-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, UShRbBUq9/D6nJz77lW87JN8NJbB8N7gv0Yboye7d2yHB2Ji7uYehDQixyaQL3RR naPYM/lFBBcOrf9Gh5kZ7Q== 0000893220-03-002087.txt : 20031223 0000893220-03-002087.hdr.sgml : 20031223 20031223134720 ACCESSION NUMBER: 0000893220-03-002087 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 20030930 FILED AS OF DATE: 20031223 FILER: COMPANY DATA: COMPANY CONFORMED NAME: FIRST KEYSTONE FINANCIAL INC CENTRAL INDEX KEY: 0000856751 STANDARD INDUSTRIAL CLASSIFICATION: SAVINGS INSTITUTION, FEDERALLY CHARTERED [6035] IRS NUMBER: 232576479 STATE OF INCORPORATION: PA FISCAL YEAR END: 0930 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-25328 FILM NUMBER: 031070360 BUSINESS ADDRESS: STREET 1: 22 WEST STATE ST CITY: MEDIA STATE: PA ZIP: 19063 BUSINESS PHONE: 6105656210 10-K 1 w92688e10vk.txt FORM 10-K FIRST KEYSTONE FINANCIAL, INC. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE YEAR ENDED SEPTEMBER 30, 2003 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER: 0-25328 FIRST KEYSTONE FINANCIAL, INC. (Exact name of registrant as specified in its charter) PENNSYLVANIA 23-0469351 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification Number) 22 WEST STATE STREET, MEDIA, PENNSYLVANIA 19063 (Address of principal executive office) (Zip Code) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (610) 565-6210 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NOT APPLICABLE SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK (PAR VALUE $.01 PER SHARE) Indicate by check mark whether the Registrant (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 126-2). Yes [ ] No [X] The aggregate market value of the shares of Common Stock of the Registrant issued and outstanding on December 10, 2003, which excludes 369,970 shares held by all directors and officers of the Registrant as a group, was approximately $31.8 million. This figure is based on the closing price of $20.98 per share of the Registrant's Common stock on March 31, 2003, the last business day of the Registrant's second fiscal quarter. Number of shares of Common Stock outstanding as of December 10, 2003: 1,886,897 DOCUMENTS INCORPORATED BY REFERENCE Listed hereunder are the documents incorporated by reference and the Part of the Form 10-K into which the document is incorporated: (1) Portions of the definitive proxy statement for the 2003 Annual Meeting of Stockholders are incorporated into Part III. FIRST KEYSTONE FINANCIAL, INC. FORM 10-K FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 2003 INDEX
Page ---- PART I Item 1. Business 1 Item 2. Properties 37 Item 3. Legal Proceedings 38 Item 4. Submission of Matters to a Vote of Security Holders 38 PART II Item 5. Market for Registrant's Common Stock and Related Stockholder Matters 38 Item 6. Selected Financial Data 40 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 42 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 54 Item 8. Financial Statements and Supplementary Data 55 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures 82 Item 9A. Control and Procedures 82 PART III Item 10. Directors and Executive Officers of the Registrant 82 Item 11. Executive Compensation 82 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 83 Item 13. Certain Relationships and Related Transactions 83 Item 14. Principal Accounting Fees and Services 83 PART IV Item 15. Exhibits, Financial Statement Schedules, and Reports of Form 8-K 83 SIGNATURES 86
[This page left blank intentionally] PART I. ITEM 1. BUSINESS. GENERAL First Keystone Financial, Inc. (the "Company") is a Pennsylvania corporation and sole shareholder of First Keystone Bank, a federally chartered stock savings bank (the "Bank"), which converted to the stock form of organization in January 1995. The only significant assets of the Company are the capital stock of the Bank, the Company's loan to its employee stock ownership plan, and various equity and other investments. See Note 18 of the Notes to Consolidated Financial Statements for the fiscal year ended September 30, 2003 set forth in Item 8, "Financial Statements and Supplementary Data." The business of the Company primarily consists of the business of the Bank. The Bank is a community oriented bank emphasizing customer service and convenience. The Bank's primary business is attracting deposits from the general public and using those funds together with other available sources of funds, primarily borrowings, to originate loans. A substantial portion of the Bank's deposits are comprised of core deposits consisting of NOW, non-interest-bearing accounts, money market ("MMDA") and passbook. Core deposits amounted to $184.1 million or 50.8% of the Bank's total deposits at September 30, 2003. The Bank's primary lending emphasis is the origination of loans secured by first and second liens on single-family (one-to-four units) residences located in Delaware and Chester Counties, Pennsylvania and to a lesser degree, Montgomery County, Pennsylvania and New Castle County, Delaware. The Bank originates residential first mortgage loans with either fixed and/or adjustable rates. Adjustable-rate loans are retained for the Bank's portfolio while fixed-rate loans may be sold in the secondary market depending on the Bank's asset/liability strategy, cash flow needs and current market conditions. The Bank also originates for portfolio, due to their generally shorter terms, adjustable or variable interest rates and generally higher yields, loans secured by commercial and multi-family residential real estate properties as well as residential and commercial construction loans secured by properties located in the Bank's market area. The Bank's management, however, remains focused on its long-term strategic plan to continue to shift to its loan composition toward commercial business, construction and home equity loans and lines of credit in order to provide a higher yielding portfolio with generally shorter terms. This effort to keep shorter term loans in portfolio resulted in a $5.9 million increase in outstanding balances in home equity loans and equity lines of credit at fiscal year end, representing a 21.3% increase in this category compared to the previous fiscal year. Multi-family residential and commercial real estate loans amounted to $59.0 million or 19.7% of the total loan portfolio at September 30, 2003 as compared to $60.4 million or 19.9% at September 30, 2002. The Bank has on occasion purchased loan participation interests in both residential and commercial real estate loans depending on market conditions and portfolio needs, although no such purchases were made during the fiscal year ended September 30, 2003. In addition to its deposit gathering and lending activities, the Bank invests in mortgage-related securities, which are issued or guaranteed by U.S. Government agencies and government sponsored or private enterprises, as well as U.S. Treasury and federal government agency obligations, corporate bonds and municipal obligations. At September 30, 2003, the Bank's mortgage-related securities (both available for sale and held to maturity) amounted to $128.2 million, or 22.9% of the Company's total assets, and investment securities (both available for sale and held to maturity) amounted to $84.0 million, or 15.0% of total assets. 1 MARKET AREA AND COMPETITION The Bank's primary market area is in Delaware and Chester Counties, which is located in the southeastern corner of Pennsylvania between two metropolitan areas, Philadelphia, Pennsylvania and Wilmington, Delaware. There is easy access to I-95, the Philadelphia International Airport and the Delaware River. The Bank is fortunate to be located in such a desirable geographic area. New York City is just 92 miles away from the Bank's headquarters in Media, Pennsylvania, Baltimore, Maryland is only 80 miles away, and the distance to Washington, DC is just 127 miles. Through an extensive highway and telecommunications network, the Delaware County's economy is knitted tightly into a regional economy of more than 2.5 million workers. Census 2000 lists Delaware County as having 14,394 business establishments with the number of jobs in the County (258,922) at an all time high. Most of the businesses are in corporate and professional services, distributive services and the manufacturing sector. Census 2000 shows Delaware County has a large, well-educated, and skilled local labor force of 258,782. Nearly one quarter of the County's population is 25 years or older and has earned a four-year college degree. The total number of people employed as executives, managers, professionals, and technicians is 101,646. Philadelphia's central location in the Northeast corridor, infrastructure and other factors has made the Bank's market area attractive to many large corporate employers including Comcast Corp., Boeing, State Farm Insurance, United Parcel Service, PECO Energy, SAP America, Inc., Wawa and many others. The Philadelphia area economy is typical of many large Northeastern cities where the traditional manufacturing based economy has declined and has been replaced by the service sector including the health care market. Crozer/Keystone Health System and Mercy Health Corp are amongst the larger employers within the Bank's market area. According to the Delaware County Chamber of Commerce, there are 82 degree-granting institutions and 47,000 graduates annually in the region, representing more colleges and universities than any other area in the United States. Delaware County also has one of the nation's lowest unemployment rates and one of the most active Chamber of Commerce Offices in the State. The U.S. Small Business Administration, Philadelphia District Office, named the Delaware County Chamber the Eastern Region Chamber of the Year in 2001. This is the second time the Chamber received this level of recognition. According to the 2000 Census, the population of Delaware County is 550,864, a modest 0.6% increase since 1990. During the year 2000, Delaware County Planning Commission reviewed proposals for almost twice as many residential units compared to 1997. Due to the availability of land still suitable for development, the majority of this growth has occurred in the western part of Delaware County, and its contiguous neighbor Chester County. The Bank had benefited from this growth with the opening of its Chester Heights office in December 1999 which has exceeded the Company's deposit and consumer loan projections. Chester County's continual growth is expected to increase further in the next decade. The communities in Chester County that are experiencing growth are East Marlborough Township, New Garden Township and East Goshen which surround the Bank's Chester County office. As a result of the continual anticipated growth, the Bank is expanding its Willowdale Branch, Chester County to a full-service free-standing office to be completed in fiscal 2004. The Bank faces strong competition both in attracting deposits and making real estate loans. Its most direct competition for deposits has historically come from other savings associations, credit unions and commercial banks located in its market area including many large regional financial institutions which have greater financial and marketing resources available to them. The ability of the Bank to attract and retain core deposits depends on its ability to provide a competitive rate of return, liquidity and risk comparable to that offered by competing investment opportunities. The Bank experiences strong competition for real estate loans principally from other savings associations, commercial banks and mortgage-banking companies. The Bank competes for loans principally through the interest rates and loan fees it charges, the efficiency and quality of the services it provides borrowers and the convenient locations of its branch office network. Recognizing that convenience, as it relates to branch locations, is still a primary motivator in attracting new deposits, the Bank is undergoing construction of a new full-service free-standing branch on a corner property in Aston Township, Delaware County, a densely populated area in the heart of the Bank's marketplace. 2 FORWARD LOOKING STATEMENTS In this Annual Report on Form 10-K, the Company has included certain forward-looking statements concerning the future operations of the Company. It is management's desire to take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. This statement is for the express purpose of availing the Company of the protections of such safe harbor with respect to all forward-looking statements contained in this Annual Report. Such forward-looking statements are subject to risks and uncertainties which could cause actual results to differ materially from those currently anticipated due to a number of factors. Such forward-looking statements may be identified by the use of words such as believe, expect, should, estimated, potential and similar expressions. Examples of forward-looking statements include, but are not limited to, estimates with respect to the financial condition, business strategy, expected or anticipated revenue, results of operations and the business of the Company that are subject to various factors which could cause actual results to differ materially from these estimates. Factors that could affect results include interest rate trends, deposit flows, competition, the general economic climate in Delaware and Chester counties, the mid-Atlantic region and the United States as a whole, loan demand, real estate values, loan delinquency rates, levels of non-performing assets, changes in federal and state regulation, changes in accounting policies and practices and other uncertainties described in the Company's filings with the Securities and Exchange Commission, including its Form 10-K for the year ended September 30, 2003. These factors should be considered in evaluating the forward-looking statements, and undue reliance should not be placed on such statements. The Company assumes no obligation to update or revise forward-looking statements to reflect any changed assumptions, any unanticipated events or any changes in the future. 3 LENDING ACTIVITIES Loan Portfolio Composition. The following table sets forth the composition of the Bank's loan portfolio by type of loan at the dates indicated (excluding loans held for sale).
September 30, -------------------------------------------------------------- 2003 2002 2001 ------------------ ------------------ ------------------ Amount % Amount % Amount % ------------------ ------------------ ------------------ (Dollars in thousands) Real estate loans: Single-family $166,042 55.51% $173,736 57.32% $160,289 59.81% Multi-family and commercial 59,022 19.73 60,379 19.92 43,472 16.22 Construction and land 28,975 9.69 28,292 9.33 29,117 10.86 Home equity loans and lines of credit 33,459 11.19 27,595 9.10 25,847 9.65 -------- ------- -------- ------- -------- ------- Total real estate loans 287,498 96.12 290,002 95.67 258,725 96.54 -------- ------- -------- ------- -------- ------- Consumer: Deposit 112 .04 144 .05 232 .09 Education -- -- -- -- -- -- Unsecured personal loans 547 .18 322 .11 133 .05 Other(1) 779 .26 736 .24 760 .28 -------- ------- -------- ------- -------- ------- Total consumer loans 1,438 .48 1,202 .40 1,125 .42 -------- ------- -------- ------- -------- ------- Commercial business loans 10,161 3.40 11,919 3.93 8,158 3.04 -------- ------- -------- ------- -------- ------- Total loans receivable(2) 299,097 100.00% 303,123 100.00% 268,008 100.00% -------- ======= -------- ======= -------- ======= Less: Loans in process (construction and land) 10,655 11,384 17,016 Deferred loan origination fees and discounts 35 605 1,147 Allowance for loan losses 1,986 2,358 2,181 -------- -------- -------- Total loans receivable, net $286,421 $288,776 $247,664 ======== ======== ========
September 30, ---------------------------------------- 2000 1999 ------------------ ------------------ Amount % Amount % ------------------ ------------------ (Dollars in thousands) Real estate loans: Single-family $160,143 65.54% $166,802 69.82% Multi-family and commercial 37,870 15.50 31,188 13.05 Construction and land 17,905 7.33 18,426 7.71 Home equity loans and lines of credit 22,597 9.25 18,624 7.80 -------- ------- -------- ------- Total real estate loans 238,515 97.62 235,040 98.38 -------- ------- -------- ------- Consumer: Deposit 251 .10 243 .10 Education 285 .12 365 .15 Unsecured personal loans -- -- -- -- Other(1) 807 .33 1,080 .45 -------- ------- -------- ------- Total consumer loans 1,343 .55 1,688 .70 -------- ------- -------- ------- Commercial business loans 4,475 1.83 2,190 .92 -------- ------- -------- ------- Total loans receivable(2) 244,333 100.00% 238,918 100.00% -------- ======= -------- ======= Less: Loans in process (construction and land) 10,330 9,005 Deferred loan origination fees and discounts 1,298 1,610 Allowance for loan losses 2,019 1,928 -------- -------- Total loans receivable, net $230,686 $226,375 ======== ========
- ----------------------------- (1) Consists primarily of credit card loans. (2) Does not include $4.5 million, $501,000, $225,000, $3.1 million and $1.8 million of loans held for sale at September 30, 2003, 2002, 2001, 2000 and 1999, respectively. 4 Contractual Principal Repayments. The following table sets forth the scheduled contractual maturities of the Bank's loans held to maturity at September 30, 2003. Demand loans, loans having no stated schedule of repayments and no stated maturity and overdraft loans are reported as due in one year or less. The amounts shown for each period do not take into account loan prepayments and normal amortization of the Bank's loan portfolio held to maturity.
Real Estate Loans ------------------------------------------------------------------------------------ Multi-family Consumer and Single-family and Construction Commercial (1) Commercial and Land Total Business Loans Total ------------- ------------ ------------ --------- --------------- --------- (Dollars in thousands) Amounts due in: One year or less $ 9,970 $ 6,597 $ 28,975 $ 45,542 $ 10,839 $ 56,381 After one year through three years 19,971 8,601 -- 28,572 335 28,907 After three years through five years 24,808 10,308 -- 35,116 160 35,276 After five years through ten years 74,564 12,913 -- 87,477 97 87,574 After ten years through fifteen years 43,070 9,619 -- 52,689 23 52,712 Over fifteen years 27,118 10,984 -- 38,102 145 38,247 ------------ ------------ ------------ --------- --------------- --------- Total(2) $ 199,501 $ 59,022 $ 28,975 $ 287,498 $ 11,599 $ 299,097 ============ ============ ============ ========= =============== ========= Interest rate terms on amounts due after one year: Fixed $ 156,927 $ 463 $ 157,390 Adjustable 85,029 297 85,326 --------- --------------- --------- Total(2) $ 241,956 $ 760 $ 242,716 ========= =============== =========
- ---------------------------- (1) Includes home equity loans and lines of credit. (2) Does not include adjustments relating to loans in process, allowances for loan losses and deferred fee income. 5 Scheduled contractual amortization of loans does not reflect the expected term of the Bank's loan portfolio. The average life of loans is substantially less than their contractual terms because of prepayments and due-on-sale clauses, which give the Bank the right to declare a conventional loan immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase when current mortgage loan rates are higher than rates on existing mortgage loans and, conversely, decrease when current mortgage loan rates are lower than rates on existing mortgage loans (due to refinancings of adjustable-rate and fixed-rate loans at lower rates). Under the latter circumstances, the weighted average yield on loans decreases as higher yielding loans are repaid or refinanced at lower rates. Loan Origination, Purchase and Sale Activity. The following table shows the loan origination, purchase and sale activity of the Bank during the periods indicated.
Year Ended September 30, -------------------------------------- 2003 2002 2001 ---------- ---------- ---------- (Dollars in thousands) Gross loans at beginning of period(1) $ 303,624 $ 268,233 $ 247,532 ---------- ---------- ---------- Loan originations for investment: Real estate: Residential 80,722 60,719 25,889 Commercial and multi-family 13,890 31,300 11,265 Construction 24,578 28,741 18,503 Home equity and lines of credit 29,920 21,710 10,363 ---------- ---------- ---------- Total real estate loans originated for investment 149,110 142,470 66,020 Consumer 2,927 2,825 1,287 Commercial business 17,548 21,555 12,102 ---------- ---------- ---------- Total loans originated for investment 169,585 166,850 79,409 Participations purchased(2) -- -- 1,124 Loans originated for resale 30,995 3,712 20,685 ---------- ---------- ---------- Total originations 200,580 170,562 101,218 ---------- ---------- ---------- Deduct: Principal loan repayments and prepayments (171,489) (131,374) (56,086) Transferred to real estate owned (2,122) (361) (872) Loans sold in secondary market (26,998) (3,436) (23,559) ---------- ---------- ---------- Subtotal (200,609) (135,171) (80,517) ---------- ---------- ---------- Net (decrease) increase in loans(1) (29) 35,391 20,701 ---------- ---------- ---------- Gross loans at end of period(1) $ 303,595 $ 303,624 $ 268,233 ========== ========== ==========
- ------------------- (1) Includes loans held for sale of $4.5 million, $501,000 and $225,000 at September 30, 2003, 2002 and 2001, respectively. (2) Consist of commercial real estate loans. 6 The residential lending activities of the Bank are subject to written underwriting standards and loan origination procedures established by the Bank's Board of Directors and management. Loan applications may be taken at all of the Bank's branch offices by the branch manager or other designated loan officers. Applications for single-family residential mortgage loans for portfolio retention are obtained predominately through loan originators who are employees of the Bank. The Bank's residential loan originators will take loan applications outside of the Bank's offices at the customer's convenience and are compensated on a commission basis. The Residential Lending Department supervises the process of obtaining credit reports, appraisals and other documentation involved with a loan. In most cases, the Bank requires that a property appraisal be obtained in connection with all new first mortgage loans. Generally, appraisals are not required on home equity loans because alternative means of valuation are used (i.e. tax assessments). Property appraisals generally are performed by an independent appraiser from a list approved by the Bank's Board of Directors. The Bank requires that title insurance (other than with respect to home equity loans) and hazard insurance be maintained on all security properties and that flood insurance be maintained if the property is within a designated flood plain. Residential mortgage loan applications are primarily developed from referrals from real estate brokers and builders, existing customers and walk-in customers. Commercial and multi-family real estate loan applications are obtained primarily from previous borrowers, direct solicitations by Bank personnel, as well as referrals. Consumer loans originated by the Bank are obtained primarily through existing and walk-in customers who have been made aware of the Bank's programs by advertising and other means. Applications for single-family residential mortgage loans which are originated for resale in the secondary market or loans designated for portfolio retention that conform to the requirements for resale into the secondary market and do not exceed Fannie Mae ("FNMA") or Freddie Mac ("FHLMC") limits are approved by at least one of the following: the Bank's Senior Vice President of Residential Lending, the Vice President of Residential Lending, the Senior Mortgage Loan underwriter or the Loan Committee (a committee comprised of four directors and the Vice President of Residential Lending). Residential mortgage loans in excess of FNMA/FHLMC maximum amounts (currently $322,700) but less than $1.0 million must be approved by the Loan Committee. All mortgage loans in excess of $1.0 million must be approved by the Bank's Board of Directors or the Executive Committee thereof. Commercial and multi-family residential real estate loans in excess of $200,000 and construction loans must be approved by the Board of Directors. All mortgage loans which do not require approval by the Board of Directors are submitted to the Board at its next meeting for review and ratification. Home equity loans and lines of credit up to $150,000 can be approved by the Vice President of Residential Lending, the Vice President of Construction Loans, the Vice President of Residential Lending or the Senior Mortgage Loan Underwriter. Loans in excess of such amount must be approved by the Loan Committee. Single-Family Residential Loans. Substantially all of the Bank's single-family residential mortgage loans consist of conventional loans. Conventional loans are loans that are neither insured by the Federal Housing Administration or partially guaranteed by the Department of Veterans Affairs. The vast majority of the Bank's single-family residential mortgage loans are secured by properties located in Pennsylvania, primarily in Delaware and Chester counties, and are originated under terms and documentation which permit their sale to FHLMC or FNMA. The Bank, consistent with its asset/liability management strategies, sells some of its newly originated longer term fixed-rate residential mortgage loans and to a limited degree, existing longer term fixed-rate residential mortgage loans while retaining adjustable-rate mortgage loans and shorter term fixed-rate residential mortgage loans. See "- Mortgage-Banking Activities." The single-family residential mortgage loans offered by the Bank currently consist of fixed-rate loans, including bi-weekly and balloon loans and adjustable-rate loans. Fixed-rate loans generally have maturities ranging from 15 to 30 years and are fully amortizing with monthly loan payments sufficient to repay the total amount of the loan with interest by the end of the loan term. The Bank's fixed-rate loans are originated under terms, conditions and documentation which permit them to be sold to U.S. Government-sponsored agencies, such as FHLMC or FNMA, and other purchasers in the secondary mortgage market. The Bank also offers bi-weekly loans under the terms of which the borrower makes payments every two weeks. Although such loans have a 30 year amortization schedule, due to the bi-weekly payment schedule, such loans repay substantially more rapidly than a standard monthly amortizing 30-year fixed-rate loan. The Bank also offers five and seven year balloon loans which provide that the borrower can conditionally renew the loan at the fifth or seventh year at a then to-be-determined interest rate for the remaining 25 or 23 years, respectively, of the amortization period. At September 30, 2003, $147.8 million, or 89.0% of the Bank's single-family residential mortgage loans held in portfolio were fixed-rate loans, including $12.4 million of bi-weekly, fixed-rate residential mortgage loans. 7 The adjustable-rate loans currently offered by the Bank have interest rates which adjust every one, three or five years in accordance with a designated index, such as U.S. Treasury obligations, adjusted to a constant maturity ("CMT"), plus a stipulated margin. The Bank's adjustable-rate single-family residential real estate loans generally have a cap of 2% on any increase or decrease in the interest rate at any adjustment date, and a cap and floor of 6% on any such increase or decrease over the life of the loan. In order to increase the originations of adjustable-rate loans, the Bank has been originating loans which bear a fixed interest rate for a period of three to five years after which they convert to one-year adjustable-rate loans. The Bank's adjustable-rate loans require that any payment adjustment resulting from a change in the interest rate of an adjustable-rate loan be sufficient to result in full amortization of the loan by the end of the loan term and, thus, do not permit any of the increased payment to be added to the principal amount of the loan, creating negative amortization. Although the Bank does offer adjustable-rate loans with initial rates below the fully indexed rate, loans tied to the one-year CMT are underwritten using methods approved by FHLMC or FNMA which require borrowers to be qualified at 2% above the discounted loan rate under certain conditions. At September 30, 2003, $18.2 million, or 11.0%, of the Bank's single-family residential mortgage loans held for portfolio were adjustable-rate loans. Adjustable-rate loans decrease the risks associated with changes in interest rates but involve other risks, primarily because in the event interest rates increase, the loan payment by the borrower also increases to the extent permitted by the terms of the loan, thereby increasing the potential for default. In addition, adjustable-rate loans tend to prepay and convert to fixed rates when the overall interest rate environment is low. Moreover, as with fixed-rate loans, as interest rates increase, the marketability of the underlying collateral property may be adversely affected by higher interest rates. The Bank believes that these risks, which have not had a material adverse effect on the Bank to date, generally are less than the risks associated with holding fixed-rate loans in an increasing interest rate environment. For conventional residential mortgage loans held in portfolio and also for those loans originated for sale in the secondary market, the Bank's maximum loan-to-value ("LTV") ratio is 97%, and is based on the lesser of sales price or appraised value. On loans with a LTV ratio of over 80%, private mortgage insurance may be required to be obtained or the Bank may lend the excess as a home equity loan. Commercial and Multi-Family Residential Real Estate Loans. In fiscal 2003, the Bank has maintained its increased investment in commercial and multi-family residential lending. Such loans are being made primarily to small- and medium-sized businesses located in the Bank's primary market area, a segment of the market that the Bank believes continues to be under served in recent years. Loans secured by commercial and multi-family residential real estate amounted to $59.0 million, or 19.7%, of the Bank's total loan portfolio, at September 30, 2003. The Bank's commercial and multi-family residential real estate loans are secured primarily by professional office buildings, small retail establishments, warehouses and apartment buildings (with 36 units or less) located in the Bank's primary market area. The Bank's adjustable-rate multi-family residential and commercial real estate loans generally are either three or five-year adjustable-rate loans indexed to the CMT plus a margin. In addition, depending on collateral value and strength of the borrower, fixed-rate balloon loans and longer term fixed-rate loans may be originated. Generally, fees of 1% to 3% of the principal loan balance are charged to the borrower upon closing. Although terms for multi-family residential and commercial real estate loans may vary, the Bank's underwriting standards generally provide for terms of up to 25 years with amortization of the principal over the term of the loan and LTV ratios of not more than 75%. Generally, the Bank obtains personal guarantees of the principals of the borrower as additional security for any commercial real estate and multi-family residential loans and requires that the borrower have at least a 25% equity investment in any such property. 8 The Bank evaluates various aspects of commercial and multi-family residential real estate loan transactions in an effort to mitigate risk to the extent possible. In underwriting these loans, consideration is given to the stability of the property's cash flow history, future operating projections, current and projected occupancy, position in the market, location and physical condition. In recent periods, the Bank has generally imposed a debt coverage ratio (the ratio of net cash from operations before payment of debt service to debt service) of not less than 110%. The underwriting analysis also includes credit checks and a review of the financial condition of the borrower and guarantor, if applicable. An appraisal report is prepared by a state-licensed and certified appraiser (generally an appraiser who is qualified as a Member of the Appraisal Institute ("MAI")) commissioned by the Bank to substantiate property values for every commercial real estate and multi-family loan transaction. All appraisal reports are reviewed by the commercial loan underwriter prior to the closing of the loan. Multi-family residential and commercial real estate lending entails different and significant risks when compared to single-family residential lending because such loans often involve large loan balances to single borrowers and because the payment experience on such loans is typically dependent on the successful operation of the project or the borrower's business. These risks also can be significantly affected by supply and demand conditions in the local market for apartments, offices, warehouses or other commercial space. The Bank attempts to minimize its risk exposure by limiting such lending to proven developers/owners, only considering properties with existing operating performance which can be analyzed, requiring conservative debt coverage ratios, and periodically monitoring the operation and physical condition of the collateral. During fiscal 2003, the Bank continued to experience difficulties with two borrowers in its commercial real estate loan portfolio which has increased non-performing assets. See "-Non-performing Assets" for further discussion of these non-performing loans. Construction Loans. Substantially all of the Bank's construction loans consist of loans for acquisition and development of properties to construct single-family properties extended either to individuals or to selected developers with whom the Bank is familiar to build such properties on a pre-sold or limited speculative basis. To a lesser extent, the Bank provides financing for construction to permanent commercial real estate properties. Commercial construction loans have a maximum term of 24 months during the construction period with interest based upon the prime rate published in the Wall Street Journal ("Prime Rate") plus a margin and have LTV ratios of 80% or less of the appraised value upon completion. The loans convert to permanent commercial real estate loans upon completion of construction. With respect to construction loans to individuals, such loans have a maximum term of 12 months, have variable rates of interest based upon the Prime Rate plus a margin and have LTV ratios of 80% or less of the appraised value of the property upon completion and generally do not require the amortization of principal during the term. Upon completion of construction, the borrower is required to refinance the loan although the Bank may be the lender of the permanent loan secured by the property. The Bank also provides construction loans (including acquisition and development) and revolving lines of credit to developers. The majority of construction loans consist of loans to selected local developers with whom the Bank is familiar and who build single-family dwellings on a pre-sold or, to a significantly lesser extent, on a speculative basis. The Bank generally limits to two the number of unsold units that a developer may have under construction in a project. Such loans generally have terms of 36 months or less, have generally a maximum LTV ratios of 75% of the appraised value of the property upon completion and do not require the amortization of the principal during the term. The loans are made with variable rates of interest based on the Prime Rate plus a margin adjusted on a monthly basis. The Bank also receives origination fees that generally range from .5% to 3.0% of the loan commitment. The borrower is required to fund a portion of the project's costs, the exact amount being determined on a case-by-case basis. Loan proceeds are disbursed by percentage of completion of the cost of the project after inspections indicate that such disbursements are for costs already incurred and which have added to the value of the project. Only interest payments are due during the construction phase and the Bank may provide the borrower with an interest reserve from which it can pay the stated interest due thereon. At September 30, 2003, residential construction loans totaled $16.4 million, or 5.5%, of the total loan portfolio, primarily consisting of construction loans to developers. At September 30, 2003, commercial construction loans totaled $2.1 million, or .71%, of the total loan portfolio. 9 The Bank also originates ground or land loans to individuals to purchase a property on which they intend to build their primary residences, as well as to developers to purchase lots to build speculative homes at a later date. Such loans have terms of 36 months or less with a maximum LTV ratio of 75% of the lower of appraised value or sale price. The loans are made with variable rates based on the Prime Rate plus a margin. The Bank also receives origination fees, which generally range between 1.0% and 3.0% of the loan amount. At September 30, 2003, land loans (including loans to acquire and develop land) totaled $10.4 million, or 3.5%, of the total loan portfolio. Loans to developers include both secured and unsecured lines of credit (which are classified as commercial business loans) with outstanding commitments totaling $2.2 million. All have personal guaranties of the principals and are cross-collateralized with existing loans. At September 30, 2003, loans outstanding under builder lines of credit totaled $1.4 million, or .47%, of the total loan portfolio, of which $788,000 were unsecured and given only to the Bank's most creditworthy long standing customers. Prior to making a commitment to fund a construction loan, the Bank requires an appraisal of the property by an appraiser approved by the Board of Directors. In addition, during the term of the construction loan, the project is inspected by an independent inspector. Construction financing generally is considered to involve a higher degree of risk of loss than long-term financing on improved, owner-occupied real estate. Risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property's value at completion of construction or development and the estimated cost (including interest) of construction. During the construction phase, a number of factors could result in delays and cost overruns. If the estimate of value proves to be inaccurate, the Bank may be confronted, at or prior to the maturity of the loan, with a project, when completed, having a value which is insufficient to assure full repayment. Loans on lots may run the risk of adverse zoning changes as well as environmental or other restrictions on future use. Home Equity Loans and Lines of Credit. Home equity loans and home equity lines of credit are secured by the underlying equity in the borrower's primary residence or, occasionally, other types of real estate. Home equity loans are amortizing loans with fixed interest rates and generally maximum terms of 15 years while equity lines of credit have adjustable interest rates indexed to the Prime Rate. Generally home equity loans or home equity lines of credit do not exceed $100,000. The Bank's home equity loans and lines of credit generally require combined LTV ratios of 80% or less. Loans with higher LTV ratios are available but with higher interest rates and stricter credit standards. At September 30, 2003, home equity loans and lines of credit amounted to $33.5 million, or 11.2%, of the Bank's total loan portfolio. Consumer Lending Activities. The Bank also offers a variety of consumer loans in order to provide a full range of retail financial services to its customers. At September 30, 2003, $1.4 million, or .5 %, of the Bank's total loan portfolio was comprised of consumer loans. The Bank originates substantially all of such loans in its market area. At September 30, 2003, the Bank's consumer loan portfolio was comprised of credit card, deposit, unsecured personal loans and other consumer loans. The Bank's credit card program is primarily offered to only the Bank's most creditworthy customers. At September 30, 2003, these loans totaled $620,000, or .2%, of the total loan portfolio. Another component of the consumer loan portfolio is unsecured loans amounting to $547,000, or .2%, of the Bank's loan portfolio at September 30, 2003. Consumer loans generally have shorter terms and higher interest rates than mortgage loans but generally involve more credit risk than mortgage loans because of the type and nature of the collateral and, in certain cases, the absence of collateral. Commercial Business Loans. The Bank has also emphasized the growth in commercial business loans by granting such loans directly to business enterprises that are located in its market area. The majority of such loans are for less than $1.0 million. The Bank actively targets and markets to small- and medium-sized businesses. Applications for commercial business loans are obtained from existing commercial customers, branch and customer referrals, direct inquiry and those that are obtained by our commercial lending officers. As of September 30, 2003, commercial business loans amounted to $10.2 million, or 3.4%, of the Bank's total loan portfolio. 10 The commercial business loans consist of a limited number of commercial lines of credit secured by real estate, securities, some working capital financings secured by accounts receivable and inventory and, to a limited extent, unsecured lines of credit. Commercial business loans originated by the Bank ordinarily have terms of five years or less and fixed rates or adjustable rates tied to the Prime Rate plus a margin. Although commercial business loans generally are considered to involve greater credit risk than other certain types of loans, management intends to continue to offer commercial business loans to small- and medium-sized businesses in an effort to better serve our community's needs, obtain core non-interest-bearing deposits and increase the Bank's interest rate spread. Mortgage-Banking Activities. Due to customer preference for fixed-rate loans, the Bank has continued to originate fixed-rate loans. Long-term (generally 30 years) fixed-rate loans not taken into portfolio for asset/liability purposes are sold into the secondary market. The Bank's net gain on sales of mortgage loans amounted to $410,000, $84,000, and $122,000 during the fiscal years ended September 30, 2003, 2002 and 2001, respectively. Profits from sales of loans held for sale significantly increased due to the increased originations in 30-year loans resulting from the low interest rate environment. The Bank had $4.5 million and $501,000 of mortgage loans held for sale at September 30, 2003 and 2002, respectively. Subsequent to fiscal year end, management determined, based on its asset liability position, to retain a substantial portion of such loans in its loan portfolio. The Bank's conforming mortgage loans sold to others are sold, generally with servicing retained, on a loan-by-loan basis primarily to FHLMC or FNMA. A period of less than five days generally elapses between the closing of the loan by the Bank and its purchase by the investor. Mortgages with established interest rates generally will decrease in value during periods of increasing interest rates. Accordingly, fluctuations in prevailing interest rates may result in a gain or loss to the Bank as a result of adjustments to the carrying value of loans held for sale or upon sale of loans. The Bank attempts to protect itself from these market fluctuations through the use of forward commitments entered into at the same time of the commitment by the Bank of a loan rate to the borrower. These commitments are mandatory delivery contracts with FHLMC or FNMA within a certain time frame and within certain dollar amounts by a price determined at the commitment date. Market risk does exist as non-refundable points paid by the borrower may not be sufficient to offset fees associated with closing the forward commitment contract. See Note 13 of the Notes to Consolidated Financial Statements set forth in Item 8 hereof. Loan Origination Fees and Servicing. Borrowers may be charged an origination fee, which is a percentage of the principal balance of the loan. In accordance with the provisions of Statement of Financial Accounting Standards ("SFAS") No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases," the various fees received by the Bank in connection with the origination of loans are deferred and amortized as a yield adjustment over the lives of the related loans using the interest method. However, when such loans are sold, the remaining unamortized fees (which is all or substantially all of such fees due to the relatively short period during which such loans are held) are recognized as income on the sale of loans held for sale. The Bank, for conforming loan products, generally retains the servicing on all loans sold to others. In addition, the Bank services substantially all of the loans that it retains in its portfolio. Loan servicing includes collecting and remitting loan payments, accounting for principal and interest, making advances to cover delinquent payments, making inspections as required of mortgaged premises, contacting delinquent mortgagors, supervising foreclosures and property dispositions in the event of unremedied defaults and generally administering the loans. Funds that have been escrowed by borrowers for the payment of mortgage-related expenses, such as property taxes and hazard and mortgage insurance premiums, are maintained in noninterest-bearing accounts at the Bank. 11 The following table presents information regarding the loans serviced by the Bank for others at the dates indicated. Substantially all the loans were secured by properties in Pennsylvania. A small percentage of the loans are secured by properties located in Delaware, Maryland or New Jersey.
SEPTEMBER 30, ---------------------------------- 2003 2002 2001 ---------------------------------- (Dollars in thousands) Loans originated by the Bank and serviced for: FNMA $ 822 $ 1,054 $ 1,726 FHLMC 50,373 50,405 64,195 Others 352 367 380 ------- ------- ------ Total loans serviced for others $ 51,547 $ 51,826 $66,301 ======= ======= ======
The Bank receives fees for servicing mortgage loans, which generally amount to 0.25% per annum on the declining principal balance of mortgage loans. Such fees serve to compensate the Bank for the costs of performing the servicing function. Other sources of loan servicing revenues include late charges. The Bank retains a portion of funds received from borrowers on the loans it services for others in payment of its servicing fees received on loans serviced for others. For fiscal years ended September 30, 2003, 2002 and 2001, the Bank earned gross fees of $140,000, $160,000 and $191,000, respectively, from loan servicing. Loans-to-One Borrower Limitations. Regulations impose limitations on the aggregate amount of loans that a savings institution could make to any one borrower, including related entities. Under such regulations, the permissible amount of loans-to-one borrower follows the national bank standard for all loans made by savings institutions, which generally does not permit loans-to-one borrower to exceed 15% of unimpaired capital and surplus. Loans in an amount equal to an additional 10% of unimpaired capital and surplus also may be made to a borrower if the loans are fully secured by readily marketable securities. At September 30, 2003, the Bank's six largest loans or groups of loans-to-one borrower, including related entities, ranged from an aggregate of $4.3 million to $5.8 million. The Bank's loans-to-one borrower limit was $6.8 million at such date. ASSET QUALITY General. As a part of the Bank's efforts to improve its asset quality, it has developed and implemented an asset classification system. All of the Bank's assets are subject to review under the classification system, but particular emphasis is placed on the review of multi-family residential and commercial real estate loans, construction loans and commercial business loans. All assets of the Bank are periodically reviewed and the classification recommendations submitted to the Asset Classification Committee at least monthly. The Asset Classification Committee is composed of the President and Chief Executive Officer, the Chief Financial Officer, the Vice President of Loan Administration, the Internal Auditor and the Vice President of Construction Lending. All assets are placed into one of the four following categories: Pass, Substandard, Doubtful and Loss. The criteria used to review and establish each asset's classification are substantially identical to the asset classification system used by the Office of Thrift Supervision (the "OTS") in connection with the examination process. As of September 30, 2003, the Bank did not have any assets which it had classified as doubtful or loss. See "- Non-Performing Assets" and "- Other Classified Assets" for a discussion of certain of the Bank's assets which have been classified as substandard and regulatory classification standards generally. 12 When a borrower fails to make a required payment on a loan, the Bank attempts to cure the deficiency by contacting the borrower and requesting payment. Contact is generally made after the expiration of the grace period (usually fifteen days) in the form of telephone calls and/or correspondence. In most cases, deficiencies are cured promptly. If the delinquency increases, the Bank will initiate foreclosure actions or legal collection actions if a borrower fails to enter into satisfactory repayment arrangements. Such actions generally commence at sixty to ninety days of delinquency. Loans are placed on non-accrual status when, in the judgment of management, the probability of collection of interest is deemed to be insufficient to warrant further accrual. When a loan is placed on non-accrual status, previously accrued but unpaid interest is deducted from interest income. As a matter of policy, the Bank does not accrue interest on loans past due 90 days or more. See Note 2 of the Notes to Consolidated Financial Statements set forth in Item 8 hereof. Real estate acquired by the Bank as a result of foreclosure or by deed-in-lieu of foreclosure is classified as real estate owned until sold. Real estate owned is initially recorded at the lower of fair value less estimated costs to sell the property, or cost (generally the balance of the loan on the property at the date of acquisition). After the date of acquisition, all costs incurred in maintaining the property are expenses and costs incurred for the improvement or development of such property are capitalized up to the extent of their net realizable value. Under accounting principles generally accepted in the United States of America ("GAAP"), the Bank is required to account for certain loan modifications or restructurings as "troubled debt restructurings" under SFAS No. 15. In general, the modification or restructuring of a debt constitutes a troubled debt restructuring if the Bank, for economic or legal reasons related to the borrower's financial difficulties, grants a concession to the borrower that the Bank would not otherwise consider under current market conditions. Debt restructuring or loan modifications for a borrower do not necessarily always constitute troubled debt restructuring, however, and troubled debt restructuring does not necessarily result in non-accrual loans. 13 Delinquent Loans. The following table sets forth information concerning delinquent loans at the dates indicated, in dollar amounts and as a percentage of each category of the Bank's loan portfolio. The amounts presented represent the total outstanding principal balances of the related loans, rather than the actual payment amounts which are past due.
September 30, 2003 September 30, 2002 ---------------------------------------------------------------------- 30-59 Days 60-89 Days 30-59 Days 60-89 Days ---------------------------------------------------------------------- Percent Percent Percent Percent of of of of Loan Loan Loan Loan Amount Category Amount Category Amount Category Amount Category ---------------------------------------------------------------------- (Dollars in thousands) Real estate loans: Single-family residential $ 84 .05% $127 .08% $ -- --% $405 .23% Multi-family and commercial 531 .90 -- -- 246 .41 -- -- Home equity 64 .19 167 .50 -- -- 35 .13 Consumer loans 12 .83 1 .07 18 1.50 23 1.91 Commercial business loans 60 .59 -- -- 33 .28 -- -- ---- ---- ---- ---- Total $751 .25% $295 .10% $297 .10% $463 .15% ==== ==== ==== ====
14 Non-performing Assets. The following table sets forth the amounts and categories of the Bank's non-performing assets and troubled debt restructurings at the dates indicated.
September 30, ------------------------------------------ 2003 2002 2001 2000 1999 ------------------------------------------ (Dollars in thousands) Non-performing loans: Single-family residential $ 688 $1,237 $1,924 $2,109 $2,312 Commercial and multi-family(1) 381 2,386 33 -- 289 Construction(2) -- -- -- -- 556 Consumer 16 19 314 48 16 Commercial business 268 138 -- 3 6 ------ ------ ------ ------ ------ Total non-performing loans 1,353 3,780 2,271 2,160 3,179 ------ ------ ------ ------ ------ Accruing loans more than 90 days delinquent (3) 203 1,358 31 355 1 ------ ------ ------ ------ ------ Total non-performing loans 1,556 5,138 2,302 2,515 3,180 ------ ------ ------ ------ ------ Real estate owned 1,420 248 887 947 297 ------ ------ ------ ------ ------ Total non-performing assets $2,976 $5,386 $3,189 $3,462 $3,477 ====== ====== ====== ====== ====== Troubled debt restructurings (4) $ -- $ -- $ -- $ -- $ 24 ====== ====== ====== ====== ====== Total non-performing loans and troubled debt restructurings as a percentage of gross loans receivable(5) 0.53% 1.76% 0.92% 1.07% 1.39% ====== ====== ====== ====== ====== Total non-performing assets as a percentage of total assets 0.53% 1.04% 0.65% 0.75% 0.77% ====== ====== ====== ====== ====== Total non-performing assets and troubled debt restructurings as percentage of total assets 0.53% 1.04% 0.65% 0.75% 0.78% ====== ====== ====== ====== ======
- ------------------------ (1) Consists of one loan at September 30, 2003, three loans at September 30, 2002, one loan at September 30, 2001 and two loans at September 30, 1999. (2) Consists of three loans made to two borrowers at September 30, 1999. (3) Consists of one commercial real estate loan of $1.3 million which returned to current status subsequent to September 30, 2002 (4) Consists of lease financing receivables at September 30, 1999 from the Bennett Funding Group of Syracuse, New York ("Bennett Funding"). The troubled debt restructurings entered into in 1997 performed in accordance with the terms of the agreements since the restructurings. (5) Includes loans receivable and loans held for sale, less construction and land loans in process and deferred loan origination fees and discounts. 15 The $688,000 of non-performing single-family residential loans at September 30, 2003 consisted of 16 loans with principal balances ranging from $2,700 to $164,000, with an average balance of approximately $43,000. Included within the 16 loans are four loans aggregating $291,000 to credit impaired borrowers. At September 30, 2003, non-performing commercial real estate loans were comprised of two commercial real estate loans totaling $381,000 with the largest of the two having a carrying value of $320,000. The Bank owns a 25% participation interest in this loan which is secured by a partially completed storage facility in Clifton Heights, Pennsylvania. Subsequent to fiscal year end, the loan was paid off. Non-performing commercial business loans comprised of four loans with an average balance of approximately $67,000 and the largest loan having a carrying value of $125,000. At September 30, 2003, the $1.4 million of real estate owned (including in-substance foreclosure) consisted of two single-family residential properties with an average carrying value of $167,600 and a $1.1 million commercial real estate property. The commercial real estate property is an 18-hole golf course and golf house, located in Avondale, Pennsylvania. The golf facility is fully operational and continues to generate revenues. Foreclosure is expected to occur in December 2003 and the property is currently being marketed. During fiscal 2003, the Bank incurred expenses in the amount of $299,000 relating to the workout of these loans. Management expects the costs associated with these loans to continue into the next fiscal year. Other Classified Assets. Federal banking regulations require that each insured savings association classify its assets on a regular basis. In addition, in connection with examinations of insured institutions, federal examiners have authority to identify problem assets and, if appropriate, classify them. There are three classifications for problem assets: "substandard," "doubtful" and "loss." Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. At September 30, 2003, the Bank had $3.1 million of assets classified as substandard, and no assets classified as doubtful or loss. Substantially all classified assets consist of non-performing assets. Allowance for Loan Losses. The Bank's policy is to establish reserves for estimated losses on delinquent loans when it determines that losses are probable. The allowance for losses on loans is maintained at a level believed by management to cover all known and inherent losses in its loan portfolio. Management's analysis of the adequacy of the allowance is based on an evaluation of the loan portfolio, past loss experience, current economic conditions, volume, growth and composition of the portfolio, and other relevant factors. The allowance is increased by provisions for loan losses which are charged against income. The level of provisions increased in fiscal 2002 compared, to a large part, to the nonperforming commercial assets aggregating $1.5 million as discussed above. As shown in the table below, at September 30, 2003, the Bank's allowance for loan losses amounted to 127.63% and .68% of the Bank's non-performing loans and gross loans receivable, respectively. Management of the Bank presently believes that its allowance for loan losses is adequate to cover any probable losses in the Bank's loan portfolio. However, future adjustments to this allowance may be necessary, and the Bank's results of operations could be adversely affected if circumstances differ substantially from the assumptions used by management in making its determinations in this regard. 16 The following table provides information regarding the changes in the allowance for loan losses and other selected statistics for the periods presented.
YEAR ENDING SEPTEMBER 30, ----------------------------------------------- 2003 2002 2001 2000 1999 ----------------------------------------------- (Dollars in thousands) Allowance for loan losses, beginning of period $ 2,358 $ 2,181 $ 2,019 $ 1,928 $ 1,738 Charged-off loans: Single-family residential (50) (317) (492) (182) (12) Multi-family and commercial (941) -- -- -- -- Construction -- -- -- (117) -- Consumer and commercial business (111) (56) (40) (64) (60) ------- ------- ------- ------- ------- Total charged-off loans (1,102) (373) (532) (363) (72) ------- ------- ------- ------- ------- Recoveries on loans previously charged off: Single-family residential 4 1 11 -- 2 Commercial leases (1) -- -- 134 33 -- Consumer and commercial business 11 9 9 1 1 ------- ------- ------- ------- ------- Total recoveries 15 10 154 34 3 ------- ------- ------- ------- ------- Net loans charged-off (1,087) (363) (378) (329) (69) Provision for loan losses 715 540 540 420 259 ------- ------- ------- ------- ------- Allowance for loan losses, end of period $ 1,986 $ 2,358 $ 2,181 $ 2,019 $ 1,928 ======= ======= ======= ======= ======= Net loans charged-off to average loans outstanding(2) 0.37% 0.13% 0.16% 0.14% 0.03% ======= ======= ======= ======= ======= Allowance for loan losses to gross loans receivable(2) 0.68% 0.81% 0.87% 0.86% 0.84% ======= ======= ======= ======= ======= Allowance for loan losses to total non-performing loans 127.63% 45.89% 94.74% 80.28% 60.63% ======= ======= ======= ======= ======= Net loans charged-off to allowance for loan losses 54.73% 15.39% 17.33% 16.30% 3.58% ======= ======= ======= ======= ======= Recoveries to charge-offs 1.36% 2.68% 28.95% 9.37% 4.17% ======= ======= ======= ======= =======
(1) Relate to commercial lease purchases in prior years. (2) Gross loans receivable and average loans outstanding include loans receivable and loans held for sale, less construction and land loans in process and deferred loan origination fees and discounts. 17 The following table presents the Bank's allocation of the allowance for loan losses to the total amount of loans in each category listed at the dates indicated.
SEPTEMBER 30, ------------------------------------------------------------------------------------------------------- 2003 2002 2001 2000 1999 ------------------- ------------------- ------------------- ------------------- ------------------- % OF LOANS % OF LOANS % OF LOANS % OF LOANS % OF LOANS IN EACH IN EACH IN EACH IN EACH IN EACH CATEGORY TO CATEGORY TO CATEGORY TO CATEGORY TO CATEGORY TO AMOUNT TOTAL LOANS AMOUNT TOTAL LOANS AMOUNT TOTAL LOANS AMOUNT TOTAL LOANS AMOUNT TOTAL LOANS ------ ----------- ------ ----------- ------ ----------- ------ ----------- ------ ----------- (Dollars in thousands) Single-family residential $ 733 55.51% $ 815 57.32% $ 615 59.81% $1,098 65.54% $ 572 69.82% Commercial and multi- family residential 317 19.73 767 19.92 566 16.22 198 15.50 166 13.05 Construction 329 9.69 304 9.33 249 10.86 171 7.33 320 7.71 Home equity 34 11.19 40 9.10 59 9.65 41 9.25 34 7.80 Consumer 10 .48 10 .40 11 .42 8 .55 8 .70 Commercial business 132 3.40 86 3.93 87 3.04 60 1.83 14 .92 Unallocated 431 -- 336 -- 594 -- 443 -- 814 -- ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ Total allowance for loan losses $1,986 100.00% $2,358 100.00% $2,181 100.00% $2,019 100.00% $1,928 100.00% ====== ====== ====== ====== ====== ====== ====== ====== ====== ======
18 MORTGAGE-RELATED SECURITIES AND INVESTMENT SECURITIES Mortgage-Related Securities. Federally chartered savings institutions have authority to invest in various types of liquid assets, including U.S. Treasury obligations, securities of various federal agencies and of state and municipal governments, certificates of deposit at federally insured banks and savings and loan associations, certain bankers' acceptances and federal funds. Subject to various restrictions, federally chartered savings institutions also may invest a portion of their assets in commercial paper, corporate debt securities and mutual funds, the assets of which conform to the investments that federally chartered savings institutions are otherwise authorized to make directly. The Bank maintains a significant portfolio of mortgage-related securities (including mortgage-backed securities and collateralized mortgage obligations ("CMOs") as a means of investing in housing-related mortgage instruments without the costs associated with originating mortgage loans for portfolio retention and with limited credit risk of default which arises in holding a portfolio of loans to maturity. Mortgage-backed securities (which also are known as mortgage participation certificates or pass-through certificates) represent a participation interest in a pool of single-family or multi-family residential mortgages. The principal and interest payments on mortgage-backed securities are passed from the mortgage originators, as servicer, through intermediaries (generally U.S. Government agencies and government-sponsored enterprises) that pool and repackage the participation interests in the form of securities, to investors such as the Bank. Such U.S. Government agencies and government sponsored enterprises, which guarantee the payment of principal and interest to investors, primarily include FHLMC, FNMA and the Government National Mortgage Association ("GNMA"). The Bank also invests in certain privately issued, credit enhanced mortgage-related securities rated AAA by national securities rating agencies. FHLMC is a public corporation chartered by the U.S. Government. FHLMC issues participation certificates backed principally by conventional mortgage loans. FHLMC guarantees the timely payment of interest and the ultimate return of principal on participation certificates. FNMA is a private corporation chartered by the U.S. Congress with a mandate to establish a secondary market for mortgage loans. FNMA guarantees the timely payment of principal and interest on FNMA securities. FHLMC and FNMA securities are not backed by the full faith and credit of the United States, but because FHLMC and FNMA are U.S. Government-sponsored enterprises, these securities are considered to be among the highest quality investments with minimal credit risks. GNMA is a government agency within the Department of Housing and Urban Development which is intended to help finance government-assisted housing programs. GNMA securities are backed by Federal Housing Administration ("FHA") insured and the Department of Veterans Affairs ("VA") guaranteed loans, and the timely payment of principal and interest on GNMA securities are guaranteed by the GNMA and backed by the full faith and credit of the U.S. Government. Because FHLMC, FNMA and GNMA were established to provide support for low- and middle-income housing, there are limits to the maximum size of loans that qualify for these programs which is currently $322,700. Mortgage-related securities typically are issued with stated principal amounts, and the securities are backed by pools of mortgages that have loans with interest rates that are within a range and have varying maturities. The underlying pool of mortgages can be composed of either fixed-rate or adjustable-rate loans. As a result, the risk characteristics of the underlying pool of mortgages (i.e., fixed-rate or adjustable rate) as well as prepayment risk, are passed on to the certificate holder. Thus, the life of a mortgage-backed pass-through security thus approximates the life of the underlying mortgages. The Bank's mortgage-related securities include regular interests in CMOs. CMOs were developed in response to investor concerns regarding the uncertainty of cash flows associated with the prepayment option of the underlying mortgagor and are typically issued by governmental agencies, governmental sponsored enterprises and special purpose entities, such as trusts, corporations or partnerships, established by financial institutions or other similar institutions. A CMO can be (but is not required to be) collateralized by loans or securities which are insured or guaranteed by FNMA, FHLMC or the GNMA. In contrast to pass-through mortgage-related securities, in which cash flow is received pro rata by all security holders, the cash flow from the mortgages underlying a CMO is segmented and paid in accordance with a predetermined priority to investors holding 19 various CMO classes. By allocating the principal and interest cash flows from the underlying collateral among the separate CMO classes, different classes of bonds are created, each with its own stated maturity, estimated average life, coupon rate and prepayment characteristics. The short-term classes of a CMO usually carry a lower coupon rate than the longer term classes and, therefore, the interest differential cash flow on a residual interest is greatest in the early years of the CMO. As the early coupon classes are extinguished, the residual income declines. Thus, the longer the lower coupon classes remain outstanding, the greater the cash flow accruing to CMO residuals. As interest rates decline, prepayments accelerate, the interest differential narrows, and the cash flow from the CMO declines. Conversely, as interest rates increase, prepayments decrease, generating a larger cash flow to residuals. A senior-subordinated structure often is used with CMOs to provide credit enhancement for securities which are backed by collateral which is not guaranteed by FNMA, FHLMC or the GNMA. These structures divide mortgage pools into various risk classes: a senior class and one or more subordinated classes. The subordinated classes provide protection to the senior class. When cash flow is impaired, debt service goes first to the holders of senior classes. In addition, incoming cash flows also may go into a reserve fund to meet any future shortfalls of cash flow to holders of senior classes. The holders of subordinated classes may not receive any funds until the holders of senior classes have been paid and, when appropriate, until a specified level of funds has been contributed to the reserve fund. Mortgage-related securities generally bear yields which are less than those of the loans which underlie such securities because of their payment guarantees or credit enhancements which reduce credit risk to nominal levels. However, mortgage-related securities are more liquid than individual mortgage loans and may be used to collateralize certain obligations of the Bank. At September 30, 2003, $13.1 million of the Bank's mortgage-related securities were pledged to secure various obligations of the Bank, treasury tax and loan processing and as collateral for certain municipal deposits. The Bank's mortgage-related securities are classified as either "held to maturity" or "available for sale" based upon the Bank's intent and ability to hold such securities to maturity at the time of purchase, in accordance with GAAP. As of September 30, 2003, the Bank had an aggregate of $128.1 million, or 22.9%, of total assets invested in mortgage-related securities, net, of which $3.5 million was held to maturity and $124.6 million was available for sale. The mortgage-related securities of the Bank which are held to maturity are carried at cost, adjusted for the amortization of premiums and the accretion of discounts using a method which approximates a level yield, while mortgage-related securities available for sale are carried at the current fair value. See Notes 2 and 4 of the Notes to Consolidated Financial Statements set forth in Item 8 hereof. 20 The following table sets forth the composition of the Bank's available for sale (at fair value) and held to maturity (at amortized cost) of the mortgage-related securities portfolios at the dates indicated.
September 30, --------------------------------------- 2003 2002 2001 --------------------------------------- (Dollars in thousands) Available for sale: Mortgage-backed securities: FHLMC $ 6,950 $ 5,261 $ 9,175 FNMA 46,030 13,463 15,056 GNMA 13,639 33,621 43,907 -------- -------- -------- Total mortgage-backed securities 66,619 52,345 68,138 -------- -------- -------- Collateralized mortgage obligations: FHLMC 20,239 9,509 10,994 FNMA 5,381 3,751 6,215 GNMA -- -- 17 Other 32,417(1) 20,069(2) 32,244(3) -------- -------- -------- Total collateralized mortgage obligations 58,037 33,329 49,470 -------- -------- -------- Total mortgage-related securities $124,656 $ 85,674 $117,608 ======== ======== ======== Held to maturity: Mortgage-backed securities: FHLMC $ 478 $ 1,433 $ 2,285 FNMA 2,123 3,574 4,684 -------- -------- -------- Total mortgage-backed securities 2,601 5,007 6,969 -------- -------- -------- Collateralized mortgage obligations: FNMA 886 3,848 4,485 -------- -------- -------- Total collateralized mortgage obligations 886 3,848 4,485 -------- -------- -------- Total mortgage-related securities, amortized cost $ 3,487 $ 8,855 $ 11,454 ======== ======== ======== Total fair value(4) $ 3,560 $ 9,090 $ 11,550 ======== ======== ========
(1) Includes "AAA" rated securities of Countrywide Home Loans, Washington Mutual, AMAC and First Horizon with book values of $6.5 million, $6.8 million, $4.7 million and $ 3.6 million, respectively, and fair values of $6.4 million, $6.7 million, $4.8 million and $3.5 million. (2) Includes "AAA" rated securities of Northwest Asset Securities Corporation, Credit Suisse First Boston, Washington Mutual and Countrywide Home Loans with book values of $2.9 million, $4.1 million, $5.1 million and $2.7 million, respectively, and fair value of $3.0 million, $4.1 million, $5.1 million and $2.8 million, respectively. (3) Includes "AAA" rated securities of Northwest Asset Securities Corporation, Chase Mortgage Services, Washington Mutual and Countrywide Home Loans with book values of $5.5 million, $3.1 million, $4.2 million and $5.0 million, respectively, and fair values of $5.7 million, $3.1 million, $4.3 million and $5.0 million, respectively. (4) See Note 4 of the Notes to Consolidated Financial Statements set forth in Item 8 hereof. 21 The following table sets forth the purchases, sales and principal repayments of the Bank's mortgage-related securities for the periods indicated.
YEAR ENDED SEPTEMBER 30, ------------------------------------ 2003 2002 2001 ------------------------------------ (Dollars in thousands) Mortgage-related securities, beginning of period(1)(2) $ 94,529 $ 129,062 $ 109,313 --------- --------- --------- Purchases: Mortgage-backed securities - available for sale 50,199 9,280 24,501 CMOs - available for sale 81,942 18,231 34,162 Sales: Mortgage-backed securities - available for sale (4,493) -- (6,888) CMOs - available for sale (3,064) -- -- Repayments and prepayments: Mortgage-backed securities (32,563) (26,820) (21,568) CMOs (55,941) (34,554) (14,808) Decrease in net premium (1,128) (315) (145) Change in net unrealized (loss) gain on mortgage-related securities available for sale (1,338) (355) 4,495 --------- --------- --------- Net increase (decrease) in mortgage-related securities 33,614 (34,533) 19,749 --------- --------- --------- Mortgage-related securities, end of period(1) (2) $ 128,143 $ 94,529 $ 129,062 ========= ========= =========
(1) Includes both mortgage-related securities available for sale and held to maturity. (2) Calculated at amortized cost for securities held to maturity and at fair value for securities available for sale. At September 30, 2003, the estimated weighted average maturity of the Bank's fixed-rate mortgage-related securities was approximately 3.27 years. The actual maturity of a mortgage-backed security is less than its stated maturity due to prepayments of the underlying mortgages. Prepayments that are faster than anticipated may shorten the life of the security and adversely affect its yield to maturity. The yield is based upon the interest income and the amortization of any premium or discount related to the mortgage-backed security. In accordance with GAAP, premiums and discounts are amortized over the estimated lives of the securities, which decrease and increase interest income, respectively. The prepayment assumptions used to determine the amortization period for premiums and discounts can significantly affect the yield of the mortgage-backed security, and these assumptions are reviewed periodically to reflect actual prepayments. Although prepayments of underlying mortgages depend on many factors, including the type of mortgages, the coupon rate, the age of mortgages, the geographical location of the underlying real estate collateralizing the mortgages and general levels of market interest rates, the difference between the interest rates on the underlying mortgages and the prevailing mortgage interest rates generally is the most significant determinant of the rate of prepayments. During periods of declining mortgage interest rates, such as the Bank experienced during fiscal 2003 and 2002, if the coupon rates of the underlying mortgages exceed the prevailing market interest rates offered for mortgage loans, refinancings generally increase and accelerate the prepayment rate of the underlying mortgages and the related securities. Conversely, during periods of increasing mortgage interest rates, if the coupon rates of the underlying mortgages are less than the prevailing market interest rates offered for mortgage loans, refinancings generally decrease and decrease the prepayment rate of the underlying mortgages and the related securities. As a result of the declining interest rate environment, the Bank experienced high levels of repayments and accelerated prepayments, and consequently, the Bank reinvested the proceeds of such repayments and prepayments at a lower yield. 22 Investment Securities. The following table sets forth information regarding the carrying and fair value of the Company's investment securities, both held to maturity and available for sale, at the dates indicated.
AT SEPTEMBER 30, ---------------------------------------------------------- 2003 2002 2001 ---------------------------------------------------------- CARRYING FAIR CARRYING FAIR CARRYING FAIR VALUE VALUE VALUE VALUE VALUE VALUE ---------------------------------------------------------- (Dollars in thousands) FHLB stock $ 8,294 $ 8,294 $ 6,571 $ 6,571 $ 6,917 $ 6,917 U.S. Government and agency obligations 1 to 5 years 13,020 13,004 11,986 12,114 2,961 3,133 5 to 10 years 4,880 4,988 1,861 2,071 1,843 2,050 Municipal obligations 17,373 17,895 19,012 19,800 21,890 22,626 Corporate bonds 20,621 21,693 14,299 14,720 14,333 14,087 Mutual funds 14,009 13,952 14,009 14,045 5,009 5,004 Asset backed securities 1,911 1,922 2,837 2,853 2,986 2,970 Preferred stocks 5,474 4,984 10,682 10,751 9,474 9,197 Other equity investments 3,126 5,712 3,476 4,269 2,778 3,497 ------- ------- ------- ------- ------- ------- Total $88,708 $92,444 $84,733 $87,194 $68,191 $69,481 ======= ======= ======= ======= ======= =======
At September 30, 2003, the Company had an aggregate of $92.4 million, or 16.5%, of its total assets invested in investment securities, of which $8.3 million consisted of FHLB stock, $77.7 million was investment securities available for sale and $6.5 million held to maturity. Included in U.S. Government and agency obligations are callable bonds with a remaining term of approximately four years. The Bank's investment securities (excluding mutual funds, equity securities and FHLB stock) had a weighted average maturity to the call date of 6.0 years and a weighted average yield of 6.1% (adjusted to a fully taxable equivalent yield). SOURCES OF FUNDS General. The Bank's principal source of funds for use in lending and for other general business purposes has traditionally come from deposits obtained through the Bank's branch offices. The Bank also derives funds from contractual payments and prepayments of outstanding loans and mortgage-related securities, from sales of loans, from maturing investment securities and from advances from the FHLB of Pittsburgh and other borrowings. Loan repayments are a relatively stable source of funds, while deposits inflows and outflows are significantly influenced by general interest rates and money market conditions. The Bank uses borrowings to supplement its deposits as a source of funds. Deposits. The Bank's current deposit products include passbook accounts, NOW accounts, MMDA, certificates of deposit ranging in terms from 30 days to five years and non-interest-bearing personal and business checking accounts. The Bank's deposit products also include Individual Retirement Account ("IRA") certificates and Keogh accounts. The Bank's deposits are obtained primarily from residents in Delaware and Chester counties in southeastern Pennsylvania. The Bank attracts local deposit accounts by offering a wide variety of accounts, competitive interest rates, and convenient branch office locations and service hours. The Bank utilizes traditional marketing methods to attract new customers and savings deposits, including print media, radio advertising and direct mailings. However, the Bank does not solicit funds through deposit brokers nor does it pay any brokerage fees if it accepts such deposits. 23 The Bank has been competitive in the types of accounts and interest rates it has offered on its deposit products but does not necessarily seek to match the highest rates paid by competing institutions. Even with the significant decline in interest rates paid on deposit products in fiscal 2003 and 2002, due to generally declining returns on competing investment opportunities as well as the effects of the stock market decline, the Bank did not experience disintermediation of deposits into competing investment products in fiscal 2003 and 2002. The following table shows the distribution of, and certain information relating to, the Bank's deposits by type of deposit as of the dates indicated.
SEPTEMBER 30, ------------------------------------------------------------ 2003 2002 2001 ------------------------------------------------------------ AMOUNT PERCENT AMOUNT PERCENT AMOUNT PERCENT ------------------------------------------------------------ (Dollars in thousands) Passbook $ 47,089 12.99% $ 41,659 12.60% $ 37,806 12.13% MMDA 55,889 15.41 48,721 14.73 40,781 13.09 NOW 60,221 16.61 48,803 14.75 45,161 14.49 Certificates of deposit 178,489 49.22 176,242 53.28 182,155 58.46 Non-interest-bearing 20,917 5.77 15,340 4.64 5,698 1.83 -------- ------ -------- ------ -------- ------ Total deposits $362,605 100.00% $330,765 100.00% $311,601 100.00% ======== ====== ======== ====== ======== ======
The following table sets forth the net savings flows of the Bank during the periods indicated.
YEAR ENDED SEPTEMBER 30, --------------------------- 2003 2002 2001 --------------------------- (Dollars in thousands) Increase before interest credited $25,633 $10,477 $27,876 Interest credited 6,207 8,687 11,163 ------- ------- ------- Net savings increase $31,840 $19,164 $39,039 ======= ======= =======
The following table sets forth maturities of the Bank's certificates of deposit of $100,000 or more at September 30, 2003 and 2002 by time remaining to maturity (amounts in thousands).
SEPTEMBER 30 ----------------- 2003 2002 ----------------- Three months or less $11,724 $10,764 Over three months through six months 6,581 5,509 Over six months through twelve months 5,984 6,679 Over twelve months 9,889 9,618 ------- ------- $34,178 $32,570 ======= =======
24 The following table presents, by various interest rate categories, the amount of certificates of deposit at September 30, 2003 and 2002 and the amounts at September 30, 2003 which mature during the periods indicated.
AMOUNTS AT SEPTEMBER 30, 2003 SEPTEMBER 30, MATURING WITHIN -------------------- ---------------------------------------------- Certificates of Deposit 2003 2002 ONE YEAR TWO YEARS THREE YEARS THEREAFTER -------------------- ---------------------------------------------- (Dollars in thousands) 2.0% or less $ 61,363 $ 3,475 $ 49,859 $ 11,504 $ -- $ -- 2.01% to 3.0% 39,394 63,429 19,527 16,497 2,703 667 3.01% to 4.0% 42,191 66,834 25,240 4,271 788 11,892 4.01% to 5.0% 19,694 23,064 1,882 7,335 1,214 9,263 5.01% to 6.0% 6,219 9,717 713 2,244 3,257 5 6.01% to 7.0% 9,628 9,723 9,410 218 -- -- -------- -------- -------- -------- -------- -------- Total certificate accounts $178,489 $176,242 $106,631 $ 42,069 $ 7,962 $ 21,827 ======== ======== ======== ======== ======== ========
The following table presents the average balance of each deposit type and the average rate paid on each deposit type for the periods indicated.
SEPTEMBER 30, --------------------------------------------------------- 2003 2002 2001 --------------------------------------------------------- AVERAGE AVERAGE AVERAGE AVERAGE RATE AVERAGE RATE AVERAGE RATE BALANCE PAID BALANCE PAID BALANCE PAID --------------------------------------------------------- (Dollars in thousands) Passbook accounts $ 44,105 1.20% $ 40,300 1.86% $ 37,661 2.41% MMDA accounts 51,756 1.42 47,245 2.19 31,645 3.86 Certificates of deposit 178,097 3.24 174,844 4.24 177,086 5.87 NOW accounts 55,496 .57 49,235 .81 40,681 1.32 Non-interest-bearing deposits 14,272 -- 7,720 -- 7,658 -- -------- -------- -------- Total deposits $343,726 2.14% $319,344 3.01% $294,731 4.43% ======== ==== ======== ==== ======== ====
25 Borrowings. The Bank may obtain advances from the FHLB of Pittsburgh upon the security of the common stock it owns in the FHLB and certain of its residential mortgage loans and securities held to maturity, provided certain standards related to creditworthiness have been met. Such advances are made pursuant to several credit programs, each of which has its own interest rate and range of maturities. During fiscal 2003, the Company funded a portion of its asset growth with overnight borrowings from FHLB. However, during fiscal 2002, the increase in core deposits funded asset growth, therefore borrowing from the FHLB was not necessary. At September 30, 2003, the Bank had $126.4 million in outstanding FHLB advances. The FHLB advances have certain call features whereby the FHLB of Pittsburgh can call the borrowings after the expiration of certain time frames. The time frames on the callable borrowings range from three months to seven years. See Note 9 of the Notes to Consolidated Financial Statements set forth in Item 8 hereof. SUBSIDIARIES The Bank is permitted to invest up to 2% of its assets in the capital stock of, or secured or unsecured loans to, service corporations, with an additional investment of 1% of assets when such additional investment is utilized primarily for community development purposes. It may invest essentially unlimited amounts in subsidiaries deemed operating subsidiaries that can only engage in activities that the Bank is permitted to engage in. Under such limitations, as of September 30, 2003, the Bank was authorized to invest up to approximately $11.0 million in the stock of, or loans to, service corporations. As of September 30, 2003, the net book value of the Bank's investment in stock, unsecured loans, and conforming loans to its service corporations was $38,100. At September 30, 2003, in addition to the Bank, the Company has six direct or indirect subsidiaries: First Keystone Capital Trust I, First Keystone Capital Trust II, FKF Management Corp., Inc., State Street Services Corp., First Pointe, Inc. and First Chester Services, Inc. First Keystone Capital Trust I (the "Trust") is a Delaware statutory business trust wholly owned by the Company formed in 1997 for the purpose of issuing trust preferred securities and investing the proceeds there from in Junior Subordinated Debentures issued by the Company. See Note 17 of the Notes to Consolidated Financial set forth in Item 8 hereof for further discussion regarding the issuance of trust preferred securities. First Keystone Capital Trust II (the "Trust II") is a Delaware statutory business trust wholly owned by the Company formed in 2001 for the purpose of issuing trust preferred securities and investing the proceeds in Junior Subordinated Debentures issued by the Company. See Note 17 of the Notes to the Consolidated Financial Statements set forth in Item 8 hereof for further discussion regarding the issuance of trust preferred securities. FKF Management Corp., Inc., a Delaware corporation, is a wholly owned operating subsidiary of the Bank established in 1997 for the purpose of managing certain assets of the Bank. Assets under management totaled $150.5 million at September 30, 2003 and were comprised principally of investment and mortgage-related securities. State Street Services Corp. is a wholly owned subsidiary of the Bank established in 1999 for the purpose of offering a full array of insurance products through its ownership of a 51% interest in First Keystone Insurance Services, LLC. In addition, it holds a 10% equity position in a title company which offers title services. The Bank has two remaining subsidiaries, First Chester Services, Inc. and First Pointe, Inc., which were both involved in real estate management but are now inactive. EMPLOYEES The Bank had 88 full-time employees and 15 part-time employees as of September 30, 2003. None of these employees is represented by a collective bargaining agreement. The Bank believes that it enjoys excellent relations with its personnel. 26 REGULATION The Company. The Company as a savings and loan holding company within the meaning of the Home Owners' Loan Act, as amended ("HOLA"), is registered as such with the OTS and is subject to OTS regulations, examination, supervision and reporting requirements. As a subsidiary of a savings and loan holding company, the Bank is subject to certain restrictions in its dealings with the Company and affiliates thereof. Federal Activities Restrictions. The Company operates as a unitary savings and loan holding company. Generally, there are only limited restrictions on the activities of a unitary savings and loan holding company which applied to become or was a unitary saving and loan holding company prior to May 4, 1999 and its non-savings institution subsidiaries. Under the Gramm-Leach-Bliley Act of 1999 (the "GLBA"), companies which apply to the OTS to become unitary savings and loan holding companies will be restricted to only engaging in those activities traditionally permitted to multiple saving and loan holding companies. However, if the Director of the OTS determines that there is reasonable cause to believe that the continuation by a savings and loan holding company of an activity constitutes a serious risk to the financial safety, soundness or stability of its subsidiary savings association, the Director may impose such restrictions as deemed necessary to address such risk, including limiting (i) payment of dividends by the savings association; (ii) transactions between the savings association and its affiliates; and (iii) any activities of the savings association that might create a serious risk that the liabilities of the holding company and its affiliates may be imposed on the savings association. Notwithstanding the above rules regarding permissible business activities of grandfathered unitary savings and loan holding companies under the GLBA (such as the Company), if the savings association subsidiary of such a holding company fails to meet the Qualified Thrift Lender ("QTL") test, then such unitary holding company also shall become subject to the activities restrictions applicable to multiple savings and loan holding companies and, unless the savings association qualifies as a QTL within one year thereafter, shall register as, and become subject to the restrictions applicable to, a bank holding company. If the Company were to acquire control of another savings association, other than through merger or other business combination with the Bank, the Company would thereupon become a multiple savings and loan holding company and would thereafter be subject to further restrictions on its activities. The GLBA also imposes financial privacy obligations and reporting requirements on all financial institutions. The privacy regulations require, among other things, that financial institutions establish privacy policies and disclose such policies to its customers at the commencement of a customer relationship and annually thereafter. In addition, financial institutions are required to permit customers to opt out of the financial institution's disclosure of the customer's financial information to non-affiliated third parties. The HOLA requires every savings institution subsidiary of a savings and loan holding company to give the OTS at least 30 days' advance notice of any proposed dividends to be made on its guarantee, permanent or other nonwithdrawable stock, or else such dividend will be invalid. See "- The Bank - Restrictions on Capital Distributions." Limitations on Transactions with Affiliates. Transactions between savings associations and any affiliate are governed by Sections 23A and 23B of the Federal Reserve Act ("FRA") and OTS regulations issued in connection therewith. Affiliates of a savings institution include, among other entities, the savings institution's holding company and companies that are controlled by or under common control with the savings institution. Generally, Sections 23A and 23B (i) limit the extent to which the savings association or its subsidiaries may engage in "covered transactions" with any one affiliate to an amount equal to 10% of such association's capital stock and surplus, and contain an aggregate limit on all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus and (ii) require that all such transactions be on terms substantially the same, or at least as favorable, to the association or subsidiary as those provided to a non-affiliate. The term "covered transaction" includes, among other things, the making of loans or extension of credit to an affiliate, purchase of assets, issuance of a guarantee and similar transactions. In addition to the restrictions imposed by Sections 23A and 23B, under OTS regulations no savings association may (i) loan or otherwise extend credit to an affiliate, except for any affiliate which engages only in activities which are permissible for bank holding companies, (ii) a savings association may not purchase or invest in securities of an affiliate other than shares of a subsidiary; (iii) a savings association and its subsidiaries may not purchase a low-quality asset from an affiliate; (iv) and covered transactions and certain other transactions between a savings association or its subsidiaries and an affiliate must 27 be on terms and conditions that are consistent with safe and sound banking practices. With certain exceptions, each extension of credit by a savings association to an affiliate must be secured by collateral with a market value ranging from 100% to 130% (depending on the type of collateral) of the amount of the loan or extension of credit. OTS regulations generally exclude all non-bank and non-savings association subsidiaries of savings associations from treatment as affiliates, except to the extent that the OTS or the Federal Reserve Board decides to treat such subsidiaries as affiliates. The regulations also require savings associations to make and retain records that reflect affiliate transactions in reasonable detail, and provide that certain classes of savings associations may be required to give the OTS prior notice of affiliate transactions. Restrictions on Acquisitions. Except under limited circumstances, savings and loan holding companies are prohibited from acquiring, without prior approval of the Director of the OTS, (i) control of any other savings association or savings and loan holding company or substantially all of the assets thereof; or (ii) more than 5% of the voting shares of a savings association or holding company thereof which is not a subsidiary. Except with the prior approval of the Director of the OTS, no director or officer of a savings and loan holding company or person owning or controlling by proxy or otherwise more than 25% of such company's stock, may acquire control of any savings association, other than a subsidiary savings association, or of any other savings and loan holding company. Federal Securities Laws. The Company's Common Stock is registered with the SEC under the Securities Exchange Act of 1934, as amended ("Exchange Act"). The Company is subject to the information, proxy solicitation, insider trading restrictions and other requirements under the Exchange Act. Shares of Common Stock owned by an affiliate of the Company are subject to the resale restrictions of Rule 144 under the Securities Act of 1933, as amended ("Securities Act"). As long as the Company meets the current public information requirements of Rule 144 under the Securities Act, each affiliate of the Company who complies with the other conditions of Rule 144 (including those that require the affiliate's sale to be aggregated with those of certain other persons) generally is able to sell in the public market, without registration, a number of shares not to exceed, in any three-month period, the greater of (i) 1% of the outstanding shares of the Company or (ii) the average weekly volume of trading in such shares during the preceding four calendar weeks. Sarbanes-Oxley Act of 2002. On July 30, 2002, the President signed into law the Sarbanes-Oxley Act of 2002 (the "Act") implementing legislative reforms intended to address corporate and accounting fraud. In addition to the establishment of a new accounting oversight board which will enforce auditing, quality control and independence standards and will be funded by fees from all publicly traded companies, the bill restricts provision of both auditing and consulting services by accounting firms. To ensure auditor independence, any non-audit services being provided to an audit client will require preapproval by the company's audit committee members. In addition, the audit partners must be rotated. The Act requires chief executive officers and chief financial officers, or their equivalent, to certify to the accuracy of periodic reports filed with the SEC, subject to civil and criminal penalties if they knowingly or willfully violate this certification requirement. In addition, under the Act, counsel will be required to report evidence of a material violation of the securities laws or a breach of fiduciary duty by a company to its chief executive officer or its chief legal officer, and, if such officer does not appropriately respond, to report such evidence to the audit committee or other similar committee of the board of directors or the board itself. Longer prison terms and increased penalties will also be applied to corporate executives who violate federal securities laws, the period during which certain types of suits can be brought against a company or its officers has been extended, and bonuses issued to top executives prior to restatement of a company's financial statements are now subject to disgorgement if such restatement was due to corporate misconduct. Executives are also prohibited from insider trading during retirement plan "blackout" periods, and loans to company executives are restricted. In addition, a provision directs that civil penalties levied by the SEC as a result of any judicial or administrative action under the Act be deposited to a fund for the benefit of harmed investors. The Federal Accounts for Investor Restitution ("FAIR") provision also requires the SEC to develop methods of improving collection rates. The legislation accelerates the time frame for disclosures by public companies, as they must immediately disclose any material changes in their financial condition or operations. Directors and executive officers must also provide information for most changes in ownership in a company's securities within two business days of the change. 28 The Act also increases the oversight of, and codifies certain requirements relating to audit committees of public companies and how they interact with the company's "registered public accounting firm" ("RPAF"). Audit committee members must be independent and are barred from accepting consulting, advisory or other compensatory fees from the issuer. In addition, companies must disclose whether at least one member of the committee is a "financial expert" (as such term is defined by the SEC in regulations promulgated thereby) and if not, why not. Under the Act, a RPAF is prohibited from performing statutorily mandated audit services for a company if such company's chief executive officer, chief financial officer, comptroller, chief accounting officer or any person serving in equivalent positions has been employed by such firm and participated in the audit of such company during the one-year period preceding the audit initiation date. The Act also prohibits any officer or director of a company or any other person acting under their direction from taking any action to fraudulently influence, coerce, manipulate or mislead any independent public or certified accountant engaged in the audit of the company's financial statements for the purpose of rendering the financial statement's materially misleading. The Act also requires the SEC to prescribe rules requiring inclusion of an internal control report and assessment by management in the annual report to stockholders. The Act requires the RPAF that issues the audit report to attest to and report on management's assessment of the company's internal controls. In addition, the Act requires that each financial report required to be prepared in accordance with (or reconciled to) accounting principles generally accepted in the United States of America and filed with the SEC reflect all material correcting adjustments that are identified by a RPAF in accordance with accounting principles generally accepted in the United States of America and the rules and regulations of the SEC. The Bank. The OTS has extensive regulatory authority over the operations of savings associations such as the Bank. As part of this authority, savings associations are required to file periodic reports with the OTS and are subject to periodic examinations by the OTS. The investment and lending authority of savings associations are prescribed by federal laws and regulations and they are prohibited from engaging in any activities not permitted by such laws and regulations. Those laws and regulations generally are applicable to all federally chartered savings associations and may also apply to state-chartered savings associations. Such regulation and supervision is primarily intended for the protection of depositors. Insurance of Accounts. The deposits of the Bank are insured to the maximum extent permitted by the SAIF, which is administered by the FDIC, and are backed by the full faith and credit of the U. S. Government. As insurer, the FDIC is authorized to conduct examinations of, and to require reporting by, FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious threat to the FDIC. The FDIC also has the authority to initiate enforcement actions against savings associations, after giving the OTS an opportunity to take such action. Under current Federal Deposit Insurance Corporation regulations, Savings Association Insurance Fund-insured institutions are assigned to one of three capital groups which are based solely on the level of an institution's capital - "well capitalized," "adequately capitalized" and "undercapitalized" - which are defined in the same manner as the regulations establishing the prompt corrective action system discussed below. These three groups are then divided into three subgroups which reflect varying levels of supervisory concern, from those which are considered to be healthy to those which are considered to be of substantial supervisory concern. The matrix so created results in nine assessment risk classifications, with rates during the first six months of 2003 ranging from zero for well capitalized, healthy institutions, such as the Bank, to 27 basis points for undercapitalized institutions with substantial supervisory concerns. In addition, all institutions with deposits insured by the Federal Deposit Insurance Corporation are required to pay assessments to fund interest payments on bonds issued by the Financing Corporation, a mixed-ownership government corporation established to recapitalize the predecessor to the Savings Association Insurance Fund. The assessment rate for the third quarter of 2003 was .016% of insured deposits and is adjusted quarterly. These assessments will continue until the Financing Corporation bonds mature in 2019. The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process 29 for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is not aware of any existing circumstances which could result in termination of the Bank's deposit insurance. Capital requirements. Current OTS capital standards require savings associations to satisfy three different capital requirements. Under these standards, savings associations must maintain "tangible" capital equal to 1.5% of adjusted total assets, "core" capital equal to 4% (3% if the association receives the OTS' highest rating) of adjusted total assets and "total" capital (a combination of core and "supplementary" capital) equal to 8.0% of "risk-weighted" assets. For purposes of the regulation, core capital generally consists of common stockholders' equity (including retained earnings), noncumulative perpetual preferred stock and related surplus, minority interests in the equity accounts of fully consolidated subsidiaries, certain nonwithdrawable accounts and pledged deposits and "qualifying supervisory goodwill." Tangible capital is given the same definition as core capital but does not include qualifying supervisory goodwill and is reduced by the amount of all the savings association's intangible assets, with only a limited exception for purchased mortgage servicing rights ("PMSRs"). Both core and tangible capital are further reduced by an amount equal to a savings association's debt and equity investments in subsidiaries engaged in activities not permissible for national banks (other than subsidiaries engaged in activities undertaken as agent for customers or in mortgage banking activities and subsidiary depository institutions or their holding companies). In addition, under the Prompt Corrective Action provisions of the OTS regulations, all but the most highly rated institutions must maintain a minimum leverage ratio of 4% in order to be adequately capitalized. See "- Prompt Corrective Action." At September 30, 2003, the Bank did not have any investment in subsidiaries engaged in impermissible activities and required to be deducted from its capital calculation. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") granted the OTS the authority to prescribe rules for the amount of PMSRs that may be included in a savings association's regulatory capital and required that the value of readily marketable PMSRs included in the calculation of a savings association's regulatory capital not exceed 90% of fair market value and that such value be determined at least quarterly. Under OTS regulations, (i) PMSRs do not have to be deducted from tangible and core regulatory capital, provided that they do not exceed 50% of core capital, (ii) savings associations are required to determine the fair market value and to review the book value of their PMSRs at least quarterly and to obtain an independent valuation of PMSRs annually, (iii) savings associations that desire to include PMSRs in regulatory capital may not carry them at a book value under GAAP that exceeds the discounted value of their future net income stream and (iv) for purposes of calculating regulatory capital, the amount of PMSRs reported as balance sheet assets should amount to the lesser of 90% of their fair market value, 90% of their original purchase price or 100% of their remaining unamortized book value. At September 30, 2003, the Bank had PMSRs totaling $197,600. A savings association is allowed to include both core capital and supplementary capital in the calculation of its total capital for purposes of the risk-based capital requirements, provided that the amount of supplementary capital does not exceed the savings association's core capital. Supplementary capital generally consists of hybrid capital instruments; perpetual preferred stock which is not eligible to be included as core capital; subordinated debt and intermediate-term preferred stock; and, subject to limitations, general allowances for loan losses. Assets are adjusted under the risk-based guidelines to take into account different risk characteristics, with the categories ranging from 0% (requiring no additional capital) for assets such as cash to 100% for repossessed assets or loans more than 90 days past due. Single-family residential real estate loans which are not past-due or non-performing and which have been made in accordance with prudent underwriting standards are assigned a 50% level in the risk-weighing system, as are certain privately-issued mortgage-backed securities representing indirect ownership of such loans. Off-balance sheet items also are adjusted to take into account certain risk characteristics. The OTS amended its risk-based capital requirements that would require institutions with an "above normal" level of interest rate risk to maintain additional capital. A savings association is considered to have a "normal" level of interest rate risk if the decline in the market value of its portfolio equity after an immediate 200 basis point increase or decrease in market interest rates (whichever leads to the greater decline) is less than two percent of the current estimated market value of its assets. The market value of portfolio equity is defined as the net present value of expected cash inflows and outflows from an association's assets, liabilities, and off-balance sheet items. The amount of additional capital, that an institution with an above normal interest rate risk is required to maintain (the "interest rate risk component") equals one- 30 half of the dollar amount by which its measured interest rate risk exceeds the normal level of interest rate risk. The interest rate risk component is in addition to the capital otherwise required to satisfy the risk-based capital requirement. Implementation of this component has been postponed by the OTS. The final rule was to be effective as of January 1, 1994, subject however to a three quarter lag time in implementation. However, because of continuing delays by the OTS, the interest rate risk component has never been operative. At September 30, 2003, the Bank exceeded all of its regulatory capital requirements, with tangible, core and risk-based capital ratios of 8.0%, 8.0%, and 15.0%, respectively. See Note 11 to the Notes to Consolidated Financial Statements included set forth in Item 8 hereof. The OTS and the FDIC generally are authorized to take enforcement action against a savings association that fails to meet its capital requirements, which action may include restrictions on operations and banking activities, the imposition of a capital directive, a cease-and-desist order, civil money penalties or harsher measures such as the appointment of a receiver or conservator or a forced merger into another institution. In addition, under current regulatory policy, an association that fails to meet its capital requirements is prohibited from paying any dividends. 31 The following is a reconciliation of the Bank's equity determined in accordance with GAAP to regulatory tangible, core and risk-based capital at September 30, 2003, 2002 and 2001.
September 30, 2003 September 30, 2002 September 30, 2001 -------------------------------------------------------------------------------------------- Tangible Core Risk-based Tangible Core Risk-based Tangible Core Risk-based Capital Capital Capital Capital Capital Capital Capital Capital Capital -------------------------------------------------------------------------------------------- (Dollars in thousands) GAAP equity $43,852 $43,852 $43,852 $40,873 $40,873 $40,873 $37,211 $37,211 $37,211 Assets required to be deducted (1) -- -- -- -- -- -- -- -- -- General valuation allowances -- -- 1,712 -- -- 2,084 -- -- 1,883 ------- ------- ------- ------- ------- ------- ------- ------- ------- Total regulatory capital 43,852 43,852 45,564 40,873 40,873 42,957 37,211 37,211 39,094 Minimum capital requirement 8,240 21,972 24,357 7,597 20,265 21,255 7,189 19,172 18,602 ------- ------- ------- ------- ------- ------- ------- ------- ------- Excess $35,612 $21,880 $21,207 $33,276 $20,608 $21,702 $30,022 $18,039 $20,492 ======= ======= ======= ======= ======= ======= ======= ======= =======
(1) Consists of an equity investment which was non-includable in regulatory capital. These capital requirements are viewed as minimum standards by the OTS, and most institutions are expected to maintain capital levels well above the minimum. In addition, the OTS regulations provide that minimum capital levels higher than those provided in the regulations may be established by the OTS for individual savings association's capital, upon a determination that circumstances exist that higher individual minimum capital requirements may be appropriate. 32 Prompt Corrective Action. Under the prompt corrective action regulations of the OTS, an institution shall be deemed to be (i) "well capitalized" if it has total risk-based capital of 10% or more, has a Tier I risk-based capital ratio of 6% or more, has a Tier I leverage capital ratio of 5% or more and is not subject to any order or final capital directive to meet and maintain a specific capital level for any capital measure, (ii) "adequately capitalized" if it has a total risk-based capital ratio of 8% or more, a Tier I risk-based capital ratio of 4% or more and a Tier I leverage capital ratio of 4% or more (3% under certain circumstances) and does not meet the definition of "well capitalized," (iii) "undercapitalized" if it has a total risk-based capital ratio that is less than 8%, a Tier I risk-based capital ratio that is less than 4% or a Tier I leverage capital ratio that is less than 4% (3% under certain circumstances), (iv) "significantly undercapitalized" if it has a total risk-based capital ratio that is less than 6%, a Tier I risk-based capital ratio that is less than 3% or a Tier I leverage capital ratio that is less than 3%, and (v) "critically undercapitalized" if it has a ratio of tangible equity to total assets that is equal to or less than 2%. Under specified circumstances, the OTS may reclassify a well capitalized institution as adequately capitalized and may require an adequately capitalized institution or an undercapitalized institution to comply with supervisory actions as if it were in the next lower category (except that the FDIC may not reclassify a significantly undercapitalized institution as critically undercapitalized). At September 30, 2003, the Bank met the requirements of a "well capitalized" institution under OTS regulations. Qualified Thrift Lender Test (the "QTL"). A savings association can comply with the QTL test by either meeting the QTL test set forth in the HOLA and the implementing regulations or qualifying as a domestic building and loan association as defined in Section 7701(a)(19) of the Internal Revenue Code of 1986, as amended ("Code"). Currently, the portion of the QTL test that is based on the HOLA rather than the Code requires that 65% of an institution's "portfolio assets" (as defined) consist of certain housing and consumer-related assets on a monthly average basis in nine out of every 12 months. Assets that qualify without limit for inclusion as part of the 65% requirement are loans made to purchase, refinance, construct, improve or repair domestic residential housing and manufactured housing, home equity loans, mortgage-backed securities (where the mortgages are secured by domestic residential housing or manufactured housing), stock issued by the FHLB, and direct or indirect obligations of the FDIC. In addition, small business loans, credit card loans, student loans and loans for personal, family and household purposes are allowed to be included without limitation as qualified investments. The following assets, among others, also may be included in meeting the test subject to an overall limit of 20% of the savings institution's portfolio assets: 50% of residential mortgage loans originated and sold within 90 days of origination, 100% loans for personal, family and household purposes (other then credit card loans and education loans) (limited to 10% of total portfolio assets) and stock issued by FHLMC or FNMA. Portfolio assets consist of total assets minus the sum of (i) goodwill and other intangible assets, (ii) property used by the savings institution to conduct its business, and (iii) liquid assets up to 20% of the institution's total assets. A savings institution that does not comply with the QTL test must either convert to a bank charter or comply with certain restrictions on its operations. Upon the expiration of three years from the date the association ceases to be a QTL, it must cease any activity and not retain any investment not permissible for a national bank and immediately repay any outstanding FHLB advances (subject to safety and soundness considerations). At September 30, 2003, approximately 71.6% of the Bank's assets were invested in qualified thrift investments, which was in excess of the percentage required to qualify the Bank under the QTL test in effect at that time. OTS regulations govern capital distributions by savings institutions, which include cash dividends, stock repurchases and other transactions charged to the capital account of a savings institution to make capital distributions. A savings institution must file an application for OTS approval of the capital distribution if any of the following occur or would occur as a result of the capital distribution (1) the total capital distributions for the applicable calendar year exceed the sum of the institution's net income for that year to date plus the institution's retained net income for the preceding two years, (2) the institution would not be at least adequately capitalized following the distribution, (3) the distribution would violate any applicable statute, regulation, agreement or OTS-imposed condition, or (4) the institution is not eligible for expedited treatment of its filings. If an application is not required to be filed, savings institutions which are a subsidiary of a holding company (as well as certain other institutions) must still file a notice with the OTS at least 30 days before the Board of Directors declares a dividend or approves a capital distribution. 33 OTS regulations also prohibit the Bank from declaring or paying any dividends or from repurchasing any of its stock if, as a result, the regulatory (or total) capital of the Bank would be reduced below the amount required to be maintained for the liquidation account established by it for certain depositors in connection with its conversion from mutual to stock form. Community Reinvestment. Under the Community Reinvestment Act of 1977, as amended ("CRA"), as implemented by OTS regulations, a savings association has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution's discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The Bank received a satisfactory CRA rating as a result of its last OTS evaluation. Branching by Federal Saving Institutions. OTS policy permits interstate branching to the full extent permitted by statute (which is essentially unlimited). Generally, federal law prohibits federal savings institutions from establishing, retaining or operating a branch outside the state in which the federal institution has its home office unless the institution meets the IRS' domestic building and loan test (generally, 60% of a thrift's assets must be housing-related) ("IRS Test"). The IRS Test requirement does not apply if: (a) the branch(es) result(s) from an emergency acquisition of a troubled savings institution (however, if the troubled savings institution is acquired by a bank holding company, does not have its home office in the state of the bank holding company bank subsidiary and does not qualify under the IRS Test, its branching is limited to the branching laws for state-chartered banks in the state where the savings institution is located); (b) the law of the state where the branch would be located would permit the branch to be established if the federal savings institution were chartered by the state in which its home office is located; or (c) the branch was operated lawfully as a branch under state law prior to the savings institution's reorganization to a federal charter. Furthermore, the OTS will evaluate a branching applicant's record of compliance with the Community Reinvestment Act of 1977. An unsatisfactory Community Reinvestment Act record may be the basis for denial of a branching application. Federal Home Loan Bank System. The Bank is a member of the FHLB of Pittsburgh, which is one of 12 regional FHLBs that administers the home financing credit function of savings associations. Each FHLB serves as a reserve or central bank for its members within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It makes loans to members (i.e., advances) in accordance with policies and procedures established by the Board of Directors of the FHLB. As of September 30, 2003, the Bank has overnight borrowings and advances of $133.2 million from the FHLB or 26.4% of its total liabilities. The Bank currently has the ability to obtain up to $156.9 million additional advances from FHLB of Pittsburgh. As a member, the Bank is required to purchase and maintain stock in the FHLB of Pittsburgh in an amount equal to at least 1% of its aggregate unpaid residential mortgage loans, home purchase contracts or similar obligations at the beginning of each year or 5% of its advances from the FHLB of Pittsburgh, whichever is greater. At September 30, 2003, the Bank had $8.3 million in FHLB stock, which was in compliance with this requirement. The FHLBs are required to provide funds for the resolution of troubled savings institutions and to contribute to affordable housing programs through direct loans or interest subsidies on advances targeted for community investment and low- and moderate-income housing projects. These contributions have adversely affected the level of FHLB dividends paid and could continue to do so in the future and could also result in the FHLBs imposing higher interest rates on advances to members. These contributions also could have an adverse effect on the value of FHLB stock in the future. Federal Reserve System. The Board of Governors of the Federal Reserve System ("FRB") requires all depository institutions to maintain reserves against their transaction accounts (primarily NOW and Super NOW checking accounts) and non-personal time deposits. At September 30, 2003, the Bank was in compliance with applicable requirements. However, because required reserves must be maintained in the form of vault cash or a noninterest-bearing account at a FRB, the effect of this reserve requirement is to reduce an institution's earning assets. 34 Savings institutions are authorized to borrow from a Federal Reserve Bank "discount window," but FRB regulations require savings banks to exhaust other reasonable alternative sources of funds, including FHLB advances, before borrowing from a Federal Reserve Bank. Safety and Soundness Guidelines. The OTS and the other federal banking agencies have established guidelines for safety and soundness, addressing operational and managerial, as well as compensation matters for insured financial institutions. Institutions failing to meet these standards are required to submit compliance plans to their appropriate federal regulators. The OTS and the other agencies have also established guidelines regarding asset quality and earnings standards for insured institutions. FEDERAL AND STATE TAXATION General. The Company and the Bank are subject to the corporate tax provisions of the Code, as well as certain additional provisions of the Code which apply to thrift and other types of financial institutions. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to the Company and the Bank. Fiscal Year. The Company and the Bank and its subsidiaries file a consolidated federal income tax return on a fiscal year basis ending September 30. Method of Accounting. The Bank maintains its books and records for federal income tax purposes using the accrual method of accounting. The accrual method of accounting generally requires that items of income be recognized when all events have occurred that establish the right to receive the income and the amount of income can be determined with reasonable accuracy, and that items of expense be deducted at the later of (i) the time when all events have occurred that establish the liability to pay the expense and the amount of such liability can be determined with reasonable accuracy or (ii) the time when economic performance with respect to the item of expense has occurred. Bad Debt Reserves. The Bank is permitted to establish reserves for bad debts and to make annual additions thereto which qualify as deductions from taxable income. The Company, as of October 1, 1996, changed its method of computing reserves for bad debts to the experience method (the "Experience Method"). The bad debt deduction allowable under this method is available to small banks with assets less than $500 million. Beginning October 1, 2001, the Company changed its method of computing reserves for bad debts to the specific charge-off method. The bad debt deduction allowable under this method is available to large banks with assets greater than $500 million. Generally, this method allows the Company to deduct an annual addition to the reserve for bad debts equal to it its net charge-offs. The Bank treated such change as a change in a method of accounting determined solely with respect to the "applicable excess reserves" of the institution. The amount of applicable excess reserves is taken into account ratably over a six taxable-year period, beginning with the first taxable year beginning after December 31, 1995. For financial reporting purposes, the Company has not incurred any additional tax expense. Amounts that had been previously deferred will be reversed for financial reporting purposes and will be included in the income tax return of the Company, increasing income tax payable. The change from the experience method to the specific charge-off method in the current year did not result in a recapture of bad debt reserves for tax purposes. Prior to the Small Business Protection Act of 1996, bad debt reserves created prior to January 1, 1988 were subject to recapture into taxable income if the Bank failed to meet certain thrift asset and definitional tests. New federal legislation eliminated these thrift-related recapture rules. However, to the extent that the Bank makes "non-dividend distributions" that are considered as made (i) from the reserve for losses on qualifying real property loans or (ii) from the supplemental reserve for losses on loans, then an amount based on the amount distributed will be included in its taxable income. Non-dividend distributions include distributions in excess of the Bank's current and accumulated earnings and profits, distributions in redemption of stock, and distributions in partial or complete liquidation. Dividends paid out of the Bank's current or accumulated earnings and profits, as calculated for federal income tax purposes, will not be considered to result in a distribution from our bad debt reserve. As a result, any dividends that would reduce amounts appropriated to bad debt reserve and deducted for federal income tax purposes would create a tax liability for the Bank. 35 Minimum Tax. The Code imposes an alternative minimum tax at a rate of 20% on a base of regular taxable income plus certain tax preferences ("alternative minimum taxable income" or "AMTI"). The alternative minimum tax is payable to the extent such AMTI is in excess of an exemption amount. The Code provides that an item of tax preference is the excess of the bad debt deduction allowable for a taxable year pursuant to the percentage of taxable income method over the amount allowable under the experience method. The other items of tax preference that constitute AMTI include (a) tax-exempt interest on newly-issued (generally, issued on or after August 8, 1986) private activity bonds other than certain qualified bonds and (b) for taxable years beginning after 1989, 75% of the excess (if any) of (i) adjusted current earnings as defined in the Code, over (ii) AMTI (determined without regard to this preference and prior to reduction by net operating losses). Net operating losses can offset no more than 90% of AMTI. Certain payments of alternative minimum tax may be used as credits against regular tax liabilities in future years. Audit by IRS. The Bank's consolidated federal income tax returns for taxable years through September 30, 1998 have been closed for the purpose of examination by the IRS. STATE TAXATION The Company and the Bank's subsidiaries are subject to the Pennsylvania Corporate Net Income Tax and Capital Stock and Franchise Tax. The Corporate Net Income Tax rate for fiscal 2003 is 9.99% and is imposed on the Company's unconsolidated taxable income for federal purposes with certain adjustments. In general, the Capital Stock and Franchise Tax is a property tax imposed at the rate of 1.1% of a corporation's capital stock value, which is determined in accordance with a fixed formula. The Bank is taxed under the Pennsylvania Mutual Thrift Institutions Tax Act (the ("MTIT"), as amended to include thrift institutions having capital stock. Pursuant to the MTIT, the Bank's tax rate is 11.5%. The MTIT exempts the Bank from all other taxes imposed by the Commonwealth of Pennsylvania for state income tax purposes and from all local taxation imposed by political subdivisions, except taxes on real estate and real estate transfers. The MTIT is a tax upon net earnings, determined in accordance with GAAP with certain adjustments. The MTIT, in computing GAAP income, allows for the deduction of interest earned on state and federal securities, while disallowing a percentage of a thrift's interest expense deduction in the proportion of interest income on those securities to the overall interest income of the Bank. Net operating losses, if any, thereafter can be carried forward three years for MTIT purposes. 36 ITEM 2. PROPERTIES. At September 30, 2003, the Bank conducted business from its executive offices located in Media, Pennsylvania and six full-service offices located in Delaware and Chester Counties, Pennsylvania. See also Note 7 of the Notes to Consolidated Financial Statements set forth in Item 8 hereof. The following table sets forth certain information with respect to the Bank's offices at September 30, 2003.
Net Book Value Amount of Description/Address Leased/Owned of Property Deposits - ---------------------------------------------------------------------------------------------------------- (Dollar in thousands) Executive Offices: 22 West State Street Media, Pennsylvania 19063 Owned(1) $1,223 $103,141 Branch Offices: 3218 Edgmont Avenue Brookhaven, Pennsylvania 19015 Owned 400 82,002 Routes 1 and 100 Chadds Ford, Pennsylvania 19318 Leased(2) 63 28,883 23 East Fifth Street Chester, Pennsylvania 19013 Leased(3) 85 26,984 31 Baltimore Pike Chester Heights, Pennsylvania 19017 Leased(4) 588 42,406 Route 82 and 926 Kennett Square, Pennsylvania 19348 Leased(5) 34 15,463 330 Dartmouth Avenue Swarthmore, Pennsylvania 19081 Owned 99 63,726 ------ -------- Total $2,492 $362,605 ====== ========
- ---------------------------- (1) Also a branch office. (2) Lease expiration date is September 30, 2005. The Bank has one five-year renewal option. (3) Lease expiration date is December 31, 2005. The Bank has one ten-year renewal option. (4) Lease expiration date is December 31, 2028. The Bank has options to cancel on the 15th, 20th and 25th year of the lease. (5) Lease expiration date is September 30, 2006. The Bank has three five-year renewal options. The bank exercised its option to move the branch office to a new leased facility that is within a short distance away. 37 ITEM 3. LEGAL PROCEEDINGS. The Company is involved in routine legal proceedings occurring in the ordinary course of business which, in the aggregate, are believed by management to be immaterial to the financial condition of the Company. In October 2002, the Bank was served with a Demand for Arbitration from Impac Funding Corp. before the American Arbitration Association. The arbitration proceedings are captioned In the Matter of Arbitration between Impac Funding Corp. and First Keystone Federal Savings Bank, American Arbitration Association, Arbitration No. 73-148-00498-02-JUBA. In its arbitration demand, Impac asserted breach of contract claims relating to its purchase of five residential mortgage loans. Impac Funding is claiming damages of $182,000 plus attorney fees. The Bank submitted their response to the arbitration demand on November 20, 2002. The parties have agreed to settle the claims for a payment by the Bank of $45,000. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. PART II. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. On January 25, 1995 the conversion and reorganization of the Bank and its mutual holding company parent was completed. In connection with the consummation of the Conversion, the Holding Company issued 2,720,000 shares of common stock. As of September 30, 2003, there were 1,925,337 shares of common stock outstanding. As of September 16, 2003, the Holding Company had 415 stockholders of record not including the number of persons or entities holding stock in nominee or street name through various brokers and banks. The following table sets forth the high and low closing stock prices of the Holding Company's common stock as reported by the Nasdaq Stock Market under the symbol "FKFS" during the periods presented. Price information appears in a major newspaper under the symbol "FstKeyst".
YEAR ENDED -------------------------------------------- SEPTEMBER 30, 2003 SEPTEMBER 30, 2002 ------------------ ------------------ HIGH LOW HIGH LOW ------ ------ ------ ------ First Quarter $16.45 $13.80 $14.00 $13.31 Second Quarter $21.23 $16.11 $15.32 $14.00 Third Quarter $23.74 $21.16 $18.62 $15.19 Fourth Quarter $26.50 $21.90 $18.87 $14.45
38 The following schedule summarizes the cash dividends per share of common stock paid by the Holding Company during the periods indicated.
YEAR ENDED -------------------------------------------- SEPTEMBER 30, 2003 SEPTEMBER 30, 2002 ------------------ ------------------ First Quarter $0.09 $0.08 Second Quarter 0.10 0.09 Third Quarter 0.10 0.09 Fourth Quarter 0.10 0.09
On November 12, 2003, the Board of Directors declared a quarterly cash dividend of $0.11 per share of Common Stock, payable on January 2, 2004, to stockholders of record at the close of business on December 16, 2003. See "Liquidity, Capital Resources and Commitments" set forth in Item 7 hereof and Notes 11 of the "Notes to Consolidated Financial Statements" set forth in Item 8 hereof for discussion of restrictions on the Holding Company's ability to pay dividends. 39 ITEM 6. SELECTED FINANCIAL DATA. The selected consolidated financial and other data of First Keystone Financial, Inc. set forth below does not purport to be complete and should be read in conjunction with, and is qualified in its entirety by, the more detailed information, including the Consolidated Financial Statements and related Notes, appearing elsewhere herein.
AT OR FOR THE YEAR ENDED SEPTEMBER 30, ----------------------------------------------------------- (Dollars in thousands, except per share data) 2003 2002 2001 2000 1999 -------- -------- -------- -------- -------- SELECTED FINANCIAL DATA: Total assets $558,667 $518,346 $489,050 $463,463 $450,126 Loans receivable, net 286,421 288,776 247,664 230,686 226,375 Mortgage-related securities held to maturity 3,487 8,855 11,454 13,056 14,497 Investment securities held to maturity 6,315 -- -- 10,000 16,532 Assets held for sale: Mortgage-related securities 124,656 85,674 117,608 96,257 113,046 Investment securities 77,700 80,624 62,564 42,215 44,315 Loans 4,498 501 225 3,099 1,792 Real estate owned 1,420 248 887 947 297 Deposits 362,605 330,765 311,601 272,562 260,826 Borrowings 136,272 126,384 126,234 142,902 142,437 Trust preferred securities 20,843 20,880 16,200 16,200 16,200 Stockholders' equity 32,388 32,795 30,621 26,569 23,904 Non-performing assets 2,976 5,386 3,189 3,462 3,477 SELECTED OPERATIONS DATA: Interest income $ 27,212 $ 30,121 $ 31,860 $ 31,068 $ 28,694 Interest expense 14,336 16,540 20,344 19,231 16,956 -------- -------- -------- -------- -------- Net interest income 12,876 13,581 11,516 11,837 11,738 Provision for loan losses 715 540 540 420 259 -------- -------- -------- -------- -------- Net interest income after provision for loan losses 12,161 13,041 10,976 11,417 11,479 Service charges and other fees 1,013 1,000 952 941 934 Net gain (loss) on sales of interest-earning assets 1,010 415 174 (680) 616 Other non-interest income 1,223 808 788 1,013 350 Non-interest expense 12,015 12,090 9,960 9,849 9,614 -------- -------- -------- -------- -------- Income before income taxes 3,392 3,174 2,930 2,842 3,765 Income tax expense 653 448 459 480 917 -------- -------- -------- -------- -------- Net income $ 2,739 $ 2,726 $ 2,471 $ 2,362 $ 2,848 ======== ======= ======== ======== ======== PER SHARE DATA: Basic earnings per share $ 1.44 $ 1.42 $ 1.22 $ 1.14 $ 1.40 Diluted earnings per share 1.35 1.34 1.18 1.11 1.32 Cash dividends per share 0.40 0.36 0.32 0.28 0.24
40
AT OR FOR THE YEAR ENDED SEPTEMBER 30, -------------------------------------------------------- (Dollars in thousands, except per share data) 2003 2002 2001 2000 1999 ------ ------ ------ ------ ------ SELECTED OPERATING RATIOS: (1) Average yield earned on interest-earning assets 5.48% 6.42% 7.25% 7.47% 7.15% Average rate paid on interest-bearing liabilities 3.02 3.70 4.83 4.79 4.49 Average interest rate spread 2.46 2.72 2.42 2.68 2.65 Net interest margin 2.64 2.95 2.68 2.91 2.98 Ratio of interest-earning assets to interest- bearing liabilities 106.06 106.54 105.87 104.91 107.91 Efficiency ratio (2) 74.52 76.50 74.16 75.12 70.49 Non-interest expense as a percent of average assets 2.25 2.41 2.11 2.20 2.26 Return on average assets 0.51 0.54 0.52 0.53 0.67 Return on average equity 8.39 8.77 8.42 9.96 11.18 Ratio of average equity to average assets 6.12 6.17 6.22 5.29 5.99 Full-service offices at end of period 7 7 7 7 6 ASSET QUALITY RATIOS:(3) Non-performing loans as a percent of gross loans receivable 0.53% 1.76% 0.92% 1.07% 1.39% Non-performing assets as a percent of total assets 0.53 1.04 0.65 0.75 0.77 Allowance for loan losses as a percent of gross loans receivable 0.68 0.81 0.87 0.86 0.84 Allowance for loan losses as a percent of non-performing loans 127.63 45.89 94.74 80.28 60.63 Net loans charged-off to average loans receivable 0.37 0.13 0.16 0.14 0.03 CAPITAL RATIOS:(3) (4) Tangible capital ratio 7.98% 8.07% 7.76% 8.32% 8.17% Core capital ratio 7.98 8.07 7.76 8.32 8.17 Risk-based capital ratio 14.97 16.17 16.81 17.70 18.80
(1) Adjusted for the effects of tax-free investments. See presentation of reconciliation of tax-free investments in Management's Discussion and Analysis - "Average Balances, Net Interest Income and Yield Earned and Rates Paid." (2) Reflects non-interest expense as a percent of the aggregate of net interest income and non-interest income. (3) Asset Quality Ratios and Capital Ratios are end of period ratios except for the ratio of loan charge-offs to average loans. With the exception of end of period ratios, all ratios are based on average daily balances during the indicated periods. Gross loans receivable are net of loans in process. (4) Regulatory capital ratios of the Company's wholly owned subsidiary, First Keystone Bank. 41 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION. GENERAL First Keystone Financial, Inc. (the "Company") is the holding company for its wholly owned subsidiary, First Keystone Bank (the "Bank"). For purposes of this discussion, references to the Company will include its wholly owned subsidiaries, unless otherwise indicated. The Company is a community-oriented banking organization that focuses on providing customer and business services within its primary market area, consisting primarily of Delaware and Chester counties in the Commonwealth of Pennsylvania. The following discussion should be read in conjunction with the Company's consolidated financial statements presented in Item 15 of this Annual Report on Form 10-K. The primary asset of the Company is its investment in the Bank and, accordingly, the discussion below with respect to results of operations relates primarily to the operations of the Bank. The Company's results of operations depend primarily on its net interest income which is the difference between interest income on interest-earning assets, which principally consist of loans, mortgage-related securities and investment securities, and interest expense on interest-bearing liabilities, which principally consist of deposits and FHLB advances. The Company's results of operations also are affected by the provision for loan losses (the amount of which reflects management's assessment of the known and inherent losses in its loan portfolio that are both probable and reasonably estimable), the level of its non-interest income, including service charges and other fees as well as gains and losses from the sale of certain assets, the level of its operating expenses, and income tax expense. CRITICAL ACCOUNT POLICIES Accounting policies involving significant judgments and assumptions by management, which have, or could have, a material impact on the carrying value of certain assets or comprehensive income, are considered critical accounting policies. In management's opinion, the most critical accounting policy affecting the Company's financial statements is the evaluation of the allowance for loan losses. The Company maintains an allowance for loan loss at a level management believes is sufficient to provide for known and inherent losses in the loan portfolio. The determination of the allowance for loan losses involves significant judgment and assumptions by management which may have a material impact on the carrying value of net loans and potentially on the net income we recognize from period to period. Accordingly, there is likelihood that materially different amounts would be reported under different, but reasonably plausible conditions or assumptions. For a description of the methods the Company uses to determine the Company's allowance for loan losses, see "Results of Operations - Provisions for Loan Losses." ASSET AND LIABILITY MANAGEMENT The principal objectives of the Company's asset and liability management are to (1) evaluate the interest rate risk existing in certain assets and liabilities, (2) determine the appropriate level of risk given the Company's business focus, operating environment, capital and liquidity requirements and performance objectives, (3) establish prudent asset and liability compositions, and (4) manage the assessed risk consistent with Board approved guidelines. Through asset and liability management, the Company seeks to reduce both the vulnerability and volatility of its operations to changes in interest rates and to manage the ratio of interest-rate sensitive assets to interest-rate sensitive liabilities within specified maturities or repricing periods. The Company's actions in this regard are taken under the guidance of the Asset/Liability Committee ("ALCO"), which is chaired by the Chief Financial Officer and comprised of members of the Company's senior management. The ALCO meets no less than quarterly to review, among other things, liquidity and cash flow needs, current market conditions and the interest rate environment, the sensitivity to changes in interest rates of the Company's assets and liabilities, the historical and market values of assets and liabilities, unrealized gains and losses, and the repricing and maturity characteristics of loans, investment securities, deposits and borrowings. The ALCO reports to the Company's Board of Directors no less than once a quarter. In addition, management reviews at least weekly the pricing of the Company's commercial loans and customer deposits. The pricing of residential loans including originated for sale in the secondary market is reviewed daily. 42 The Company's primary asset/liability monitoring tools consist of various asset/liability simulation models which are prepared on a quarterly basis. The models are designed to capture the dynamics of the balance sheet as well as rate and spread movements and to quantify variations in net interest income under different interest rate scenarios. One of the models consists of an analysis of the extent to which assets and liabilities are interest rate sensitive and measures an institution's interest rate sensitivity gap. An asset or liability is said to be interest rate sensitive within a specific time period if it will mature or reprice within that time period. An institution's interest rate sensitivity gap is defined as the difference between interest-earning assets and interest-bearing liabilities maturing or repricing within a given time period. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities and is considered negative when the amount of interest rate sensitive liabilities exceeds interest rate sensitive assets. During a period of falling interest rates, a negative gap would tend to result in an increase in net interest income, while a positive gap would tend to result in a decline in net interest income. Conversely, during a period of rising interest rates, a negative gap would tend to result in a decline in net interest income, while a positive gap would tend to result in an increase in net interest income. For purposes of the gap table, annual prepayment assumptions range from 6% to 40% for fixed-rate mortgage loans and mortgage-related securities and 5% to 15% for adjustable-rate mortgage loans and mortgage-related securities. Passbook and statement savings accounts are assumed to decay at a rate of 14.0% per year. Money market deposit accounts ("MMDA") are assumed to decay at a rate of 25% per year. Negotiable order of withdrawal ("NOW") accounts are assumed to decay at a rate of 20% per year. The Bank's passbook, statement savings, MMDA and NOW accounts are generally subject to immediate withdrawal. However, management considers a portion of these deposits to be core deposits (which consists of passbook, statement saving, MMDA and NOW accounts) having significantly longer effective maturities based upon the Bank's experience in retaining such deposits in changing interest rate environments. Borrowed funds are included in the period in which they can be called or when they mature. Management believes that the assumptions used to evaluate the vulnerability of the Bank's operations to changes in interest rates are considered reasonable. However, certain shortcomings are inherent in the method of analysis presented in the table below. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as adjustable-rate loans, have features which restrict changes in market rates both on a short-term and over the life of the asset. Further, in the event of a change in interest rates, prepayments and early withdrawal levels would likely deviate significantly from those assumed in calculating the table. 43 The following table summarizes the anticipated maturities or repricing of the Company's interest-earning assets and interest-bearing liabilities as of September 30, 2003 based on the information and assumptions set forth above.
More Than More Than Within Six to One Year Three Over Six Twelve to Three Years to Five (Dollars in thousands) Months Months Years Five Years Years Total --------- -------- -------- ---------- -------- -------- Interest-earning assets: Loans receivable, net(1) $ 79,161 $ 25,780 $ 84,739 $ 37,420 $ 57,765 $284,865 Mortgage-related securities 31,271 23,023 48,345 22,435 3,069 128,143 Loans held for sale 4,498 -- -- -- -- 4,498 Investment securities(2) 19,401 4,580 5,374 19,585 43,369 92,309 Interest-earning deposits 10,751 -- -- -- -- 10,751 --------- -------- -------- -------- -------- -------- Total interest-earning assets $ 145,082 $ 53,383 $138,458 $ 79,440 $104,203 $520,566 --------- -------- -------- -------- -------- -------- Interest-bearing liabilities: Deposits $ 104,679 $ 55,765 $115,365 $ 73,331 $ 13,454 $362,594 Borrowed funds 110,684 -- 25,000 259 329 136,272 --------- -------- -------- -------- -------- -------- Total interest-bearing liabilities $ 215,363 $ 55,765 $140,365 $ 73,590 $ 13,783 $498,866 --------- -------- -------- -------- -------- -------- Excess (deficiency) of interest-earning assets over interest-bearing liabilities $ (70,281) $ (2,382) $ (1,907) $ 5,850 $ 90,420 $21,700 ========= ======== ======== ======== ======== ======== Cumulative excess (deficiency) of interest-earning assets over interest-bearing liabilities $ (70,281) $(72,663) $(74,570) $(68,720) $ 21,700 ========= ======== ======== ======== ======== Cumulative excess (deficiency) of interest-earning assets over interest-bearing liabilities as a percentage of total assets (12.58)% (13.01)% (13.35)% (12.30)% 3.88% ========= ======== ======== ======== ========
(1) Balances have been reduced for non-accruing loans, which amounted to $1.6 million at September 30, 2003. (2) Balance includes Federal Home Loan Bank stock. Although an analysis of the interest rate sensitivity gap measure may be useful, it is limited in its ability to predict trends in future earnings. It makes no presumptions about changes in prepayment tendencies, deposit or loan maturity preferences or repricing time lags that may occur in response to a change in the interest rate environment. As a consequence, the Company also utilizes an analysis of the market value of portfolio equity, which addresses the estimated change in the value of the Bank's equity arising from movements in interest rates. The market value of portfolio equity is estimated by valuing the Bank's assets and liabilities under different interest rate scenarios. The extent to which assets gain or lose value in relation to gains or losses of liabilities as interest rates increase or decrease determines the appreciation or depreciation in equity on a market value basis. Market value analysis is intended to evaluate the impact of immediate and sustained shifts of the current yield curve upon the market value of the Bank's current balance sheet. The Company utilizes reports prepared by the Office of Thrift Supervision ("OTS") to measure interest rate risk. Using data submitted by the Bank, the OTS performs scenario analysis to estimate the net portfolio value ("NPV") of the Bank over a variety of interest rate scenarios. The NPV is defined as the present value of expected cash flows from existing assets less the present value of expected cash flows from existing liabilities plus the present value of net expected cash inflows from existing off-balance sheet contracts. 44 The table below sets forth the Bank's NPV assuming an immediate change in interest rates of plus and minus 100, 200 and 300 basis points. Due to the low prevailing interest rate environment, the OTS did not provide a calculation for the minus 200 and minus 300 basis point change in rates. Dollar amounts are expressed in thousands as of September 30, 2003.
Net Portfolio Value Net Portfolio Value as a % of Assets ---------------------------------------------------------------------------------- Changes in Rates Dollar Percentage NPV in Basis Points Amount Change Change Ratio Change - ------------------ ------- --------- ---------- ------ -------- 300 $25,819 $(21,301) (45)% 4.83% (341) bp 200 34,002 (13,118) (28) 6.22 (202) 100 41,322 (5,798) (12) 7.38 (86) 0 47,120 -- -- 8.24 -- (100) 46,000 (1,120) (2) 7.95 (29) (200) N/A N/A N/A N/A N/A (300) N/A N/A N/A N/A N/A
As is the case with interest rate sensitivity gap, certain shortcomings are inherent in the methodology used in the above interest rate risk measurements. Modeling changes in NPV require the making of certain assumptions which may or may not reflect the manner in which actual yields and costs respond to changes in market interest rates. In this regard, the NPV model presented assumes that the composition of the Bank's interest sensitive assets and liabilities existing at the beginning of a period remains constant over the period being measured and also assumes that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration to maturity or repricing of specific assets and liabilities. Although the NPV measurements and net interest income models provide an indication of the Bank's interest rate risk exposure at a particular point in time, such measurements are not intended to and do not provide a precise forecast of the effect of changes in market interest rates on the Bank's net interest income and may differ from actual results. The Company is aware of its interest rate risk exposure in the event of rapidly rising rates. Due to the Company's recognition of the need to control interest rate exposure, the Company's current policy is to sell new 30-year fixed-rate single-family residential mortgage loans into the secondary market. In addition, in recent years, the Company has emphasized the origination of construction and land, multi-family and commercial real estate and consumer loans which generally have either adjustable interest rates and/or shorter contractual terms than single-family residential loans. The Company plans to continue these lending strategies. Derivative financial instruments include futures, forwards, interest rate swaps, option contracts, and other financial instruments with similar characteristics. The Company currently does not enter into futures, forwards, swaps or options. However, the Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition. Commitments generally have fixed expiration dates and may require additional collateral from the borrower if deemed necessary. Commitments to extend credit are not recorded as an asset or liability until the instruments are exercised. The Company is subject to certain market risks and interest rate risks from the time a commitment is issued to originate new loans. In an effort to protect the Company against adverse interest rate movements, at the time an application is taken for a fixed-rate loan, the Company typically enters into an agreement to sell the loan, or a loan within the same interest-rate range, into the secondary market. This is known as a "matched sale" approach and reduces interest-rate risk with respect to these loans. There is still some portion of these loans which may never close for various reasons. However, the agencies the Company sells loans to permit some flexibility in delivering loan product to them. In certain instances, if the loans delivered for sale do not match the characteristics outlined in the forward sale commitments, the gain on sale may be reduced. 45 CHANGES IN FINANCIAL CONDITION GENERAL. Total assets of the Company increased by $40.3 million, or 7.8%, from $518.3 million at September 30, 2002 to $558.7 million at September 30, 2003. The increase primarily reflected growth of mortgage-related securities available for sale and to a lesser extent, investment securities held to maturity, partially offset by a decrease in mortgage-related securities held to maturity and investment securities available for sale. The asset growth was primarily funded by increases in customer deposits and advances from the FHLB. CASH AND CASH EQUIVALENTS. Cash and cash equivalents, which consists of cash on hand and deposited in other banks in interest-earning and non-interest-earning accounts, amounted to $21.1 million and $24.6 million at September 30, 2003 and 2002, respectively. The decrease in cash and cash equivalents was due to a $9.1 million, or 45.9%, decrease in interest-bearing deposits as a result of the Company investing the cash into interest-earning assets offset in part by a $5.7 million increase in cash due to higher reserve requirements at the Federal Reserve Bank. Cash and cash equivalents are available as a source of funds for originations of new loans and purchases of additional securities investments. INVESTMENT SECURITIES HELD TO MATURITY AND INVESTMENT SECURITIES AVAILABLE FOR SALE. Total investment securities increased by $3.4 million, or 4.2%, from $80.6 million at September 30, 2002 to $84.0 million at September 30, 2003. The increase in investment securities resulted from reinvesting the cash flows from the high level of prepayments from the loan and investment portfolios and the proceeds from the sale of certain investment securities. MORTGAGE-RELATED SECURITIES HELD TO MATURITY AND MORTGAGE-RELATED SECURITIES AVAILABLE FOR SALE. Mortgage-related securities held to maturity and mortgage-related securities available for sale increased in the aggregate by $33.6 million, or 35.6%, to $128.1 million at September 30, 2003 compared to $94.5 million at September 30, 2002. The significant increase in mortgage-related securities was part of the Company's strategy to increase this portfolio due to high levels of cash flows being experienced by the loan portfolio coinciding with the limited demand for originations of new loans at interest rates deemed acceptable to the Company. LOANS HELD FOR SALE. At September 30, 2003, $4.5 million of fixed-rate single-family residential loans were classified as held for sale compared to $501,000 at September 30, 2002. The increase of $4.0 million is related to increased secondary market activity as a result of the low interest rate environment. During fiscal year 2003, the Company originated $31.0 million and sold $27.0 million of such loans. Subsequent to fiscal year end, management reevaluated its asset liability position and determined to retain in its loan portfolio the majority of the loans held for sale at September 30, 2003. LOANS RECEIVABLE, NET. Total loans receivable, net, decreased slightly to $286.4 million at September 30, 2003 compared to $288.8 million at September 30, 2002. The decrease was primarily due to a $7.7 million, or 4.4%, decrease in single-family residential loans partially offset by a $5.9 million, or 21.3%, increase in home equity loans and lines of credit. Although the Company had significant loan originations in single-family residential loans during fiscal 2003, total loans decreased due to the accelerated prepayments experienced by the portfolio and the Company's decision to sell 30-year fixed-rate mortgages bearing low interest rates into the secondary market in order to minimize interest rate risk in a rising interest rate environment. NON-PERFORMING ASSETS. The Company's total non-performing loans and real estate owned decreased to $3.0 million, or 0.53% of total assets, at September 30, 2003 compared to $5.4 million, or 1.04% of total assets, at the end of the prior fiscal year. The decrease in non-performing assets in fiscal 2003 was primarily attributable to a $1.3 million commercial real estate loan returning to current status and a $549,000 decrease in non-accrual single-family residential loans. DEPOSITS. Deposits increased by $31.8 million, or 9.6%, from $330.8 million at September 30, 2002 to $362.6 million at September 30, 2003. This increase was primarily due to a $29.6 million, or 19.2%, increase in the Company's core accounts (non-interest-bearing, NOW, passbook, and MMDA accounts) as a result of the Company's continued emphasis on increasing both the amount and the percentage of the deposit portfolio accounted for by these deposit accounts. Certificates of deposit increased by $2.2 million, or 1.3%, to $178.5 million in the current fiscal year. BORROWINGS. The Company's total borrowings increased to $136.3 million at September 30, 2003 from $126.4 46 million at September 30, 2002 as the Company primarily used deposit inflows in fiscal 2003 to fund asset growth. The increase was principally due to a $6.8 million increase in FHLB overnight borrowings and to a lesser extent, $2.9 million increase in repurchase agreements. Borrowings had a weighted average interest rate of 5.20% at September 30, 2003. See Note 9 to the Consolidated Financial Statements for further information. EQUITY. At September 30, 2003, total stockholders equity was $32.4 million, or 5.8% of total assets, compared to $32.8 million, or 6.3% of total assets, at September 30, 2002. The decrease was due to the cost of repurchasing 136,219 shares of common stock at a weighted average cost of $21.92 per share during fiscal 2003 and the payment of $798,000 in dividends partially offset by net income for the year of $2.7 million. AVERAGE BALANCES, NET INTEREST INCOME AND YIELDS EARNED AND RATES PAID. The following table sets forth, for the periods indicated, information regarding (i) the total dollar amount of interest income of the Company from interest-earning assets and the resultant average yields; (ii) the total dollar amount of interest expense on interest-bearing liabilities and the resultant average rate; (iii) net interest income; (iv) interest rate spread; and (v) net interest margin. Information is based on average daily balances during the indicated periods; yields were adjusted for the effects of tax-free investments using the statutory tax rate. The adjustment of tax exempt securities to a tax equivalent yield in the table below may be considered to include non-GAAP financial information. Management believes that it is a standard practice in the banking industry to present net interest margin, net interest rate spread and net interest income on a fully tax equivalent basis when a significant proportion of interest-earning assets are tax-free. Therefore, management believes, these measures provide useful information to investors by allowing them to make peer comparisons. A GAAP reconciliation also is included below.
YEAR ENDED SEPTEMBER 30, ----------------------------------------------------------------------------------------- 2003 2002 2001 YIELD/COST ------------------------------------------------------------------------------ AT AVERAGE Average Average SEPT.30, AVERAGE YIELD/ Average Yield/ Average Yield/ 2003 BALANCE INTEREST COST Balance Interest Cost Balance Interest Cost ----------------------------------------------------------------------------------------- (Dollars in thousands) Interest-earning assets: Loans receivable(1) (2) 6.08% $290,357 $18,937 6.52% $ 267,208 $ 19,379 7.25% $237,419 18,711 7.88% Mortgage-related securities(2) 4.37 114,833 4,464 3.89 113,827 6,441 5.66 130,283 8,605 6.60 Investment securities(2) 4.25 84,038 4,094 4.87 76,826 4,509 5.87 63,545 4,396 6.92 Other interest-earning assets 0.86 14,390 120 0.83 17,946 223 1.24 14,165 560 3.95 -------- ------- --------- -------- -------- ------ Total interest-earning assets 5.23 503,618 $27,615 5.48 475,807 $ 30,552 6.42 445,412 32,272 7.25 -------- ------- --------- -------- -------- ------ Non-interest-earning assets 30,411 27,855 26,389 -------- --------- -------- Total assets $534,029 $ 503,662 $471,801 ======== ========= -------- Interest-bearing liabilities: Deposits 1.77 $343,727 $ 7,353 2.14 $ 319,344 $ 9,599 3.01 $294,731 13,062 4.43 FHLB advances and other borrowings 5.20 131,136 6,983 5.33 127,264 6,941 5.44 125,988 7,282 5.77 -------- ------- --------- -------- -------- ------ Total interest-bearing liabilities 2.70 474,863 14,336 3.02 446,608 16,540 3.70 420,719 20,344 4.83 -------- ------- --------- -------- -------- ------ Interest rate spread 2.53% 2.46% 2.72% 2.42% ==== ====== ====== ====== Non-interest-bearing liabilities 26,502 25,977 21,744 -------- --------- -------- Total liabilities 501,365 472,585 442,463 Stockholders' equity 32,664 31,077 29,338 -------- --------- -------- Total liabilities and stockholders' equity $534,029 $ 503,622 $471,801 ======== ========= ======== Net interest-earning assets $ 28,755 $ 29,199 $ 24,693 ======== ========= ======== Net interest income $13,279 $ 14,012 $11,928 ======= ======== ======= Net interest margin(3) 2.64% 2.95% 2.68% ====== ====== ====== Ratio of average interest-earning assets to average interest-bearing liabilities 106.06% 106.54% 105.87% ====== ====== ======
(1) Includes non-accrual loans. (2) Includes assets classified as either available for sale or held for sale. (3) Net interest income divided by interest-earning assets. 47 Although management believes that the above mentioned non-GAAP financial measures enhance investor's understanding of the Company's business and performance, these non-GAAP financials measures should not be considered an alternative to GAAP. The reconciliation of these non-GAAP financials measures from GAAP to non-GAAP is presented below.
(Dollars in thousands) FOR THE YEAR ENDED SEPTEMBER 30, --------------------------------------------------------------------------- 2003 2002 2001 --------------------------------------------------------------------------- AVERAGE AVERAGE AVERAGE INTEREST YIELD/COST INTEREST YIELD/COST INTEREST YIELD/COST --------------------------------------------------------------------------- Investment securities - nontaxable $ 3,691 4.39% $ 4,078 5.31% $ 3,984 6.27% Tax equivalent adjustments 403 431 412 ------- ------- ------- Investment securities - nontaxable to a taxable equivalent yield $ 4,094 4.87% $ 4,509 5.87% $ 4,396 6.92% ======= ======= ======= Net interest income $12,876 $13,581 $11,516 Tax equivalent adjustment 403 431 412 ------- ------- ------- Net interest income, tax equivalent $13,279 $14,012 $11,928 ======= ======= ======= Net interest rate spread, no tax adjustment 2.38% 2.63% 2.32% Net interest margin, no tax adjustment 2.56% 2.86% 2.59%
RATE/VOLUME ANALYSIS. The following table describes the extent to which changes in interest rates and changes in the volume of interest-related assets and liabilities have affected the Company's interest income and expense during the periods indicated. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to (i) changes in volume (change in volume multiplied by prior year rate), (ii) changes in rate (change in rate multiplied by prior year volume), and (iii) total change in rate and volume. The combined effect of changes in both rate and volume has been allocated proportionately to the change due to rate and the change due to volume. The table below has been prepared on a tax-equivalent basis.
YEAR ENDED SEPTEMBER 30, -------------------------------------------------------------------------- 2003 VS. 2002 2002 VS. 2001 -------------------------------------------------------------------------- INCREASE (DECREASE) DUE TO INCREASE (DECREASE) DUE TO -------------------------------------------------------------------------- TOTAL TOTAL INCREASE INCREASE RATE VOLUME (DECREASE) RATE VOLUME (DECREASE) -------------------------------------------------------------------------- Interest-earnings assets: Loans receivable(1) $(3,156) $ 2,713 $ (443) $(1,166) $ 1,834 $ 668 Mortgage-related securities(1) (2,035) 58 (1,977) (1,150) (1,014) (2,164) Investment securities(1) (2) (926) 510 (416) (299) 412 113 Other interest-earning assets (64) (38) (102) (551) 214 (337) ------- ------- ------- ------- ------- ------- Total interest-earning assets (6,181) 3,243 (2,938) (3,166) 1,446 (1,720) ------- ------- ------- ------- ------- ------- Interest-bearing liabilities: Deposits (3,055) 809 (2,246) (4,677) 1,214 (3,463) FHLB advances and other borrowings (146) 187 41 (413) 74 (339) ------- ------- ------- ------- ------- ------- Total interest-bearing liabilities (3,201) 996 (2,205) (5,090) 1,288 (3,802) ------- ------- ------- ------- ------- ------- Increase (decrease) in net interest income $(2,980) $ 2,247 $ (733) $ 1,924 $ 158 $ 2,082 ======= ======= ======= ======= ======= =======
(1) Includes assets classified as either available for sale or held for sale. (2) Total increase (decrease) in investment securities on a nontaxable equivalent basis would be $(388) and $93, resulting in a (decrease) increase in net interest income of $(705) and $2,065, respectively. 48 RESULTS OF OPERATIONS GENERAL. The Company reported net income of $2.7 million, $2.7 million and $2.5 million for the years ended September 30, 2003, 2002 and 2001, respectively. The $13,000 increase in net income for the year ended September 30, 2003 compared to the year ended September 30, 2002 was primarily due to a $1.0 million, or 46.0%, increase in non-interest income combined with a $75,000, or 0.6%, decrease in non-interest expense partially offset by a $880,000, or 6.7%, decrease in net interest income after provision for loan losses. The $255,000 increase in net income for the year ended September 30, 2002 compared to the year ended September 30, 2001 was primarily due to the $2.1 million, or 17.9%, increase in net interest income combined with a $309,000, or 16.1%, increase in non-interest income partially offset by a $2.1 million, or 21.3%, increase in non-interest expense. NET INTEREST INCOME. Net interest income is determined by the interest rate spread (the difference between the yields earned on interest-earning assets and the rates paid on interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities. All percentages are reported on a fully tax-equivalent basis (see the tables on the prior page for a recalculation of such percentages). The Company's average interest-rate spread was 2.46%, 2.72% and 2.42% for the years ended September 30, 2003, 2002, and 2001, respectively. The Company's interest-rate spread was 2.53% at September 30, 2003. The Company's net interest margin (net interest income as a percentage of average interest-earning assets) was 2.64%, 2.95% and 2.68% for the years ended September 30, 2003, 2002 and 2001, respectively. Due to the historically low interest rate environment existing during fiscal 2003, the interest rate compression experienced by the Company reflects the effects of the accelerated rate of repayments and prepayments of loans and mortgage-related securities, requiring the Company to reinvest the resulting proceeds at current lower market rates of interest without a corresponding decrease in the rates paid on deposits and borrowings. As the refinancing and prepayment activity comes to an end, management anticipates that the net interest spread and margin will stabilize or increase slightly during fiscal 2004 providing the Company can maintain its cost of funds at levels substantially similar to those existing at the end of fiscal 2003. Net interest income decreased to $12.9 million in fiscal 2003 as compared to $13.6 million in fiscal 2002. The $705,000, or 5.2%, decrease came as a result of a $2.9 million, or 9.7%, decrease in interest income partially offset by a $2.2 million, or 13.3%, decrease in interest expense. The decrease in net interest income was primarily due to interest-earning assets repricing downward due to the prolonged low interest rate environment without a corresponding decrease in rates paid. Net interest income increased to $13.6 million in the year ended September 30, 2002 as compared to $11.5 million in fiscal 2001. The $2.1 million, or 17.9%, increase was the result of lower short-term interest rates which impacted the rates paid on the Company's interest-bearing core deposits and shorter term certificates of deposit by repricing downward at a greater degree than its interest-earning assets. INTEREST INCOME. The $2.9 million, or 9.7%, decrease in total interest income during the year ended September 30, 2003 as compared to fiscal 2002 was primarily due to a $2.0 million, or 30.7%, decrease in interest income from mortgage-related securities as a result of a 177 basis point decrease in the yield earned offset, in part, by a $1.0 million, or .9%, increase in the average balance of the mortgage-related securities portfolio. Interest income on loans decreased $442,000, or 2.3%, due to a 73 basis point decrease in the average yield earned offset partially by a $23.1 million, or 8.7%, increase in the average balance of the loan portfolio. The decline in yield was due to the declining interest rate environment experienced in fiscal 2003 causing accelerated repayments of loans with the proceeds being reinvested in lower yielding assets. In addition, the accelerated prepayments of mortgage-related securities resulted in significant amortization of premiums. Additionally, interest income on investment securities and other interest-earning assets decreased $490,000, or 11.4%, due to a 141 basis point decrease in the average yield earned offset partially by a $3.7 million, or 3.9%, increase in the average balance. Total interest income amounted to $30.1 million for the year ended September 30, 2002 compared to $31.9 million for the year ended September 30, 2001. The decrease in fiscal 2002 was primarily due to a $2.2 million, or 25.1%, decrease in interest income from mortgage-related securities as a result of a 94 basis point decrease in the yield earned 49 combined with a $16.5 million, or 12.6%, decrease in the average balance of the securities portfolio. The decrease was offset, in part, by an increase in interest income on loans. Interest income on loans increased $668,000, or 3.6%, due to a $29.8 million, or 12.5%, increase in the average balance thereof offset, in part, by a 63 basis point decrease in the average yield earned. The increase in the average balance of loans was due to increases in the amount of commercial real estate and commercial business loans reflecting the Company's continued emphasis on expanding its commercial loan portfolio since such loans generally bear higher rates of interest and have shorter contractual maturities than single-family residential loans. INTEREST EXPENSE. Total interest expense amounted to $14.3 million for the year ended September 30, 2003 as compared to $16.5 million for fiscal 2002. Total interest expense decreased by $2.2 million, or 13.3%, during the year ended September 30, 2003 compared to fiscal 2002 due to a $2.2 million decrease in interest expense on deposits partially offset by a $42,000 increase in interest expense on borrowings. The decrease in interest expense on deposits was due to a 87 basis point decrease in the average rate paid thereon partially offset by a $24.4 million increase in the average balance of deposits. The increase in interest expense on borrowings was due to a $3.9 million increase in the average balance of borrowings offset by a 11 basis point decrease in the average rate paid. Deposits grew due to the Company's continued marketing of its core deposit products and was used to fund purchases of investment and mortgage-related securities. The decrease in the rates paid on deposits and borrowings was due to declining interest rates experienced during the fiscal year 2003. Total interest expense decreased by $3.8 million, or 18.7%, during the year ended September 30, 2002 compared to fiscal 2001 primarily due to a $3.5 million decrease in interest expense on deposits and a $341,000 decrease in interest expense on borrowings. The decrease in interest expense on deposits was due to a 142 basis point decrease in the average rate paid offset, in part, by a $24.6 million increase in the average balance of deposits. The decrease in interest expense on borrowings was due to a 33 basis point decrease in the average rate paid off set by a $1.3 million increase in the average balance of borrowings. The increased level of deposits was due to the decline in the equities market combined with the marketing efforts of the Company to attract deposits, particularly core deposits. The deposit inflow was used to fund loan originations, to purchase investment securities and to repay shorter term borrowings. PROVISIONS FOR LOAN LOSSES. Provisions for loan losses are charged to earnings to maintain the total allowance for loan losses at a level believed by management to cover all known and inherent losses in the Company's loan portfolio. Management's analysis includes consideration of the Company's historical experience, the volume and type of lending conducted by the Company, the amount of the Company's classified assets, the status of past due principal and interest payments, general economic conditions, particularly as they relate to the Company's primary market area, and other factors related to the collectibility of the Company's loan and loans held for sale portfolios. Management of the Company assesses the allowance for loan losses on a monthly basis and makes provisions for loan losses as deemed necessary in order to maintain the allowance for loan losses at a level management believes covers all known and inherent losses that are both probable and reasonably estimable. For the years ended September 30, 2003, the provision for loan loss was $715,000 as compared to $540,000 for each of fiscal 2002 and 2001. During fiscal 2003, the Company increased its provision for loan losses as compared to fiscal 2002 primarily due to its assessment of the amount of losses it would incur with respect to the non-performing commercial real estate loans. At September 30, 2003, the Company's allowance for loan losses totaled $2.0 million which amounted to 127.63% of total non-performing loans and .53% of gross loans receivable. The provision for allowance for loan losses for fiscal 2002 remained at the same level as fiscal 2001 due to the Company's re-evaluation of its estimate of losses with respect to its non-conforming loans based on its loss experience and the reallocation of a portion of the allowance to commercial real estate and commercial business loans due to the continued increased investment in such loans. Although management of the Company believes that the Company's allowance for loan losses was adequate at September 30, 2003, based on facts and circumstances available to it, there can be no assurance that additions to such allowance will not be necessary in future periods, which would adversely affect the Company's results of operations for such periods. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's provision for loan losses and the carrying value of its other non-performing assets based on their judgments about information available to them at the time of their examination. Such agencies may require the Company to make additional provisions for estimated loan losses based on judgments different from those of management. 50 NON-INTEREST INCOME. For the year ended September 30, 2003, the Company reported non-interest income of $3.2 million compared to $2.2 million for the year ended September 30, 2003. The primary reason for the $1.0 million, or 46.0%, increase in non-interest income in fiscal 2003 were a $326,000 and $269,000 increases in gain on the sale of loans and investments and mortgage-related securities, respectively. These increases were the result of the Company's strategy to sell certain single-family fixed rate loans and to restructure the securities portfolio in order to benefit in this low interest rate environment. Gain on the sale of loans was partially offset by the recording of loans held for sale of loans at its fair value. In addition, due to the overall improvement in the U.S. equities market, the Company experienced a $303,000 increase in the cash surrender value of certain insurance policies used to fund certain post-retirement benefits. The $309,000, or 16.1%, increase in non-interest income for the year ended September 30, 2002 as compared to fiscal 2001 was primarily due to a $279,000 increase in the gain on sale of $7.1 million of investment securities along with a $48,000 increase in service charges and other fees offset, in part, by a $38,000 decrease in gains on sale of loans held for sale. NON-INTEREST EXPENSE. Non-interest expense include salaries and employee benefits, occupancy and equipment expense, Federal Deposit Insurance Corporation (FDIC) deposit insurance premiums, professional fees, data processing expense, advertising and other items. Non-interest expense decreased $75,000, or 0.6%, for the year ended September 30, 2003 compared to the year ended September 30, 2002 primarily due to the absence of any litigation expenses which amounted to $570,000 in fiscal 2002 and related to the settlement of a lawsuit in the prior year. In addition, the Company experienced decreases of $99,000 and $74,000 in professional fees and advertising expenses, respectively, offset, in part by a $562,000 increase in salaries and employee benefits. Salaries and employee benefits increased primarily due to the increased cost of employee stock ownership plan resulting from the appreciation of the Company's stock price as well as general compensation increases and costs of medical and retirement plans. Non-interest expense increased $2.1 million, or 21.3%, for the year ended September 30, 2002 compared to the year ended September 30, 2001 and amounted to $12.1 million in fiscal 2002 compared to $10.0 million in fiscal 2001. The primary reasons for the increase were a $708,000 increase in salaries and employee benefits, a $570,000 expense related to a settlement of a lawsuit and a $533,000 increase in other operating expense. Salaries and employee benefits increased primarily due to a $431,000 write-down in the cash surrender value of certain life insurance policies resulting from the decline in the U.S. equities market as well as general compensation increases and higher costs of employee benefit plans. With respect to the settlement expense, it related to a lawsuit that was instituted by the purchaser of five residential mortgage loans from the Bank that alleged that it suffered losses in connection with these loans and that the Bank was required to either purchase the loans or compensate the purchaser for its alleged losses. Other non-interest expense increased $533,000 primarily due to a $213,000 expense relating to the workout of three non-performing commercial real estate loans aggregating $2.4 million combined with increases in service charges and cash loss. In addition, the increase was attributable to a $51,000 increase in occupancy and equipment expense, a $77,000 increase in data processing, a $111,000 increase in advertising and a $78,000 increase in minority interest in expense of subsidiaries. INCOME TAXES. The Company recognized income tax expense of $653,000, or 19.3%, of pre-tax income, for the year ended September 30, 2003, compared to $448,000, or 14.1%, of pre-tax income, for the year ended September 30, 2002. The Company recognized income tax expense of $459,000, or 15.7%, of pre-tax income, for fiscal 2001. The primary reason for the increase in the Company's effective tax rate for fiscal year 2003 resulted from the reduction in tax-fee income as well as the increase in income before income taxes. Comparing fiscal years 2002 and 2001, the decrease in the lower effective tax rate in fiscal 2002 was due to a increase in tax-free income resulting from purchases of tax-exempt securities and bank owned life insurance as the Company employed various strategies to reduce taxes. 51 LIQUIDITY, CAPITAL RESOURCES AND COMMITMENTS The Company's liquidity, represented by cash and cash equivalents, is a product of its operating, investing and financing activities. The Company's primary sources of funds are deposits, amortization, prepayments and maturities of outstanding loans and mortgage-related securities, sales of loans, maturities of investment securities and other short-term investments, borrowings and funds provided from operations. While scheduled payments from the amortization of loans and mortgage-related securities and maturing investment securities and short-term investments are relatively predictable sources of funds, deposit flows and loan and mortgage-related securities prepayments are greatly influenced by general interest rates, economic conditions and competition. In addition, the Company invests excess funds in overnight deposits and other short-term interest-earning assets which provide liquidity to meet lending requirements. The Company has the ability to obtain advances from the FHLB of Pittsburgh through several credit programs with the FHLB in amounts not to exceed the Bank's maximum borrowing capacity and subject to certain conditions, including holding a predetermined amount of FHLB stock as collateral. As an additional source of funds, the Company has access to the Federal Reserve discount window, but only after it has exhausted its access to the FHLB of Pittsburgh. At September 30, 2003, the Company had $126.4 million of outstanding advances and $6.8 million of overnight borrowings from the FHLB of Pittsburgh. Liquidity management is both a daily and long-term function of business management. Excess liquidity is generally invested in short-term investments such as overnight deposits. On a longer term basis, the Company maintains a strategy of investing in various lending products and mortgage-related securities. The Company uses its sources of funds primarily to meet its ongoing commitments, to pay maturing savings certificates and savings withdrawals, fund loan commitments and maintain a portfolio of mortgage related and investment securities. At September 30, 2003, the total of approved loan commitments outstanding amounted to $5.9 million. At the same date, commitments under unused lines of credit and loans in process on construction loans amounted to an aggregate of $40.8 million. Certificates of deposit scheduled to mature in one year or less at September 30, 2003 totaled $106.8 million. Based upon its historical experience, management believes that a significant portion of maturing deposits will remain with the Company. The Company has not used, and has no intention to use, any significant off-balance sheet financing arrangements for liquidity purposes. The Company's primary financial instruments with off-balance sheet risk are limited to loan servicing for others, its obligations to fund loans to customers pursuant to existing commitments and commitments to purchase and sell mortgage loans. In addition, the Company has not had, and has no intention to have, any significant transactions, arrangements or other relationships with any unconsolidated, limited purpose entities that could materially affect its liquidity or capital resources. The Company has not, and does not intend to, trade in commodity contracts. The OTS requires that the Bank meet minimum regulatory tangible, core, tier 1 risk-based and total risk based capital requirements. At September 30, 2003, the Bank exceeded all regulatory capital requirements and was deemed a well capitalized institution for regulatory purposes. See Note 11 to the Consolidated Financial Statements. The Company's assets consist primarily of its investment in the Bank and investments in various corporate debt and equity instruments. Its only material source of income consists of earnings from its investment in the Bank and interest and dividends earned on other investments. The Company, as a separately incorporated holding company, has no significant operations other than serving as the sole stockholder of the Bank and paying interest to its subsidiaries, First Keystone Capital Trust I and II, for junior subordinated debt issued in conjunction with the issuance of trust preferred securities. See Note 17 to the Consolidated Financial Statements. On an unconsolidated basis, the Company has no paid employees. The expenses primarily incurred by the Company relate to its reporting obligations under the Securities Exchange Act of 1934, related expenses incurred as a publicly traded company, and expenses relating to the issuance of the trust preferred securities and the junior subordinated debentures issued in connection therewith. Management believes that the Company has adequate liquidity available to respond to its liquidity demands. Under applicable federal regulations, the Bank may pay dividends to the Company (as sole stockholder) within certain limits after providing written notice to or obtaining the approval of the OTS. See Note 11 of the Consolidated Financial Statements. 52 INVESTMENT SECURITIES At September 30, 2003, the Company's investment securities available for sale portfolio, including short-term investments, were carried at a fair value of $77.7 million and had an amortized cost of $74.1 million. The average credit quality on the portfolio is AA. The net unrealized gain on its investment assets at September 30, 2003 was $3.6 million, or 4.9% of the amortized cost basis. The net unrealized gain included gross unrealized gains of $4.6 million and gross unrealized losses of $1.0 million. The Company reviews the securities in our fixed income portfolio on a periodic basis to specifically review individual securities for any meaningful decline in market value below amortized cost. The analysis addresses all securities whose fair value is significantly below amortized cost at the time of the analysis, with additional emphasis placed on securities whose fair value has been below amortized cost for an extended period of time. As part of the periodic review process, the Company utilizes the expertise of outside professional asset managers who provide an updated assessment of each issuer's current credit situation based on recent issuer activities, such as quarterly earnings announcements or other pertinent financial news for the issuer, recent developments in a particular industry, economic outlook for a particular industry and rating agency actions. In addition to issuer-specific financial information and general economic data, the Company also considers the ability and intent of its operations to hold a particular security to maturity or until the market value of the security recovers to a level in excess of the carrying value. Nine securities in portfolio that have been in an unrealized loss position for a substantial period of time. Eight of these securities have an unrealized loss of less than $480,000 and/or less than 13% of their amortized cost. These eight securities have an average unrealized loss per security of approximately $29,000 and have fair values at September 30, 2003 that are 87% or more of the amortized cost basis. There is only one security with an unrealized loss in excess of $500,000 at September 30, 2003 with a market value of $4.5 million and a cost of $5.0 million. The security is an equity security and is rated AAA. The Company has no current plans to dispose of this security. For all securities that are in an unrealized loss position for an extended period of time, an evaluation is performed of the specific events attributable to the decline in the market value of the security. Factors that are considered are the length of time and extent to which the security's market value has been below cost as well as the general market conditions, industry characteristics and the fundamental operating results of the issuer to determine if the decline is due to changes in interest rates, changes relating to a decline in credit quality of the issuer, or general market conditions. An additional part of the evaluation is the Company's intent and ability to hold the security until its market value has recovered to a level at least equal to the amortized cost. If the security's unrealized loss is other than temporary, a realized loss is recognized in the period in which the decline in value is determined to be other than temporary. Based on our evaluation as of September 30, 2003, the Company determined the declines in market value of securities of these nine securities were temporary. The Company will continue to review these securities and evaluate the temporary nature of the impairment on a quarterly basis. RECENT ACCOUNTING PRONOUNCEMENTS For discussion of recent accounting pronouncements, see Note 2 of the Consolidated Financial Statements set forth in Item 8 hereof. 53 IMPACT OF INFLATION AND CHANGING PRICES The Consolidated Financial Statements of the Company and related notes presented herein have been prepared in accordance with accounting principles generally accepted in the United States of America which require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, substantially all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution's performance than the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or in the same magnitude as the prices of goods and services, since such prices are affected by inflation to a larger extent than interest rates. In the current interest rate environment, liquidity and the maturity structure and repricing characteristics of the Company's assets and liabilities are critical to the maintenance of acceptable performance levels. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. The information required herein is incorporated by reference to "Asset and Liability Management" set forth in Item 7 above. 54 [DELOITTE LOGO] Deloitte Touche LLP 22nd Floor 1700 Market Street Philadelphia, PA 19103-3984 Tel: 215-246-2300 Fax: 215-569-2441 www.deloitte.com INDEPENDENT AUDITORS' REPORT Board of Directors and Stockholders of First Keystone Financial, Inc. and subsidiaries Media, Pennsylvania 19063 We have audited the accompanying consolidated statements of financial condition of First Keystone Financial, Inc. and subsidiaries (the "Company") as of September 30, 2003 and 2002, and the related consolidated statements of income, stockholders equity and cash flows for each of the three years in the period ended September 30, 2003. 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 auditing standards generally accepted in the United States of America. 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, such consolidated financial statements present fairly, in all material respects, the consolidated financial position of First Keystone Financial, Inc. and subsidiaries as of September 30, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 2003 in accordance with accounting principles generally accepted in the United States of America. - -s- Deloitte Touche LLP - ----------------------- December 12, 2003 A member firm of DELOITTE TOUCHE TOHMATSU 55 FIRST KEYSTONE FINANCIAL, INC. CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
SEPTEMBER 30 ---------------------- 2003 2002 ---------------------- ASSETS Cash and amounts due from depository institutions $ 10,439 $ 4,753 Interest-bearing deposits with depository institutions 10,751 19,870 --------- --------- Total cash and cash equivalents 21,190 24,623 Investment securities available for sale 77,700 80,624 Mortgage-related securities available for sale 124,656 85,674 Loans held for sale 4,498 501 Investment securities held to maturity (approximate fair value of $6,450 at September 30, 2003) 6,315 -- Mortgage-related securities held to maturity - at amortized cost (approximate fair value of $3,560 and $9,090 at September 30, 2003 and 2002, respectively) 3,487 8,855 Loans receivable (net of allowance for loan losses of $1,986 and $2,358 at September 30, 2003 and 2002, respectively) 286,421 288,776 Accrued interest receivable 2,654 2,971 Real estate owned 1,420 248 Federal Home Loan Bank stock at cost 8,294 6,571 Office properties and equipment, net 3,427 3,491 Cash surrender value of life insurance 15,365 14,362 Prepaid expenses and other assets 3,240 1,650 --------- --------- Total Assets $ 558,667 $ 518,346 ========= ========= LIABILITIES, MINORITY INTEREST IN SUBSIDIARIES AND STOCKHOLDERS EQUITY Liabilities: Deposits $ 362,605 $ 330,765 Advances from Federal Home Loan Bank and other borrowings 136,272 126,384 Accrued interest payable 814 1,000 Advances from borrowers for taxes and insurance 958 832 Deferred income taxes 581 424 Accounts payable and accrued expenses 4,206 5,266 --------- --------- Total liabilities 505,436 464,671 --------- --------- Company-obligated mandatory redeemable preferred securities of subsidiary trusts holding solely junior subordinated debentures of the Company 20,843 20,880 --------- --------- Stockholders' Equity: Preferred stock, $.01 par value, 10,000,000 shares authorized; none issued Common stock, $.01 par value, 20,000,000 shares authorized; issued and outstanding: September 30, 2003 and 2002, 1,925,337 and 2,008,611 shares, respectively 14 14 Additional paid-in capital 13,443 13,622 Employee stock ownership plan (830) (995) Treasury stock at cost: 787,219 and 703,945 shares at September 30, 2003 and 2002, respectively (11,378) (9,175) Accumulated other comprehensive income 3,069 3,200 Retained earnings-partially restricted 28,070 26,129 --------- --------- Total stockholders' equity 32,388 32,795 --------- --------- Total Liabilities, Minority Interest in Subsidiaries and Stockholders' Equity $ 558,667 $ 518,346 ========= =========
See notes to consolidated financial statements. 56 FIRST KEYSTONE FINANCIAL, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
YEAR ENDED SEPTEMBER 30 -------------------------------- 2003 2002 2001 -------------------------------- INTEREST INCOME Interest on: Loans $ 18,937 $ 19,379 $18,711 Mortgage-related securities 4,464 6,441 8,605 Investment securities: Taxable 2,295 2,445 2,030 Tax-exempt 1,040 1,203 1,370 Dividends 356 430 584 Interest-bearing deposits 120 223 560 -------- -------- ------- Total interest income 27,212 30,121 31,860 -------- -------- ------- INTEREST EXPENSE: Interest on: Deposits 7,353 9,599 13,062 Federal Home Loan Bank advances and other borrowings 6,983 6,941 7,282 -------- -------- ------- Total interest expense 14,336 16,540 20,344 -------- -------- ------- Net interest income 12,876 13,581 11,516 Provision for loan losses 715 540 540 -------- -------- ------- Net interest income after provision for loan losses 12,161 13,041 10,976 -------- -------- ------- NON-INTEREST INCOME: Service charges and other fees 1,013 1,000 952 Net gain on sale of: Investments and mortgage-related securities 600 331 52 Loans held for sale 410 84 122 Increase in cash surrender value 960 680 664 Other income 263 128 124 -------- -------- ------- Total non-interest income 3,246 2,223 1,914 -------- -------- ------- NON-INTEREST EXPENSE: Salaries and employee benefits 5,358 4,796 4,088 Occupancy and equipment 1,242 1,229 1,178 Professional fees 679 778 749 Federal deposit insurance premium 55 57 55 Net cost of operation of other real estate 38 (4) 25 Data processing 467 478 401 Advertising 397 471 360 Litigation settlement -- 570 -- Minority interest in expense of subsidiaries 1,615 1,649 1,571 Other 2,164 2,066 1,533 -------- -------- ------- Total non-interest expense 12,015 12,090 9,960 -------- -------- ------- Income before income tax expense 3,392 3,174 2,930 Income tax expense 653 448 459 -------- -------- ------- Net income $ 2,739 $ 2,726 $ 2,471 ======== ======== ======= Earnings per common share: Basic $ 1.44 $ 1.42 $ 1.22 Diluted $ 1.35 $ 1.34 $ 1.18
See notes to consolidated financial statements. 57 FIRST KEYSTONE FINANCIAL, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (DOLLARS IN THOUSANDS)
EMPLOYEE ACCUMULATED RETAINED ADDITIONAL STOCK OTHER EARNINGS- TOTAL COMMON PAID-IN OWNERSHIP TREASURY COMPREHENSIVE PARTIALLY STOCKHOLDERS' STOCK CAPITAL PLAN STOCK INCOME(LOSS) RESTRICTED EQUITY -------- --------- -------- -------- ------------- ---------- ------------ Balance October 1, 2000 $ 14 $ 13,491 $ (1,287) $ (5,622) $ (2,386) $ 22,359 $ 26,569 -------- --------- -------- -------- ------------- --------- ------------ Comprehensive income: Net income -- -- -- -- -- 2,471 2,471 Other comprehensive income, net of tax: Net unrealized gain on securities net of reclassification adjustment(1) -- -- -- -- 5,050 -- 5,050 -------- --------- -------- -------- ------------- --------- ------------ Comprehensive income -- -- -- -- -- -- 7,521 -------- --------- -------- -------- ------------- --------- ------------ ESOP stock committed to be released -- -- 140 -- -- -- 140 Excess of fair value above cost of ESOP shares committed to be released -- 111 -- -- -- -- 111 Exercise of stock options -- (66) -- 84 -- -- 18 Purchase of treasury stock -- -- -- (3,045) -- -- (3,045) Dividends paid -- -- -- -- -- (693) (693) -------- --------- -------- -------- ------------- --------- ------------ Balance at September 30, 2001 14 13,536 (1,147) (8,583) 2,664 24,137 30,621 -------- --------- -------- -------- ------------- --------- ------------ Comprehensive income: Net income -- -- -- -- -- 2,726 2,726 Other comprehensive income, net of tax: Net unrealized gain on securities net of reclassification adjustment(1) -- -- -- -- 536 -- 536 -------- --------- -------- -------- ------------- --------- ------------ Comprehensive income -- -- -- -- -- -- 3,262 -------- --------- -------- -------- ------------- --------- ------------ ESOP stock committed to be released -- -- 152 -- -- -- 152 Excess of fair value above cost of ESOP shares committed to be released -- 161 -- -- -- -- 161 Exercise of stock options -- (75) -- 421 -- -- 346 Purchase of treasury stock -- -- -- (1,013) -- -- (1,013) Dividends paid -- -- -- -- -- (734) (734) -------- --------- -------- -------- ------------- --------- ------------ Balance at September 30, 2002 14 13,622 (995) (9,175) 3,200 26,129 32,795 -------- --------- -------- -------- ------------- --------- ------------ Comprehensive income: Net income -- -- -- -- -- 2,739 2,739 Other comprehensive income, net of tax: Net unrealized loss on securities net of reclassification adjustment(1) -- -- -- -- (131) -- (131) -------- --------- -------- -------- ------------- --------- ------------ Comprehensive income -- -- -- -- -- -- 2,608 -------- --------- -------- -------- ------------- --------- ------------ ESOP stock committed to be released -- -- 165 -- -- -- 165 Excess of fair value above cost of ESOP shares committed to be released -- 231 -- -- -- -- 231 Exercise of stock options -- (410) -- 783 -- -- 373 Purchase of treasury stock -- -- -- (2,986) -- -- (2,986) Dividends paid -- -- -- -- -- (798) (798) -------- --------- -------- -------- ------------- ---------- ------------ Balance at September 30, 2003 $ 14 $ 13,443 $ (830) $(11,378) $ 3,069 $ 28,070 $ 32,388 ======== ========= ======== ======== ============= ========= ============
2003 2002 2001 ------ ------ ------ (1) Disclosure of reclassification amount, net of tax for the years ended: Net unrealized (depreciation) appreciation arising during the year $ 265 $ 754 $5,084 Less: reclassification adjustment for net gains included in net income 396 218 34 ------ ------ ------ Net unrealized (loss) gain on securities $ (131) $ 536 $5,050 ====== ====== ======
See notes to consolidated financial statements. 58 FIRST KEYSTONE FINANCIAL, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS)
YEAR ENDED SEPTEMBER 30 ----------------------------------- 2003 2002 2001 --------- --------- --------- OPERATING ACTIVITIES: Net income $ 2,739 $ 2,726 $ 2,471 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Provision for depreciation and amortization 426 457 429 Amortization of premiums and discounts 1,202 (3) (123) (Gain) loss on sales of: Loans held for sale (410) (84) (122) Investment securities available for sale (660) (331) (14) Mortgage-related securities available for sale 60 -- (38) Real estate owned 1 (124) (49) Provision for loan losses 715 540 540 Provision for real estate owned losses -- 18 -- Amortization of employee stock ownership plan 396 384 251 Deferred income taxes 225 (135) -- Changes in assets and liabilities which provided (used) cash: Origination of loans held for sale (30,995) (3,712) (20,685) Loans sold in the secondary market 26,998 3,436 23,559 Accrued interest receivable 317 382 20 Prepaid expenses and other assets (2,593) (455) 5,544 Accrued interest payable (186) (804) (490) Accrued expenses (1,060) 3,637 (388) --------- --------- --------- Net cash (used in) provided by operating activities (2,825) 5,932 10,905 --------- --------- --------- INVESTING ACTIVITIES: Loans originated (174,407) (172,860) (70,781) Purchases of: Investment securities available for sale (23,334) (37,909) (32,137) Investment securities held to maturity (6,329) -- -- Mortgage-related securities available for sale (132,141) (27,511) (58,663) (Purchase) redemption of FHLB stock (1,723) 346 (245) Proceeds from sales of investment and mortgage-related securities available for sale 14,600 8,936 14,931 Proceeds from sales of real estate owned 150 1,003 849 Principal collected on loans 175,198 131,402 53,046 Proceeds from maturities, calls or repayments of: Investment securities available for sale 20,793 12,343 7,000 Mortgage-related securities available for sale 83,135 58,779 34,782 Mortgage-related securities held to maturity 5,369 2,595 1,594 Purchase of property and equipment (362) (258) (495) Net expenditures on real estate owned -- (11) (180) --------- --------- --------- Net cash used in investing activities (39,051) (23,145) (50,299) --------- --------- --------- FINANCING ACTIVITIES: Net increase in deposit accounts 31,840 19,164 39,039 Net increase (decrease) in FHLB advances and other borrowings 9,888 167 (16,832) Net increase (decrease) in advances from borrowers for taxes and insurance 126 136 (76) Issuance of trust preferred securities -- 8,000 -- Purchase of trust preferred securities -- (3,290) -- Proceeds from exercise of stock options 373 275 18 Purchase of treasury stock (2,986) (1,013) (3,045) Cash dividends (798) (734) (693) --------- --------- --------- Net cash provided by financing activities 38,443 22,705 18,411 --------- --------- --------- (Decrease) increase in cash and cash equivalents (3,433) 5,492 (20,983) Cash and cash equivalents at beginning of year 24,623 19,131 40,114 --------- --------- --------- Cash and cash equivalents at end of year $ 21,190 $ 24,623 $ 19,131 ========= ========= ========= SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash payments for interest on deposits and borrowings $ 14,522 $ 17,331 $ 15,605 Cash payments of income taxes 800 650 125 Transfers of loans receivable into real estate owned 2,122 361 872
See notes to consolidated financial statements. 59 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 1. NATURE OF OPERATIONS AND ORGANIZATION STRUCTURE The primary business of First Keystone Financial, Inc. (the "Company") is to act as a holding company for First Keystone Bank (the "Bank"), a federally chartered stock savings association founded in 1934, and First Keystone Capital Trust I and Capital Trust II which are companies that are used to issue trust preferred securities. The Bank has two active subsidiaries, FKF Management Corp., Inc. which manages investment securities, and State Street Services Corporation, which has ownership interest in an insurance agency and title company. The primary business of the Bank is to offer a wide variety of commercial and retail products through its branch system located in Delaware and Chester counties in Pennsylvania. The Bank is primarily supervised and regulated by the Office of Thrift Supervision ("OTS"). 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The accompanying consolidated financial statements include the accounts of the Company, the Bank, and the Company's and the Bank's wholly owned subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation. USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS The preparation of 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 the disclosure of contingent assets and liabilities at the dates of the consolidated financial statements and the reported amounts of income and expense during the reporting periods. Actual results could differ from those estimates. SECURITIES HELD TO MATURITY AND SECURITIES AVAILABLE FOR SALE Securities held to maturity are carried at amortized cost only if the Company has the positive intent and ability to hold these securities to maturity. Securities available for sale are carried at fair value with the resulting unrealized gains or losses recorded in equity, net of tax. For the years ended September 30, 2003 and 2002, the Company did not maintain a trading portfolio. ALLOWANCE FOR LOAN LOSSES An allowance for loan losses is maintained at a level that management considers adequate to provide for probable losses based upon an evaluation of known and inherent losses in the loan portfolio. Management's evaluation of the portfolio is based upon past loss experience, current economic conditions and other relevant factors. While management uses the best information available to make such evaluation, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. Impaired loans are predominantly measured based on the fair value of the collateral. The provision for loan losses charged to expense is based upon past loan loss experience and an evaluation of probable losses and impairment existing in the current loan portfolio. A loan is considered to be impaired when, based upon current information and events, it is probable that the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan. An insignificant delay or insignificant shortfall in amounts of payments does not necessarily result in the loan being identified as impaired. For this purpose, delays less than 90 days are considered to be insignificant. Large groups of smaller balance homogeneous loans, including residential real estate and consumer loans, are collectively evaluated for impairment, except for loans restructured under a troubled debt restructuring. MORTGAGE BANKING ACTIVITIES The Company originates mortgage loans held for investment and for sale. At origination, the mortgage loan is identified as either held for sale or for investment. Mortgage loans held for sale are carried at the lower of cost or forward committed contracts (which approximates market), determined on a net aggregate basis. 60 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) At September 30, 2003, 2002 and 2001, loans serviced for others totaled approximately $51,547, $51,826, and $66,301, respectively. Servicing loans for others consists of collecting mortgage payments, maintaining escrow accounts, disbursing payments to investors, and processing foreclosures. Loan servicing income is recorded on a cash basis and includes servicing fees from investors and certain charges collected from borrowers, such as late payment fees. The Company has fiduciary responsibility for related escrow and custodial funds aggregating approximately $603 and $584 at September 30, 2003 and 2002, respectively. The Company assesses the retained interest in the servicing asset or liability associated with the sold loans based on the relative fair values. The servicing asset or liability is amortized in proportion to and over the period during which estimated net servicing income or net servicing loss, as appropriate, will be received. Assessment of the fair value of the retained interest is performed on a continual basis. At September 30, 2003 and 2002, mortgage servicing rights of $198 and $89, respectively, were included in other assets. TRANSFERS OF FINANCIAL ASSETS Transfers of financial assets are accounted for as sales when control over the assets has been surrendered. Control is surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. INCOME RECOGNITION ON LOANS Interest on loans is credited to income when earned. Accrual of loan interest is discontinued and a reserve established on existing accruals if management believes after considering, among other things, economic and business conditions and collection efforts, that the borrowers financial condition is such that collection of interest is doubtful. REAL ESTATE OWNED Real estate owned consists of properties acquired by foreclosure or deed in-lieu of foreclosure. These assets are initially recorded at the lower of carrying value of the loan or estimated fair value less selling costs at the time of foreclosure and at the lower of the new cost basis or net realizable value thereafter. The amounts recoverable from real estate owned could differ materially from the amounts used in arriving at the net carrying value of the assets at the time of foreclosure because of future market factors beyond the control of the Company. Costs relating to the development and improvement of real estate owned properties are capitalized and those relating to holding the property are charged to expense. OFFICE PROPERTIES AND EQUIPMENT Office properties and equipment are recorded at cost. Depreciation is computed using the straight-line method over the expected useful lives of the assets. The costs of maintenance and repairs are expensed as they are incurred, and renewals and betterments are capitalized. CASH SURRENDER VALUE OF LIFE INSURANCE The Bank funded the purchase of insurance policies on the lives of officers and employees of the Bank. The Company has recognized any increase in cash surrender value of life insurance, net of insurance costs, in the consolidated statements of income. The cash surrender value of the insurance policies is recorded as an asset in the statements of financial condition. 61 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) INTEREST RATE RISK At September 30, 2003 and 2002, the Company's assets consisted primarily of assets that earned interest at either adjustable or fixed interest rates and the average life of which is longer term. These assets were funded primarily with shorter term liabilities that have interest rates which vary over time with market rates and, in some cases, certain call features that are affected by changes in market rates. The shorter duration of the interest-sensitive liabilities indicates that the Company is exposed to interest rate risk because, in a rising rate environment, liabilities will be repricing faster at higher interest rates, thereby reducing the market value of long-term assets and net interest income. EARNINGS PER SHARE Basic earnings per share ("EPS") is computed based on the weighted average number of shares of common stock outstanding. Diluted earnings per common share is computed based on the weighted average number of shares of common stock outstanding increased by the number of common shares that are assumed to have been purchased with the proceeds from the exercise of stock options. Weighted average shares used in the computation of earnings per share were as follows:
YEAR ENDED SEPTEMBER 30 ----------------------------------- 2003 2002 2001 --------- --------- --------- Average common shares outstanding 1,901,682 1,915,818 2,021,332 Increase in shares due to options 127,310 118,100 78,396 --------- --------- --------- Adjusted shares outstanding - diluted 2,028,992 2,033,918 2,099,728 ========= ========== =========
For the year ended September 30, 2003, there were no outstanding options that were antidilutive. For the years ended September 30, 2002 and 2001, 9,000 shares and 9,600 shares, respectively, related to outstanding options were excluded from the calculation of diluted EPS because the effect was antidilutive. INCOME TAXES Deferred income taxes are recognized for the tax consequences of temporary differences by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. ACCOUNTING FOR STOCK OPTIONS The Company accounts for stock options in accordance with Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation," which allows an entity to choose between the intrinsic value method, as defined in Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees" or the fair value method of accounting for stock-based compensation described in SFAS No. 123. An entity using the intrinsic value method must disclose pro forma net income and earnings per share as if stock-based compensation was accounted for using the fair value method (see Note 12). The Company continues to account for stock-based compensation using the intrinsic value method and, accordingly, has not recognized compensation expense under this method. OTHER COMPREHENSIVE INCOME The Company presents as a component of comprehensive income the amounts from transactions and other events which currently are excluded from the statement of income and are recorded directly to stockholders' equity. 62 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) ACCOUNTING FOR DERIVATIVE INSTRUMENTS SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities," as amended by SFAS Nos. 137 and 138 and interpreted by the FASB and the Derivative Implementation Group through Statement 133 Implementation Issues, requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial condition and measure those instruments at fair value. Under SFAS No. 133, the accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. The Company adopted this statement on October 1, 2000. The adoption of this statement did not have a material impact on the Company's financial position or results of operations. Currently, the Company does not have any embedded derivatives. The Company currently does not employ hedging activities that require designation as either fair value or cash flow hedges, or hedges of a net investment in a foreign operation. STATEMENT OF CASH FLOWS For purposes of reporting cash flows, cash and cash equivalents include cash and amounts due from depository institutions and interest-bearing deposits with depository institutions. RECENT ACCOUNTING PRONOUNCEMENTS In November 2002, the Financial Accounting Standards Board issued FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others." This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. This Interpretation also incorporates, without change, the guidance in FASB Interpretation No. 34, "Disclosure of Indirect Guarantees of Indebtedness of Others," which is being superseded. The initial recognition and initial measurement provisions of this Interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor's fiscal year-end. The disclosure requirements in this Interpretation are effective for financial statements of interim or annual periods ending after December 15, 2002. The Company currently has no guarantees that would be required to be recognized, measured or disclosed under this Interpretation. In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable Interest Entities." The Interpretation clarifies the application of Accounting Research Bulletin No. 51, "Consolidated Financial Statements," to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The Company has participated in the issue of trust preferred securities through a trust established for such purpose. Currently, the Company classifies such securities after total liabilities and before stockholders' equity on the Consolidated Balance Sheet. The Company is currently assessing the trust preferred securities structure and the continued consolidation of the related trust pursuant to FIN No. 46. Management does not believe the results of such assessment will result in a material impact on the Company's financial statements upon the deferred adoption of FIN No. 46 in the first quarter of fiscal 2004. In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities". The standard requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. Examples of costs covered by the standard include lease termination costs and certain employee severance costs that are associated with a restructuring, discontinued operation, plant closing, or other exit or disposal activity. SFAS No. 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The Company adopted this statement and it did not have a material impact on the Company's financial statements. 63 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) In October 2002, the FASB issued SFAS No. 147, "Acquisitions of Certain Financial Institutions", which provides guidance on the accounting for the acquisition of a financial institution. This statement requires that the excess of the fair value of liabilities assumed over the fair value of tangible and identifiable intangible assets acquired in a business combination which represents goodwill be accounted for under SFAS No. 142. Thus, the specialized accounting guidance in paragraph 5 of SFAS No. 72, will not apply after September 30, 2002. If certain criteria in SFAS No. 147 are met, the amount of the unidentifiable intangible asset will be reclassified to goodwill upon adoption of the statement. Financial institutions meeting the conditions outlined in SFAS No. 147 will be required to restate previously issued financial statements. Additionally, the scope of SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", is amended to include long-term customer-relationship intangible assets such as deposit or/and borrower-relationship intangible assets and credit cardholder intangible assets. This statement became effective for the Company for its fiscal year beginning October 1, 2002. This statement did not have any impact on the Company's financial statements upon adoption. In December 2002 SFAS" No. 148, "Accounting for Stock-Based Compensation - --Transition and Disclosure, an amendment of FASB Statement No. 123." SFAS No. 148 amends SFAS No. 123 to provide alternative methods of transition in connection with a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. This statement is effective for financial statements for fiscal years ending after December 15, 2002. The Company adopted certain disclosure provisions for interim periods beginning after December 15, 2002. This statement did not have a material impact on the Company's financial statements in adopting this statement. In April 2003, the SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." SFAS No. 149 amends and clarifies accounting for derivative instruments and hedging activities under Statement 133. In addition, this Statement clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative and when a derivative contains a financing component that warrants special reporting in the statement of cash flows. This statement is effective for contracts entered into or modified after June 30, 2003. The Company adopted this statement as it relates to the Company's loan commitments and it did not have a material impact on the Company's financial statements. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." This statement requires that certain financial instruments, which previously could be designated as equity, now be classified as liabilities on the balance sheet. The Company currently classifies its trust preferred securities after total liabilities and before stockholders' equity on the Consolidated Balance Sheet. Under the provisions of SFAS No. 150, these securities would be reclassified as borrowed funds. The effective date of SFAS No. 150 has been indefinitely deferred by the FASB when certain criteria are met. As the structure of the Company's trust preferred securities meets such criteria, the Company qualifies for this limited deferral. Therefore, the Company will assess the classification of the trust preferred securities in conjunction with adoption of FIN No. 46 in the first quarter of fiscal 2004, as noted above. RECLASSIFICATIONS Certain reclassifications have been made to the September 30, 2002 and 2001 consolidated financial statements to conform with the September 30, 2003 presentation. Such reclassifications had no impact on the reported net income. 64 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 3. INVESTMENT SECURITIES The amortized cost and approximate fair value of investment securities available for sale and investment securities held to maturity are as follows:
SEPTEMBER 30, 2003 ------------------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED APPROXIMATE COST GAIN LOSS FAIR VALUE ------------------------------------------------------- Available for Sale: U.S. Treasury securities and securities of U.S. Government agencies: 1 to 5 years $ 13,020 $ 35 $ 51 $ 13,004 5 to 10 years 4,880 139 31 4,988 Municipal obligations 14,112 503 -- 14,615 Corporate bonds 17,567 1,288 332 18,523 Mutual funds 14,009 -- 57 13,952 Asset-backed securities 1,911 11 -- 1,922 Preferred stocks 5,474 34 524 4,984 Other equity investments 3,126 2,586 -- 5,712 --------- ---------- ---------- ---------- Total $ 74,099 $ 4,596 $ 995 $ 77,700 --------- ---------- ---------- ---------- Held to Maturity: Municipal obligations $ 3,261 $ 19 -- $ 3,280 Corporate bonds 3,054 116 -- 3,170 --------- ---------- ---------- ---------- Total $ 6,315 $ 135 -- $ 6,450 ========= ========== ========== ==========
SEPTEMBER 30, 2002 ------------------------------------------------------ GROSS GROSS AMORTIZED UNREALIZED UNREALIZED APPROXIMATE COST GAIN LOSS FAIR VALUE ------------------------------------------------------ Available for Sale: U.S. Treasury securities and securities of U.S. Government agencies: 1 to 5 years $ 11,986 $ 128 $ 12,114 5 to 10 years 1,861 210 2,071 Municipal obligations 19,012 788 19,800 Corporate bonds 14,299 827 $ 406 14,720 Mutual funds 14,009 42 6 14,045 Asset-backed securities 2,837 16 2,853 Preferred stocks 10,682 293 224 10,751 Other equity investments 3,476 884 90 4,270 --------- ---------- ---------- ---------- Total $ 78,162 $ 3,188 $ 726 $ 80,624 ========= ========== ========== ==========
For the years ended September 30, 2003, 2002 and 2001, proceeds from sales of investment securities available for sale amounted to $7,309, $7,066 and $8,005, respectively. For such periods, gross realized gains on sales amounted to $660, $351 and $34, respectively, while gross realized losses amounted to $0, $20 and $20, respectively. The tax provision applicable to these net realized gains and losses amounted to $224, $112 and $5, respectively. Investment securities with an aggregate carrying value of $4,930 and $2,986 were pledged as collateral for financings at September 30, 2003 and 2002, respectively (see Note 8). 65 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 4. MORTGAGE-RELATED SECURITIES Mortgage-related securities available for sale and mortgage-related securities held to maturity are summarized as follows:
SEPTEMBER 30, 2003 ------------------------------------------------------ GROSS GROSS AMORTIZED UNREALIZED UNREALIZED APPROXIMATE COST GAIN LOSS FAIR VALUE ------------------------------------------------------- Available for Sale: FHLMC pass-through certificates $ 6,862 $ 126 $ 38 $ 6,950 FNMA pass-through certificates 45,740 412 122 46,030 GNMA pass-through certificates 13,043 596 -- 13,639 Collateralized mortgage obligations 57,961 433 357 58,037 --------- ---------- ---------- ---------- Total $ 123,606 $ 1,567 $ 517 $ 124,656 ========= ========== ========== ========== Held to Maturity: FHLMC pass-through certificates $ 478 $ 22 $ -- $ 500 FNMA pass-through certificates 2,123 40 3 2,160 Collateralized mortgage obligations 886 14 -- 900 --------- ---------- ---------- ---------- Total $ 3,487 $ 76 $ 3 $ 3,560 ========= ========== ========== ==========
SEPTEMBER 30, 2002 ------------------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED APPROXIMATE COST GAIN LOSS FAIR VALUE ------------------------------------------------------- Available for Sale: FHLMC pass-through certificates $ 4,986 $ 275 $ -- $ 5,261 FNMA pass-through certificates 13,009 454 -- 13,463 GNMA pass-through certificates 32,407 1,214 -- 33,621 Collateralized mortgage obligations 32,884 449 4 33,329 --------- ---------- ---------- ---------- Total $ 83,286 $ 2,392 $ 4 $ 85,674 ========= ========== ========== ========== Held to Maturity: FHLMC pass-through certificates $ 1,433 $ 77 $ -- $ 1,510 FNMA pass-through certificates 3,574 96 -- 3,670 Collateralized mortgage obligations 3,848 62 -- 3,910 --------- ---------- ---------- ---------- Total $ 8,855 $ 235 $ -- $ 9,090 ========= ========== ========== ==========
The collateralized mortgage obligations contain both fixed and adjustable classes of securities which are repaid in accordance with a predetermined priority. The underlying collateral of the securities are loans which are primarily guaranteed by FHLMC, FNMA, and GNMA. For the years ended September 30, 2003 and 2001, proceeds from sales of mortgage-related securities available for sales amounted to $7,485 and $6,926, respectively. Gross realized gains amounted to $39 and $38 for the years ended September 30, 2003 and 2001, respectively. Gross realized losses amounted to $99 for the year ended September 30, 2003. The tax provision (benefit) applicable to these net realized gains and losses amounted to $(38) and $13 for the years ended September 30, 2003 and 2001, respectively. During the year ended September 30, 2002, there were no sales of mortgage-related securities. Mortgage-related securities with aggregate carrying values of $13,059 and $12,907 were pledged as collateral for municipal deposits and financings at September 30, 2003 and 2002, respectively (see Note 8). 66 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 5. ACCRUED INTEREST RECEIVABLE The following is a summary of accrued interest receivable by category:
SEPTEMBER 30 ------------------ 2003 2002 ------------------ Loans $ 1,438 $ 1,689 Mortgage-related securities 513 457 Investment securities 703 825 ------- ------- Total $ 2,654 $ 2,971 ======= =======
6. LOANS RECEIVABLE Loans receivable consist of the following:
SEPTEMBER 30 ---------------------- 2003 2002 ---------------------- Single-family $ 166,042 $ 173,736 Construction and land 28,975 28,292 Multi-family and commercial 59,022 60,379 Home equity and lines of credit 33,459 27,595 Consumer loans 1,438 1,202 Commercial loans 10,161 11,919 --------- --------- Total loans 299,097 303,123 Loans in process (10,655) (11,384) Allowance for loan losses (1,986) (2,358) Deferred loan fees (35) (605) --------- --------- Loans receivable net $ 286,421 $ 288,776 ========= =========
The Company originates loans primarily in its local market area of Delaware and Chester Counties, Pennsylvania to borrowers that share similar attributes. This geographic concentration of credit exposes the Company to a higher degree of risk associated with this economic region. The Company participated in the origination and sale of fixed-rate single family residential loans in the secondary market. The Company recognized gains on sale of loans held for sale on sales of conforming agency loans of $410, $84 and $122 for fiscal years ended September 30, 2003, 2002 and 2001, respectively. The Company offers loans to its directors and senior officers on terms permitted by Regulation O. There were approximately $2,068, $1,703 and $1,550 of loans outstanding to senior officers and directors as of September 30, 2003, 2002 and 2001, respectively. The amount of repayments during the years ended September 30, 2003, 2002 and 2001, totaled $1,163, $948 and $165 respectively. There were $1,527, $725 and $772 of new loans granted during fiscal years 2003, 2002 and 2001, respectively. The Company had undisbursed portions under consumer and commercial lines of credit as of September 30, 2003 of $30,147 and $10,349, respectively. The Company originates both adjustable and fixed interest rate loans and purchases mortgage-related securities in the secondary market. The originated adjustable-rate loans have interest rate adjustment limitations and are generally indexed to U.S. Treasury securities plus a fixed margin. Future market factors may affect the correlation of the interest rate adjustment with rates the Company pays on the short-term deposits that have been the primary funding source for these loans. The adjustable-rate mortgage-related securities adjust to various national indices plus a fixed margin. At September 30, 2003, the composition of these loans and mortgage-related securities was as follows: 67 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
FIXED-RATE - ------------------------------------- TERM TO MATURITY BOOK VALUE - ---------------- ---------- 1 month to 1 year $ 5,321 1 year to 3 years 6,451 3 years to 5 years 14,753 5 years to 10 years 58,643 Over 10 years 205,505 -------- Total $290,673 ========
ADJUSTABLE-RATE - ----------------------------------- TERM TO RATE ADJUSTMENT BOOK VALUE - ----------------------- ---------- 1 month to 1 year $ 55,431 1 year to 3 years 25,879 3 years to 5 years 44,602 -------- Total $125,912 ========
The following is an analysis of the allowance for loan losses:
YEAR ENDED SEPTEMBER 30 --------------------------------------- 2003 2002 2001 ------- ------- ------- Beginning balance $ 2,358 $ 2,181 $ 2,019 Provisions charged to income 715 540 540 Charge-offs (1,102) (373) (532) Recoveries 15 10 154 ------- ------- ------- Total $ 1,986 $ 2,358 $ 2,181 ======= ======= =======
At September 30, 2003 and 2002, non-performing loans (which include loans in excess of 90 days delinquent) amounted to approximately $1,556 and $5,138, respectively. At September 30, 2001, non-performing loans consisted of loans that were collectively evaluated for impairment. As of September 30, 2002, the Company had impaired loans with a total recorded investment of $2.4 million and an average recorded investment of $2.1 million. There was not any cash basis interest income recognized on these impaired loans during the year ended September 30, 2002. Interest income of approximately $150 was not recognized as interest income due to the non-accrual status of loans during 2002. 7. OFFICE PROPERTIES AND EQUIPMENT Office properties and equipment are summarized by major classification as follows:
SEPTEMBER 30 ------------------------- 2003 2002 -------- -------- Land and buildings $ 6,082 $ 5,926 Furniture, fixtures and equipment 4,555 4,476 -------- -------- Total 10,637 10,402 Accumulated depreciation and amortization (7,210) (6,911) -------- -------- Net $ 3,427 $ 3,491 ======== ========
68 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) The future minimum rental payments required under operating leases that have initial or remaining non-cancelable lease terms in excess of one year as of September 30, 2003 are as follows: September 30 2004 $ 239 2005 267 2006 172 2007 158 2008 167 Thereafter 754 ------ Total minimum future rental payments $1,757 ======
Leasehold expense was approximately $375, $335 and $329 for the years ended September 30, 2003, 2002 and 2001, respectively. Depreciation expense amounted to $426, $457 and $429 for the years ended September 30, 2003, 2002 and 2001, respectively. 8. DEPOSITS Deposits consist of the following major classifications:
SEPTEMBER 30 ------------------------------------------------------ 2003 2002 ------------------------------------------------------ AMOUNT PERCENT AMOUNT PERCENT -------- ------- -------- ------- Non-interest-bearing $ 20,917 5.8% $ 15,340 4.6% NOW 60,221 16.6 48,803 14.8 Passbook 47,089 13.0 41,659 12.6 Money Market 55,889 15.4 48,721 14.7 Certificates of Deposit 178,489 49.2 176,242 53.3 -------- ----- -------- ----- Total $362,605 100.0% $330,765 100.0% ======== ===== ======== =====
The weighted average interest rates paid on deposits were 1.77% and 2.44% at September 30, 2003 and 2002, respectively. Included in deposits as of September 30, 2003 and 2002 are deposits greater than $100 totaling approximately $103,734 and $81,976, respectively. Deposits in excess of $100 are not federally insured. At September 30, 2003 and 2002, the Company pledged certain mortgage-related securities aggregating approximately $12,867 and $7,371, respectively, as collateral for municipal deposits. A summary of scheduled maturities of certificates is as follows:
SEPTEMBER 30 ------------------------ 2003 2002 -------- -------- Within one year $106,631 $109,694 One to two years 42,069 39,829 Two to three years 7,962 11,852 Thereafter 21,827 14,867 -------- -------- Total $178,489 $176,242 ======== ========
69 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) A summary of interest expense on deposits is as follows:
YEAR ENDED SEPTEMBER 30 ------------------------------------- 2003 2002 2001 ------- ------- ------- NOW $ 316 $ 401 $ 537 Passbook 530 750 907 Money Market 736 1,036 1,223 Certificates of Deposit 5,771 7,412 10,395 ------- ------- ------- Total $ 7,353 $ 9,599 $13,062 ======= ======= =======
9. BORROWINGS A summary of borrowings is as follows:
SEPTEMBER 30 ------------------------ 2003 2002 -------- -------- FHLB advances $126,403 $126,237 Repurchase agreements 2,885 -- FHLB overnight borrowings 6,800 -- Other 184 147 -------- -------- Total borrowings $136,272 $126,384 ======== ========
Advances from the FHLB are made at fixed rates with remaining maturities, summarized as follows:
SEPTEMBER 30 ------------------------ 2003 2002 -------- -------- Over one year through five years (1) $ 25,704 -- Over five years through ten years (1) 100,500 126,032 Over 10 years 199 205 -------- -------- $126,403 $126,237 ======== ========
(1) Although the contractual maturities of these borrowings are between one and ten years, the FHLB has the right to convert these advances to adjustable-rate advances. The amount of FHLB advances with the convertible feature, which are subject to conversion in each of fiscal 2004, 2005, and 2006, is $101.0 million, $10.0 million and $15.0 million, respectively. Included in the table above at September 30, 2003 and 2002 are FHLB advances whereby the FHLB has the option at predetermined times to convert the fixed interest rate to an adjustable rate tied to the London Interbank Offered Rate (LIBOR). The Company then has the option to prepay these advances if the FHLB converts the interest rate. These advances are included in the periods in which they mature. The average balance of FHLB advances was $126.4 million with an average cost of 5.4% for the year ended September 20, 2003. Advances from the FHLB are collateralized by all FHLB stock owned by the Bank in addition to a blanket pledge of eligible assets in an amount required to be maintained so that the estimated fair value of such eligible assets exceeds, at all times, 110% of the outstanding advances. The Company enters into sales of securities under agreements to repurchase. These agreements are recorded as financing transactions, and the obligation to repurchase is reflected as a liability in the consolidated statements of financial condition. The securities underlying the agreements are delivered to the dealer with whom each transaction is executed. The dealers, who may sell, loan or otherwise dispose of such securities to other parties in the normal course of their operations, agree to resell to the Company substantially the same securities at the maturities of the agreements. The Company retains the right of substitution of collateral throughout the terms of the agreement. At September 30, 2003, outstanding FHLB repurchase agreements were secured by U.S. Government securities. The average balance of FHLB repurchase agreements during the year ended September 30, 2003 was $8 with an average cost of 25 basis points. The maximum amount outstanding at any month end during the year ended September 30, 2003 was $2.9 million. 70 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 10. INCOME TAXES The Company and its subsidiaries file a consolidated federal income tax return. The Company uses the specific charge-off method for computing reserves for bad debts. The bad debt deduction allowable under this method is available to large banks with assets greater than $500 million. Generally, this method allows the Company to deduct an annual addition to the reserve for bad debts equal to its net charge-offs. Retained earnings at September 30, 2003 and 2002 included approximately $2.5 million representing bad debt deductions for which no income tax has been provided. Income tax expense is comprised of the following:
YEAR ENDED SEPTEMBER 30 -------------------------------- 2003 2002 2001 ----- ----- ----- Federal: Current $ 428 $ 583 $ 456 Deferred 225 (135) -- State -- -- 3 ----- ----- ----- Total $ 653 $ 448 $ 459 ===== ===== =====
The tax effect of temporary differences that give rise to significant portions of the deferred tax accounts, calculated at 34%, is as follows:
SEPTEMBER 30 ----------------------- 2003 2002 ------- ------- Deferred tax assets: Accelerated depreciation $ 374 $ 346 Allowance for loan losses 840 769 Accrued expenses 146 463 Other -- -- ------- ------- Total deferred tax assets 1,360 1,578 ======= ======= Deferred tax liabilities: Deferred loan fees (310) (306) Unrealized gain on available for sale securities (1,581) (1,649) Other (50) (47) ------- ------- Total deferred tax liabilities (1,941) (2,002) ------- ------- Net deferred income taxes $ (581) $ (424) ======= =======
71 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) The Company's effective tax rate is less than the statutory federal income tax rate for the following reasons:
YEAR ENDED SEPTEMBER 30 ---------------------------------------------------------------------- 2003 2002 2001 ---------------------------------------------------------------------- PERCENTAGE PERCENTAGE PERCENTAGE OF PRETAX OF PRETAX OF PRETAX AMOUNT INCOME AMOUNT INCOME AMOUNT INCOME ------ ------ ------ ------ ------ ------ Tax at statutory rate $ 1,153 34.0% $ 1,079 34.0% $ 991 34.0% Increase (decrease) in taxes resulting from: Tax exempt interest, net (274) (8.1) (290) (9.1) (281) (9.6) Increase in cash surrender value (223) (6.5) (231) (7.3) (226) (7.7) Other (3) (0.1) (110) (3.5) (25) (1.0) ------- ---- ------- ---- ------- ---- Total $ 653 19.3% $ 448 14.1% $ 459 15.7% ======= ==== ======= ==== ======= ====
11. REGULATORY CAPITAL REQUIREMENTS The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum regulatory capital requirements can result in certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth below) of tangible and core capital (as defined in the regulations) to adjusted assets (as defined), and of Tier I and total capital (as defined) to average assets (as defined). Management believes, as of September 30, 2003, that the Bank meets all capital adequacy requirements to which it is subject. As of September 30, 2003, the most recent notification from the OTS categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier-1 risk-based, and Tier-1 core capital ratios as set forth in the table below. There are no conditions or events since that notification that management believes have changed the institution's category.
REQUIRED FOR WELL CAPITALIZED CAPITAL ADEQUACY UNDER PROMPT ACTUAL PURPOSE CORRECTIVE ACTION ---------------------------------------------------------------- AMOUNT PERCENTAGE AMOUNT PERCENTAGE AMOUNT PERCENTAGE ------ ---------- ------ ---------- ------ ---------- At September 30, 2003: Core Capital (to Adjusted Tangible Assets) $43,852 8.0% $21,972 4.0% $27,465 5.0% Tier I Capital (to Risk-Weighted Assets) 43,852 14.4 N/A N/A 18,268 6.0 Total Capital (to Risk-Weighted Assets) 45,564 15.0 24,357 8.0 30,446 10.0 Tangible Capital (to Tangible Assets) 43,852 8.0 8,240 1.5 N/A N/A At September 30, 2002: Core Capital (to Adjusted Tangible Assets) $40,873 8.1% $20,265 4.0% $25,325 5.0% Tier I Capital (to Risk-Weighted Assets) 40,873 15.4 N/A N/A 15,941 6.0 Total Capital (to Risk-Weighted Assets) 42,957 16.2 21,255 8.0 26,569 10.0 Tangible Capital (to Tangible Assets) 40,873 8.1 7,597 1.5 N/A N/A
72 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) The Bank's capital at September 30, 2003 and 2002 for financial statement purposes differs from tangible, core (leverage), and Tier-1 risk-based capital amounts by $ and $ , respectively, representing the inclusion of unrealized gain on securities available for sale and a portion of capital securities (see Note 17) that qualifies as regulatory capital as well as adjustments to the Bank's capital that do not affect the parent company. At September 30, 2003 and 2002, total risk-based capital, for regulatory requirements, was increased by $1,712 and $2,406, respectively, of general loan loss reserves, for a total of $45,564 and $42,957, respectively. At the date of the Bank's conversion from the mutual to stock form in January 1995 (the "Conversion"), the Bank established a liquidation account in an amount equal to its retained income as of August 31, 1994. The liquidation account is maintained for the benefit of eligible account holders and supplemental eligible account holders who continue to maintain their accounts at the Bank after the Conversion. The liquidation account is reduced annually to the extent that eligible account holders (as defined in the Bank's plan of conversion) and supplemental eligible account holders have reduced their qualifying deposits as of each anniversary date. Subsequent increases in such balances will not restore an eligible account holder's or supplemental eligible account holder's interest in the liquidation account. In the event of a complete liquidation of the Bank, each eligible account holder and supplemental eligible account holder will be entitled to receive a distribution from the liquidation account in an amount proportionate to the current adjusted qualifying balances for accounts then held. The principal source of cash flow for the Company is dividends from the Bank. Various federal banking regulations and capital guidelines limit the amount of dividends that may be paid to the Company by the Bank. Future payment of dividends by the Bank is dependent on individual regulatory capital requirements and levels of profitability. In addition, loans or advances made by the Bank to the Company are generally limited to 10 percent of the Bank's capital stock and surplus on a secured basis. Accordingly, funds available for loans or advances by the Bank to the Company amounted to $4,431. 12. EMPLOYEE BENEFITS 401(k) PROFIT SHARING PLAN The Bank's 401(k) profit sharing plan covers substantially all full-time employees of the Company and provides for pre-tax contributions by the employees with matching contributions at the discretion of the Board of Directors determined at the beginning of the calendar year. All amounts are fully vested. For calendar years 2003, 2002 and 2001, the Company matched twenty-five cents for every dollar contributed up to 5% of a participant's salary. The profit sharing expense for the plan was $38, $36 and $32 for the fiscal years ended September 30, 2003, 2002 and 2001, respectively. EMPLOYEE STOCK OWNERSHIP PLAN In connection with the Conversion, the Company established an employee stock ownership plan ("ESOP") for the benefit of eligible employees. At September 30, 2003, 244,865 shares were committed to be released, of which 19,229 shares have not yet been allocated to participant accounts. The Company accounts for its ESOP in accordance with AICPA Statement of Position 93-6, Employers Accounting for Employee Stock Ownership Plans, which requires the Company to recognize compensation expense equal to the fair value of the ESOP shares during the periods in which they become committed to be released. To the extent that the fair value of the ESOP shares released differs from the cost of such shares, this difference is charged or credited to equity as additional paid-in capital. Management expects the recorded amount of expense in any given period to fluctuate from period to period as continuing adjustments are made to reflect changes in the fair value of the ESOP shares. The Company's ESOP, which is internally leveraged, does not report the loan receivable extended to the ESOP as an asset and does not report the ESOP debt due the Company. The Company recorded compensation and employee benefit expense related to the ESOP of $516, $395 and $308 for the years ended September 30, 2003, 2002 and 2001, respectively. 73 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) RECOGNITION AND RETENTION PLAN Under the 1995 Recognition and Retention Plan and Trust (the "RRP"), there are 81,600 shares authorized under the RRP. At September 30, 2002, the Company awarded 79,350 shares to the Company's Board of Directors and executive officers subject to vesting and other provisions of the RRP. At September 30, 2003, all the shares awarded had been allocated to plan participants. Compensation expense was recognized ratably over the five year vesting period for the shares awarded. Since all the shares awarded have been allocated, no compensation expense was recognized relating to the RRP for fiscal years ended September 30, 2003, 2002 and 2001. STOCK OPTION PLANS Under the 1995 Stock Option Plan (the "Option Plan"), common stock totaling 272,000 shares has been reserved for issuance pursuant to the exercise of options. During fiscal year 1999, stockholders approved the adoption of the 1998 Stock Option Plan ("1998 Option Plan") (collectively with the Option Plan, the "Plans") which reserves an additional 111,200 shares of common stock for issuance. Options covering an aggregate of 357,106 shares have been granted to the Company's executive officers, nonemployee directors and other key employees, subject to vesting and other provisions of the Plans. At September 30, 2003, 2002 and 2001, the number of shares exercisable was 210,209, 261,913 and 271,889, respectively, and the weighted average exercise price of those options was $9.19, $8.91 and $8.57, respectively. The following table summarizes transactions regarding the stock option plans:
Weighted Number of Average Option Exercise Exercise Price Shares Price Range per share ------ ----------- --------- Outstanding at October 1, 2000 339,140 $ 7.50 - 14.25 $ 9.05 Exercised (14,607) 7.50 - 7.50 7.50 ------- -------------- --------- Outstanding at September 30, 2001 324,533 $ 7.50 - 14.25 $ 9.11 Granted 13,300 14.84 - 16.15 15.73 Exercised (30,856) 7.50 - 12.38 7.97 ------- -------------- --------- Outstanding at September 30, 2002 306,977 $ 7.50 - 16.15 $ 9.52 Granted 3,000 16.15 - 16.15 16.15 Exercised (62,678) 7.50 - 14.25 8.79 ------- -------------- --------- Outstanding at September 20, 2003 247,299 $ 7.50 - 16.15 $ 9.78 ======= ============== =========
A summary of the exercise price range at September 30, 2003 is as follows:
Weighted Average Weighted Average Number of Remaining Contractual Exercise Price per Option Shares Exercise Price Range Life Share - ------------- -------------------- ---- ----- 146,769 $ 7.50 - 10.13 2.24 $ 7.63 100,530 12.13 - 16.15 6.41 12.90 ------- -------------- ---- --------- 247,299 $ 7.50 - 16.15 3.93 $ 9.78 ======= ============== ==== =========
74 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) The Company applies APB Opinion No. 25 in accounting for stock options and, accordingly, no compensation expense has been recognized in the financial statements. Had the Company determined compensation expense based on the fair value at the grant date for its stock options under SFAS No. 123, the Company's net income and income per share would have been reduced to the pro forma amounts indicated below:
YEAR ENDED SEPTEMBER 30 2003 2002 2001 ---- ---- ---- Net income: As reported $ 2,739 $ 2,726 $ 2,471 Pro forma 2,665 2,649 2,405 Net income per common and common equivalent share: Earnings per common share - As reported $ 1.35 $ 1.34 $ 1.18 - Pro forma 1.31 1.30 1.15 Weighted average fair value of options granted during the period $ 4.83 $ 9.67 N/A
The binomial option-pricing model was used to determine the fair value of options at the grant date. Significant assumptions used to calculate the above fair value of the awards are as follows:
SEPTEMBER 30 ---------------------------- 2003 2002 2001 ---- ---- ---- Risk-free interest rate of return 3.03% 2.98% 3.77% Expected option life (months) 100 100 60 Expected Volatility 27% 73% 52% Expected dividends 1.8% 2.8% 2.3%
OTHER The Company established an expense accrual in connection with the anticipated funding of a trust to be created to formalize the Company's deferred compensation arrangements with four former officers of the Company. A total of $31 and $85 was included in the Company's liabilities at September 30, 2003 and 2002, respectively. 13. DERIVATIVE FINANCIAL INSTRUMENTS The Company concurrently adopted the provisions of SFAS No. 133, and SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities -- an amendment of FASB Statement No. 133" on October 1, 2000. The Company adopted the provisions of SFAS No. 149 effective July 1, 2003. The Company's derivative instruments outstanding during fiscal year end September 30, 2003 include commitments to fund loans available-for-sale and forward loan sale agreements. The Company adopted new accounting requirements relating to SFAS No. 149 which requires that mortgage loan commitments related to loans originated for sale be accounted for as derivative instruments. In accordance with SFAS No. 133 and SFAS No. 149, derivative instruments are recognized in the statement of financial condition at fair value and changes in the fair value thereof are recognized in the statement of operations. The Company originates single-family residential loans for sale pursuant to programs with FHLMC. Under the structure of the programs, at the time the Company initially issues a loan commitment in connection with such programs, it does not lock in a specific interest rate. At the time the interest rate is locked in by the borrower, the Company concurrently enters into a forward loan sale agreement with respect to the sale of such loan at a set price in an effort to manage the interest rate risk inherent in the locked loan commitment. The forward loan sale agreement also meets the definition of a derivative instrument under SFAS No. 133. Any change in the fair value of the loan commitment after the borrower locks in the interest rate is substantially offset by the corresponding change in the fair value of the forward loan sale agreement related to such loan. The period from the time the borrower locks in the interest rate to the time the Company funds the loan and sells it to FHLMC is generally 60 days. The fair value of each instrument will rise or fall in response to changes in market interest 75 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) rates subsequent to the dates the interest rate locks and forward loan sale agreements are entered into. In the event that interest rates rise after the Company enters into an interest rate lock, the fair value of the loan commitment will decline. However, the fair value of the forward loan sale agreement related to such loan commitment should increase by substantially the same amount, effectively eliminating the Company's interest rate and price risk. At September 30, 2003, the Company had $1.5 million of loan commitments outstanding related to loans being originated for sale. Of such amount, $230 related to loan commitments for which the borrowers had not entered into interest rate locks and $1.3 million which were subject to interest rate locks. At September 30, 2003, the Company had $1.3 million of forward loan sale agreements. Due to the structure of these transactions, the Company concluded that the derivative instruments involving its loans held for sale were not material to the consolidated statements of the financial condition and operations of the Company as of and for the year ended September 30, 2003 since the Company does not bear any interest rate or price risk with respect to such transactions. 14. COMMITMENTS AND CONTINGENCIES The Company has outstanding loan commitments, excluding undisbursed portion of loans in process and equity lines of credit, of approximately $5,922 and $10,621 as of September 30, 2003 and 2002, respectively, all of which are expected to be funded within four months. Of these commitments outstanding, the breakdown between fixed and adjustable-rate loans is as follows:
SEPTEMBER 30 ------------------- 2003 2002 ---- ---- Fixed-rate (ranging from 4.49% to 6.75%) $ 5,578 $ 4,525 Adjustable-rate 344 6,096 ------- ------- Total $ 5,922 $10,621 ======= =======
Depending on cash flow, interest rate, risk management and other considerations, longer term fixed-rate residential loans are sold in the secondary market. There was approximately $1,307 and $2,936 in outstanding commitments to sell loans at September 30, 2003 and 2002, respectively. In the fourth quarter of fiscal 2002, the Company settled a lawsuit related to certain loan sales. The lawsuit was instituted by the purchaser of five residential mortgage loans from the Bank that alleged that it suffered losses in connection with these loans and that the Bank was required to purchase the loans or compensate the purchaser for its alleged losses. The Bank settled all the purchaser's claims for $570. There are various claims and pending actions against the Company and its subsidiaries arising out of the conduct of its business. In the opinion of the Company's management and based upon advice of legal counsel, the resolution of these matters will not have a material adverse impact on the consolidated financial position or the results of operations of the Company and its subsidiaries. 15. RELATED PARTY TRANSACTIONS The Company retains the services of a law firm in which one of the Company's directors is a member. In addition to providing general legal counsel to the Company, the firm also prepares mortgage documents and attends loan closings for which it is paid directly by the borrower. The Company also utilizes one of the Company's directors as a consultant on various real estate matters. In addition, one of the Company's board members has an interest in an insurance agency, First Keystone Insurance Services, LLC in which one of the Bank's subsidiaries has a majority position. 76 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 16. FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
SEPTEMBER 30 ------------------------------------------------ 2003 2002 ------------------------------------------------ CARRYING/ ESTIMATED CARRYING/ ESTIMATED NOTIONAL FAIR NOTIONAL FAIR AMOUNT VALUE AMOUNT VALUE ------ ----- ------ ----- Assets: Cash and cash equivalents $ 21,190 $ 21,190 $ 24,623 $ 24,623 Investment securities 84,015 84,150 80,624 80,624 Loans 286,421 287,996 288,776 293,509 Loans held for sale 4,498 4,498 501 501 Mortgage-related securities 128,143 129,646 94,529 94,764 FHLB stock 8,294 8,294 6,571 6,571 Liabilities: Passbook deposits 47,089 47,089 41,659 41,659 NOW and money market deposits 116,110 116,110 102,770 102,770 Certificates of deposit 178,489 179,699 176,242 178,404 Borrowings 136,272 137,709 126,237 128,539 Off balance sheet commitments 43,024 43,024 35,732 35,732
The fair value of cash and cash equivalents is their carrying value due to their short-term nature. The fair value of investments and mortgage-related securities is based on quoted market prices, dealer quotes, and prices obtained from independent pricing services. The fair value of loans is estimated, based on present values using approximate current entry value interest rates, applicable to each category of such financial instruments. The fair value of FHLB stock approximates its carrying amount. The fair value of NOW deposits, money market deposits and passbook deposits is the amount reported in the financial statements. The fair value of certificates of deposit and FHLB advances is based on a present value estimate, using rates currently offered for deposits and borrowings of similar remaining maturity. Fair values for off-balance sheet commitments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties credit standings. No adjustment was made to the entry-value interest rates for changes in credit performing commercial loans, construction loans, and land loans for which there are no known credit concerns. Management believes that the risk factor embedded in the entry-value interest rates, along with the general reserves applicable to the performing commercial, construction, and land loan portfolios for which there are no known credit concerns, result in a fair valuation of such loans on an entry-value basis. The fair value of non-performing loans, with a recorded book value of approximately $1,556 and $5,138 (which are collateralized by real estate properties with property values in excess of carrying amounts) as of September 30, 2003 and 2002, respectively, was not estimated because it is not practicable to reasonably assess the credit adjustment that would be applied in the marketplace for such loans. The fair value estimates presented herein are based on pertinent information available to management as of September 30, 2003 and 2002. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since September 30, 2003 and 2002 and, therefore, current estimates of fair value may differ significantly from the amounts presented herein. 77 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 17. CAPITAL SECURITIES On August 21, 1997, First Keystone Capital Trust I (the "Trust"), a trust formed under Delaware law, that is a subsidiary of the Company, issued $16.2 million of preferred securities (the "Preferred Securities") at an interest rate of 9.7%, with a scheduled maturity of August 15, 2027. The Company owns all the common stock of the Trust. The proceeds from the issue were invested in Junior Subordinated Debentures (the "Debentures") issued by the Company. The Debentures are unsecured and rank subordinate and junior in right of payment to all indebtedness, liabilities and obligations of the Company. The Debentures represent the sole assets of the Trust. Interest on the Preferred Securities is cumulative and payable semiannually in arrears. The Company has the option, subject to required regulatory approval, if any, to prepay the securities beginning August 15, 2007. The securities are shown on the balance sheet as Company-obligated mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company. The Company has, under the terms of the Debentures and the related Indenture as well as the other operative corporate documents, agreed to irrevocably and unconditionally guarantee the Trust's obligations under the Debentures. The Company contributed approximately $6.0 million of the net proceeds to the Bank to support the Bank's lending activities. The interest cost associated with this issue is treated as a non-interest expense on the consolidated statement of income rather than interest expense. On November 15, 2001, the Company purchased $3.5 million of the Preferred Securities. On November 28, 2001, First Keystone Capital Trust II (the "Trust II"), a trust formed under Delaware law, that is a subsidiary of the Company, issued $8.0 million of securities ("Preferred Securities II") in a pooled securities offering at a floating rate of 375 basis over the six month LIBOR with a maturity date of December 8, 2031. The Company owns all the common stock of the Trust II. The proceeds from the issue were invested in Junior Subordinated Debentures (the "Debentures II") issued by the Company. The Debentures II are unsecured and rank subordinate and junior in right of payment to all indebtedness, liabilities and obligations of the Company. The Debentures II represent the sole assets of the Trust II. Interest on the Preferred Securities II is cumulative and payable semi-annually in arrears. The Company has the option, subject to required regulatory approval, if any, to prepay the securities beginning December 8, 2006. 78 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 18. PARENT COMPANY ONLY FINANCIAL INFORMATION Condensed financial statements of First Keystone Financial, Inc. are as follows: CONDENSED STATEMENTS OF FINANCIAL CONDITION
SEPTEMBER 30 ----------------- 2003 2002 ----------------- Assets: Interest-bearing deposits $ 1,800 $ 2,269 Investment securities available for sale 6,246 7,060 Investment in subsidiaries 46,482 44,192 Other assets 1,089 1,798 ------- ------- Total assets $55,617 $55,319 ======= ======= Liabilities and Stockholders' Equity Junior subordinated debt $21,593 $21,630 Other liabilities 1,636 894 ------- ------- Total liabilities 23,229 22,524 Stockholders' equity 32,388 32,795 ------- ------- Total liabilities and stockholders' equity $55,617 $55,319 ======= =======
CONDENSED STATEMENTS OF INCOME
YEAR ENDED SEPTEMBER 30 ----------------------------- 2003 2002 2001 ----------------------------- Interest and dividend income: Dividends from subsidiary $ 9 $ 5 $ 4,500 Loan to ESOP 79 92 105 Interest and dividends on investments 286 502 608 Interest on deposits 50 67 7 ------- ------- ------- Total Interest and dividend income 424 666 5,220 ------- ------- ------- Interest on debt and other borrowed money 1,677 1,723 1,762 Other income 241 44 25 Operating expenses 194 154 403 ------- ------- ------- (Loss) income before income taxes and equity in undistributed income (loss) of subsidiaries (1,206) (1,167) 3,080 Income tax benefit (402) (385) (477) ------- ------- ------- (Loss) income before equity in undistributed (loss) income of subsidiaries (804) (782) 3,557 Equity in undistributed income (loss) of subsidiaries 3,543 3,508 (1,086) ------- ------- ------- Net income $ 2,739 $ 2,726 $ 2,471 ======= ======= =======
79 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) CONDENSED STATEMENTS OF CASH FLOWS
YEAR ENDED SEPTEMBER 30 ----------------------------- 2003 2002 2001 ----------------------------- Cash flows from operating activities: Net income $ 2,739 $ 2,726 $ 2,471 Adjustment to reconcile net income to cash provided by (used in) operations: Equity in undistributed (income) loss of subsidiaries (3,543) (3,508) 1,086 Amortization of common stock acquired by stock benefit plans 374 384 251 Gain (loss) on sales of investment securities available for sale (241) 44 (25) Amortization of premium 26 (22) 29 (Increase) decrease in other assets 709 (1,205) 455 (Increase) decrease in other liabilities 165 145 (459) ------- ------- ------- Net cash (used in) provided by operating activities 229 (1,436) 3,808 ------- ------- ------- Cash flows from financing activities: Purchase of investments available for sale (3,870) (278) Proceeds from calls or repayments of investment securities 1,100 Proceeds from sale of investments available for sale 1,591 4,956 1,025 ------- ------- ------- Net cash provided by (used in) investing activities 2,691 1,086 747 ------- ------- ------- Cash flows from financing activities: Issuance of preferred trust securities -- 8,000 -- Purchase of preferred trust securities -- (3,290) -- Repayment in other borrowed money -- (815) (711) Purchase of treasury stock (2,986) (1,013) (3,045) Dividends paid (798) (734) (693) Proceeds from exercise of stock options 395 275 18 ------- ------- ------- Net cash provided by (used in) financing activities (3,389) 2,423 (4,431) ------- ------- ------- Increase (decrease) in cash (469) 2,073 124 Cash at beginning of year 2,269 196 72 ------- ------- ------- Cash at end of year $ 1,800 $ 2,269 $ 196 ======= ======= =======
80 FIRST KEYSTONE FINANCIAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 19. QUARTERLY FINANCIAL DATA (UNAUDITED) Unaudited quarterly financial data for the years ended September 30, 2003 and 2002 is as follows:
2003 2002 ------------------------------------------------------------------------ 1ST 2ND 3RD 4TH 1ST 2ND 3RD 4TH QTR QTR QTR QTR QTR QTR QTR QTR ------------------------------------------------------------------------ Interest income $7,217 $6,973 $6,614 $6,407 $7,757 $7,416 $7,547 $7,403 Interest expense 3,710 3,576 3,579 3,470 4,641 4,157 3,899 3,843 ------ ------ ------ ------ ------ ------ ------ ------ Net interest income 3,507 3,397 3,035 2,937 3,116 3,259 3,648 3,560 Provision for loan losses 195 195 195 130 135 135 135 135 ------ ------ ------ ------ ------ ------ ------ ------ Net income after provision for loan losses 3,312 3,202 2,840 2,807 2,981 3,124 3,513 3,425 Non-interest income 614 540 998 1,093 458 450 456 859(1) Non-interest expense 2,921 2,906 3,020 3,168 2,666 2,753 3,053 3,622(1) ------ ------ ------ ------ ------ ------ ------ ------ Income before income taxes 1,005 836 818 732 773 821 916 662 Income tax expense 224 143 153 132 120 137 173 17 ------ ------ ------ ------ ------ ------ ------ ------ Net income $ 781 $ 693 $ 665 $ 600 $ 653 $ 684 $ 743 $ 645 ====== ====== ====== ====== ====== ====== ====== ====== Per Share: Earnings per share - basic $ .41 $ .36 $ .35 $ .32 $ .34 $ .35 $ .39 $ .34 Earnings per share - diluted $ .39 $ .34 $ .33 $ .29 $ .32 $ .34 $ .36 $ .32 Dividend per share $ .10 $ .10 $ .10 $ .10 $ .09 $ .09 $ .09 $ .09
(1) During the fourth quarter, the Company sold and realized a pre-tax net gain on certain available for sale securities of $331. Additionally, due to a settlement of a lawsuit concerning certain loan sales, a $570 expense was incurred. Certain reclassifications have been made to the quarters presented to conform with the presentation. Such reclassifications had no impact on the reported net income. 81 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. ITEM 9-A. CONTROLS AND PROCEDURES. Under the supervision and with the participation of the Company's management, including its chief executive officer and chief financial officer, the Company has evaluated the effectiveness of the design and operation of its disclosure controls and procedures as of September 30,2003, and based on their evaluation, the Company's chief executive officer and chief financial officer have concluded that these controls and procedures are designed to ensure that the information required to be disclosed by the Company. The reports that it files or submits under the Exchange Act is recorded, processed, summarized in the SEC's rules and regulations and are operating in an effective manner. No change in the Company's internal control over financial reporting (as defined in Rules 13a-15(f) and 15(d)-15(f) under the Exchange Act) occurred during the fourth fiscal quarter of fiscal 2003 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information required herein with respect to directors and executive officers of the Company is incorporated by reference from the information contained in the section captioned "Information with Respect to Nominees for Director, Directors Whose Terms Continue and Executive Officers" in the Company's definitive Proxy Statement for the Annual Meeting of Stockholders to be held January 28, 2004 (the "Proxy Statement"), a copy of which will be filed with the SEC before the meeting date. The Company has adopted a Code of Ethics that applies to its principal executive officer and principal financial officer, as well as other officers and employees of the Company and the Bank. A copy of the Code of Ethics, included as an exhibit to this Form 10-K and filed with the Securities and Exchange Commission, may also be found on the Company's website at www.firstkeystone.com. ITEM 11. EXECUTIVE COMPENSATION. The information required herein is incorporated by reference from the information contained in the section captioned "Executive Compensation" in of the Registrant's Proxy Statement. The reports of the Audit Committee and the Compensation Committee included in the Registrant's Proxy Statement should be deemed filed or incorporated into this filing or any other filing by the Company under the Exchange Act or the Securities Act of 1933 except to the extent the Company specifically incorporates said reports herein or therein by reference thereto. 82 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS. The information required herein is incorporated by reference from the information contained in the section captioned "Beneficial Ownership of Common Stock by Certain Beneficial Owners and Management" in the Registrant's Proxy Statement. EQUITY COMPENSATION PLAN INFORMATION. The following table sets forth certain information for all equity compensation plans and individual compensation arrangements (whether with employees or non-employees, such as directors), in effect as of September 30, 2003.
Number of Shares to be issued upon Weighted-Average Number of Shares Remaining Available the Exercise of Outstanding Options, Exercise Price of for Future Issuance (Excluding Shares Plan Category Warrants and Rights Outstanding Options Reflected in the First Column) - ------------------------------------------------------------------------------------------------------------------------------------ Equity Compensation Plans Approved by Security Holders 247,299 $9.78 26,094 Equity Compensation Plans Not Approved by Security Holders -- -- -- ------- ----- ------ Total 247,299 $9.78 26,094 ======= ===== ======
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required herein is incorporated by reference from the information contained in the section captioned "Transactions with Certain Related Persons" in of the Registrant's Proxy Statement. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES. Not applicable. PART IV. ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Documents filed as part of this Report. (1) The following documents are filed as part of this report and are incorporated herein by reference from the Registrant's Annual Report. Report of Independent Auditors. Consolidated Statements of Financial Condition at September 30, 2003 and 2002. Consolidated Statements of Income for the Years Ended September 30, 2003, 2002 and 2001. Consolidated Statements of Changes in Stockholders' Equity for the Years Ended September 30, 2003, 2002 and 2001. Consolidated Statements of Cash Flows for the Years Ended September 30, 2003, 2002 and 2001. Notes to the Consolidated Financial Statements. 83 (2) All schedules for which provision is made in the applicable accounting regulation of the SEC are omitted because they are not applicable or the required information is included in the Consolidated Financial Statements or notes thereto. (3) The following exhibits are filed as part of this Form 10-K, and this list includes the Exhibit Index.
No Description -- ----------- 3.1 Amended and Restated Articles of Incorporation of First Keystone Financial, Inc. * 3.2 Amended and Restated Bylaws of First Keystone Financial, Inc. * 4 Specimen Stock Certificate of First Keystone Financial, Inc. * 10.1 Employee Stock Ownership Plan and Trust of First Keystone Financial, Inc. * 10.2 401(K)/ Profit-sharing Plan of First Keystone Federal Savings Bank. * 10.3 Employment Agreement between First Keystone Financial, Inc. and Donald S. Guthrie dated May 26, 1999. ** 10.4 Employment Agreement between First Keystone Financial, Inc. and Stephen J. Henderson dated May 26, 1999. ** 10.5 Employment Agreement between First Keystone Financial, Inc. and Thomas M. Kelly dated May 26, 1999. ** 10.6 Form of Severance Agreement between First Keystone Financial, Inc. and Elizabeth M. Mulcahy dated May 26, 1999. ** 10.8 Form of Severance Agreement between First Keystone Financial, Inc. and Carol Walsh dated May 26, 1999. ** 10.9 1995 Stock Option Plan.*** 10.10 1995 Recognition and Retention Plan and Trust Agreement.*** 10.11 1998 Stock Option Plan.**** 10.12 Employment Agreement between First Keystone Federal Savings Bank and Donald S. Guthrie dated May 26, 1999. ** 10.13 Employment Agreement between First Keystone Federal Savings Bank and Stephen J. Henderson dated May 26, 1999. ** 10.14 Employment Agreement between First Keystone Federal Savings Bank and Thomas M. Kelly dated May 26, 1999. ** 10.15 Form of Severance Agreement between First Keystone Federal Savings Bank and Elizabeth M. Mulcahy dated May 26, 1999. ** 10.16 Form of Severance Agreement between First Keystone Federal Savings Bank and Carol Walsh dated May 26, 1999. **
84 11 Statement re: computation of per share earnings. See Note 2 to the Consolidated Financial Statements included in Item 8 hereof. 21 Subsidiaries of the Registrant - Reference is made to Item 1 "Business," for the required information. 23 Consent of Deloitte & Touche LLP. 31.1 Certification of Chief Executive Officer 31.2 Certification of Chief Financial Officer 32.1 Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32.2 Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 99.1 Codes of Ethics
- ---------- (*) Incorporated by reference from the Registration Statement Form S-1 (Registration No. 33-84824) filed by the Registrant with the SEC on October 6, 1994, as amended. (**) Incorporated by reference from the Form 10-K filed by the Registrant with the SEC on December 29, 1999 (File No. 000-25328). (***) Incorporated by reference from the Form 10-K filed by the Registrant with SEC on December 29, 1995 (File No. 000-25328). (****) Incorporated from Appendix A of the Registrant's definitive proxy statement dated December 24, 1998 (File No. 000-25328). (b) Reports filed on Form 8-K.
Date Item and Description ---- -------------------- 08/01/03 Item 12 - Filing of press release reporting the Company's results of operation for the three and nine months ended June 30, 2003.
(c) Exhibits. See the list set forth above under subsection (a) (3) (d) Financial Statement Schedules. 85 SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FIRST KEYSTONE FINANCIAL, INC. By: /s/ Donald S. Guthrie ----------------------- Donald S. Guthrie Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities and Exchange Act of 1934, this report had been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. /s/ Donald S. Guthrie December 23, 2003 - -------------------------------------- Donald S. Guthrie Chairman of the Board and Chief Executive Officer (Principal Executive Officer) /s/ Thomas M. Kelly December 23, 2003 - -------------------------------------- Thomas M. Kelly President and Chief Financial Officer (Principal Financial and Accounting Officer) /s/ Donald A. Purdy December 23, 2003 - -------------------------------------- Donald A. Purdy Director /s/ Edward Calderoni December 23, 2003 - -------------------------------------- Edward Calderoni Director /s/ Edmund Jones December 23, 2003 - -------------------------------------- Edmund Jones Director /s/ Donald G. Hosier, Jr. December 23, 2003 - -------------------------------------- Donald G. Hosier, Jr. Director /s/ Marshall J. Soss December 23, 2003 - -------------------------------------- Marshall J. Soss Director /s/ William J. O'Donnell December 23, 2003 - -------------------------------------- William J. O'Donnell Director /s/ Bruce C. Hendrixson December 23, 2003 - -------------------------------------- Bruce C. Hendrixson Director 86 EX-23 3 w92688exv23.txt CONSENT OF DELOITTE & TOUCHE LLP EXHIBIT 23 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statement Nos. 333-88676, 333-09565 and 333-97562 of First Keystone Financial, Inc. on Form S-8 of our report dated December 12, 2003, incorporated by reference in this Annual Report on Form 10-K of First Keystone Financial, Inc. for the year ended September 30, 2003. /s/ DELOITTE & TOUCHE LLP Philadelphia, Pennsylvania December 22, 2003 87 EX-31.1 4 w92688exv31w1.txt CERTIFICATION OF CHIEF EXECUTIVE OFFICER EXHIBIT 31.1 CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO RULES 13a-14 AND 15d-14 OF THE SECURITIES EXCHANGE ACT OF 1934 AND SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Donald S. Guthrie, certify that: 1. I have reviewed this annual report on Form 10-K of First Keystone Financial, Inc. (the "registrant"); 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: December 23, 2003 /s/ Donald S. Guthrie ---------------------------- Donald S. Guthrie Chairman of the Board and Chief Executive Officer 88 EX-31.2 5 w92688exv31w2.txt CERTIFICATION OF CHIEF FINANCIAL OFFICER EXHIBIT 31.2 CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO RULES 13a-14 AND 15d-14 OF THE SECURITIES EXCHANGE ACT OF 1934 AND SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Thomas M. Kelly, certify that: 1. I have reviewed this quarterly report on Form 10-K of First Keystone Financial, Inc. (the "registrant"); 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: December 23, 2003 /s/ Thomas M. Kelly -------------------------------------- Thomas M. Kelly President and Chief Financial Officer 89 EX-32.1 6 w92688exv32w1.txt CERTIFICATION OF CEO PURSUANT TO SECTION 906 EXHIBIT 32.1 CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 (18 U.S.C. 1350) The undersigned Chairman of the Board and Chief Executive Officer of First Keystone Financial, Inc. (the "Registrant") hereby certifies that the Registrant's Form 10-K for the fiscal year ended September 30, 2003 fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934 and that the information contained therein fairly presents, in all material respects, the financial condition and results of operations of the Registrant. /s/ Donald S. Guthrie - ----------------------- Name: Donald S. Guthrie Title: Chairman of the Board and Chief Executive Officer Date: December 23, 2003 90 EX-32.2 7 w92688exv32w2.txt CERTIFICATION OF CFO PURSUANT TO SECTION 906 EXHIBIT 32.2 CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 (18 U.S.C. 1350) The undersigned President and Chief Financial Officer of First Keystone Financial, Inc. (the "Registrant") hereby certifies that the Registrant's Form 10-K for the fiscal year ended September 30, 2003 fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934 and that the information contained therein fairly presents, in all material respects, the financial condition and results of operations of the Registrant. /s/ Thomas M. Kelly - ---------------------- Name: Thomas M. Kelly Title: President and Chief Financial Officer Date: December 23, 2003 91 EX-99.1 8 w92688exv99w1.txt CODE OF CONDUCT AND ETHICS EXHIBIT 99.1 Date: December 19, 2003 FIRST KEYSTONE FINANCIAL, INC. CODE OF CONDUCT AND ETHICS INTRODUCTION In order to assure the proper and ethical performance of our business and to maintain the confidence of the public, our customers and our stockholders in First Keystone Financial, Inc. ("First Keystone") and its subsidiaries, all Directors, Officers and Employees of Company are expected to act in accordance with the highest standards of personal and professional integrity in all aspects of their activities, to comply with applicable laws, rules and regulations and to avoid misconduct and conflicts of interest and the appearance of conflicts of interest. To promote these standards and values, the Board of Directors of First Keystone has established and adopted this Code of Conduct and Ethics to provide guidance concerning the standards of ethical conduct by and responsibilities of persons employed by First Keystone or its subsidiaries and Directors of First Keystone and its subsidiaries. This Code applies to First Keystone and all of its subsidiaries. This Code outlines the broad principles of legal and ethical business conduct embraced by the Company. To assist you, certain sections of this Code describe clarifying examples or hypothetical situations that might arise within the context of the particular section. These are illustrative only and are not intended to limit the scope of the section. However, a written code cannot answer all questions raised in the context of business relationships. Therefore, this Code must be applied using common sense and good judgment. Issues with respect to conflicts, legality or ethics may not always be clear cut and Officers and Employees should consult with higher levels of management, the Human Resources Department or the Compliance Officer and Directors should discuss the matter with the Compliance Officer or outside counsel. Donald S. Guthrie Chairman and Chief Executive Officer CODE OF CONDUCT AND ETHICS -- INDEX I. DEFINITIONS......................................................................... 1 II. ETHICAL PRINCIPLES AND CORPORATE VALUES ............................................ 2 III. CONFLICTS OF INTEREST............................................................... 3 A. Compensation and Gifts.......................................................... 3 B. Business Gratuities............................................................. 5 C. Transactions with Insiders...................................................... 5 IV. CONFIDENTIAL INFORMATION............................................................ 5 A. Confidential Information Regarding Customers and Others......................... 5 B. Permissible Dissemination of Confidential Information........................... 6 C. Confidential Information Regarding Current or Former Directors and Employees.... 6 D. Company Resources; Proprietary Information...................................... 6 V. PERSONAL INVESTMENTS AND FINANCES................................................... 6 A. Trading in Company Securities................................................... 6 B. Personal Investments............................................................ 6 C. Purchase of Company Owned Property.............................................. 7 D. Loans........................................................................... 7 VI. BUSINESS CONDUCT.................................................................... 7 A. Business and Accounting Practices............................................... 7 B. Political Contributions; Expenditures for Political Purposes.................... 8 C. Outside Business Interests...................................................... 9 D. Management Interlocks........................................................... 9 VII. SPECIAL ETHICS OBLIGATIONS FOR EMPLOYEES WITH FINANCIAL REPORTING RESPONSIBILITIES.. 9 VIII. REPORTING ILLEGAL OR UNETHICAL BEHAVIOR OR ACCOUNTING COMPLAINTS.................... 10 A. Reporting Illegal or Unethical Behavior......................................... 10 B. Accounting Complaints........................................................... 11 C. Procedure for Submissions to the Audit Committee................................ 11 D. Non-Retaliation................................................................. 11 IX. CONCLUSION.......................................................................... 11
I. DEFINITIONS A. Bank: First Keystone Bank. B. Code: This Code of Conduct and Ethics adopted by the Board of Directors of First Keystone Financial, Inc. C. Company: First Keystone Financial, Inc. and/or all subsidiaries currently existing or hereafter formed or acquired, which employ personnel or have Boards of Directors. D. Director; Board(s) of Directors: Includes all members of the Boards of Directors of the Company and its subsidiaries. E. Employee: Includes all employees and Officers of the Company and its subsidiaries. F. Immediate Family: Includes father, mother, spouse and children of a Person. These may be blood relationships, step relationships, or adoptions. G. Officer: Includes all Persons employed by the Company with the title Assistant Vice President or higher. H. Person: Any individual or group of individuals identified in D, E and G above. I. Regulation O: Refers to Regulation O promulgated by the Board of Governors of the Federal Reserve System, as amended from time to time, to implement the lending restrictions set forth in the Federal Reserve Act regarding loans and other extensions of credit made to executive officers, directors, principal shareholders and other insiders. 1 II. ETHICAL PRINCIPLES AND CORPORATE VALUES The nature of the business of the Company requires careful observance of applicable laws and regulations. High standards of conduct and personal integrity are essential for the Company to maintain the confidence of its stockholders, customers, Employees, and the general public. To ensure that the Company and all Persons embrace and promote sound ethical business practices, the Company requires that all Persons agree that they will: - - Act with honesty and integrity, avoiding actual or apparent conflicts of interest in personal and professional relationships; - - Comply with rules and regulations of federal, state and local governments, and other appropriate regulatory agencies; - - Act in good faith, responsibly, and with due care, competence and diligence, without misrepresenting material facts or allowing one's independent judgment to be impaired; - - Provide information that is accurate, complete, objective, relevant, timely and understandable to ensure full, fair, accurate, timely, and understandable disclosure in reports and documents; and - - Promptly report any conduct that the individual believes to be a violation of law or business ethics or of any provision of the Code, including any transaction or relationship that reasonably could be expected to give rise to a conflict of interest. 2 III. CONFLICTS OF INTEREST A conflict of interest exists whenever a Person (or a member of his or her Immediate Family) has a personal interest in any entity or matter that may influence a decision or cloud that Person's judgment in the discharge of his or her responsibilities to the Company. It is the duty of every Person to avoid situations from which he or she (or an Immediate Family member) might benefit personally, directly or indirectly, or that give the perception that the Person (or an Immediate Family member) is benefiting personally, from business decisions, use of Company facilities or from relationships with Company customers, vendors or contacts. If a business opportunity relating to the Company's lines of business becomes available to or is made known to a Person, subject to pre-existing contractual agreements with the Company and such Person, it must first be made available to the Company before being acted upon by that Person, by his or her Immediate Family or by any other Person. Employees are prohibited from underwriting, approving or granting Bank loans to companies in which the Employee has a substantial interest as an owner, director, officer, or partner, or to companies in which a member of his or her Immediate Family has such an interest; or to a member of his or her Immediate Family. Such loans must be directed to another loan officer. When that is not possible, the application may be taken and processed, but must be reviewed and approved by another loan officer. Employees should avoid any relationship that would cause a conflict of interest with their duties and responsibilities at the Company. Employees are expected to disclose any situations that may involve inappropriate or improper conflicts of interests affecting them personally or affecting other employees or those with whom the Company does business. Waivers of conflicts of interest involving executive officers require the approval of the Board of Directors or an appropriate committee. To avoid conflicts of interest, Directors are expected to disclose to their fellow Directors any personal interest they may have in a transaction upon which the Board passes and to recuse themselves from participation in any decision in which there is a conflict between their personal interests and the interests of the Company. A. Compensation and Gifts. The Bank Bribery Act prohibits any Person or agent of the Company or attorney representing the Company from offering or receiving anything of value where the item of value is offered with the intent of influencing the Person, agent or attorney or a business transaction. This law is broad and carries civil and criminal penalties, including fines and/or imprisonment. Gifts or awards given in recognition of a Person's service or accomplishment in civic, charitable, educational, or religious organizations are not prohibited by this Code. Generally, there is no threat of a violation of the Bank Bribery Act if acceptance of a gift or benefit is based on an Immediate Family (or other familial relationship) or personal relationship, which exists independent of any business with the Company or if the gift or benefit is made available to the general public under the same conditions on which it is made available to a Person. 3 1. General Prohibitions: Except as provided below, Persons are prohibited from soliciting or receiving anything of value in any amount in connection with the business of the Company, including but not limited to money, goods, or services. This prohibition applies whether such was obtained as a gratuity/gift or as a "quid pro quo" exchange (something received or given as a reward for preferential action or service rendered by a Director or Employee). Additionally, this prohibition includes receiving compensation of any kind from any source for rendering services of a type that are performed or offered by the Company. A Director or Employee may not do indirectly what he or she is prohibited from doing directly; for example, arrange to have a prohibited gift made to a member of his or her Immediate Family. Similarly, a Person may not give gifts, meals, or entertainment (including a quid pro quo exchange) which are intended to influence, or that might give the appearance of influencing, another Person or a business contact in a business decision. Any action by a Person perceived to compromise another's judgment is prohibited. Example: An Employee may not solicit any sort of personal compensation in return for making a loan to a customer. Example: A Director who is in a position, whether directly or indirectly, to sell goods or services to the Company may not give gifts to the department responsible for making such purchasing decisions. 2. Permissible Gifts: Any Person may accept anything of value from customers or individuals or entities with business relationships with the Company if it is of reasonable and not excessive value but only if it: a. Is not intended to influence any decision by the Person; b. Is unsolicited; c. Is infrequent; and d. Is not a quid pro quo. Notwithstanding the foregoing, under no circumstances shall any person accept money as a gift from any customer or individual or entity with a business relationship with the Company. Additionally, a Person may accept gifts from individuals who have both a personal relationship with that Person and a business relationship with the Company, for such commonly recognized events or occasions as a promotion, wedding, retirement, or religious observance, if reasonable in value. 4 If a Person is offered or receives something of value in excess of the above-stated amounts which he or she believes may be impermissible under this Code, that Person must disclose the matter to the Human Resources Department or the Compliance Officer and seek a determination that the item of value may be accepted or must be returned. The reviewer will give due consideration to the criteria for permissible gifts and whether receipt poses a threat to the integrity of the Company. B. Business Gratuities. Payments for travel, lodging, meals and entertainment are normally permissible if they (i) are reasonable in amount; (ii) are expended in the course of a legitimate business meeting or an event intended to foster better business relations; (iii) would be paid by the Company as a business expense if not paid for by the outside source; and (iv) are unsolicited. If a Person is offered payments of the type which he or she believes may be impermissible, that Person must disclose the matter to the Human Resources Department or the Compliance Officer and seek a determination that the offer may be accepted or must be rejected. The reviewer will give due consideration to the criteria for permissible payments and whether receipt poses a threat to the integrity of the Company. Example: It is not a prohibited business gratuity to accept a vendor's offer to pay lodging and meals for an Employee's attendance at a conference sponsored in whole or in part by the vendor so long as the Employee's attendance has a business purpose. C. Transactions with Insiders. The Company from time to time may purchase or lease real or personal property or goods or services from a Person, a member of a Person's Immediate Family, or from business entities in which a Person or in which a member of that Person's Immediate Family is an officer, director and/or controlling stockholder. It is the policy of the Company that any transaction involving insiders must be conducted at arm's length and that any consideration paid or received by the Company in connection with such a transaction shall be on terms no less favorable than terms available to an unaffiliated third party under the same or similar circumstances. In accordance with Regulation O, the Director's or Officer's interest in any such transactions requiring Board action shall be disclosed to the Board prior to any action being taken, and any such transactions not requiring Board approval shall be reported to the Board quarterly. IV. CONFIDENTIAL INFORMATION A. Confidential Information Regarding Customers and Others. Persons must take all reasonable measures to protect the confidentiality of non-public information about the Company or its subsidiaries and their customers, stockholders and suppliers obtained or created in connection with such persons' activities and to prevent the 5 unauthorized disclosure of such information unless required by applicable law or regulation or legal or regulatory process. B. Permissible Dissemination of Confidential Information. Dissemination of confidential customer information among Company subsidiaries is permissible. Notwithstanding the foregoing, all queries of a legal nature that involve confidential information relating to a subsidiary's customers must initially be directed to the Company's Corporate Secretary who may refer such matter to the Compliance Officer and/or outside counsel if deemed necessary and appropriate. C. Confidential Information Regarding Current or Former Directors and Employees. All requests for information regarding current or former Directors or Employees must be referred to the Human Resources Department. The amount of information the Human Resources Department may provide is limited by the Company's internal procedures and applicable laws. D. Company Resources; Proprietary Information. Persons are prohibited from selling, disclosing, or otherwise using the Company's physical resources or proprietary information for personal benefit or for the benefit of any other party. The definition of the Company's "physical resources or proprietary information" includes all the Company's intellectual property, including but not limited to any written materials, any computer or network-based information, data, any other types of information or data developed for the Company by an Employee or a vendor, supplier or other contractor of the Company. Example: Employees are prohibited from using the Company's marketing research for a personal venture or disclosing proprietary information to a competitor. V. PERSONAL INVESTMENTS AND FINANCES A. Trading in Company Securities. The Board of Directors of the Company has approved a policy to prevent insider trading. A copy of the Company's insider trading policy is available upon request from the Stock Compliance Officer. B. Personal Investments. Directors must disclose to the Chairman of the Board and Employees must disclose to their direct supervisor when they know of any ownership or beneficial interest which they or members of their Immediate Families have with customers or suppliers of the Company if they have responsibility for the account relationship. Persons and their Immediate Families are prohibited from investing in securities of customers or suppliers if they hold or share any responsibility for the account relationship, unless the securities are listed on an exchange and the purchase or sale is based upon information available to the general public, or unless approval is granted by a 6 majority vote of the Board of Directors. In those instances where a personal investment in a given customer has been approved, Persons must avoid participation in any Company decisions concerning that customer. Example: An Employee who is the account officer for or deals with the loan account of ABC Company (a customer) may not invest personally in ABC Company without receiving prior approval of the Board of Directors. (See also Section V (D) "Loans" below). C. Purchase of Company Owned Property. Purchase of Company owned or subsidiary owned property (real or personal) by Persons or members of their Immediate Families is strictly prohibited unless such purchase is on terms no more favorable than would be offered to an unaffiliated third party under the same or similar circumstances. For example, the Company may allow Persons to purchase Company owned vehicles at fair market value. D. Loans. Loans by the Bank are available to Directors and designated Regulation O Officers on the same terms and conditions, including interest rates and collateral, as those prevailing for comparable loans with other customers; provided, however, that discounted consumer and residential loans which are offered as a benefit to all other Employees may be extended to Directors and Regulation O Officers on the same terms. Such loans must not involve more than the normal risk of repayment or present other unfavorable features. The Securities Exchange Act of 1934, as amended, makes it unlawful for the Company, directly or indirectly, including through any subsidiary, to extend or maintain credit, arrange for the extension of credit or renew the extension of credit in the form of a personal loan to or for any of its Directors or executive officers. Regulation O loans are exempt from this prohibition set forth in the Securities Exchange Act. Persons are prohibited from lending personal funds to persons known to them as Company customers, except if the customer is an Immediate Family member or other relative including the Person's siblings and grandchildren or the mother, father and siblings of the Person's spouse. Persons may not borrow from a customer unless the customer is an Immediate Family member or other relative including the Person's siblings and grandchildren or the mother, father and siblings of the Person's spouse or if the customer is a recognized lending institution. VI. BUSINESS CONDUCT A. Business and Accounting Practices. 1. No funds or assets of the Company shall be used for unlawful purposes. 2. No unrecorded fund or asset of the Company shall be established or maintained for any purpose. 7 3. No false or misleading entries shall be made in the books and records of the Company for any purpose. All items of income or expense shall be appropriately recorded. 4. No payment by the Company shall be made with the intent or understanding that all or any part of such payment be used for any purpose other than that described in the books and records of the Company. 5. No payment on behalf of the Company shall be approved without adequate supporting documentation or with the intention or understanding that all or any part of such payment is to be used for any purpose other than that described by the documents supporting the payment. 6. Compliance is required with generally accepted accounting principles and procedures and with established internal accounting controls and procedures. 7. The Company may require submission by Directors and Employees of reports or statements in compliance with this section, at such time or from time to time and in such form as the Company may specify. B. Political Contributions; Expenditures for Political Purposes. 1. No funds or assets of the Company are to be used to make any unlawful political contribution. For purposes of this section, the term "political contribution" shall be deemed to include not only the direct or indirect delivery of cash or property of the Company to a political party, candidate, committee or organization but also includes: (a) the reimbursement by the Company to any Person or any other person, for a political contribution made or to be made by such Person or other person; or (b) the provision of services or the use of property or the making of a loan, to a political party, candidate, committee or organization by the Company, except in the ordinary course of Company business and on customary commercial terms. Purchases of tickets to political dinners or other similar events or of advertisements in political publications are considered to be political contributions and are not reimbursable. 2. Neither the Company nor any Person acting on its behalf shall establish any program to solicit, collect or distribute political contributions from a Person. 3. No Person shall be under any obligation of any kind to the Company or to any other Person, to utilize any of his or her compensation to make political contributions and no Person or any other person acting on the Company's behalf, shall seek to create or enforce any such obligation. Nothing contained in this section is intended to discourage Persons from active personal involvement in the political process, including the making of personal political contributions, or to otherwise limit the rights and obligations of Persons as responsible citizens. Notwithstanding the foregoing, this Code prohibits political campaigning, wearing and/or displaying political 8 campaign slogans, distributing political literature, and/or soliciting campaign funds at or in the work place. C. Outside Business Interests. Prior approval must be obtained in situations where a Person or his or her Immediate Family members may profit from a relationship with a company or other entity with which that Person deals with in the course of his or her Company duties. D. Management Interlocks. Persons should be aware of the various statutes and regulations either prohibiting or restricting dual service by them in the following areas: 1. Service as a director, officer or employee of any other commercial bank, banking association, trust company, savings bank, savings and loan association, or credit union; 2. Service in an organization primarily engaged in the issue, underwriting, public sale or distribution of stocks, bonds or other securities; 3. Service as an officer or director of a public utility or a registered public utility holding company or subsidiary; or 4. Service as a director, officer, partner, employee, appointee or representative of any obligor of securities for which the Company subsidiary with which he or she is affiliated is the indenture (corporate) trustee. VII. SPECIAL ETHICS OBLIGATIONS FOR EMPLOYEES WITH FINANCIAL REPORTING RESPONSIBILITIES As a public company, it is critical that the Company's filings with the Securities and Exchange Commission be accurate and timely. Depending on their position with the Company, Persons may be called upon to provide information to assure that the Company's public reports are complete, fair and understandable. The Company expects all Persons to take this responsibility seriously and to provide prompt and accurate answers to inquiries related to the Company's public disclosure requirements. All Persons bear a responsibility for promoting integrity throughout the Company. The CEO, the CFO, the Treasurer, the Controller, the principal accounting officer and all those Persons acting in a similar capacity have a special role both to adhere to these principles and also to ensure that the Company's corporate culture ensures the fair and timely reporting of the Company's financial results and condition. Because of this special role, the Company's CEO, CFO, Treasurer, Controller, principal accounting officer and all those Persons acting in a similar capacity of the Company are bound by the following Financial Officer Code of Ethics, and by signing the Certificate of Compliance attached to this Code, each agrees that he or she will: 9 - Act with honesty and integrity, avoiding actual or apparent conflicts of interest in personal and professional relationships; - Provide information that is accurate, complete, objective, relevant, timely and understandable to ensure full, fair, accurate, timely, and understandable disclosure in reports and documents that the Company files with, or submits to, government agencies and in other public communications; - Comply with rules and regulations of federal, state and local governments, and other appropriate regulatory agencies; - Act in good faith, responsibly, and with due care, competence and diligence, without misrepresenting material facts or allowing one's independent judgment to be impaired; and - Promptly report to the Company's CEO, CFO, or a member of the Company's Audit Committee of the Company's Board of Directors any conduct that the individual believes to be a violation of law or business ethics or of any provision of the Code of Conduct, including any transaction or relationship that reasonably could be expected to give rise to a conflict of interest. Violations of this Financial Officer Code of Ethics, including failures to report potential violations by others, is a serious matter that may result in disciplinary action, including termination of employment. If any Person believes that a violation of the Financial Officer Code of Ethics has occurred, he or she should promptly contact the Company's CEO, CFO or a member of the Company's Audit Committee. VIII. REPORTING ILLEGAL OR UNETHICAL BEHAVIOR OR ACCOUNTING COMPLAINTS A. Reporting Illegal or Unethical Behavior Persons who suspect or know of violations of this Code or illegal or unethical business or workplace conduct by Employees, Officers or Directors have an obligation to contact their supervisor or superiors. If the individuals to whom such information is conveyed are not responsive, or if there is a reason to believe that reporting to such individuals is inappropriate in particular cases, then the Employee, Officer or Director may contact the CEO of the Company. Such communications will be kept confidential to the extent feasible. If the employee is still not satisfied with the response, the employee may contact the Audit Committee of the Board of Directors of the Company in accordance with the procedures set forth in Paragraph C of this Section VIII. If concerns or complaints require confidentiality, then this confidentiality will be protected to the extent feasible, subject to applicable law. 10 B. Accounting Complaints The Company's policy is to comply with all applicable financial reporting and accounting regulations. If any Director, Officer or Employee of the Company has unresolved concerns or complaints regarding questionable accounting or auditing matters of the Company, then he or she is encouraged to submit those concerns or complaints (anonymously, confidentially or otherwise) to the Audit Committee. Subject to its legal duties, the Audit Committee and the Board will treat such submissions confidentially. Such submissions may be directed to the attention of the Audit Committee in accordance with the procedures set forth in Paragraph C of this Section VIII. C. Procedure for Submissions to the Audit Committee Upon receipt of a report of alleged violations of this Code, illegal or unethical conduct, or questionable accounting or auditing matters of the Company, the Audit Committee is responsible for initiating a full and impartial investigation. To the extent feasible, and subject to its legal duties, the Audit Committee will treat all such reports confidentially. The Audit Committee shall maintain procedures for the receipt, retention and treatment of reports or complaints of alleged violations of this Code, illegal or unethical conduct, or questionable accounting, internal accounting controls or auditing matters of the Company. Submission of such reports or complaints, made anonymously or otherwise, may be made in accordance with procedures maintained by the Audit Committee, which shall be disseminated to all Employees, Officers and Directors. D. Non-Retaliation The Company prohibits retaliation of any kind against individuals who have made good faith reports or complaints of violations of this Code or other known or suspected illegal or unethical conduct. IX. CONCLUSION The Company conducts itself and its business dealings so as to comply with all applicable laws and regulations. Where the requirements of such laws and regulations are unclear, the advice of the Compliance Officer or outside counsel must be sought to secure interpretation and to ensure compliance. Every Person must understand the Company's internal policies and procedures and the legal and regulatory framework within which the Company operates and must take those steps necessary to ensure that any Persons working with or under their supervision understand them. Persons are urged to reread the Code from time to time to refresh their recollection of the statutory and regulatory matters and the policies outlined herein. This Code may be amended or modified by the Board of Directors of the Company. Waivers of this Code may only be granted by the Board of Directors or a committee of the Board with specific delegated authority. However, with respect to waivers of this Code for executive officers or directors, such waivers may be granted only by the independent members of the Board of Directors of the Company. Waivers will be promptly disclosed to stockholders as 11 required by the Securities Exchange Act and the rules thereunder and the applicable rules of the Nasdaq Stock Market. 12 CERTIFICATE OF COMPLIANCE I have reviewed and read the Company's Code of Conduct and Ethics (the "Code") for First Keystone Financial, Inc. and its subsidiaries as adopted by the Board of Directors on December __, 2003. I hereby certify that I am complying with all provisions of the Code and that I am not aware of any violations of the Code. I understand that the Code requires that if I become aware of any violations of the Code, I must report them. I have read and understand the Code and agree to comply with it at all times and in connection with the purchase and sale of Company stock. I also understand that violations of the Code can result in sanctions, including discipline, suspension, discharge, and referral for criminal prosecution or civil action. Date: __________________________ Signature: _______________________________________ Name (printed or typed): _________________________________ PLEASE RETURN TO DONALD S. GUTHRIE CHAIRMAN AND CHIEF EXECUTIVE OFFICER 13 -----END PRIVACY-ENHANCED MESSAGE-----