment in wholly owned subsidiaries is carried under the equity method of accounting.  When necessary, prior years’ consolidated financial statements have been reclassified to conform to the current-year financial statement presentation.


Cash and Cash Equivalents - Cash and cash equivalents include the following items:  cash at branches, due from bank balances, cash items in the process of collection, interest-bearing bank balances and federal funds sold.  


Securities - Management determines the appropriate classification of securities at the time of purchase.  Securities reported as held-to-maturity are those debt securities which Arrow has both the positive intent and ability to hold to maturity and are stated at amortized cost.  Securities available-for-sale are reported at fair value, with unrealized gains and losses reported in accumulated other comprehensive income or loss, net of taxes.  Realized gains and losses are based upon the amortized cost of the specific security sold.  A decline in the fair value of any available-for-sale or held-to-maturity security below cost that is deemed to be other-than-temporary results in an impairment to reduce the carrying amount to fair value.  To determine whether an impairment is other-than-temporary, we consider all available information relevant to the collectibility of the security, including past events, current conditions, and reasonable and supportable forecasts when developing an estimate of cash flows expected to be collected.  Evidence considered in this assessment includes the reasons for impairment, the severity and duration of the impairment, changes in value subsequent to year-end, forecasted performance of the investee, and the general market condition in the geographic area or industry the investee operates in.  When an other-than-temporary impairment has occurred on a debt security, the amount of the other-than-temporary impairment recognized in earnings depends on whether we intend to sell the debt security or more likely than not will be required to sell the debt security before recovery of its amortized cost basis less any current-period credit loss.  If we intend to sell the debt security or more likely than not will be required to sell the debt security before recovery of its amortized cost basis less any current-period credit loss, the other-than-temporary impairment is recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date.  If we do not intend to sell the debt security and it is not more likely than not that we will be required to sell the debt security before recovery of its amortized cost basis less any current-period credit loss, the other-than-temporary impairment is separated into the amount representing the credit loss and the amount related to all other factors.  The amount of the total other-than-temporary impairment related to the credit loss is recognized in earnings.  The amount of the total other-than-temporary impairment related to other factors is recognized in other comprehensive income, net of applicable income taxes

Our Consolidated Statement of Income reflects the full impairment (that is, the difference between the security’s amortized cost basis and fair value) on debt securities that we intend to sell or would more-likely-than-not be required to sell before the expected recovery of the amortized cost basis.  For available-for-sale and held-to-maturity debt securities that management has not intent to sell and believes that more likely-than-not will be required to sell prior to recovery, only the credit loss component of the impairment is recognized in earnings, while the rest of the fair value loss is recognized in accumulated other comprehensive income.  The credit loss component recognized in earnings is identified as the amount of principal cash flows not expected to be received over the remaining term of the security as projected using our cash flow projections using our base assumptions.


Loans and Allowance for Loan Losses - Interest income on loans is accrued and credited to income based upon the principal amount outstanding.  Loan fees and costs directly associated with loan originations are deferred and amortized as an adjustment to yield over the lives of the loans originated.

From time-to-time, Arrow has sold (some with servicing retained) residential real estate loans at or shortly after origination.  At any point, the amount of loans pending settlement are not material, as well as any loan commitments on loans intended for sale.  Any gain or loss on the sale of loans, along with the value of the servicing right, is recognized at the time of sale as the difference between the recorded basis in the loan and net proceeds from the sale.  The balance of loans serviced for others was $52,078 at December 31, 2009.

Loans are placed on nonaccrual status either due to the delinquency status of principal and/or interest (generally when past due 90 or more days) or a judgment by management that the full repayment of principal and interest is unlikely.

The allowance for loan losses is maintained by charges to operations based upon our best estimate of the probable amount of loans that we will be unable to collect based on current information and events.  Provisions to the allowance for loan losses are offset by actual loan charge-offs (net of any recoveries).  In general, when consumer loans are 120 days past due, an evaluation of estimated proceeds from the liquidation of the loan’s collateral is compared to the loan carrying amount and a charge to the allowance for loan losses is taken for any deficiency.  While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions in Arrow's market area.  In addition, various Federal and State regulatory agencies, as an integral part of their examination process, review Arrow's allowance for loan losses.  Such agencies may require Arrow to recognize additions to the allowance in future periods, based on their judgments about information available to them at the time of their examination, which may not be currently available to management.

Impaired loans, except for large groups of smaller-balance homogeneous loans, are measured based on either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's observable market price or the fair value of the collateral if the loan is collateral dependent.  If the measurement of the impaired loan is less than the recorded investment in the loan, an impairment reserve is recognized as part of the allowance for loan losses.  



52



NOTE 1:

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)


All impaired commercial and commercial real estate loans over $250 are measured for impairment as well as all troubled debt restructured loans. Allowance for loan losses on the remaining loans are primarily determined based on historical loss factors adjusted for current trends.  Arrow determines impairment for collateral dependent loans based on the fair value of the collateral less estimated costs to sell.  For other loans, impairment is determined by comparing the recorded investment in the loan to the present value of the expected cash flows, discounted at the loan’s effective interest rate.  Arrow determines the interest income recognition method on a loan-by-loan basis.  Based upon the borrowers’ payment histories and cash flow projections, interest recognition methods include full accrual or cash basis.

In management’s opinion, the balance of the allowance for loan losses, at each balance sheet date, is sufficient to provide for probable loan losses.  


Other Real Estate Owned and Repossessed Assets - Real estate acquired by foreclosure and assets acquired by repossession are recorded at the lower of the recorded investment in the loan or the fair value of the property less estimated costs to sell.  Subsequent declines in fair value, after transfer to other real estate owned and repossessed assets are recognized through a valuation allowance.  Such declines in fair value along with related operating expenses to administer such properties or assets are charged directly to operating expense.


Premises and Equipment - Premises and equipment are stated at cost, less accumulated depreciation and amortization.   Depreciation and amortization included in operating expenses are computed largely on the straight-line method.  The provision is based

on the estimated useful lives of the assets (buildings and improvements 20-40 years; furniture and equipment 7-10 years; data processing equipment 5-7 years) and, in the case of leasehold improvements, amortization is computed over the terms of the respective leases or their estimated useful lives, whichever is shorter.  Gains or losses on disposition are reflected in earnings.


Income Taxes - Arrow accounts for income taxes under the asset and liability method.  Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income tax expense in the period that includes the enactment date.  Arrow’s policy is that deferred tax assets are reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.


Goodwill and Other Intangible Assets – Identifiable intangible assets acquired in a business combination are capitalized and amortized.  Any remaining unidentifiable intangible asset is classified as goodwill, for which amortization is not required but which must be evaluated annually for impairment.  Annually, Arrow tests for any impairment of goodwill and other intangible assets by comparing the carrying amount of those assets to the fair value of each reporting unit’s intangible assets, applying rates derived from recent actual transactions.

In April 2005 Arrow completed the cash purchase of three branches from HSBC Bank USA, N.A.  Arrow recorded the following intangible assets as a result of the acquisition: goodwill ($3,690) and core deposit intangible asset ($2,247).  The value of the core deposit intangible asset is being amortized over ten years.

In November 2004, Arrow acquired all of the outstanding shares of common stock of Capital Financial Group, Inc. in a tax-free exchange for Arrow’s common stock (70,628 shares, as restated for stock dividends).  As adjusted for subsequent contingency payments, Arrow recorded the following intangible assets as a result of the acquisition (none of which are deductible for income tax purposes): goodwill ($1,735), covenant ($117) and expirations ($686).  The value of the covenant is being amortized over five years and the value of the expirations is being amortized over twenty years.  The agreement provides for annual contingent future payments of Company stock, based upon earnings, over a five-year period.  Management has concluded that, under criteria established by SFAS No. 141, these payments will be recorded as additional goodwill at the time of payment.  The amount of additional goodwill recorded in 2009 and 2008 was $542 (20,070 shares) and $112 (5,283 shares), respectively.

The carrying amounts of other recognized intangible assets that meet recognition criteria and for which separate accounting records have been maintained (core deposit intangibles and mortgage servicing rights), have been included in the consolidated balance sheet as “Other Intangible Assets, Net.”  Core deposit intangibles are being amortized on a straight-line basis over a period of ten to fifteen years.  

Arrow has sold residential real estate loans (primarily to Freddie Mac) with servicing retained.   Mortgage servicing rights are recognized as an asset when loans are sold with servicing retained, by allocating the cost of an originated mortgage loan between the loan and servicing right based on estimated relative fair values.  The cost allocated to the servicing right is capitalized as a separate asset and amortized in proportion to, and over the period of, estimated net servicing income.  Capitalized mortgage servicing rights are evaluated for impairment by comparing the asset’s carrying value to its current estimated fair value.  Fair values are estimated using a discounted cash flow approach, which considers future servicing income and costs, current market interest rates, and anticipated prepayment, and default rates.  Impairment losses are recognized through a valuation allowance for servicing rights having a current fair value that is less than amortized cost.  Adjustments to increase (decrease) the valuation allowance are charged (credited) to income as a component of other operating income. There was no allowance for impairment losses at December 31, 2009 or 2008.


Pension and Postretirement Benefits - Arrow maintains a non-contributory, defined benefit pension plan covering substantially all employees, a supplemental pension plan covering certain executive officers selected by the Board of Directors, and certain post-retirement medical, dental and life insurance benefits for employees and retirees.  The costs of these plans, based on actuarial computations of current and future benefits for employees, are charged to current operating expenses. The cost of post-retirement benefits other than pensions is recognized on an accrual basis as employees perform services to earn the benefits.  Arrow recognizes the overfunded or underfunded status of our single employer defined benefit postretirement plan as an asset or liability on its consolidated balance sheet and recognizes changes in the funded status in comprehensive income in the year in which the change occurred. 



53



NOTE 1:

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)


Stock-Based Compensation Plans – Arrow has two stock option plans, which are described more fully in Notes 17 and 18.  The company expenses the grant date fair value of options granted.  The expense is recognized over the four year vesting period of the grant.  

Arrow sponsors an Employee Stock Purchase Plan (“ESPP”) under which employees purchased Arrow’s common stock at a 5% discount below market price at the time of purchase. This stock purchase plan is not considered a compensatory plan.

Arrow sponsors an Employee Stock Ownership Plan (ESOP), a qualified defined contribution plan.   The ESOP has borrowed funds from one of Arrow’s subsidiary banks to purchase Arrow common stock.  The shares pledged as collateral are reported as a reduction of Arrow’s stockholders’ equity.  Compensation expense is recognized as shares are release for allocation to individual employee accounts equal to the difference between the current average market price and the purchase price.


Securities Sold Under Agreements to Repurchase - In securities repurchase agreements, Arrow receives cash from a counterparty in exchange for the transfer of securities to a third party custodian’s account that explicitly recognizes Arrow’s interest in the securities.  These agreements are accounted for by Arrow as secured financing transactions, since it maintains effective control over the transferred securities, and meets other criteria for such accounting.  Accordingly, the cash proceeds are recorded as borrowed funds, and the underlying securities continue to be carried in Arrow’s securities available-for-sale portfolio.


Earnings Per Share (“EPS”) - Basic EPS excludes dilution and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period.  Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity (such as Arrow’s stock options), computed using the treasury stock method.  Unallocated common shares held by Arrow’s Employee Stock Ownership Plan are not included in the weighted average number of common shares outstanding for either the basic or diluted EPS calculation.


Financial Instruments - Arrow is a party to certain financial instruments with off-balance sheet risk, such as:  commercial lines of credit, construction lines of credit, overdraft protection, home equity lines of credit and standby letters of credit.  Arrow's policy is to record such instruments when funded.  Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument.  These estimates do not reflect any premium or discount that could result from offering for sale at one time Arrow's entire holdings of a particular financial instrument.  Because no market exists for a significant portion of Arrow's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors.  These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision.  Changes in assumptions could significantly affect the estimates.

Fair value estimates are based on existing on- and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments.  For example, Arrow has a substantial trust department that contributes net fee income annually.  The value of trust department customer relationships is not considered a financial instrument, and therefore this value has not been incorporated into the fair value estimates.  Other significant assets and liabilities that are not considered financial assets or liabilities include deferred taxes, premises and equipment, the value of low-cost, long-term core deposits and goodwill.  In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of the estimates.

The carrying amount of the following short-term assets and liabilities is a reasonable estimate of fair value: cash and due from banks, federal funds sold and purchased, securities sold under agreements to repurchase, demand deposits, savings, N.O.W. and money market deposits, other short-term borrowings, accrued interest receivable and accrued interest payable.  The fair value estimates of other on- and off-balance sheet financial instruments, as well as the method of arriving at fair value estimates, are included in the related footnotes and summarized in Note 23.  As of December 31, 2009 and 2008, and during 2009, 2008 and 2007, Arrow had no derivative instruments, other than loans pending settlement and loan commitments on loans intended for sale, the amounts of which are not material.


Fair Value Measures – We determine the fair value of financial instruments under the following hierarchy:

·

Level 1 – Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;

·

Level 2 – Quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability;

·

Level 3 – Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity).  


A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.  


Trust Assets and Fiduciary Income - Assets held by Arrow in a fiduciary or agency capacity for its customers are not included in the consolidated balance sheets since these assets are not assets of Arrow.  Income from fiduciary activities is reported on the accrual basis.


Segment Reporting - Management evaluates the operations of Arrow based solely on one business segment - commercial banking, which constitutes Arrow’s only segment for financial reporting purposes.  Arrow operates primarily in northern New York State in Warren, Washington, Saratoga, Essex and Clinton counties and surrounding areas.



54



NOTE 1:

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)


Management’s Use of Estimates -The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of income and expenses during the reporting period.  Our most significant estimates are the allowance for loan losses, the evaluation of other-than-temporary impairment of investment securities, goodwill impairment, pension and other postretirement liabilities, analysis of a need for a valuation allowance for deferred tax assets and other fair value calculations. Actual results could differ from those estimates.

A material estimate that is particularly susceptible to significant change in the near term is the allowance for loan losses.  In connection with the determination of the allowance for loan losses, management obtains appraisals for properties.  The allowance for loan losses is management’s best estimate of probable loan losses incurred as of the balance sheet date.  While management uses available information to recognize losses on loans, future adjustments to the allowance for loan losses may be necessary based on changes in economic conditions.  In addition, various regulatory agencies, as an integral part of their examination process, periodically review Arrow’s allowance for loan losses.  Such agencies may require Arrow to recognize adjustments to the allowance for loan losses based on their judgments about information available to them at the time of their examination, which may not be currently available to management.


Recent Accounting Pronouncements


In June 2009, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 168 “The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles—a replacement of FASB Statement No. 162.”  Effective for interim and annual financial statements issued after September 15, 2009, the FASB Accounting Standards CodificationTM (FASB ASC) became the sole source of authoritative U.S. generally accepted accounting principles (GAAP) recognized by the FASB to be applied by nongovernmental entities.  Rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. On the effective date of this Statement, the FASB ASC superseded all then-existing non-SEC accounting and reporting standards. All other nongrandfathered non-SEC accounting literature not included in the Codification became nonauthoritative. FASB updates to the codification will be promulgated as “Accounting Standards Updates” (ASU). This Statement did not have a material impact on our financial condition or results of operation.  


ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820)  - Improving Disclosures about Fair Value Measurements:  ASU 2010-06 requires additional disclosures including:

1.

transfers in and out of levels 1 and 2,

2.

report purchases, sales, issuances and settlements gross (rather than net) for level 3 fair value measurements,

3.

present fair value disclosures for classes of assets and liabilities, and

4.

for level 2 and 3 fair value measurements, provide disclosures about the valuation techniques and inputs used to measure  fair value for both recurring and nonrecurring fair value measurements.

The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances and settlements in the roll forward of activity in Level 3 fair value measurements, which are effective for interim and annual reporting periods beginning after December 15, 2010.  This ASU will not have an impact on the way we measure fair values.


FASB ASU 2009-05, Fair Value Measurements and Disclosures (Topic 820) – Measuring Liabilities at Fair Value:  ASU 2009-05 allows companies to use as the fair value of a liability the perspective of an investor that holds the related obligation as an asset.  Effective for financial statements issued on September 30, 2009, the standard did not change the way we determine the fair value of our liabilities (see footnote 8).


FASB ASC Subtopic 860-10:  On June 12, 2009, the FASB issued FASB Statement No. 166, “Accounting for Transfers of Financial Assets – an Amendment of FASB Statement No. 140.”  The FASB’s objective in issuing this Statement was to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets.   The Board undertook this project to address (1) practices that have developed since the issuance of FASB Statement No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” that are not consistent with the original intent and key requirements of that Statement and (2) concerns of financial statement users that many of the financial assets (and related obligations) that have been derecognized should continue to be reported in the financial statements of transferors.  This Statement must be applied as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter. Earlier application is prohibited.   This Statement must be applied to transfers occurring on or after the effective date.  Additionally, on and after the effective date, the concept of a qualifying special-purpose entity is no longer relevant for accounting purposes.   Therefore, formerly qualifying special-purpose entities (as defined under previous accounting standards) should be evaluated for consolidation by reporting entities on and after the effective date in accordance with the applicable consolidation guidance.   If the evaluation on the effective date results in consolidation, the reporting entity should apply the transition guidance provided in the pronouncement that requires consolidation.  Additionally, the disclosure provisions of this Statement should be applied to transfers that occurred both before and after the effective date of this Statement.  The adoption of this Statement will not have a material impact on our financial condition or results of operation.



55



NOTE 1:

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)



FASB ASC Subtopic 810-10: On June 12, 2009 the FASB issued FASB Statement No. 167, “Amendments to FASB Interpretation No. 46(R).”  The FASB’s objective in issuing this Statement was to improve financial reporting by enterprises involved with variable interest entities. The FASB undertook this project to address (1) the effects on certain provisions of FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities, as a result of the elimination of the qualifying special-purpose entity concept in FASB Statement No. 166, Accounting for Transfers of Financial Assets, and (2) constituent concerns about the application of certain key provisions of Interpretation 46(R), including those in which the accounting and disclosures under the Interpretation do not always provide timely and useful information about an enterprise’s involvement in a variable interest entity.  This Statement shall be effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter.  Earlier application is prohibited.  The adoption of this Statement will not have a material impact on our financial condition or results of operation. The adoption of this Statement did not have a material impact on our financial condition or results of operation.


FASB ASC Subtopic 855-10:  In May 2009, SFAS No. 165, “Subsequent Events,” as amended by FASB ASU 2010-09, was issued which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or available to be issued. SFAS 165 sets forth (i) the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements, (ii) the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements and (iii) the disclosures that an entity should make about events or transactions that occurred after the balance sheet date. This pronouncement was effective for the period ended June 30, 2009 and did not have a significant impact on the Company’s financial statements.  FASB ASU 2010-09, which was issued February 25, 2010 became effective immediately and eliminated the requirement to disclose the date through which subsequent events have been evaluated as well as modified the scope of disclosures related to subsequent events.


FASB ASC Subtopic 820-10:  On April 9, 2009, the FASB issued FASB Staff Position (FSP) 157-4, “Determining Fair Value When the Volume and Level of Activity of the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly,” which provided additional guidance for estimating fair value in accordance with FAS 157, “Fair Value Measurements”, when the volume and level of activity for the asset or liability have significantly decreased.  This FSP provides guidance to determine if a market is active or inactive in order to obtain fair value, which is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions. This FSP amends FAS 157 to require certain disclosures to discuss the inputs and valuation techniques used to measure fair value, is effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009 and shall be applied prospectively. Arrow adopted FSP 157-4 in the second quarter of 2009. The adoption of this FSP did not have a material impact on our financial condition or results of operation.


FASB ASC Subtopic 320-10:  The FASB issued FSP FAS 115-2 and FAS 124-2 “Recognition and Presentation of Other-Than-Temporary Impairments,” on April 9, 2009, which provided clarity and consistency in applying accounting rules surrounding the accounting for assets considered to be other-than-temporarily-impaired by improving the presentation and disclosure in the financial statements. This FSP is effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009 and shall be applied prospectively. Arrow adopted FSP FAS 115-2 and FAS 124-2 in the second quarter of 2009. The adoption of this FSP did not have a material impact on our financial condition or results of operation.  


FASB ASC Subtopic 825-10:  Also on April 9, 2009, the FASB issued FSP FAS 107-1 and APB 28-1, "Interim Disclosures about Fair Value of Financial Instruments" which amends FASB Statement No. 107, “Disclosures about Fair Value of Financial Instruments,” to require disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements. This FSP also amends APB Opinion No. 28, “Interim Financial Reporting,” to require those disclosures in summarized financial information at interim reporting periods.  This FSP is effective for interim and annual reporting periods ending after June 15, 2009.  Arrow adopted this FSP in the second quarter 2009.  Since this FSP only relates to disclosures about fair values and, as such, did not have a material impact on our financial condition or results of operations.


FASB ASC Subtopic 715-20:  In December 2008 the FASB adopted FSP FAS 132(R)-1, "Employers’ Disclosures about Postretirement Benefit Plan Assets," which amends FASB Statement No. 132 (revised 2003), “Employers’ Disclosures about Pensions and Other Postretirement Benefits,” to provide guidance on an employer’s disclosures about plan assets of a defined benefit pension or other postretirement plan.  An employer shall disclose information about how investment allocation decisions are made, including factors that are pertinent to an understanding of investment policies and strategies and an employer shall disclose separately for pension plans and other postretirement benefit plans the fair value of each major category of plan assets as of each annual reporting date for which a statement of financial position is presented. Asset categories shall be based on the nature and risks of assets in an employer’s plan.  In addition, an employer shall disclose information that enables users of financial statements to assess the inputs and valuation techniques used to develop fair value measurements of plan assets at the annual reporting date. For fair value measurements using significant unobservable inputs (Level 3, under FAS 157), an employer shall disclose the effect of the measurements on changes in plan assets for the period and an employer shall provide users of financial statements with an understanding of significant concentrations of risk in plan assets.  The FSP is effective for fiscal years ending on or after December 15, 2009 and only relates to disclosures about fair values and, as such, will not have a material impact on our financial condition or results of operations.



56



NOTE 1:

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)


FASB ASC Subtopic 805-10:  In December 2007, the FASB issued revised Statement of Financial Accounting Standards (“SFAS”) No. 141, "Business Combinations."  SFAS No. 141(R) retains the fundamental requirements of SFAS No. 141 that the acquisition method of accounting (formerly the purchase method) be used for all business combinations; that an acquirer be identified for each business combination; and that intangible assets be identified and recognized separately from goodwill.  SFAS No. 141(R) requires the acquiring entity in a business combination to recognize the assets acquired, the liabilities assumed and any non-controlling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions.  Additionally, SFAS No. 141(R) changes the requirements for recognizing assets acquired and liabilities assumed arising from contingencies and recognizing and measuring contingent consideration.  SFAS No. 141(R) also enhances the disclosure requirements for business combinations.  SFAS No. 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008 and may not be applied before that date.  The impact that SFAS No. 141(R) is expected to have on our financial condition or results of operations is indeterminable as it is prospective in nature.  While the adoption of SFAS No. 141(R) did not have an impact on the Company’s consolidated financial position or results of operations upon its adoption on January 1, 2009, the adoption of SFAS No. 141(R) would have a significant impact on business combinations, if any, entered into by the Company subsequent to January 1, 2009.



NOTE 2:

CASH AND CASH EQUIVALENTS (In Thousands)


 

 

2009

2008

Cash and Due From Banks

 

$44,386 

$37,239 

Interest-Bearing Deposits at Banks

 

22,730 

21,099 

  Total Cash and Cash Equivalents

 

$67,116 

$58,338 


Beginning in the fourth quarter of 2008, the Federal Reserve Bank began paying interest on both required reserve balances and excess reserve balances.   Required reserve balances at December 31, 2009 and 2008 were approximately $10,687 and $6,590, respectively and excess reserve balances were approximately $12,043 and $14,509 for the same respective periods.  Excess reserve balances would have been maintained as federal funds sold or overnight Federal Home Loan Bank deposits in prior periods.  The bank subsidiaries are required to maintain certain reserves of vault cash and/or deposits with the Federal Reserve Bank.  The total amount of the required reserves at December 31, 2009 and 2008 was approximately $19,007 and $15,018, respectively.



NOTE  3:

INVESTMENT SECURITIES (In Thousands)


A summary of the amortized costs and the approximate fair values of securities at December 31, 2009 and 2008 is presented below.  Amortized cost is reported net of other-than-temporary impairment charges.


Securities Available-for-Sale:

 


Amortized

Cost


Fair

Value

Gross Unrealized Gains

Gross Unrealized Losses

December 31, 2009:

U.S. Treasury and Agency Obligations

$122,768

$123,331

$   566

$       3

State and Municipal Obligations

18,843

18,913

75

5

Collateralized Mortgage Obligations

196,359

199,781

4,625

1,203

Mortgage-Backed Securities - Residential

91,745

93,017

2,110

838

Corporate and Other Debt Securities

1,465

1,331

---

134

Mutual Funds and Equity Securities

      1,308

      1,333

       31

         6

  Total Securities Available-for-Sale

$432,488

$437,706

$7,407

$2,189

 

December 31, 2008:

U.S. Treasury and Agency Obligations

$  11,375

$  11,528

$   153

$   ---

State and Municipal Obligations

15,410

15,446

36

---

Collateralized Mortgage Obligations

183,256

185,830

2,594

  20

Mortgage-Backed Securities - Residential

91,900

93,849

2,038

89

Corporate and Other Debt Securities

7,911

7,433

---

478

Mutual Funds and Equity Securities

      1,534

      1,328

         4

  210

  Total Securities Available-for-Sale

$311,386

$315,414

$4,825

$797

 




57



NOTE  3:

SECURITIES (Continued)


Securities Held-to-Maturity:

 

 


Amortized

Cost


Fair

Value

Gross

Unrealized

Gains

Gross

Unrealized

Losses

December 31, 2009:

 

 

 

 

 

State and Municipal Obligations

$167,931

$170,183

$ 2,706

$454

Corporate and Other Debt Securities

      1,000

      1,000

        ---

    ---

  Total Securities Held-to-Maturity

$168,931

$171,183

$2,706

$454

 

December 31, 2008:

 

 

 

 

 

State and Municipal Obligations

$133,976

$134,331

$1,146

$    791


As reported in the Consolidated Balance Sheets, Other Investments include Federal Home Loan Bank of New York (“FHLBNY”) and Federal Reserve Bank (“FRB”) stock, which are reported at cost.  FHLBNY and FRB stock are restricted investment securities and amounted to $8,107 and $828 at December 31, 2009, respectively and $8,859 and $817 at December 31, 2008, respectively.  The required level of FHLBNY stock is based on the amount of FHLBNY borrowings (see Note 11) and is pledged to secure those borrowings.   While some Federal Home Loan Banks have stopped paying dividends and repurchasing stock upon reductions in debt levels, the FHLBNY continues to pay dividends and repurchase its stock.  Accordingly, we have not recognized any impairment on our holdings of FHLBNY common stock.  However, the FHLBNY has reported impairment issues among its holdings of mortgage-backed securities.


A summary of the maturities of securities as of December 31, 2009 is presented below.  Mutual funds and equity securities, which have no stated maturity, are not included in the table below.  Collateralized mortgage obligations and other mortgage-backed-securities are included in the schedule based on their expected average lives.  Actual maturities will differ from the table below because issuers may have the right to call or prepay obligations with or without prepayment penalties.


  

Debt Securities:

 

  Available-for-Sale

  Held-to-Maturity

 

 

Amortized

Cost

Fair

Value

Amortized

Cost

Fair

Value

Within One Year:

 

 

 

 

 

  U.S. Treasury and Agency Obligations

 

$ 86,006

$  86,345

$         ---

$          ---

  State and Municipal Obligations

 

9,644

9,680

44,391

44,541

  Collateralized Mortgage Obligations

 

20,792

21,021

---

---

  Mortgage-Backed Securities - Residential

 

3,988

4,038

   ---

   ---

  Corporate and Other Debt Securities

 

           ---

          ---

           ---

           ---

    Total

 

  120,430

 121,084

    44,391

    44,541

 

From 1 - 5 Years:

  U.S. Treasury and Agency Obligations

 

36,762

36,986

   ---

   ---

  State and Municipal Obligations

 

4,670

4,708

41,753

42,856

  Collateralized Mortgage Obligations

 

77,740

79,599

---

---

  Mortgage-Backed Securities - Residential

 

37,777

39,120

   ---

   ---

  Corporate and Other Debt Securities

 

          80

           80

           ---

           ---

    Total

 

 157,029

  160,493

    41,753

    42,856

 

From 5 - 10 Years:

 

 

 

 

 

  State and Municipal Obligations

 

1,660

1,657

68,788

69,565

  Collateralized Mortgage Obligations

 

91,577

93,315

---

---

  Mortgage-Backed Securities - Residential

 

   12,591

   13,306

           ---

          ---

    Total

 

 105,828

 108,278

    68,788

   69,565

 

Over 10 Years:

  State and Municipal Obligations

 

2,868

2,868

 12,999

13,221

  Collateralized Mortgage Obligations

 

6,251

5,846

   ---

   ---

  Mortgage-Backed Securities - Residential

 

37,389

 36,553

   ---

   ---

  Corporate and Other Debt Securities

 

      1,385

      1,251

      1,000

      1,000

    Total

 

    47,893

    46,518

    13,999

    14,221

      Total Securities

 

$431,180

$436,373

$168,931

$171,183

 




58



NOTE  3:

SECURITIES (Continued)


The following table sets forth the components of interest and dividend income on securities available-for-sale,  securities held-to-maturity  and other investments for the year ended December 31:


Components of Investment Securities Interest and Dividend Income

2009

2008

2007

Available-for-Sale:

 

 

 

  Taxable Interest Income

$14,138

$15,490

$13,589

  Nontaxable Interest Income

468

805

982

  Dividend Income

         47

         38

         30

    Total Interest and Dividend Income, on Securities Available-for-Sale

$14,653

$16,333

$14,601

Held-to-Maturity

 

 

 

  Taxable Interest Income

$     63

$     13

$     16

  Nontaxable Interest Income

  5,074

  4,380

  4,242

    Total Interest Income, on Securities Held-to-Maturity

$5,137

$4,393

$4,258

Other Investments

$491

$623

$716

The fair value of securities pledged to secure repurchase agreements amounted to $72,020 and $59,339 at December 31, 2009 and 2008, respectively.  The fair value of securities pledged to secure public and trust deposits and for other purposes totaled $360,885 and $257,831 at December 31, 2009 and 2008, respectively.  Other mortgage-backed securities at December 31, 2009 and 2008 included $2,147 and $2,742, respectively, of loans previously securitized by Arrow, which it continues to service.

Information on temporarily impaired securities at December 31, 2009 and 2008, segregated according to the length of time such securities had been in a continuous unrealized loss position, is summarized as follows:


December 31, 2009

Less than 12 Months

12 Months or Longer

Total

Available-for-Sale Portfolio:

Fair

Value

Unrealized

Losses

Fair

Value

Unrealized

Losses

Fair

Value

Unrealized

Losses

U.S. Treasury and Agency Securities

$ 4,998

  $     3

$     ---

$ ---

$  4,998

$       3

State & Municipal Obligations

1,230

5

---

---

1,230

5

Collateralized Mortgage Obligations

49,034

 1,184

    162

19

49,196

  1,203

Mortgage-Backed Securities - Residential

36,547

  836

1,402

2

37,949

838

Corporate & Other Debt Securities

946

54

305

80

1,251

 134

Mutual Funds and Equity Securities

        20

         0

       20

      6

         40

         6

  Total Securities Available-for-Sale

$92,775

$2,082

$1,889

$107

$94,664

$2,189

Held-to-Maturity Portfolio

 

 

 

 

 

 

State & Municipal Obligations

$14,270

$270

$6,624

$184

$20,894

$454


The table above for December 31, 2009 consists of 103 securities where the current fair value is less than the related amortized cost.  These unrealized losses do not reflect any deterioration of the credit worthiness of the issuing entities.  Agency-backed CMOs are all rated AAA, as are the mortgage-backed securities.  The municipal obligations are general obligations supported by the general taxing authority of the issuer, and in some cases are insured.  Obligations issued by school districts are supported by state aid.  For any non-rated municipal securities, third party credit analysis shows no deterioration in the credit worthiness of the municipalities.  Corporate and other debt securities consist of one private placement trust preferred, and one trust preferred pool.  The private placement trust preferred is rated AAA by Standard & Poor’s; the trust preferred pool is rated investment grade, with the privately issued securities securing the note performing.  Subsequent to December 31, 2009, there were no securities downgraded below investment grade.  

The unrealized losses on these temporarily impaired securities are primarily the result of changes in interest rates for fixed rate securities where the interest rate received is less than the current rate available for new offerings of similar securities, changes in market spreads as a result of shifts in supply and demand, and/or changes in the level of prepayments for mortgage related securities.   Because we do not currently intend to sell any of our temporarily impaired securities, and because it is not more likely-than-not we would be required to sell the securities prior to recovery, the impairment is considered temporary.


December 31, 2008

Less than 12 Months

12 Months or Longer

Total

Available-for-Sale Portfolio:

Fair

Value

Unrealized

Losses

Fair

Value

Unrealized

Losses

Fair

Value

Unrealized

Losses

Collateralized Mortgage Obligations

$4,597

  $ 20

$    102

$   0

$ 4,699

$  20

Mortgage-Backed Securities - Residential

143

  0

8,492

89

8,635

89

Corporate & Other Debt Securities

5,038

402

1,950

76

6,988

 478

Mutual Funds and Equity Securities

       26

      0

    1,283

  210

    1,309

  210

  Total Securities Available-for-Sale

$9,804

$422

$11,827

$375

$21,631

$797

Held-to-Maturity Portfolio

 

 

 

 

 

 

State & Municipal Obligations

$5,970

$94

$22,218

$697

$28,188

$791




59



NOTE  3:

SECURITIES (Continued)


The table above for December 31, 2008 consists of 133 securities where the current fair value is less than the related amortized cost.  These unrealized losses do not reflect any deterioration of the credit worthiness of the issuing entities.  Agency-backed CMOs are all rated AAA, as are the mortgage-backed securities.  The municipal obligations are partially insured, with the remainder supported by the general taxing authority of the municipality and, in the cases of school districts, are supported by state aid.  For any non-rated municipal securities, third party credit analysis shows no deterioration in the credit worthiness of the municipalities.  Corporate and other debt securities consist of three corporate bonds, one private placement trust preferred, and one trust preferred pool.  The three corporate bond issues are rated investment grade, and are performing.  The private placement trust preferred is rated AAA by Standard & Poor’s; the trust preferred pool is rated investment grade, with the privately issued securities securing the note performing. Mutual funds and equity securities include four common stock holdings that show unrealized losses which are not deemed to be other-than-temporarily impaired, at December 31, 2008.

These unrealized losses do not reflect deterioration in the credit worthiness of the companies, since they have adequate capital positions.  The unrealized losses on these temporarily impaired securities are primarily the result of changes in interest rates for fixed rate securities where the interest rate received is less than the current rate available for new offerings of similar securities, changes in market spreads as a result of shifts in supply and demand, and/or changes in the level of prepayments for mortgage related securities. Since we have the intent and ability to hold these investments until a recovery of fair value, which may be until maturity for the debt securities, we do not consider these investments to be other-than-temporarily impaired at December 31, 2008.


Other-Than-Temporary Impairment


On a quarterly basis, Arrow performs an assessment to determine whether there have been any events or economic circumstances indicating that a security with an unrealized loss has suffered other-than-temporary impairment. A debt security is considered impaired if the fair value is less than its amortized cost basis at the reporting date. If impaired, Arrow then assesses whether the unrealized loss is other-than-temporary. An unrealized loss on a debt security is generally deemed to be other-than-temporary and a credit loss is deemed to exist if the present value of the expected future cash flows is less than the amortized cost basis of the debt security. As a result, the credit loss component of an other-than-temporary impairment write-down for debt securities is recorded in earnings while the remaining portion of the impairment loss is recognized, net of tax, in other comprehensive income provided that Arrow does not intend to sell the underlying debt security and it is more-likely-than not that Arrow would not have to sell the debt security prior to recovery.

At December 31, 2009, mutual funds and equity securities included shares of one common stock that had been deemed to be other-than-temporarily impaired.  The common stock had a book value of $1,469 prior to the recognition of $375 in losses charged to earnings for the year ended December 31, 2009. The book value and approximate fair value for this security was $1,094 at December 31, 2009.  

At December 31, 2008, corporate and other debt securities included a corporate bond issued by Lehman Brothers Holdings (“Lehman”) that has been deemed to be other-than-temporarily impaired. This Lehman bond had a book value of $2,010 prior to the recognition of $1,610 in losses charged to earnings (all of which was considered to be credit related) for the year ended December 31, 2008. The book value and approximate fair value for this security was $400 at December 31, 2008.  The bond was sold during 2009 for an additional loss of $60 thousand.


NOTE 4:

LOANS (In Thousands)


Loans at December 31, 2009 and 2008 consisted of the following:

 

 

2009

2008

Commercial, Financial and Agricultural

 

$     89,222

$     86,872

Real Estate - Commercial

 

185,582

183,676

Real Estate - Residential

 

472,605

444,655

Real Estate - Construction

 

34,906

34,428

Indirect and Other Consumer Loans

 

     329,835

     360,181

  Total Loans

 

$1,112,150

$1,109,812


Included in the carrying amount of loans in the table above are unamortized deferred loan origination costs, net of deferred loan origination fees, of $1,118 and $1,219 at December 31, 2009 and 2008, respectively.   Included in loan balances are the balances of overdrawn deposit accounts of $661 and $492 at December 31, 2009 and 2008, respectively.


Certain executive officers and directors, including their immediate families and organizations in which they are principals of Arrow or affiliates, have various loan, deposit and other transactions with Arrow.  Such transactions are entered into on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with others.  The amount of such related party loans was $15,345 at December 31, 2009 and $12,782 at December 31, 2008.  During 2009, the amount of new loans and renewals extended to such related parties was $7,379 and the total of loan repayments was $4,816.


Arrow has pledged certain loans secured by one-to-four family residential mortgages under a blanket collateral agreement to secure borrowings from the Federal Home Loan Bank of New York (see Note 11).  As of December 31, 2009, the amount of such pledged loans amounted to $237,098.




60



NOTE 4:

LOANS  (Continued)


Arrow designates certain loans as nonaccrual and suspends the accrual of interest and the amortization of net deferred fees or costs when payment of interest and/or principal is due and unpaid for a period of, generally, ninety days or the likelihood of repayment is uncertain in the opinion of management.  The following table presents information concerning nonperforming loans at December 31:

 

 

 

 

2009

2008

Nonaccrual Loans

 

 

$4,390

$3,469

Loans Past Due 90 or More Days and Still Accruing Interest

 

 

    270

    457

   Total Nonperforming Loans

 

 

$4,660

$3,926


Arrow has no material commitments to make additional advances to borrowers with nonperforming loans.  The following table presents information with respect to interest on the nonaccrual loans shown in the table above for the years ended December 31:


 

 

2009

2008

2007

Gross Interest That Would Have Been Earned Under Original Terms

 

$357

$295

$162

Interest Included in Income

 

163

208

70



NOTE 5:

ALLOWANCE FOR LOAN LOSSES AND IMPAIRED LOANS (In Thousands)


The following summarizes the changes in the allowance for loan losses during the years ended December 31:

 

 

2009

2008

2007

Balance at Beginning of Year

 

$13,272 

$12,401 

$12,278 

Provision for Loan Losses

 

1,783 

1,671 

513 

Recoveries

 

  389 

  492 

  440 

Charge-Offs

 

  (1,430)

  (1,292)

     (830)

Balance at End of Year

 

$14,014 

$13,272 

$12,401 


The balance of impaired loans was $1,900 and $2,231 at December 31, 2009 and 2008, respectively.  The allowance for loan losses included no allocation for these impaired loans at either date.  All impaired loans for both periods were measured for impairment based on collateral value.  We obtain unadjusted appraisals from independent third parties at least annually.  The average recorded investment in impaired loans for 2009, 2008 and 2007 was $2,038, $1,065 and $733, respectively.  For all years, no interest income was recorded on such loans during the period of impairment.


NOTE  6:

PREMISES AND EQUIPMENT (In Thousands)


A summary of premises and equipment at December 31, 2009 and 2008 is presented below:

 

 

2009

2008

Land and Bank Premises

 

$23,436 

$22,423 

Equipment, Furniture and Fixtures

 

17,166 

15,828 

Leasehold Improvements

 

      753 

      864 

  Total Cost

 

 41,355 

 39,115 

Accumulated Depreciation and Amortization

 

(22,599)

(21,513)

  Net Premises and Equipment

 

$18,756 

$17,602 


Amounts charged to expense for depreciation totaled $1,673, $1,224 and $1,280 in 2009, 2008 and 2007, respectively. Amounts charged to expense for leasing office space totaled $313, $321 and $306 in 2009, 2008 and 2007, respectively.



NOTE  7:

OTHER REAL ESTATE OWNED AND REPOSSESSED ASSETS (In Thousands)


The balance of other real estate owned was $53 at December 31, 2009 and was comprised of one residential real estate property.  The balance of other real estate owned was $581 at December 31, 2008 and was comprised of four residential real estate properties. Repossessed assets totaled $59 and $64 at December 31, 2009 and 2008, respectively, and consisted solely of motor vehicles repossessed in satisfaction of loans.



61



NOTE 8:

OTHER INTANGIBLE ASSETS (In Thousands)


The following table presents information on Arrow’s intangible assets (other than goodwill) as of December 31, 2009, 2008 and 2007:



Depositor

Intangibles1

Mortgage

Servicing

Rights2


Covenants3


Expirations4



Total  

Gross Carrying Amount, December 31, 2009

$2,247 

$506 

$117 

$751 

$3,621 

Accumulated Amortization

 (1,573)

 (294)

 (117)

 (194)

 (2,178)

Net Carrying Amount, December 31, 2009

$   674 

$ 212 

$  --- 

$557 

$1,443 

 

 

 

 

 

 

Gross Carrying Amount, December 31, 2008

$2,247 

$329 

$117 

$751 

$3,444 

Accumulated Amortization

 (1,318)

 (232)

  (96)

 (146)

 (1,792)

Net Carrying Amount, December 31, 2008

$   929 

$  97 

$ 21 

$605 

$1,652 

 

 

 

 

 

 

Gross Carrying Amount, December 31, 2007

$2,247 

$306 

$117 

$686 

$3,356 

Accumulated Amortization

 (1,021)

 (181)

  (73)

 (105)

 (1,380)

Net Carrying Amount, December 31, 2007

$1,226 

$125 

$ 44 

$581 

$1,976 

 

 

 

 

 

 

Amortization Expense:

 

 

 

 

 

   2009

$255 

$62 

$21 

$48 

$386 

   2008

297 

51 

23 

41 

412 

   2007

337 

51 

24 

34 

446 



 


Depositor

Intangibles1

Mortgage

Servicing

Rights2


Expirations4



Total

Estimated Annual Amortization Expense:1,2,3,4

 

 

 

   2010

$214 

$57 

$ 47 

$318 

   2011

174 

43 

47 

264 

   2012

133 

34 

47 

214 

   2013

92 

33 

41 

166 

   2014

51 

33 

34 

118 

   Later Years

10 

12 

341 

363 

 

 

 

 

 

1 Amortization of Depositor Intangibles is reported in the income statement as a component of other operating expense.

2 Amortization of Mortgage Servicing Rights is reported in the income statement as a reduction of servicing fee income.

3 Amortization of Covenants is reported in the income statement as a component of other operating expense.

4 Amortization of Expirations is reported in the income statement as a component of other operating expense.


During 2009, no impairment losses were recognized with respect to Arrow’s existing goodwill or intangible assets.



NOTE 9:

TIME DEPOSITS (In Thousands)


The following summarizes the contractual maturities of time deposits during years subsequent to December 31, 2009:


    

Time

Deposits

of $100,000

or More


Other

Time

Deposits

2010

$ 96,523

$114,550

2011

15,141

51,720

2012

19,906

45,955

2013

7,124

14,920

2014

9,817

17,197

2015 and Beyond

           ---

         148

Total

$148,511

$244,490





62



NOTE 10:

SHORT-TERM BORROWINGS (Dollars in Thousands)


Federal Funds Purchased and Securities Sold

  Under Agreements to Repurchase:

 

2009

2008

2007

    Balance at December 31

 

$72,020

$59,339

$52,630

    Maximum Month-End Balance

 

72,020

69,547

55,926

    Average Balance During the Year

 

58,290

57,711

48,851

    Average Rate During the Year

 

0.22%

1.35%

2.80%

    Rate at December 31

 

0.21%

0.49%

2.53%

Other Short-Term Borrowings:

 

 

 

 

    Balance at December 31

 

$1,888

$   617

$ 1,089

    Maximum Month-End Balance

 

3,224

3,751

2,377

    Average Balance During the Year

 

1,276

762

504

    Average Rate During the Year

 

0.00%

1.31%

4.37%

    Rate at December 31

 

0.00%

0.02%

4.00%

Average Aggregate Short-Term Borrowing Rate During the Year

 

0.22%

1.35%

2.81%


Securities sold under agreements to repurchase generally mature within ninety days.  Arrow maintains effective control over the securities underlying the agreements.  Federal funds purchased represent overnight transactions.

Other short-term borrowings primarily include demand notes issued to the U.S. Treasury.   In addition, Arrow has in place federal funds lines of credit with three correspondent banks totaling $30 million, the Federal Home Loan Bank of New York (“FHLBNY”) and the Federal Reserve Bank of New York.


NOTE 11:

FHLBNY ADVANCES (Dollars in Thousands)


Arrow has established overnight and 30 day term lines of credit with the FHLBNY each in the amount of $125,740.  If advanced, such lines of credit will be collateralized by mortgage-backed securities, loans and FHLBNY stock.  Participation in the FHLBNY program requires an investment in FHLBNY stock.  The investment in FHLBNY stock, included in Other Investments on the Consolidated Balance Sheets, amounted to $8,107 and $8,859 at December 31, 2009 and 2008, respectively.  Arrow also borrows longer-term funds from the FHLBNY.  Certain borrowings are in the form of “convertible advances.”  These advances have a set final maturity, but are callable by the FHLBNY at certain dates beginning no earlier than one year from the issuance date.  If the advances are called, Arrow may elect to have the funds replaced by the FHLBNY at the then prevailing market rate of interest.  The borrowings are secured by mortgage loans and/or mortgage-backed securities and/or FHLBNY stock held by Arrow.  The total amount of assets pledged to the FHLBNY for borrowing arrangements at December 31, 2009 and 2008 amounted to $243,314 and $232,399, respectively.  


The table below presents information applicable to FHLBNY advances as of December 31, 2009 and 2008:


2009 Amount

2008 Amount

Effective Rate

Next Call Date

Call Frequency

Maturity Date

$ 10,000

$ 10,000

3.88%

01/06/2010

Quarterly

10/06/2015

10,000

10,000

4.24%

01/06/2010

Quarterly

10/06/2010

10,000

10,000

4.70%

01/12/2010

Quarterly

01/12/2012

5,000

5,000

4.91%

01/28/2010

Quarterly

07/28/2011

5,000

5,000

4.82%

01/28/2010

Quarterly

07/28/2011

10,000

10,000

4.41%

03/19/2010

Quarterly

12/19/2010

10,000

10,000

4.72%

07/27/2010

Quarterly

07/27/2012

10,000

10,000

4.46%

08/28/2010

Quarterly

08/28/2012

10,000

10,000

3.73%

12/20/2010

Quarterly

12/20/2012

10,000

10,000

5.12%

 

One-Time

02/14/2011

10,000

10,000

5.18%

 

One-Time

02/23/2011

10,000

10,000

5.03%

 

One-Time

04/28/2011

10,000

10,000

5.20%

 

One-Time

05/19/2011

10,000

10,000

5.07%

 

One-Time

05/19/2011

    10,000

10,000

4.32%

 

One-Time

10/09/2012

--- 

10,000

4.76%

 

 

11/27/2009

          --- 

    10,000

4.53%

 

 

12/04/2009

$140,000

$160,000

 

 

 

 


The table below presents the amounts of FHLBNY advances maturing in the next five years and beyond:


Final Maturity

Amount

2010

$ 20,000

2011

60,000

2012

50,000

2015

    10,000

  Total FHLBNY Advances

$140,000




63



NOTE 12:

GUARANTEED PREFERRED BENEFICIAL INTERESTS IN CORPORATION’S JUNIOR SUBORDINATED

DEBENTURES (In Thousands)


During 2009, there were outstanding two classes of financial instruments issued by two separate subsidiary business trusts of Arrow, having an aggregate amount of $20,000, identified as “Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts” on the Consolidated Balance Sheets and the Consolidated Income Statements.

The first of the two classes of trust-issued instruments outstanding at year-end was issued by Arrow Capital Statutory Trust II ("ACST II"), a Delaware business trust established on July 16, 2003, upon the filing of a certificate of trust with the Delaware Secretary of State.  In July 2003, ACST II issued all of its voting (common) stock to Arrow and issued and sold to an unaffiliated purchaser 30-year guaranteed preferred beneficial interests in the trust's assets ("ACST II trust preferred securities") in the aggregate amount of $10,000.  The ACST II trust preferred securities bore a rate of 6.53% through September 30, 2008.  After that date the rate became variable, adjusting quarterly to the 3-month LIBOR plus 3.15%.  ACST II used the proceeds of the sale of its trust preferred securities to purchase an identical amount ($10,000) of junior subordinated debentures issued by Arrow that bear an interest rate identical at all times to the rate payable on the ACST II trust preferred securities.  The ACST II trust preferred securities became redeemable after July 23, 2008.

The second of the two classes of trust-issued instruments outstanding at year-end was issued by Arrow Capital Statutory Trust III ("ACST III"), a Delaware business trust established on December 23, 2004, upon the filing of a certificate of trust with the Delaware Secretary of State. On December 28, 2004, the ACST III issued all of its voting (common) stock to Arrow and issued and sold to an unaffiliated purchaser 30-year guaranteed preferred beneficial interests in the trust's assets ("ACST III trust preferred securities") in the aggregate amount of $10,000.  The rate on the ACST III trust preferred securities is a variable rate, adjusted quarterly, equal to the 3-month LIBOR plus 2.00%.  ACST III used the proceeds of the sale of its trust preferred securities to purchase an identical amount ($10,000) of junior subordinated debentures issued by Arrow that bear an interest rate identical at all times to the rate payable on the ACST III trust preferred securities.  The ACST III trust preferred securities are redeemable on or after March 31, 2010.

The primary assets of the two subsidiary trusts having trust preferred securities outstanding at year-end, ACST II and ACST III (the “Trusts”), are Arrow's junior subordinated debentures discussed above, and the sole revenues of the Trusts are payments received by them from Arrow with respect to the junior subordinated debentures.  The trust preferred securities issued by the Trusts are non-voting.  All common voting securities of the Trusts are owned by Arrow.  Arrow used the net proceeds from its sale of junior subordinated debentures to the Trusts, facilitated by the Trust’s sale of their trust preferred securities to the purchasers thereof, for general corporate purposes.  The trust preferred securities and underlying junior subordinated debentures, with associated expense that is tax deductible, qualify as Tier I capital under regulatory definitions.

Arrow's primary source of funds to pay interest on the debentures that are held by the Trusts are current dividends received by Arrow from its subsidiary banks.  Accordingly, Arrow's ability to make payments on the debentures, and the ability of the Trusts to make payments on their trust preferred securities, are dependent upon the continuing ability of Arrow's subsidiary banks to pay dividends to Arrow.  Since the trust preferred securities issued by the subsidiary trusts and the underlying junior subordinated debentures issued by Arrow at December 31, 2009, 2008 and 2007 are classified as debt for financial statement purposes, the expense associated with these securities is recorded as interest expense in the consolidated statements of income for the three years.



NOTE 13:

ACCUMULATED OTHER COMPREHENSIVE LOSS (In Thousands)


The following table presents the components, net of tax, of accumulated other comprehensive loss as of December 31:

 

 

2009

2008

Retirement Plan Net Loss

 

$(10,185)

$(12,495)

Retirement Plan Prior Service Cost

 

395 

659 

Net Unrealized Securities Holding Gains

 

    3,150 

    2,432 

  Total Accumulated Other Comprehensive Loss

 

$ (6,640)

$ (9,404)


NOTE 14:

EARNINGS PER COMMON SHARE (In Thousands, Except Per Share Amounts)


The following table presents a reconciliation of the numerator and denominator used in the calculation of basic and diluted earnings per common share (“EPS”) for each of the years in the three-year period ended December 31, 2009.  All share and per share amounts have been adjusted for the 2009 3% stock dividend.

 

 

Net Income

(Numerator)

Weighted-Average Shares

(Denominator)

Per Share

Amount

For the Year Ended December 31, 2009:

 

 

 

 

Basic EPS

 

$21,792

 10,904

$2.00

Dilutive Effect of Stock Options

 

         ---

       49

 

Diluted EPS

 

$21,792

10,953

$1.99

For the Year Ended December 31, 2008:

Basic EPS

 

$20,437

 10,882

$1.88

Dilutive Effect of Stock Options

 

         ---

       59

 

Diluted EPS

 

$20,437

10,941

$1.87

For the Year Ended December 31, 2007:

Basic EPS

 

$17,332

 11,036

$1.57

Dilutive Effect of Stock Options

 

         ---

       73

 

Diluted EPS

 

$17,332

11,109

$1.56




64



NOTE 14:

EARNINGS PER COMMON SHARE (Continued)


During a portion of 2009, options to purchase 69 shares of common stock at an average price of $28.42 per share were outstanding but were not included in the computation of diluted EPS because the options’ exercise price was greater than the average market price of the common shares during that period.  Anti-dilutive shares for 2008 and 2007 were 247 shares at an average price of $24.97 per share and 259 shares at an average price of $24.96, for the respective years.


NOTE 15:

REGULATORY MATTERS (Dollars in Thousands)


In the normal course of business, Arrow and its subsidiaries operate under certain regulatory restrictions, such as the extent and structure of covered inter-company borrowings and maintenance of reserve requirement balances.

The principal source of the funds for the payment of stockholder dividends by Arrow has been from dividends declared and paid to Arrow by its bank subsidiaries.  As of December 31, 2009, the maximum amount that could have been paid by subsidiary banks to Arrow, without prior regulatory approval, was approximately $20,385.

Under current Federal Reserve regulations, Arrow is prohibited from borrowing from the subsidiary banks unless such borrowings are secured by specific obligations.  Additionally, the maximum of any such borrowing is limited to 10% of an affiliate’s capital and surplus.

Arrow and its subsidiary banks are subject to various regulatory capital requirements administered by the federal banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory--and possibly additional discretionary--actions by regulators that, if undertaken, could have a direct material effect on an institution’s financial statements.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, Arrow and its subsidiary banks must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices.  Capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require Arrow and its subsidiary banks to maintain minimum capital amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined).  Management believes, as of December 31, 2009 and 2008, that Arrow and both subsidiary banks meet all capital adequacy requirements to which they are subject.

As of December 31, 2009, Arrow and both subsidiary banks qualified as well-capitalized under the regulatory framework for prompt corrective action.  To be categorized as “well-capitalized,” Arrow and its subsidiary banks must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table below.  There are no conditions or events that management believes have changed Arrow’s or its subsidiary banks’ categories.

Arrow’s and its subsidiary banks’, Glens Falls National Bank and Trust Company (“Glens Falls National”) and Saratoga National Bank and Trust Company (“Saratoga National”), actual capital amounts and ratios are presented in the table below as of December 31, 2009 and 2008:


 



Actual

Minimum Amounts

For Capital

Adequacy Purposes

Minimum Amounts

To Be

Well-Capitalized

 

Amount

Ratio

Amount

Ratio

Amount

Ratio

As of December 31, 2009:

 

 

 

 

 

 

Total Capital

 (to Risk Weighted Assets):

 

 

 

 

 

 

  Arrow

$168,121

15.4%

$87,336

8.0%

$109,169

10.0%

  Glens Falls National

141,498

15.7

72,101

8.0

90,126

10.0

  Saratoga National

26,027

13.9

14,980

8.0

18,724

10.0

Tier I Capital

 (to Risk Weighted Assets):

 

 

 

 

 

 

  Arrow

154,490

14.2

43,518

4.0

65,277

 6.0

  Glens Falls National

130,209

14.4

36,169

4.0

54,254

 6.0

  Saratoga National

23,687

12.7

7,460

4.0

11,191

 6.0

Tier I Capital

 (to Average Assets):

 

 

 

 

 

 

  Arrow

154,490

 8.4

73,567

4.0

73,567

 4.0

  Glens Falls National

130,209

 8.3

62,751

4.0

78,439

 5.0

  Saratoga National

23,687

8.6

11,017

4.0

13,772

 5.0

 

 

 

 

 

 




65



NOTE 15:

REGULATORY MATTERS (Continued)


 



Actual

Minimum Amounts

For Capital

Adequacy Purposes

Minimum Amounts

To Be

Well-Capitalized

 

Amount

Ratio

Amount

Ratio

Amount

Ratio

As of December 31, 2008:

 

 

 

 

 

 

Total Capital

 (to Risk Weighted Assets):

 

 

 

 

 

 

  Arrow

$155,015

14.3%

$86,722

8.0%

$108,402

10.0%

  Glens Falls National

131,825

14.5

72,731

8.0

90,914

10.0

  Saratoga National

23,911

13.4

14,275

8.0

17,844

10.0

Tier I Capital

 (to Risk Weighted Assets):

 

 

 

 

 

 

  Arrow

141,743

13.1

43,280

4.0

64,920

 6.0

  Glens Falls National

120,968

13.3

36,381

4.0

54,572

 6.0

  Saratoga National

21,677

12.1

7,166

4.0

10,749

 6.0

Tier I Capital

 (to Average Assets):

 

 

 

 

 

 

  Arrow

141,743

 8.5

66,703

4.0

66,703

 4.0

  Glens Falls National

120,968

 8.4

57,604

4.0

72,005

 5.0

  Saratoga National

21,677

9.1

9,528

4.0

11,910

 5.0




NOTE  16:

RETIREMENT PLANS (Dollars in Thousands)


Arrow sponsors qualified and nonqualified defined benefit pension plans and other postretirement benefit plans for its employees.  For the qualified pension plan, the fair value of the plan’s assets, at $33,585, exceeded the projected benefit obligation by $4,898 at December 31, 2009.  Arrow maintains a non-contributory pension plan, which covers substantially all employees.  Effective December 1, 2002, all active participants in the qualified defined benefit pension plan were given a one-time irrevocable election to continue participating in the traditional plan design, for which benefits were based on years of service and the participant’s final compensation (as defined), or to begin participating in the new cash balance plan design.  All employees who participate in the plan after December 1, 2002 automatically participate in the cash balance plan design.  The interest credits under the cash balance plan are based on the 30-year U.S. Treasury rate in effect for November of the prior year.  The service credits under the cash balance plan are equal to 6.0% of eligible salaries for employees who become participants on or after January 1, 2003.  For employees in the plan prior to January 1, 2003, the service credits are scaled based on the age of the participant, and range from 6.0% to 12.0%.  The funding policy is to contribute up to the maximum amount that can be deducted for federal income tax purposes and to make all payments required under ERISA.  Arrow also maintains a supplemental non-qualified unfunded retirement plan to provide eligible employees of Arrow and its subsidiaries with benefits in excess of qualified plan limits imposed by federal tax law.

Arrow has multiple non-pension postretirement benefit plans.  The health care, dental and life insurance plans are contributory, with participants’ contributions adjusted annually.  Arrow’s policy is to fund the cost of postretirement benefits based on the current cost of the underlying policies.  However, the health care plan provision for automatic increases of Company contributions each year is based on the increase in inflation and is limited to a maximum of 5%.  




66



NOTE 16:

RETIREMENT PLANS (Continued)


The following tables set forth changes in the plans’ benefit obligations (projected benefit obligation for pension benefits and accumulated benefit obligation for postretirement benefits) and changes in the plans’ assets and the funded status of the pension plans and other postretirement benefit plan at December 31:


Pension Plans:

2009

2008

 

Employee’s Pension Plan

Select

Executive

Retirement

Plan

Total

Pension

Plan

Employee’s Pension Plan

Select

Executive

Retirement

Plan

Total

Pension

Plan

Change in Benefit Obligation:

 

 

 

 

 

 

Benefit Obligation at January 1

$25,594 

$ 3,645 

$29,239 

$25,181 

$ 3,547 

$28,728 

Service Cost

1,042 

55 

1,097 

980 

45 

1,025 

Interest Cost

 1,532 

 219 

 1,751 

 1,563 

 224 

 1,787 

Amendments

--- 

70 

70 

184 

--- 

184 

Actuarial Loss

 1,666 

 318 

 1,984 

 357 

 139 

 496 

Benefits Paid

  (1,147)

    (304)

  (1,451)

  (2,671)

    (310)

  (2,981)

  Benefit Obligation at December 311

 28,687 

  4,003 

 32,690 

 25,594 

  3,645 

 29,239 

 

 

 

 

 

 

 

Change in Plan Assets:

 

 

 

 

 

 

Fair Value of Plan Assets at January 1

26,568 

--- 

26,568 

31,040 

--- 

31,040 

Actual Return on Plan Assets

6,164 

--- 

6,164 

(8,301)

--- 

(8,301)

Employer Contributions

2,000 

304 

2,304 

6,500 

310 

6,810 

Benefits Paid

  (1,147)

     (304)

  (1,451)

  (2,671)

     (310)

  (2,981)

  Fair Value of Plan Assets at December 31

  33,585 

         --- 

  33,585 

  26,568 

         --- 

  26,568 

Funded Status

$  4,898 

$(4,003)

$     895 

$     974 

$(3,645)

$ (2,671)



Postretirement Benefits:

 

 

2009

2008

Change in Benefit Obligation:

 

 

Benefit Obligation at January 1

$ 7,341 

$ 6,821 

Service Cost

    147 

    154 

Interest Cost

   415 

   423 

Plan Participants’ Contributions

    285 

    236 

Amendments

185 

152 

Actuarial (Gain) Loss

(345)

70 

Medicare Part D Prescription  Drug Federal Subsidy

--- 

10 

Benefits Paid

   (586)

   (525)

  Benefit Obligation at December 311

 7,442 

 7,341 

 

 

 

Change in Plan Assets:

 

 

Employer Contributions

 301 

 279 

Plan Participants’ Contributions

  285 

  236 

Medicare Part D Prescription Drug Federal Subsidy

--- 

10 

Benefits Paid

    (586)

    (525)

  Fair Value of Plan Assets at December 31

         --- 

         --- 

Funded Status

$(7,442)

$(7,341)

1 Represents the projected benefit obligation for pension benefits and the accumulated benefit obligation for postretirement benefits.



67



NOTE 16:

RETIREMENT PLANS (Continued)


The following tables summarize the funded status of the pension and postretirement plans, reconciled to the amounts recognized in the consolidated balance sheets as of December 31, 2009 and 2008:


Pension Plans:

2009

2008

 

Employee’s Pension Plan

Select

Executive

Retirement

Plan

Total

Pension

Plan

Employee’s Pension Plan

Select

Executive

Retirement

Plan

Total

Pension

Plan

Prepaid Benefit Cost

$4,898

$       ---

$ 4,898

$974

$       ---

$     974

Accrued Benefit Liability

        --- 

  (4,003)

  (4,003)

     --- 

  (3,645)

  (3,645)

  Net Benefit Cost Recognized

$4,898 

$(4,003)

$     895 

$974 

$(3,645)

$(2,671)


Postretirement Benefits:

2009

2008

Accrued Benefit Liability

$(7,442)

$(7,341)

  Net Benefit Cost Recognized

$(7,442)

$(7,341)


The components of accumulated other comprehensive income related to pension plans and other postretirement benefits, on a pre-tax basis, at December 31 are summarized below.  



Pension Plans:

2009

2008

Change in Benefit Obligation:

Employee’s Pension Plan

Select

Executive

Retirement

Plan

Total

Pension

Plan

Employee’s Pension Plan

Select

Executive

Retirement

Plan

Total

Pension

Plan

Net Actuarial Loss

$13,312 

$1,868 

$15,180 

$16,933 

$1,661 

$18,594 

Prior Service Credit

     (305)

     158 

     (147)

     (279)

     (20)

     (299)

Total Pre-tax Amounts Recognized in

  Accumulated Other Comprehensive Loss

$13,007 

$2,026 

$15,033 

$16,654 

$1,641 

$18,295 



Postretirement Benefits:

2009

2008

Net Actuarial Loss

$1,692    

$2,099    

Prior Service Credit

    (512)   

    (792)   

Total Pre-tax Amounts Recognized in

  Accumulated Other Comprehensive Loss

$1,180    

$1,307    


We expect that $1,006 of net actuarial loss and $175 of prior service credit, included in accumulated other comprehensive income at December 31, 2009, will be recognized as components of net periodic benefit cost in 2010.

At December 31, 2009 and 2008, the accumulated benefit obligation (the actuarial present value of benefits, vested and non-vested, earned by employees based on current and past compensation levels) for Arrow’s qualified defined benefit pension plan totaled $28,084 and $25,070, respectively, which compared with total plan assets of $33,585 and $26,567, respectively.  At December 31, 2009 and 2008, the accumulated benefit obligation for Arrow’s non-qualified defined benefit pension plan was $4,003 and $3,645, respectively, which compared with no plan assets at December 31, 2009 and 2008.



68



NOTE 16:

RETIREMENT PLANS (Continued)


The following table provides the components of net periodic benefit costs for the plans for the years ended December 31:


Pension Plans:

2009

2008

2007

 

Employee’s Pension Plan

Select

Executive

Retirement

Plan

Total

Pension

Plan

Employee’s Pension Plan

Select

Executive

Retirement

Plan

Total

Pension

Plan

Employee’s Pension Plan

Select

Executive

Retirement

Plan

Total

Pension

Plan

Net Periodic Benefit Cost

 

 

 

 

 

 

 

 

 

Service Cost

$1,042 

$55 

$1,097 

$980 

$45 

$1,025 

$   950 

$   44 

$   994 

Interest Cost

1,532 

218 

1,750 

1,564 

223 

1,787 

1,442 

180 

1,622 

Expected Return on Plan Assets

(2,072)

--- 

(2,072)

(2,547)

--- 

(2,547)

(2,501)

--- 

(2,501)

Amortization of Prior Service Credit

25 

(108)

(83)

10 

(102)

(92)

(11)

(110)

(121)

Amortization of Net Loss

  1,195 

     112 

   1,307 

     244 

     108 

     352 

    225 

    100 

    325 

  Net Periodic Benefit Cost

  1,722 

     277 

   1,999 

     251 

     274 

     525 

    105 

    214 

    319 

Other Changes in Plan Assets and Benefit Obligations Recognized in Other Comprehensive Loss:

Net (Gain) Loss

(2,425)

318

(2,107)

11,204

140

11,344

907 

269 

1,176 

Prior Service Cost (Credit)

---

70

70

184

---

184

150 

180 

330 

Amortization of Net Loss

(1,195)

(112)

(1,307)

(244)

(108)

(352)

(225)

(100)

(325)

Amortization of Prior Service Credit

    (25)

      108

       83

    (10)

      102

       92

    11 

  110 

    121 

  Total Recognized in

     Other Comprehensive

     Loss

(3,645)

384

(3,261)

11,134

134

11,268

 843 

 459 

 1,302 

  Total Recognized in Net

    Periodic (Benefit) Cost

    And Other

    Comprehensive

    (Income) Loss

$(1.923)

$661

$(1.262)

$11.385

$408

$11.793

$948 

$673 

$1,621 



Postretirement Benefits:

 

Net Periodic Benefit Cost

2009

2008

2007

Service Cost

$147 

$154 

$165 

Interest Cost

415 

423 

384 

Amortization of Prior Service Credit

(96)

(108)

(118)

Amortization of Net Loss

    62 

    91 

  119 

  Net Periodic Benefit Cost

  528 

  560 

 550 

Other Changes in Plan Assets and Benefit

    Obligations Recognized in Other Comprehensive Loss

 

 

 

Net (Gain) Loss

 (345)

 127

348 

Prior Service Cost (Credit)

185 

152 

(659)

Amortization of Net Loss

(62)

(91)

(119)

Amortization of Prior Service Credit

  96

  108

  118 

  Total Recognized in Other Comprehensive (Gain) Loss

 (126)

  296 

 (312)

  Total Recognized in Net Periodic Benefit Cost and

    Other Comprehensive Loss

$402

$856

$238 




69



NOTE 16:

RETIREMENT PLANS (Continued)


The prior service costs or credits are amortized on a straight-line basis over the average remaining service period of active participants.  Gains and losses in excess of 10% of the greater of the benefit obligation or the fair value of assets are amortized over the average remaining service period of active participants.  


Additional Information:

 

Employee Pension Plan and Select Executive Retirement Plan

Postretirement Benefits

 

 

2009

2008

2007

2009

2008

2007

Weighted-Average Assumptions Used

  To Determine Benefit Obligation at

  December 31:

 

 

 

 

 

 

 

    Discount Rate

 

5.80%

6.15%

6.40%

5.80%

6.15%

6.40%

    Rate of Compensation Increase

 

3.50%

3.50%

3.50%

3.50%

3.50%

3.50%

    Interest Rate Credit for Determining

      Projected Cash Balance Account

 

4.50%

4.50%

4.75%

---

---

---

    Interest Rate to Annuitize Cash

      Balance Account

 

6.00%

6.00%

6.00%

---

---

---

    Interest Rate to Convert Annuities

      To Actuarially Equivalent Lump

      Sum Amounts

 

6.00%

6.00%

6.00%

---

---

---



 

 

Employee Pension Plan and Select Executive Retirement Plan

     Postretirement Benefits

 

 

2009

2008

2007

2009

2008

2007

Weighted-Average Assumptions Used

  To Determine Net Periodic Benefit

  Cost for Years Ended December 31:

 

 

 

 

 

 

 

    Discount Rate

 

6.15%

6.40%

5.85%

6.15%

6.40%

5.85%

    Expected Long-Term Return on

      Plan Assets

 

7.50%

8.00%

8.50%

---

---

---

    Rate of Compensation Increase

 

3.50%

3.50%

3.50%

3.50%

3.50%

3.50%

    Interest Rate Credit for Determining

      Projected Cash Balance Account

 

4.50%

4.75%

4.75%

---

---

---

    Interest Rate to Annuitize Cash

      Balance Account

 

6.00%

6.00%

4.75%

---

---

---

    Interest Rate to Convert Annuities

      To Actuarially Equivalent Lump

      Sum Amounts

 

6.00%

6.00%

4.75%

---

---

---


 

The discount rate assumption is based on the Citigroup Pension Discount Curve as adjusted to provide the necessary cash flows for the payment of benefits when due.


The following table presents management’s estimated benefit payments for the next ten years:



 

Employee

Select Executive

Postretirement

Payment Period

Pension Plan

Retirement Plan

Plan

2010

$ 1,709

$   290

$  473

2011

1,878

388

494

2012

2,131

384

501

2013

2,033

375

515

2014

2,154

366

541

2015-2019

10,524

1,668

2,928




70



NOTE  16:

RETIREMENT PLANS (Continued)


Assumed Health Care Cost Trend Rates at December 31,

 

Health Care – Pre 65

Health Care – Post 65

Drug Benefits

 

2009

2008

2009

2008

2009

2008

Health Care Cost Trend

  Rate Assumed for Next Year

9.00%

8.30%

7.00%

7.50%

9.00%

10.00%

Rate to which the Cost Trend

  Rate is Assumed to Decline

  (the Ultimate Trend Rate)

5.00%

5.00%

5.00%

5.00%

5.00%

5.00%

Year that the Rate Reaches

   the Ultimate Trend Rate

2017

2015

2015

2015

2015

2015


Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans.  A one-percentage-point change in assumed health care cost trend rates would have the following effects:


 

1-Percentage-

Point Increase

1-Percentage-

Point Decrease

Effect on Total Service and Interest Cost Components of Net Periodic

   Postretirement Benefit Cost For the Year Ended December 31, 2009

$  51

$(46)

Effect on the Accumulated Postretirement Benefit Obligation as of

  December 31, 2009

556

(507)


Fair Value of Plan Assets (Defined Benefit Plan):


For information on fair value measurements, including descriptions of level 1, 2 and 3 of the fair value hierarchy and the valuation methods employed by Arrow, see Note 1 - “Summary of Significant Accounting Policies” and Note 23 - “Fair Value of Financial Instruments.”


The fair value of level 1 and 2 pension plan assets, in the table below, are determined utilizing an independent pricing service for identical assets or significantly similar securities.  The pricing service uses a variety of techniques to arrive at fair value including market maker bids, quotes and pricing models.  Inputs to the pricing models include recent trades, benchmark interest rates, spreads, actual and projected cash flows relative credit information, and perceived market movements. There were no Level 3 assets at December 31, 2009 or at any time during 2009.


Plan investment assets measured at fair value by level and in total at December 31, 2009 are summarized in the following table:


 

Fair Value Measurements Using:

 

 

Asset Category:

Quoted Prices

In Active

Markets for

Identical Assets

(Level 1)

Significant

Other

Observable

Inputs

(Level 2)

Significant

Unobservable

Inputs

(Level 3)

Total

Percent

of Total

Cash

$  2,384

$---

$---

$  2,384

7.1%

Mortgage-Backed Securities

---

7

---

7

0.0

Equity Securities

2,942

---

---

2,942

8.8

Mutual Funds - Equity

20,848

---

---

20,848

62.1

Mutual Funds – Fixed Income

    7,404

 ---

---

    7,404

  22.0

  Total

$33,578

$ 7

$---

$33,585

100.0%


At December 31, 2009 and 2008, plan assets included shares of mutual funds advised by Arrow’s subsidiary, North Country Investment Advisers, Inc., with a market value of $19,308 and $14,453, respectively. At December 31, 2009 and 2008, the market value of plan assets also included $2,942 and $3,262, respectively, of Arrow Financial Corporation common stock. In accordance with ERISA guidelines, the Board authorized the purchase of Arrow common stock up to 10% of the fair market value of the plan's assets at the time of acquisition.  




71



NOTE  16:

RETIREMENT PLANS (Continued)


 Pension Plan Investment Policies and Strategies:


The Company maintains a non-contributory pension benefit plan covering substantially all employees for the purpose of rewarding long and loyal service to the Company.  The pension assets are held in trust and are invested in a prudent manner for the exclusive purpose of providing benefits to participants.  The investment objective is to achieve an inflation-protected rate of return that meets the actuarial assumption which is used for funding purposes.  The investment strategy attempts to maximize the investment return on assets at a level of risk deemed appropriate by the Company while complying with ERISA and any applicable regulations and laws.  The investment strategy utilizes asset allocation as a principal determinant for establishing the risk/reward profile of the assets. Asset allocation ranges are established, periodically reviewed, and adjusted as funding levels, and participant benefit characteristics change. Active and passive investment management is employed to help enhance the risk/return profile of the assets.

The Plan’s assets are invested in a diversified portfolio of equity securities comprised of companies with small, mid, and large capitalizations.  Both domestic and international equities are allowed to provide further diversification and opportunity for return in potentially higher growth economies with lower correlation of returns.  Growth and value styles of investment are employed to increase the diversification and offer varying opportunities for appreciation.  The fixed income portion of the plan may be invested in U.S. dollar denominated debt securities that shall be rated within the top four ratings categories by nationally recognized ratings agencies.   The fixed income portion will be invested without regard to industry or sector based on analysis of each target security’s structural and repayment features, current pricing and trading opportunities as well as credit quality of the issuer.  Individual bonds with ratings that fall below the Plan’s rating requirements will be sold only when it is in the best interests of the Plan.  Hybrid investments, such as convertible bonds, may be used to provide growth characteristics while offering some protection to declining equity markets by having a fixed income component.  Alternative investments such as Treasury Inflation Protected Securities, commodities, and REITs may be used to further enhance diversification while offering opportunities for return, although none of these securities were held during the years ended December 31, 2009, 2008 or 2007.  In accordance with ERISA guidelines, common stock of the Company may be purchased up to 10% of the fair market value of the Plan’s assets at the time of acquisition.  Derivative investments are prohibited in the plan.  


The return on assets assumption was developed through review of historical market returns, historical asset class volatility and correlations, current market conditions, the Plan’s past experience, and expectations on potential future market returns. The assumption represents a long-term average view of the performance of the assets in the Plan, a return that may or may not be achieved during any one calendar year. The assumption is based on the return of the Plan using the historical fifteen year return adjusted for the potential for lower than historical returns due to low interest rates, and an expected modest recovery in global economic growth as a result of the deep recession.    


The range of plan asset allocations as of December 31, 2009 by asset category is as follows: Equity securities 65-85%; Fixed Income securities 10-30%; and Money market 0-5%.       


Cash Flows

We are not required to make any contribution to our qualified pension plan in 2010 and therefore, do not expect to make any contribution during 2010.  The expected 2010 contribution for the nonqualified plan is $290.  Arrow makes contributions for its postretirement benefits in an amount equal to actual expenses for the year.  The expected contribution is estimated to be $473 for 2010.



NOTE 17:

OTHER EMPLOYEE BENEFIT PLANS (In Thousands)


Arrow maintains an employee stock ownership plan (“ESOP”).  Substantially all employees of Arrow and its subsidiaries are eligible to participate upon satisfaction of applicable service requirements.  The ESOP borrowed $1,000, $1,500, $105, $464 and $853 in 2008, 2007, 2001, 2000 and 1999, respectively, from one of Arrow’s subsidiary banks to purchase outstanding shares of Arrow’s common stock.  The notes require annual payments of principal and interest through 2018.  Arrow’s ESOP expense amounted to $500, $549 and $168 in 2009, 2008 and 2007, respectively.  As the debt is repaid, shares are released from collateral based on the proportion of debt paid to total debt outstanding for the year and allocated to active employees.  

Shares pledged as collateral are reported as unallocated ESOP shares in stockholders’ equity.  As shares are released from collateral, Arrow reports compensation expense equal to the current average market price of the shares, and the shares become outstanding for earnings per share computations.  The ESOP shares as of December 31, 2009 were as follows:


Allocated Shares

676

Shares Released for Allocation During 2009

 21

Unallocated Shares

105

  Total ESOP Shares

802

 

 

Market Value of Unallocated Shares

$2,632


Under the employee stock purchase plan (“ESPP”), employees may purchase shares of Arrow’s common stock, up to $24 annually, at a discount to the prevailing market price (currently a 5% discount).  Under the ESPP, shares are issued by Arrow without a charge to earnings.  Substantially all employees of Arrow and its subsidiaries are eligible to participate upon satisfaction of applicable service requirements.  Arrow also sponsors a Long-Term Incentive Award Plan and a Short-Term Incentive Award Plan for senior management and a Profit Sharing Plan for substantially all employees.  The combined cost of these plans was $999, $1,184 and $336 for 2009, 2008 and 2007, respectively.



72



NOTE 18:

STOCK OPTION PLANS


Arrow has established fixed Incentive Stock Option and Non-qualified Stock Option Plans.  At December 31, 2009, approximately 247,000 shares remained available for grant under these plans.  Options may be granted at a price no less than the greater of the par value or fair market value of such shares on the date on which such option is granted, and generally expire ten years from the date of grant.  The options usually vest over a four-year period.

For years ended December 31, 2009, 2008 and 2007, the amount expensed for grants issued under these plans was $189, $115 and $70, respectively.  

Grants were issued in 2009 and 2007, but no grants were issued in 2008.  The following table presents information on the grants (restated for the 3% September 2009 stock dividend):


Grants issued:

Jul 2009

Jan 2009

Nov 2007

Fair Value of Options Granted

$7.00

$4.48

$4.24

Shares Granted

1,030

71,264

45,835

Dividend Yield

3.60%

4.70%

4.34%

Expected Volatility

33.2%

33.2%

27.3%

Risk Free Interest Rate

3.20%

2.10%

3.77%

Expected Lives (in years)

7.78

7.78

8.09


A summary of the status of Arrow’s stock option plans as of December 31, 2009 and changes during the year then ended is presented below.






Options:





Shares


Weighted

Average

Exercise

Price

Weighted

Average

Remaining

Contractual

Life (in years)



Aggregate

Intrinsic

Value

 Outstanding at January 1, 2009

447,616 

$21.19 

 

 

 Granted

72,294 

22.00 

 

 

 Exercised

(75,543)

15.60 

 

 

 Forfeited

   (5,045)

15.94 

 

 

 Outstanding at December 31, 2009

439,322 

22.35 

5.1

$1,175

 Exercisable at December 31, 2009

333,334 

22.47 

3.9

852

 Expected to Vest

105,998 

21.96 

8.6

--- 


Cash proceeds, tax benefits and intrinsic value related to total stock options exercised were as follows:


 

Years Ended

December 31,

 

2009

2008

2007

Proceeds From Stock Options Exercised

$1,178

$1,176

$1,055

Tax Benefits Related to Stock Options Exercised

193

176

164

Intrinsic Value of Stock Options Exercised

1,922

874

485

 

 

 

 


The following table summarizes information about Arrow’s stock options at December 31, 2009:

 

 

Options Outstanding

Options Exercisable



Range of

Exercise

  Prices



Number

Outstanding

At 12/31/09

Weighted-

Average

Remaining

Contractual

Life (Years)


Weighted-

Average

Exercise

Price



Number

Exercisable

at 12/31/09


Weighted-

Average

Exercise

Price

$11.63

31,280

1.0

$11.63

31,280

$11.63

$18.66

57,082

2.0

18.66

57,082

18.66

$21.07-21.93

 115,554

8.6

21.60

 22,138

21.07

$23.41-24.01

 166,852

4.4

23.64

155,310

23.65

$28.45

  68,554

5.1

28.42

  67,524

28.45

 

439,322

5.1

22.35

333,334

22.47





73



NOTE 19:

OTHER OPERATING EXPENSE (In Thousands)


Other operating expenses included in the consolidated statements of income are as follows:


 

 

2009

2008

2007

FDIC and Other Insurance

 

 $  1,987

$     853

$     354

FDIC Special Assessment

 

787

---

---

Legal and Other Professional Fees

 

1,936

1,835

1,369

Postage

 

 1,331

 1,335

 1,332

Computer Services

 

  1,224

  1,467

  1,460

Advertising and Promotion

 

1,030

977

758

Stationery and Printing

 

980

970

926

Telephone and Communications

 

796

839

751

Intangible Asset Amortization

 

324

361

395

Charitable Contributions

 

138

124

145

Visa-Related Litigation Exposure

 

--- 

(306)

600

All Other

 

    2,437

    2,697

    2,203

  Total Other Operating Expense

 

$12,970

$11,152

$10,293

 

 

 

 

 


NOTE 20:

INCOME TAXES (In Thousands)


The provision for income taxes is summarized below:

  

Current Tax Expense:

 

2009

2008

2007

  Federal

 

$8,178

$6,263

$5,421

  State

 

    907

    533

    365

    Total Current Tax Expense

 

 9,085

 6,796

 5,786

Deferred Tax Expense

 

 

 

 

  Federal

 

579

1,852

 867

  State

 

     126

     351

     154

    Total Deferred Tax Expense

 

     705

  2,203

  1,021

      Total Provision for Income Taxes

 

$9,790

$8,999

$6,807

 

The provisions for income taxes differed from the amounts computed by applying the U.S. Federal Income Tax Rate of 35% for 2009, 2008 and 2007 to pre-tax income as a result of the following:


 

 

2009

2008

2007

Computed Tax Expense at Statutory Rate

 

$11,054

$10,303

$8,449

Increase (Decrease) in Income Taxes Resulting From:

 

 

 

 

  Tax-Exempt Income

 

(2,117)

(2,026)

(2,068)

  Nondeductible Interest Expense

 

178

199

258

  State Taxes, Net of Federal Income Tax Benefit

 

671

575

338

  Other Items, Net

 

          4 

       (52)

   (170)

    Total Provision for Income Taxes

 

$ 9,790

$ 8,999

$6,807

 


The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2009 and 2008 are presented below:


Deferred Tax Assets:

 

2009

2008

  Allowance for Loan Losses

 

$ 5,446

$ 5,144

  Pension and Deferred Compensation Plans

 

3,747

3,631

  Pension Liability (Included in Accumulated Other Comprehensive Income)

 

6,417

7,766

  Other

 

     530

     980

    Total Gross Deferred Tax Assets

 

16,140

17,521

 

 

 

 

Deferred Tax Liabilities:

 

 

 

  Pension Plans

 

7,093

6,983

  Depreciation

 

845

750

  Deferred Income

 

2,704

2,639

  Net Unrealized Gains on Securities Available-for-Sale included in

     Accumulated Other Comprehensive Income

 

2,067

1,596

  Goodwill

 

  3,154

  2,757

    Total Gross Deferred Tax Liabilities

 

 15,863

 14,725

    Net Deferred Tax Assets (Included in Other Assets)

 

$    277

$ 2,796

 

 

 

 





74



NOTE 20:

INCOME TAXES (Continued)


Management believes that the realization of the recognized net deferred tax assets at December 31, 2009 and 2008 is more likely than not, based on existing loss carryback ability, available tax planning strategies and expectations as to future taxable income.  Accordingly, there was no valuation allowance for deferred tax assets as of December 31, 2009 and 2008.

At January 1, 2009 and for the period ended December 31, 2009, Arrow had no unrecognized tax benefits.  Interest and penalties are recorded as a component of the provision for income taxes, if any.  During 2008, the Internal Revenue Service completed an examination of our 2006 federal income tax return, which resulted in an additional payment of $38.  Tax years 2007 through 2009 are subject to examination.  During 2007, the New York State Department of Taxation and Finance conducted an examination of our 2003, 2004 and 2005 bank franchise tax returns, which concluded with no adjustments.  Tax years 2006 through 2009 are subject to New York State examination.


NOTE 21:

LEASE COMMITMENTS (In Thousands)


At December 31, 2009, Arrow was obligated under a number of noncancellable operating leases for buildings and equipment.  Certain of these leases provide for escalation clauses and contain renewal options calling for increased rentals if the lease is renewed.

Future minimum lease payments on operating leases at December 31, 2009 were as follows:


 

Operating

Leases

2010

$   344

2011

345

2012

350

2013

356

2014

356

Later Years

  1,074

Total Minimum Lease Payments

$2,825


Arrow leases three of its branch offices, at market rates, from Stewart’s Shops Corp.  Gary Dake, President of Stewart’s Shops Corp., serves on both the boards of Arrow and Saratoga National Bank and Trust Company.   Arrow will lease an additional office from Stewart’s in 2010.


NOTE 22:

FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND CONTINGENT LIABILITIES

(In Thousands)


Arrow is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit and standby letters of credit.  Commitments to extend credit include home equity lines of credit, commitments for residential and commercial construction loans and other personal and commercial lines of credit.  Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.  The contract or notional amounts of those instruments reflect the extent of the involvement Arrow has in particular classes of financial instruments.

Arrow's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments.  Arrow uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

Commitments to extend credit were $183,189 and $160,559 at December 31, 2009 and 2008, respectively.  These commitments are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  Arrow evaluates each customer's creditworthiness on a case-by-case basis.  Home equity lines of credit are secured by residential real estate.  Construction lines of credit are secured by underlying real estate.  For other lines of credit, the amount of collateral obtained, if deemed necessary by Arrow upon extension of credit, is based on management's credit evaluation of the counterparty.  Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties.  Most of the commitments are variable rate instruments.

Arrow does not issue any guarantees that would require liability-recognition or disclosure, other than its standby letters of credit.

Arrow has issued conditional commitments in the form of standby letters of credit to guarantee payment on behalf of a customer and guarantee the performance of a customer to a third party.  Standby letters of credit generally arise in connection with lending relationships. The credit risk involved in issuing these instruments is essentially the same as that involved in extending loans to customers. Contingent obligations under standby letters of credit totaled $14,710 and $15,095 at December 31, 2009 and 2008, respectively, and represent the maximum potential future payments Arrow could be required to make.  Typically, these instruments have terms of 12 months or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements.  Each customer is evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit and on-balance sheet instruments.  Company policies governing loan collateral apply to standby letters of credit at the time of credit extension.  Loan-to-value ratios will generally range from 50% for movable assets, such as inventory, to 100% for liquid assets, such as bank CD's.  Fees for standby letters of credit range from 1% to 3% of the notional amount.  Fees are collected upfront and amortized over the life of the commitment.  The carrying amount and fair value of Arrow's standby letters of credit at December 31, 2009 and 2008 were insignificant.  The fair value of standby letters of credit is based on the fees currently charged for similar agreements or the cost to terminate the arrangement with the counterparties.



75



NOTE 22:

FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND CONTINGENT LIABILITIES (Continued)


The fair value of commitments to extend credit is determined by estimating the fees to enter into similar agreements, taking into account the remaining terms and present creditworthiness of the counterparties, and for fixed rate loan commitments, the difference between the current and committed interest rates.  Arrow provides several types of commercial lines of credit and standby letters of credit to its commercial customers.  The pricing of these services is not isolated as Arrow considers the customer's complete deposit and borrowing relationship in pricing individual products and services.  The commitments to extend credit also include commitments under home equity lines of credit, for which Arrow charges no fee.  The carrying value and fair value of commitments to extend credit are not material and Arrow does not expect to incur any material loss as a result of these commitments.

In the normal course of business, Arrow and its subsidiary banks become involved in a variety of routine legal proceedings.  At present, there are no legal proceedings pending or threatened, which in the opinion of management and counsel, would result in a material loss to Arrow.


NOTE 23:

FAIR VALUE OF FINANCIAL INSTRUMENTS (In Thousands)


FASB ASC Subtopic 820-10 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP) and requires certain disclosures about fair value measurements.  We do not have any nonfinancial assets or liabilities measured at fair value. The only assets or liabilities that Arrow measured at fair value on a recurring basis at December 31, 2009 and 2008 were securities available-for-sale.  Arrow held no securities or liabilities for trading on such date.  For information on fair value measurements, including descriptions of level 1, 2 and 3 of the fair value hierarchy and the valuation methods employed by Arrow, see Note 1 - “Summary of Significant Accounting Policies.”  The fair value measurement of securities available-for-sale on such date was as follows:


 

 

Fair Value Measurements at Reporting Date Using:

Description

Total

Quoted Prices

In Active Markets for Identical Assets

(Level 1)

Significant Other

Observable Inputs

(Level 2)

Significant Unobservable Inputs

(Level 3)

December 31, 2009:

 

 

 

 

Securities Available-for Sale:

 

 

 

 

U.S. Treasury and Agency Obligations

$123,331

$---

$123,331

$    ---

State and Municipal Obligations

18,913

---

18,913

---

Collateralized Mortgage Obligations

199,781

---

199,781

---

Mortgage-Backed Securities - Residential

93,017

---

93,017

---

Corporate and Other Debt Securities

1,331

---

1,026

305

Mutual Funds and Equity Securities

      1,333

  ---

       1,333

     ---

  Total Securities Available-for-Sale

$437,706

$---

$437,401

$305

 

 

 

 

 

December 31, 2008:

 

 

 

 

Securities Available-for Sale:

 

 

 

 

U.S. Treasury and Agency Obligations

$ 11,528

$---

$ 11,528

$   ---

State and Municipal Obligations

15,446

---

15,446

---

Collateralized Mortgage Obligations

185,830

---

185,830

---

Mortgage-Backed Securities - Residential

93,849

---

93,849

---

Corporate and Other Debt Securities

7,433

---

6,878

555

Mutual Funds and Equity Securities

      1,328

  ---

      1,328

     ---

  Total Securities Available-for Sale

$315,414

$---

$314,859

$555


Securities available-for-sale are fair valued utilizing an independent bond pricing service for identical assets or significantly similar securities.  The pricing service uses a variety of techniques to arrive at fair value including market maker bids, quotes and pricing models.  Inputs to the pricing models include recent trades, benchmark interest rates, spreads and actual and projected cash flows.  There were no assets or liabilities measured at fair value on a nonrecurring basis at December 31, 2009.  


Level 3 securities available-for-sale at December 31, 2009, in the table above, included one trust preferred pooled security.   In our analysis of fair value, we determined that the market for this security was inactive.  We reviewed the collateral within the pool and performed a discounted cash flow analysis using additional value estimates from unobservable inputs including expected cash flows after estimated deferrals and defaults.  The discount rate used was based on a market based rate of return including an assumed risk premium for securities with similar credit characteristics plus a market price adjustment for the small size and lack of an established market for this type of security.





76



NOTE 23:

FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)


Level 3 securities available-for-sale at December 31, 2008, in the table above, included a Lehman Brothers bond and a  trust preferred pooled security.   We employed the following methods in our analysis of the fair values:


a) Lehman bond - since Lehman Brothers declared bankruptcy on September 15, 2008, the market for this bond has been very illiquid. The price provided by our third-party pricing service reflected values from distressed sales that have occurred, which we have determined do not reflect the fair value of this security. We obtained additional value estimates from unobservable inputs including an estimated future recovery range of values, an estimated future recovery period and an estimated risk premium for securities with similar credit characteristics.   Based on using the median price from the estimated recovery price range obtained, and a discount rate including the estimated risk premium obtained, we performed a discounted cash flow analysis to determine the fair value at December 31, 2008;


b) Trust preferred pooled security - due to the fact that the market for this security was inactive, we performed a discounted cash flow analysis in addition to reviewing the price provided to us by our third-party pricing service in order to determine a fair value estimate for this security as of December 31, 2008. In performing the discounted cash flow analysis, we obtained additional value estimates from unobservable inputs including expected cash flows and a market based rate of return including an assumed risk premium for securities with similar credit characteristics plus a market price adjustment for the small size and lack of an established market for this type of security. We determined the fair value for this security at December 31, 2008 to be the lower of the fair value obtained from our third-party pricing service and our discounted cash flow analysis.


The following table is a reconciliation of the beginning and ending balances for 2009 and 2008 of the Level 3 assets of Arrow, i.e., as to which fair value is measured using significant unobservable inputs, all of which are securities available-for-sale:


 

2009

2008

Beginning Balance

$555 

$     --- 

Transfers In

--- 

1,006 

Principal payment received

(23)

(5)

Purchases, issuances and settlements

(340)

--- 

Total net losses (realized/unrealized):

 

 

Included in earnings    

(60)

--- 

Included in earnings, as a result of other-than-temporary impairment

--- 

(400)

Included in other comprehensive income

  173 

    (46)

Ending Balance

$305 

$  555 

The amount of total losses for the year included in earnings attributable to the change in unrealized gains or losses relating to assets still held at period-end, as a result of other-than-temporary impairment

$--- 

$(1,610)


There were no assets or liabilities that Arrow measured at fair value on a nonrecurring basis on December 31, 2009.  The only asset or liability that Arrow measured at fair value on a nonrecurring basis at December 31, 2008 was other real estate owned:


 

 

Fair Value Measurements Using:

 

Description

Period

Ended

12/31/2008

Quoted Prices

In Active

Markets for

Identical Assets

(Level 1)

Significant

Other

Observable

Inputs

(Level 2)

Significant

Unobservable

Inputs

(Level 3)

Total

Gains

(Losses)

Other Real Estate Owned

$142

---

$142

---

---


Other real estate owned, in the table above, consists of one property acquired during the first quarter of 2008.  Fair value was obtained from an appraisal by an independent third party appraiser and was based on a comparison to recent sales of similar properties and the fact that we are improving the property, prior to sale.  The charge to reduce the property to its fair value, less estimated cost to sell, was recorded as a loan charge-off, prior to the transfer to other real estate owned.

Other impaired assets which might have been included in this table include mortgage servicing rights, goodwill and other intangible assets.  Arrow evaluates each of these assets for impairment on a quarterly basis, with no impairment recognized for these assets at December 31, 2009.  




77



NOTE 23:

FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)


The following table presents a summary at December 31 of the carrying amount and fair value of Arrow’s financial instruments not carried at fair value or an amount approximating fair value:


 

 

2009

2008

 

 

Carrying

Amount

Fair

Value

Carrying

Amount

Fair

Value

Securities Held-to-Maturity (Note 3)

 

$  168,931

$  171,183

$  133,976

$  134,331

Net Loans (Note 4)

 

1,098,136

1,115,414

1,096,540

1,111,411

Time Deposits (Note 9)

 

393,001

400,421

403,698

411,853

FHLBNY Advances (Note 11)

 

140,000

147,754

160,000

171,287

Junior Subordinated Obligations Issued to

   Unconsolidated Subsidiary Trusts (Note 12)

 

20,000

20,000

20,000

20,000

Accrued Interest Receivable

 

7,115

7,115

6,611

6,611

Accrued Interest Payable

 

2,257

2,257

2,966

2,966


Securities held-to-maturity are fair valued utilizing an independent bond pricing service for identical assets or significantly similar securities.  The pricing service uses a variety of techniques to arrive at fair value including market maker bids, quotes and pricing models.  Inputs to the pricing models include recent trades, benchmark interest rates, spreads and actual and projected cash flows.

Fair values for loans are estimated for portfolios of loans with similar financial characteristics.  Loans are segregated by type such as commercial, commercial real estate, residential mortgage, indirect and other consumer loans.  Each loan category is further segmented into fixed and adjustable interest rate terms and by performing and nonperforming categories.  The fair value of performing loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan.  The estimate of maturity is based on historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions.   Fair value for nonperforming loans is generally based on recent external appraisals.  If appraisals are not available, estimated cash flows are discounted using a rate commensurate with the risk associated with the estimated cash flows.  Assumptions regarding credit risk, cash flows and discount rates are judgmentally determined using available market information and specific borrower information.

The fair value of time deposits is based on the discounted value of contractual cash flows, except that the fair value is limited to the extent that the customer could redeem the certificate after imposition of a premature withdrawal penalty.  The discount rates are estimated using the FHLBNY yield curve, which is considered representative of Arrow’s time deposit rates.

The fair value of FHLBNY advances is estimated based on the discounted value of contractual cash flows.  The discount rate is estimated using current rates on FHLBNY advances with similar maturities and call features.

Based on Arrow’s capital adequacy, the book value of the outstanding trust preferred securities (Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts) are considered to approximate fair value since the interest rates are variable (indexed to LIBOR) and Arrow is well-capitalized.


NOTE 24:

CONCENTRATIONS OF CREDIT RISK


Most of Arrow's loans are with customers in northeastern New York.  Although the loan portfolios of the subsidiary banks are well diversified, tourism has a substantial impact on the northeastern New York economy.  The commitments to extend credit are fairly consistent with the distribution of loans presented in Note 4.  Generally, the loans are secured by assets and are expected to be repaid from cash flow or the sale of selected assets of the borrowers.  Arrow evaluates each customer's creditworthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary by Arrow upon extension of credit, is based upon management's credit evaluation of the counterparty.  The nature of the collateral varies with the type of loan and may include:  residential real estate, cash and securities, inventory, accounts receivable, property, plant and equipment, income producing commercial properties and automobiles.


NOTE 25:

PARENT ONLY FINANCIAL INFORMATION (In Thousands)


Condensed financial information for Arrow Financial Corporation is as follows:

BALANCE SHEETS

 

December 31,

ASSETS

 

2009 

2008 

Interest-Bearing Deposits with Subsidiary Banks

 

$    1,662 

$    1,389 

Securities Available-for-Sale

 

1,413 

1,373 

Securities Held-to-Maturity

 

1,000 

--- 

Investment in Subsidiaries at Equity

 

161,810 

148,009 

Other Assets

 

      3,334 

      3,069 

  Total Assets

 

$169,219 

$153,840 

 

 

 

 

LIABILITIES

 

 

 

Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts

 

$ 20,000 

$ 20,000 

Other Liabilities

 

     8,401 

     8,038 

  Total Liabilities

 

 28,401 

 28,038 

STOCKHOLDERS’ EQUITY

 

 

 

  Total Stockholders’ Equity

 

  140,818 

  125,802 

  Total Liabilities and Stockholders’ Equity

 

$169,219 

$153,840 




78



NOTE 25:

 PARENT ONLY FINANCIAL INFORMATION (Continued)

  

STATEMENTS OF INCOME

 

Years Ended December 31,

Income:

 

2009

2008

2007

  Dividends from Bank Subsidiaries

 

$11,500 

$13,919

$15,850

  Interest and Dividends on Securities Available-for-Sale

 

100 

42

31

  Other Income (Including Management Fees)

 

  1,305 

  784

  665

  Other-Than-Temporary Impairment on Securities Available-for-Sale

 

(375)

---

---

  Net Gains on the Sale of Securities Available-for-Sale

 

        15 

        10

         ---

    Total Income

 

 12,545 

 14,755

 16,546

 

 

 

 

 

Expense:

 

 

 

 

  Interest Expense

 

774

1,356

1,547

  Salaries and Benefits

 

  211

  199

  138

  Other Expense

 

      884

       821

      698

    Total Expense

 

   1,869

    2,376

   2,383

Income Before Income Tax Benefit and Equity

 

 

 

 

  in Undistributed Net Income of Subsidiaries

 

10,676

12,379

14,163

Income Tax Benefit

 

       482

       744

       782

Income Before Equity in Undistributed

 

 

 

 

  Net Income of Subsidiaries

 

11,158

13,123

14,945

Equity in Undistributed Net Income of Subsidiaries

 

  10,634

    7,314

    2,387

Net Income

 

$21,792

$20,437

$17,332


The Statement of Changes in Stockholders’ Equity is not reported because it is identical to the Consolidated Statement of Changes in Stockholders’ Equity.


STATEMENTS OF CASH FLOWS

Years Ended December 31,

 

2009

2008

2007

Cash Flows from Operating Activities:

 

 

 

Net Income

$21,792 

$20,437 

$17,332 

Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities:

 

 

 

Undistributed Net Income of Subsidiaries

(10,634)

(7,314)

(2,387)

Other-Than-Temporary Impairment

375 

--- 

--- 

Net Gains on the Sale of Securities Available-for-Sale

(15)

(10)

 --- 

Shares Issued Under the Directors’ Stock Plan

116 

121 

140 

Stock-Based Compensation Expense

189 

115 

70 

Changes in Other Assets and Other Liabilities

      525 

      498 

      659 

Net Cash Provided by Operating Activities

 12,348 

 13,847 

 15,814 

Cash Flows from Investing Activities:

 

 

 

Proceeds from the Sale of Securities Available-for-Sale

109 

 86 

  8 

Purchases of Securities Available-for-Sale

   (1,278)

     (396)

     (156)

Net Cash Used in Investing Activities

   (1,169)

     (310)

     (148)

Cash Flows from Financing Activities:

 

 

 

Treasury Stock Issued for Stock-Based Plans

 1,644 

 1,604 

 1,544 

Treasury Stock Issued for Dividend Reinvestment Plans

1,658 

430 

--- 

Tax Benefit from Exercise of Stock Options

193 

176 

164 

Purchase of Treasury Stock

(3,761)

(4,325)

(7,303)

Cash Dividends Paid

 (10,640)

 (10,330)

 (10,027)

Net Cash Used in Financing Activities

(10,906)

(12,445)

(15,622)

Net Increase in Cash and Cash Equivalents

273 

1,092 

44 

Cash and Cash Equivalents at Beginning of the Year

    1,389 

       297 

       253 

Cash and Cash Equivalents at End of the Year

$  1,662 

$  1,389 

$     297 

 

 

 

 

Supplemental Disclosures to Statements of

  Cash Flow Information:

 

 

 

Interest Paid

$   774 

$1,356 

$1,547 

Non-cash Investing and Financing Activities:

 

 

 

    Changes in the Valuation Allowance for Securities Available-for-Sale, Net of Tax

718 

(2,468)

3,707 

    Shares Issued for Acquisition of Subsidiary

542 

112 

111 

    ESOP Note

--- 

(1,000)

(1,500)

    Surplus Adjustment for Allocated ESOP Shares

151 

250 

200 

    Allocation of Common Stock Purchased by ESOP

368 

470 

320 

    Change in Retirement Plan Net Loss and Prior Service Cost, Net of Tax

2,046 

(6,983)

(616)

 



79



SUMMARY OF QUARTERLY FINANCIAL DATA (Unaudited)


The following quarterly financial information for 2009 and 2008 is unaudited, but, in the opinion of management, fairly presents the results of Arrow.  


SELECTED QUARTERLY FINANCIAL DATA

(In Thousands, Except Per Share Amounts)


 

 

2009

 

 

First

Quarter

Second

Quarter

Third

Quarter

Fourth

Quarter

Total Interest and Dividend Income

 

$21,523 

$21,501 

$21,664 

$22,169 

Net Interest Income

 

14,731 

14,785 

15,202 

15,647 

Provision for Loan Losses

 

502 

419 

427 

435 

Net Securities Gains

 

277 

4 

48 

28 

Income Before Provision for Income Taxes

 

9,823 

7,091 

7,350 

7,318 

Net Income

 

6,682 

4,931 

5,062 

5,117 

 

 

 

 

 

 

Basic Earnings Per Common Share

 

$.61 

$ .45 

$.46 

$ .47 

Diluted Earnings Per Common Share

 

.61 

 .45 

.46 

 .47 


 

 

2008

 

 

First

Quarter

Second

Quarter

Third

Quarter

Fourth

Quarter

Total Interest and Dividend Income

 

$22,082 

$22,115 

$22,592 

$22,719 

Net Interest Income

 

12,787 

14,364 

14,902 

15,178 

Provision for Loan Losses

 

290 

248 

253 

880 

Net Securities (Losses) Gains

 

--- 

(35)

6 

412 

Income Before Provision for Income Taxes

 

7,165 

7,888 

7,206 

7,177 

Net Income

 

4,981 

5,436 

5,008 

5,012 

 

 

 

 

 

 

Basic Earnings Per Common Share

 

$.45 

$.50 

$.46 

$.46 

Diluted Earnings Per Common Share

 

.45 

 .50 

.46 

 .46 


Item 9.  Changes in and Disagreements With Accountants on Accounting and Financial Disclosure - None.


Item 9A.  Controls and Procedures


Senior management maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods provided in the SEC's rules and forms, and that such information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.  In designing and evaluating the disclosure controls and procedures, senior management has recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and therefore has been required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.


Senior management, including the Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13(a)-15(e) under the Exchange Act) as of December 31, 2009.  Based upon that evaluation, senior management, including the Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective on that date.  There were no changes made in our internal controls or in other factors that could significantly affect these internal controls subsequent to the date of the evaluation performed by the Chief Executive Officer and Chief Financial Officer.


Management’s Report on Internal Control Over Financial Reporting


Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an assessment of the effectiveness of our internal control over financial reporting.  Our evaluation is based on the framework set forth in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our assessment, our management concluded that our internal control over financial reporting was effective as of December 31, 2009.



Item 9B. Other Information – None.



80



PART III


Item 10.  Directors, Executive Officers and Corporate Governance


The information required by this item regarding directors and nominees for directors and the Company's committees is set forth under the captions "Information Regarding Director Nominees and our Continuing Board of Directors," “Qualifications of the Board of Directors” and "Board Committees" of Arrow's Proxy Statement for its Annual Meeting of Shareholders to be held April 28, 2010 (the Proxy Statement), which sections are incorporated herein by reference.  Information regarding Compliance with Section 16(a) of the Exchange Act is set forth in the Company's Proxy Statement under the caption "Section 16(a) Beneficial Ownership Reporting Compliance" and is incorporated herein by reference.  Certain required information regarding our Executive Officers is contained in Part I, Item 1.G., of this Report, "Executive Officers of the Registrant."  Arrow has adopted a Financial Code of Ethics applicable to our principal executive officer, principal financial officer and principal accounting officer, a copy of which can be found on our website at www.arrowfinancial.com<http://www.arrowfinancial.com/> under the link "Corporate Governance."


Item 11.  Executive Compensation


The information required by this item is set forth under the captions "Compensation Discussion and Analysis, "Executive Compensation," "Summary Compensation Table," "Grants of Plan-Based Awards Table," "Outstanding Equity Awards at Fiscal Year-End Table," "Option Exercises and Stock Vested Table," "Pension Plans," "Pension Benefits Table," "Nonqualified Deferred Compensation Table," "Agreements with Executive Officers," "Potential Payments to Executives upon  Termination or Change-in-Control,"  "Compensation of Directors," "Director Compensation Table,"  "Compensation Committee Report, " and "Compensation Committee Interlocks and Insider Participation" of the Proxy Statement, which sections are incorporated herein by reference.


Item 12.  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters


Certain information required by this item is set forth under the caption "Ownership of Our Common Stock" of the Proxy Statement, which section is incorporated herein by reference, and in the section entitled "Equity Compensation Plan Information" in Part II of this Form 10-K on page 12.


Item 13.  Certain Relationships and Related Transactions, and Director Independence


The information required by this item is set forth under the captions "Transactions with Directors, Officers and Associated Persons," "Corporate Governance,”  "Board Independence," and "Audit Committee Independence and Financial Experts" of the Proxy Statement, which sections are incorporated herein by reference.


Item 14.  Principal Accounting Fees and Services


The information required by this item is set forth under the captions "Ratification of the Independent Auditor" and "Independent Auditor's Fees" of the Proxy Statement, which sections are incorporated herein by reference.


PART IV


Item 15.  Exhibits, Financial Statement Schedules


1.  Financial Statements


The following financial statements, the notes thereto, and the independent auditors’ report thereon are filed in Part II, Item 8 of this report.  See the index to such financial statements at the beginning of Item 8.


Reports of Independent Registered Public Accounting Firm

Consolidated Balance Sheets as of December 31, 2009 and 2008

Consolidated Statements of Income for the Years Ended December 31, 2009, 2008 and 2007

Consolidated Statements of Changes in Stockholders’

   Equity for the Years Ended December 31, 2009, 2008 and 2007

Consolidated Statements of Cash Flows for the Years Ended December 31, 2009, 2008 and 2007

Notes to Consolidated Financial Statements


2.  Schedules


All schedules are omitted as the required information is either not applicable or not required or is contained in the respective financial statements or in the notes thereto.


3.  Exhibits:


See Exhibit Index on page 83



81



SIGNATURES


Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


ARROW FINANCIAL CORPORATION



Date: March 4, 2010

By   /s/ Thomas L. Hoy

Thomas L. Hoy

Chairman, President and Chief Executive Officer


Date: March 4, 2010

By:   /s/ Terry R. Goodemote

Terry R. Goodemote

Senior Vice President, Treasurer and

Chief Financial Officer

(Principal Financial and Accounting Officer)



Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 4, 2010 by the following persons in the capacities indicated.



  /s/ Herbert O. Carpenter

Herbert O. Carpenter

Director

  /s/ David G. Kruczlnicki

David G. Kruczlnicki

Director

  /s/ John J. Carusone, Jr.

John J. Carusone, Jr.

Director

  /s/ Elizabeth O’C. Little

Elizabeth O’C. Little

Director

  /s/ Michael B. Clarke

Michael B. Clarke

Director

  /s/ David L. Moynehan

David L. Moynehan

Director

  /s/ Gary C. Dake

Gary C. Dake

Director

  /s/ John J. Murphy

John J. Murphy

Director

  /s/ Mary Elizabeth T. FitzGerald

Mary Elizabeth T. FitzGerald

Director

  /s/ Richard J. Reisman, D.M.D.

Richard J. Reisman, D.M.D.

Director

  /s/ Thomas L. Hoy

Thomas L. Hoy

Director and Chairman, President and CEO

 

 

 




82



EXHIBIT INDEX


The following exhibits are incorporated by reference herein.


Exhibit

Number


Exhibit

3.(i)

Certificate of Incorporation of the Registrant, incorporated herein by reference from the Registrant’s Annual Report filed on Form 10-K for the year ended December 31, 2007, Exhibit 3.(i)

3.(ii)

By-laws of the Registrant, as amended, incorporated herein by reference from the Registrant’s Current Report on Form 8-K filed on November 24, 2009, Exhibit 3.(ii)

4.1

Amended and Restated Declaration of the Trust by and among U.S. Bank National Association, as Institutional Trustee, the Registrant, as Sponsor and certain Administrators named therein, dated as of July 23, 2003, relating to Arrow Capital Statutory Trust II, incorporated herein by reference from the Registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2003, Exhibit 4.1

4.2

Indenture between the Registrant, as Issuer, and U.S. Bank National Association, as Trustee, dated as of July 23, 2003, incorporated herein by reference from the Registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2003, Exhibit 4.2

4.3

Placement Agreement by and among the Registrant, Arrow Capital Statutory Trust II and SunTrust Capital Markets, Inc., dated July 23, 2003, incorporated herein by reference from the Registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2003, Exhibit 4.3

4.4

Guarantee Agreement by and between the Registrant and U.S. Bank National Association, dated as of July 23, 2003, incorporated herein by reference from the Registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2003, Exhibit 4.4

4.5

Amended and Restated Trust Agreement among the Registrant, as Depositor, Wilmington Trust Company, as Property Trustee, Wilmington Trust Company, as Delaware trustee, and certain Administrators named therein, dated as of December 28, 2004, relating to Arrow Capital Statutory Trust III, incorporated herein by reference from the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2004, Exhibit 4.6

4.6

Junior Subordinated Indenture between the Registrant, as Issuer, and Wilmington Trust Company, as Trustee, dated as of December 28, 2004, incorporated herein by reference from the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2004, Exhibit 4.7

4.7

Placement Agreement among the Registrant, Arrow Capital Statutory Trust III and SunTrust Capital Markets, Inc., dated December 28, 2004, incorporated herein by reference from the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2004, Exhibit 4.8

4.8

Guarantee Agreement between the Registrant and Wilmington Trust Company, dated as of December 28, 2004, incorporated herein by reference from the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2004, Exhibit 4.9

10.1


10.2

1993 Long Term Incentive Plan of the Registrant, incorporated herein by reference from Registrant’s 1933 Act Registration Statement on Form S-8, Exhibit 4.1 (File number 33-66192; filed July 19, 1993)*

1998 Long Term Incentive Plan of the Registrant, incorporated herein by reference from Registrant’s 1933 Act

Registration Statement on Form S-8, Exhibit 4.1 (File number 333-62719; filed on September 2, 1998)*

10.3

2008 Long Term Incentive Plan of the Registrant, incorporated herein by reference from the Registrant’s Current Report on Form 8-K filed on May 6, 2008, Exhibit 10.1*  

10.4

2000 Employee Stock Purchase Plan of the Registrant, incorporated herein by reference from Registrant's 1933 Act Registration Statement on Form S-3 (File number 333-47912; filed on October 13, 2000)*

10.5

Award under Schedule A of Select Executive Retirement Plan to Thomas L. Hoy, dated May 2, 2001, incorporated herein by reference from the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2001, Exhibit 10.15*

10.6

Profit Sharing Plan of the Registrant, as amended, incorporated herein by reference from the Registrant’s Annual Report filed on Form 10-K for the year ended December 31, 2008, Exhibit 10.6*

10.7

Directors’ Deferred Compensation Plan of the Registrant, as amended and restated, incorporated herein by reference from the Registrant’s Annual Report filed on Form 10-K for the year ended December 31, 2008, Exhibit 10.7*

10.8

Directors’ Stock Plan of the Registrant, as amended, incorporated herein by reference from the Registrant’s Annual Report filed on Form 10-K for the year ended December 31, 2008, Exhibit 10.8*

10.9

Select Executive Retirement Plan of the Registrant for benefits accrued or vested after December 31, 2004, as amended and restated, incorporated herein by reference from the Registrant’s Annual Report filed on Form 10-K for the year ended December 31, 2008, Exhibit 10.9*

10.10

Select Executive Retirement Plan of the Registrant for benefits accrued or vested on or before December 31, 2004, as amended and restated, incorporated herein by reference from the Registrant’s Annual Report filed on Form 10-K for the year ended December 31, 2008, Exhibit 10.10*

10.11

Senior Officers Deferred Compensation Plan of the Registrant, as amended, incorporated herein by reference from the Registrant’s Annual Report filed on Form 10-K for the year ended December 31, 2008, Exhibit 10.11*

10.12

Short Term Incentive Plan of the Registrant, as amended, incorporated herein by reference from the Registrant’s Annual Report filed on Form 10-K for the year ended December 31, 2008, Exhibit 10.12*

10.13

Employment Agreement among the Registrant, its subsidiary bank, Glens Falls National Bank and Trust Company, and Thomas L. Hoy, dated December 22, 2009, incorporated herein by reference from the Registrant’s Current Report on Form 8-K filed on December 22, 2009, Exhibit 10.1*




83




Exhibit

Number


Exhibit

10.14

Employment Agreement among the Registrant, its subsidiary bank, Glens Falls National Bank and Trust Company, and Terry R. Goodemote, dated December 22, 2009, incorporated herein by reference from the Registrant’s Current Report on Form 8-K filed on December 22, 2009, Exhibit 10.2*

10.15

Amended and Restated Consulting Agreement by and between the Registrant and John J. Murphy, dated December 29, 2008, incorporated herein by reference from the Registrant’s Annual Report filed on Form 10-K for the year ended December 31, 2008, Exhibit 10.16*

10.16

Form of Incentive Stock Option Certificate (Employee Award) of the Registrant, incorporated herein by reference from the Registrant’s Quarterly Report filed on Form 10-Q for the quarter ended June 30, 2009, Exhibit 10.1*

10.17

Form of Non-Qualified Stock Option Certificate (Employee Award) of the Registrant, incorporated herein by reference from the Registrant’s Quarterly Report filed on Form 10-Q for the quarter ended June 30, 2009, Exhibit 10.2*

10.18

Form of Non-Qualified Stock Option Certificate (Director Award) of the Registrant, incorporated herein by reference from the Registrant’s Quarterly Report filed on Form 10-Q for the quarter ended June 30, 2009, Exhibit 10.3*

14

Financial Code of Ethics, incorporated herein by reference from the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2003, Exhibit 14

 

 

 

* Management contracts or compensation plans required to be filed as an exhibit.



84



The following exhibits are submitted herewith:



Exhibit

Number


Exhibit

10.19

Employment Agreement among the Registrant, its subsidiary bank, Saratoga National Bank and Trust Company, and  Raymond F. O’Conor, dated December 22, 2009*

10.20

Employment Agreement among the Registrant, its subsidiary bank, Glens Falls National Bank and Trust Company, and  David S. DeMarco, dated December 22, 2009*

10.21

Change of Control Agreement among the Registrant, its subsidiary bank, Glens Falls National Bank and Trust Company, and Thomas J. Murphy, dated December 22, 2009*

21

Subsidiaries of Arrow Financial Corporation

23

Consent of Independent Registered Public Accounting Firm

31.1

Certification of Chief Executive Officer under SEC Rule 13a-14(a)/15d-14(a)

31.2

Certification of Chief Financial Officer under SEC Rule 13a-14(a)/15d-14(a)

32

Certification of Chief Executive Officer under 18 U.S.C. Section 1350 and Certification of Chief Financial Officer under 18 U.S.C. Section 1350

 

 

 

* Management contracts or compensation plans required to be filed as an exhibit.

 



85