10-Q 1 ub-sep05_10q.txt UNITED BANCSHARES 10-Q SEPT. 2005 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. -------------- FORM 10-Q -------------- (Mark One) _X_ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005 OR ___ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ______________ TO ______________ UNITED BANCSHARES, INC. ----------------------- (Exact name of registrant as specified in its charter) 0-25976 ----------------------- Commission File Number Pennsylvania 23-2802415 ---------------------- ---------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 30 S. 15th Street, Suite 1200, Philadelphia, PA 19102 ----------------------------------------------- --------- (Address of principal executive office) (Zip Code) (215) 351-4600 ----------------------- (Registrant's telephone number, including area code) N/A ----------------------- (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or such shorter period that the registrant was required to filed such reports), and (2) has been subject to such filing requirements for the past 90 day. Yes _X_ No ___ Indicate by check mark whether registrant is an accelerated filer (as defined in Rule 12b-2 of the Act) Yes ___ No __X__ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act. Yes ___ No _X__ APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS: Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13, or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes _____ No _____ Not Applicable. Applicable only to corporate issuers: Indicate the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date. United Bancshares, Inc. (sometimes herein also referred to as the "Company" or "UBS") has two classes of capital stock authorized - 2,000,000 shares of $.01 par value Common Stock and a Series Preferred Stock (Series A Preferred Stock). The Board of Directors designated a subclass of the common stock, Class B Common Stock, by filing of Articles of Amendment to its Articles of Incorporation on September 30, 1998. This Class B Common Stock has all of the rights and privileges of Common Stock with the exception of voting rights. Of the 2,000,000 shares of authorized Common Stock, 250,000 have been designated Class B Common Stock. There is no market for the Common Stock. As of November 1, 2005 the aggregate number of the shares of the Registrant's Common Stock outstanding was 1,068,588 (including 191,667 Class B non-voting). There are 33,500 shares of Common Stock held in treasury stock at November 1, 2005. The Series A Non-Voting Preferred Stock consists of 500,000 authorized shares of stock of which 136,842 shares are issued and outstanding and 6,308 shares are held in treasury stock as of November 1, 2005. 2 -------------- FORM 10-Q -------------- Index Item No. Page PART I-FINANCIAL INFORMATION 1. Financial Statements.................................................. 5 2. Management's Discussion and Analysis of Financial Condition and Results of Operations................................................. 9 3. Quantitative and Qualitative Disclosures about Market Risk........... 24 4. Controls and Procedures .............................................. 26 PART II-OTHER INFORMATION 1. Legal Proceedings..................................................... 27 2. Unregistered Sales of Equity Securities and Use of Proceeds........... 27 3. Defaults upon Senior Securities....................................... 27 4 Submission of Matters to a Vote of Security Holders................... 27 5. Other Information..................................................... 27 6. Exhibits ............................................................ 27 3 SPECIAL CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS Certain of the matters discussed in this document and the documents incorporated by reference herein, including matters discussed under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" may constitute forward looking statements for the purposes of the Securities Act of 1933, as amended and the Securities Exchange Act of 1934, as amended, and may involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of United Bancshares, Inc ("UBS") to be materially different from future results, performance or achievements expressed or implied by such forward looking statements. The words "expect," "anticipate," "intended," "plan," "believe," "seek," "estimate," and similar expressions are intended to identify such forward-looking statements. UBS' actual results may differ materially from the results anticipated by the forward-looking statements due to a variety of factors, including without limitation: (a) the effects of future economic conditions on UBS and its customers, including economic factors which affect consumer confidence in the securities markets, wealth creation, investment and consumer saving patterns; (b) UBS' interest rate risk exposure and credit risk; (c) changes in the securities markets with respect to the market values of financial assets and the stability of particular securities markets; (d) governmental monetary and fiscal policies, as well as legislation and regulatory changes; (e) changes in interest rates or the level and composition of deposits, loan demand, and the values of loan collateral and securities, as well as interest-rate risks; (f) changes in accounting requirements or interpretations; (g) the effects of competition from other commercial banks, thrifts, mortgage companies, consumer finance companies, credit unions securities brokerage firms, insurance companies, money-market and mutual funds and other financial institutions operating in the UBS' trade market area and elsewhere including institutions operating locally, regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone, computer and the internet; (h) any extraordinary events (such as the September 11, 2001 events and the war in Iraq) and the U.S. Government's response to those events or the U.S. Government becoming involved in an additional conflict in a foreign country; (i) the failure of assumptions underlying the establishment of reserves for loan losses and estimates in the value of collateral, and various financial assets and liabilities and technological changes being more difficult or expensive than anticipated; (j) UBS' success in generating new business in its existing markets, as well as its success in identifying and penetrating targeted markets and generating a profit in those markets in a reasonable time; (k) UBS' timely development of competitive new products and services in a changing environment and the acceptance of such products and services by customers; and (l) UBS' success in managing the risks involved in the foregoing. All written or oral forward-looking statements attributed to UBS are expressly qualified in their entirety by use of the foregoing cautionary statements. All forward-looking statements included in this document are based upon information presently available, and UBS assumes no obligation to update any forward-looking statement. 4 Item 1. Financial Statements
Consolidated Balance Sheets unaudited September 30, December 31, 2005 2004 ------------ ------------ Assets Cash and due from banks $ 3,813,461 $ 4,317,645 Interest bearing deposits with banks 290,186 888,924 Federal funds sold 4,937,000 3,727,000 ----------- ----------- Cash & cash equivalents 9,040,647 8,933,569 Investment securities: Held-to-maturity, at amortized cost (fair value of $8,240,563 and $8,784,495 at September 30, 2005 and December 31, 2004, respectively) 8,355,309 8,762,796 Available-for-sale, at market value 3,784,415 4,797,549 Loans held for sale (market value of $1,437,274 at December 31, 2004) 0 1,412,554 Loans, net of unearned discount 49,135,159 45,680,014 Less: allowance for loan losses (805,668) (602,939) ----------- ----------- Net loans 48,329,491 45,077,075 Bank premises & equipment, net 1,050,241 1,074,855 Accrued interest receivable 349,700 328,354 Other real estate owned 164,500 0 Core deposit intangible 1,426,799 1,560,358 Prepaid expenses and other assets 520,491 353,789 ----------- ----------- Total Assets 73,021,593 72,300,899 =========== =========== Liabilities & Shareholders' Equity Demand deposits, non-interest bearing 14,114,087 13,439,567 Demand deposits, interest bearing 10,109,720 8,333,631 Savings deposits 16,637,656 17,591,981 Time deposits, $100,000 and over 13,023,418 13,641,202 Time deposits 9,945,051 10,165,837 ----------- ----------- 63,829,932 63,172,219 Accrued interest payable 97,706 78,196 Accrued expenses and other liabilities 213,923 239,156 ----------- ----------- Total Liabilities 64,141,562 63,489,571 Shareholders' equity: Preferred Stock, Series A, non-cumulative, non-voting, 6%, $.01 par value, 1,368 1,368 500,000 shrs auth., 136,842 issued and 6,308 held in treasury Common Stock, $.01 par value; 2,000,000 shares authorized; 876,921 shares issued 8,769 8,769 Class B Non-voting common stock; 250,000 shares authorized; $0.01 par value; 191,667 shares issued and outstanding 1,917 1,917 Treasury Stock, 33,500 shares of Common Stock and 6,308 shares of Series A Preferred Stock, at cost 0 0 Additional-paid-in-capital 14,749,852 14,749,852 Accumulated deficit (5,869,926) (5,968,140) Accumulated other compensation income (loss) (11,949) 17,562 ----------- ----------- Total Shareholders' equity 8,880,031 8,811,328 ----------- ----------- $73,021,593 $72,300,899 =========== =========== See Accompanying Notes
5
Statements of Operations (unaudited) Quarter ended Quarter ended Nine months ended Nine months ended September 30, September 30, September 30, September 30, 2005 2004 2005 2004 ----------------------------------------------------------------------- Interest Income: Interest Income: Interest and fees on loans 886,079 784,367 2,559,622 2,259,986 Interest on investment securities 131,501 123,429 404,203 419,568 Interest on Federal Funds sold 54,834 24,665 116,848 49,851 Interest on time deposits with other banks 2,021 14,605 11,574 23,735 ----------- ----------- ----------- ----------- Total interest income 1,074,435 947,066 3,092,247 2,753,140 Interest Expense: Interest on time deposits 124,480 67,179 318,510 211,244 Interest on demand deposits 18,766 11,712 40,804 37,296 Interest on savings deposits 14,269 15,492 43,443 47,324 ----------- ----------- ----------- ----------- Total interest expense 157,515 94,383 402,757 295,864 Net interest income 916,920 852,683 2,689,490 2,457,276 Provision for loan losses 50,000 36,000 160,000 6,000 ----------- ----------- ----------- ----------- Net interest income less provision for loan losses 866,920 816,683 2,529,490 2,451,276 ----------- ----------- ----------- ----------- Noninterest income: Gain on sale of loans 2,615 0 27,335 6,299 Customer service fees 174,715 211,923 514,878 662,805 ATM activity fees 139,315 146,057 434,886 458,396 Loan Syndication Fees 20,000 25,752 142,172 127,552 Realized gain on investments 0 0 0 31,115 Realized gain on sale of fixed assets 0 1,506,645 0 1,874,203 Other income 26,538 18,469 74,164 91,990 ----------- ----------- ----------- ----------- Total noninterest income 363,183 1,908,846 1,193,435 3,252,360 Noninterest expense Salaries, wages, and employee benefits 454,418 425,043 1,371,471 1,451,074 Occupancy and equipment 247,850 248,628 750,283 863,360 Office operations and supplies 79,081 105,014 261,276 320,589 Marketing and public relations 22,539 21,348 57,448 48,668 Professional services 56,762 54,782 184,639 176,692 Data processing 105,979 145,388 322,134 421,261 Deposit insurance assessments 28,125 29,104 85,384 43,977 Other noninterest expense 198,241 207,514 592,075 629,894 ----------- ----------- ----------- ----------- Total noninterest expense 1,192,995 1,236,821 3,624,710 3,955,515 ----------- ----------- ----------- ----------- Net income $ 37,108 $ 1,488,708 $ 98,215 $ 1,748,121 =========== =========== =========== =========== Earnings per share--basic and diluted $0.03 $1.39 $0.09 $1.64 =========== =========== =========== =========== Weighted average number of shares outstanding-- basic and diluted 1,068,588 1,068,588 1,068,588 1,068,588 =========== =========== =========== ===========
See Accompanying Notes 6
Statements of Cash Flows (unaudited) Nine Months ended Nine Months ended September 30, September 30, 2005 2004 ----------- ----------- Cash flows from operating activities Net income $ 98,215 $ 1,748,121 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 160,000 6,000 Gain on sale of investments 0 (31,115) Gain on sale of loans (27,335) (6,299) Proceeds from the sale of loans 1,439,889 3,283,536 Depreciation and amortization 370,381 460,129 (Increase) Decrease in accrued interest receivable and other assets (188,048) 211,940 Decrease in accrued interest payable and other liabilites (5,722) (137,821) ----------- ----------- Net cash provided by operating activities 1,847,380 376,752 Cash flows from investing activities Purchase of investments--Held-to-maturity (2,763,785) (250,000) Purchase of investments--Available-for-sale 0 (2,500,000) Proceeds from maturity & principal reductions of investments--Available-for-Sale 915,713 3,476,592 Proceeds from maturity & principal reductions of investments--Held-to-Maturity 3,056,647 1,426,398 Proceeds from sale of investments--Available-for-Sale 0 786,526 Net (increase) decrease in loans (3,412,416) 1,211,165 Purchase of premises and equipment (194,174) (101,681) ----------- ----------- Net cash (used in) provided by investing activities (2,398,015) 7,332,535 Cash flows from financing activities Net increase (decrease) in deposits 657,714 (935,456) ----------- ----------- Net cash provided by (used in) financing activities 657,714 (935,456) Increase in cash and cash equivalents 107,078 6,773,832 Cash and cash equivalents at beginning of period 8,933,569 6,692,946 Cash and cash equivalents at end of period $ 9,040,647 $13,466,778 =========== =========== Supplemental disclosures of cash flow information Cash paid during the period for interest 383,247 314,747 ----------- -----------
See Accompanying Notes 7 NOTES TO FINANCIAL STATEMENTS 1. General United Bancshares, Inc. (the "Company") is a bank holding company registered under the Bank Holding Company Act of 1956. The Company's principal activity is the ownership and management of its wholly owned subsidiary, United Bank of Philadelphia (the "Bank"). During interim periods, the Company follows the accounting policies set forth in its Annual Report on Form 10-K filed with the Securities and Exchange Commission. Readers are encouraged to refer to the Company's Form 10-K for the fiscal year ended December 31, 2004 when reviewing this Form 10-Q. Quarterly results reported herein are not necessarily indicative of results to be expected for other quarters. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of normal recurring adjustments) considered necessary to present fairly the Company's consolidated financial position as of September 30, 2005 and December 31, 2004 and the consolidated results of its operations for the three and nine month periods ended September 30, 2005 and 2004, and its consolidated cash flows for the nine month periods ended September 30, 2005 and 2004. 2. Stock-based Compensation At November 1, 2005, the Bank had one stock-based employee compensation plan. The Bank accounts for that plan under the recognition and measurement principles of APB 25, "Accounting for Stock Issued to Employees, and related interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table provides the disclosures required by SFAS No. 148 and illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation.
Nine Months Ended September 30, 2005 2004 ------ ------ (in 000's) Net income As reported $ 98 $1,748 Stock-based compensation costs determined under fair value method for all awards $ - $ - ------ ----- Pro forma $ 98 $1,748 Earnings per share (Basic) As reported $0.09 $1.64 Pro forma $0.09 $1.64 Earnings per share (Diluted) As reported $0.09 $1.64 Pro forma $0.09 $1.64
There were no options granted in 2005 and 2004. 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. The Company is a bank holding company for the Bank and the accompanying financial statements in this report are prepared on a consolidated basis to include the accounts of the Company and the Bank. The purpose of this discussion is to focus on information about the Bank's financial condition and results of operations, which is not otherwise apparent from the consolidated financial statements included in this quarterly report. This discussion and analysis should be read in conjunction with the financial statements presented elsewhere in this report. Executive Overview United Bancshares, Inc. is an African American controlled and managed bank holding company for United Bank of Philadelphia (the "Bank"), a commercial bank chartered in 1992 by the Commonwealth of Pennsylvania, Department of Banking and a member of the Federal Reserve System. The deposits held by the Bank are insured by the Federal Deposit Insurance Corporation ("FDIC"). The Bank engages in the commercial banking business, serving the banking needs of its customers with a particular focus on, and sensitivity to, groups that have been traditionally under-served, including Blacks, Hispanics and women. The Bank offers a wide range of deposit products, including checking accounts, interest-bearing NOW accounts, money market accounts, certificates of deposit, savings accounts and Individual Retirement Accounts. During the past five years, management has implemented re-capitalization strategies and expense control measures to stabilize the Bank and position it for growth. While re-capitalization and expense reductions have been achieved, management believes that a greater impact will be realized with deposit growth and increased loan originations that build the Bank's core earnings. Increased deposits will increase the Bank's ability to fund and grow its earning assets while an increased loan-to-deposit ratio will generally result in a higher net interest margin on those assets. Thus, while continuing to control expenses, management has placed more focus on the implementation of business development strategies to achieve deposit and loan growth as a means to achieve core profitability. Executive management has taken the lead in generating new business from companies and organizations within the region by personally calling on corporate and governmental leaders in the region. This program has yielded results in the form of additional loan and deposit business. Loan activity is also being generated through an Emerging Contractors' Program of the African American Chamber of Commerce, Small Business Development Centers of local colleges and universities, Faith-Based Organizations and banking partners in the region. Although the Bank funded $4.3 million in commercial loans during the quarter, new loan originations were offset by an extraordinary level of payoffs related to residential mortgage loans, home equity lines of credit and loan participations with other financial institutions where the Bank does not have a direct relationship with the loan customer. However, through its business development initiatives, the Bank's loan pipeline is growing. At September, 2005, there were $3 million in loans in the pipeline scheduled to be closed before December 31, 2005. The focus of the Bank's lending activities is primarily on the origination of commercial, consumer and residential loans. A broad range of credit products is offered to the businesses and consumers in the Bank's service area, including commercial loans, mortgage loans, student loans, home improvement loans, auto loans, personal loans, and home equity loans. The Bank has built a strong reputation as the "lender of choice" for many religious organizations with this sector constituting 30% of the Bank's commercial loan portfolio at September 30, 2005. In 2005, the Bank implemented a business development strategy that includes the utilization of a Clergy Advisory Council to generate more referrals from this well performing sector. 9 During the quarter ended September 30, 2005, average deposits increased $671 thousand, or 1.06%. The increase was primarily in the category of interest-bearing demand deposit accounts. The Bank has been successful in attracting additional institutional deposits. Instead of the traditional jumbo certificates of deposit these institutions typically place their funds, at the request of the Bank, funds were placed in money market checking accounts that are considered core and are less rate sensitive and allow for easy growth in the deposit balance. However, growth in this area was somewhat offset by a decline in average savings deposit balances. In July 2004, the Bank closed its 2 Penn Center Office located in Center City Philadelphia. The closure of this branch office resulted in some savings passbook account attrition. Electronic banking alternatives including ATMs and e-banking could not be used to help retain the savings account deposits. because passbook customers must physically enter the branch to complete transactions. The Bank will continue to focus on its niche business lines to include the basic deposit and loan business, while developing relationships with corporate entities that have a commitment to community and economic development in the urban sector. Strategic alliances and partnerships are key to the economic strength of inner city neighborhoods. The Bank currently has alliances with mortgage and investment companies. Strategic alliances/partnerships will continue to be sought to help ensure that the communities the Bank serves have full access to financial products and services. Management accomplished the re-capitalization of the Bank in 2004 with gains on the sale of bank-owned assets. The tier 1 leverage ratio of the Bank at September 30, 2005 was 9.86%--above the regulatory minimum required level of 7.00%. Although the Bank is now considered adequately capitalized, management continues to seek capital through internal capital generation (retained earnings) as well as external capital through the possible future sale of common/preferred stock. Additional capital will be used to support growth in the Bank's balance sheet and fee income initiatives. During the quarter ended September 30, 2005, net income from core operations was approximately $37 thousand, or $.03 per share. Net interest income continues to improve from increased loan volume and prime rate increases during the year. In addition, management of loan syndications for major corporations where the Bank serves in the role of arranger and/or administrative agent has become a significant source of fee income. Consistent with 2004, the Bank manages four such syndications with fee income projected to exceed $180 thousand for 2005 of which approximately $20 thousand was recognized in the quarter ended September 30, 2005. Efforts will continue to attract additional corporate partners to join the Bank's minority credit syndication business line to generate more fee income. Critical Accounting Policies Allowance for Credit Losses The Bank considers that the determination of the allowance for loan losses involves a higher degree of judgment and complexity than its other significant accounting policies. The balance in the allowance for loan losses is determined based on management's review and evaluation of the loan portfolio in relation to past loss experience, the size and composition of the portfolio, current economic events and conditions, and other pertinent factors, including management's assumptions as to future delinquencies, recoveries and losses. All of these factors may be susceptible to significant change. To the extent actual outcomes differ from management's estimates, additional provisions for loan losses may be required that would adversely impact earnings in future periods. Income Taxes Under the liability method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities. Deferred tax assets are subject to management's judgment based upon available evidence that future realization is more likely than not. For financial reporting purposes, a valuation allowance of 100% of the deferred tax asset has been recognized to offset the deferred tax assets related to cumulative temporary differences and tax loss carryforwards. If management determines that the Bank may be able to realize all or part of the deferred tax asset in the future, a credit to income tax expense may be required to increase the recorded value of net deferred tax asset to the expected realizable amount. No current income tax expense is recorded due to the partial utilization of the Bank's net operating loss carryforward. 10 Selected Financial Data The following table sets forth selected financial data for each of the following periods: (Thousands of dollars, Quarter ended Quarter ended except per share data) September 30, 2005 September 30, 2004 ------------------ ------------------ Net interest income $917 $853 Provision for loan losses 50 36 Noninterest income 363 1,909 Noninterest expense 1,193 1,237 Net income 37 1,489 Earnings per share-basic and diluted $0.03 $1.39 Balance sheet totals: September 30, 2005 December 31, 2004 ------------------ ----------------- Total assets $73,022 $72,301 Loans, net $48,329 $45,077 Investment securities $12,140 $13,560 Deposits $63,830 $63,172 Shareholders' equity $ 8,880 $ 8,811 Ratios Quarter ended Quarter ended September 30, 2005 September 30, 2004 ------------------ ------------------ Return on assets 0.13% 3.21% Return on equity 1.32% 33.11% Tangible Equity to assets ratio 9.86% 9.85% 11 Financial Condition Sources and Uses of Funds The financial condition of the Bank can be evaluated in terms of trends in its sources and uses of funds. The comparison of average balances in the following table indicates how the Bank has managed these elements. Average funding sources increased approximately $671 thousand, or 1.06%, during the quarter ending September 30, 2005. Average funding uses increased $969 thousand, or 1.46%, for the same quarter. Sources and Uses of Funds Trends
September 30, 2005 June 30, 2005 ------------------ -------------- (Thousands of Dollars, Average Increase (Decrease) Average except percentages) ------- ------------------- ------- Balance Amount % Balance ------- ------ ------- ------- Funding uses: Loans $48,099 $ 321 0.67% $47,778 Investment securities Held-to-maturity 8,602 52 0.61 8,550 Available-for-sale 4,001 (152) (3.66) 4,153 Federal funds sold 6,359 1,347 26.88 5,012 Balances with other banks 290 (599) (67.38) 889 ------- ------ ----- ------- Total uses $67,351 $ 969 1.46% $66,382 ======= ====== ====== ======= Funding sources: Demand deposits Noninterest-bearing $14,446 $ 431 3.08% $14,015 Interest-bearing 8,945 622 7.47 8,323 Savings deposits 17,274 (231) (1.32) 17,505 Time deposits 23,526 (151) (0.64) 23,677 ------- ------ ------ ------- Total sources $64,191 $ 671 1.06% $63,520 ======= ====== ====== =======
12 Loans Average loans increased $321 thousand, or 0.67%, during the quarter ended September 30, 2005. Although the Bank funded $4.3 million in commercial loans during the quarter, loan originations were offset by an extraordinary level of payoffs. Most of the payoff activity was attributed to residential mortgage loans, home equity lines of credit and loan participations with other financial institutions where the Bank does not have a direct relationship with the loan customer. Additional emphasis has been placed on the Bank's business development efforts. Strategies have been implemented that include the utilization of a Clergy Advisory Council to generate referrals; the development of a professional contact list including attorneys and accountants for business referrals; and, the utilization of existing and new account reports to cross-sell the Bank's products and services. As a result of these efforts, the Bank's commercial loan pipeline is growing. At September 30, 2005, there were more than $3 million in loans in the pipeline scheduled to be closed before December 31, 2005. Other consumer loans including home equity, automobile, student and credit card loans continue to be focused on for growth in the portfolio to allow for risk diversification. To mitigate portfolio reduction from payoff and paydowns, new strategies to increase the volume of these loans are being implemented that include cross sell/referral business from strategic alliances, new brochures and in-branch advertising campaigns. In addition, the Bank has cultivated relationships with other financial institutions in the region with which it participates in loans as a strategy to grow its commercial loan portfolio. Although the Bank's direct loan originations have increased, this strategy continues to be utilized as a low cost means to build the Bank's earning assets while it enhances its own business development capacity. Most participations are secured by commercial real estate. The Bank's loan-to-deposit ratio at September 30, 2005 was 75.7%. This ratio increased slightly from 74% at June 30, 2005. The target loan-to-deposit ratio continues to be 75%. This level allows the Bank to optimize interest income on earning assets while maintaining adequate liquidity. Although the Bank has met its target loan-to-deposit ratio, deposit growth is projected for the remainder of 2005. To ensure that loan activity keeps pace with deposit growth and that this ratio is maintained, management will continue to implement the loan growth strategies outlined above. While the Bank's target loan-to-deposit ratio is 75%, this ratio does not represent a policy limit. The Bank has adequate liquidity to continue to fund loan originations for the foreseeable future. If necessary, to create additional liquidity, the Bank has the ability to sell a portion of its investment portfolio or its lower yielding student loan portfolio. The Bank's loan portfolio is heavily concentrated in commercial loans that comprise $33 million, or 67%, of total loans at September 30, 2005. As result of payoffs/paydowns, there has been a gradual shift in the mix of the portfolio from December 31, 2004 from residential mortgage loans and consumer home equity loans to commercial loans. The Bank continues to build its niche in lending to religious organizations for which total loans now approximate 30% of the commercial portfolio. The following table shows the composition of the loan portfolio of the Bank by type of loan. (Thousands of Dollars) September 30, June 30, March 31, December 31, ------------- --------- --------- ------------ 2005 2005 2005 2004 --------- --------- --------- --------- Commercial and industrial $20,643 $19,718 $18,300 $15,217 Commercial real estate 12,643 11,313 12,590 13,070 Consumer loans 6,434 6,454 6,971 6,729 Residential mortgages 9,415 9,790 10,569 10,665 ------- ------- ------- ------- Total Loans $49,135 $47,275 $48,430 $45,681 ======= ======= ======= ======= 13 Allowance for Loan Losses The allowance for loan losses reflects management's continuing evaluation of the loan portfolio, the diversification and size of the portfolio, and adequacy of collateral. The following factors are considered in determining the adequacy of the allowance for loan losses: levels and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volumes and terms of loans, effects of any changes in risk selection and underwriting standards, and other changes in lending policies, procedures and practices; experience, ability, and depth of lending management and relevant staff; national and local economic conditions; industry conditions; and effects of changes in credit concentrations. The following Table presents an analysis of the allowance for loan losses. ANALYSIS OF ALLOWANCE FOR LOAN LOSSES (Dollars in thousands) 2005 2004 ---- ---- Balance at January 1, $603 $339 Charge-offs: Commercial loans (107) -- Consumer loans (103) (137) ---- ---- Total charge-offs (210) (137) Recoveries 253 363 Net(charge-offs)recoveries 43 226 Additions charged to operations 160 6 ---- ---- Balance at September 30, $806 $571 ==== ==== The allowance for loan losses as a percentage of total loans was 1.64% at September 30, 2005 compared to 1.22% at June 30, 2005. The increase in the required allowance is the result of an increase in classified loans for which specific reserves are required. Specifically, the Bank participated in a micro-loan fund that was not properly administered. The Bank's participant interest in the fund included forty-seven (47) loans totaling $368 thousand which the Bank has classified as "doubtful" and provided a reserve of fifty percent (50%) of the outstanding balance. In conjunction with other participant financial institutions, the Bank continues its review and investigation of the micro-loan fund administration to determine the level of potential loss related to these loans. The level of allowance for loan losses at September 30, 2005 is higher than the Bank's peer group average of 1.20% because of the level of classified loans in the portfolio. At September 30, 2005, the Bank's classified loans totaled $1.7 million , or 3.5%, of total loans. Specific reserves of $463 thousand have been allocated to these loans. In addition, at September 30, 2005, approximately $502 thousand of the classified loans are guaranteed by the Small Business Administration ("SBA") that minimizes the risk of loss. Management is in the process of submitting the SBA-guaranteed net exposure of three of these loans totaling $319 thousand to the SBA for collection. (Refer to Nonperforming and Nonaccrual Loans discussion below.) While management uses available information to recognize losses on loans, future additions may be necessary based on changes in economic conditions. The Bank proactively monitors its credit quality while working with borrowers in an effort to identify and control credit risk. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses. Such agencies may require the Bank to recognize additions to the allowance based on their judgments of information available to them at the time of the examination. Management believes the level of the allowance for loan losses is adequate as of September 30, 2005. 14 Nonperforming and Nonaccrual Loans The Bank generally determines a loan to be "nonperforming" when interest or principal is past due 90 days or more. If it otherwise appears doubtful that the loan will be repaid, management may consider the loan to be "nonperforming" before the lapse of 90 days. The policy of the Bank is to charge-off unsecured loans after 90 days past due. Interest on "nonperforming" loans ceases to accrue except for loans that are well collateralized and in the process of collection. When a loan is placed on non-accrual, previously accrued and unpaid interest is generally reversed out of income unless adequate collateral from which to collect the principal of and interest on the loan appears to be available. At September 30, 2005, non-accrual loans were approximately $1.1 million--down from $1.6 million at June 30, 2005. The Bank had one borrower in the telecommunications industry with loans totaling approximately $1.3 million that experienced severe financial difficulty. As a result, in December 2003, the Bank charged-off the non-SBA-guaranteed portion of this credit totaling $710 thousand. The Bank presented the balance of this credit to the SBA for collection of the guaranteed portion that totaled $569 thousand. In July 2005, the guarantee was honored by the SBA and the Bank collected the balance of $569 thousand plus accrued interest. Approximately $378 thousand of the Bank's remaining non-accrual loans are guaranteed by the SBA. Management is in the process of submitting three of these loans totaling $319 thousand these loans to the SBA for collection. This balance represents the remaining balance on three separate loans that each carried a 75% guarantee from the SBA. In June 2005, the un-guaranteed portion of these loans totaling $107 thousand was charged-off. There is no other known information about possible credit problems other than those classified as nonaccrual that causes management to be uncertain as to the ability of any borrower to comply with present loan terms. The Bank grants commercial, residential and consumer loans to customers primarily located in Philadelphia County, Pennsylvania and surrounding counties in the Delaware Valley. From time to time, the Bank purchases loans from other financial institutions. These loans are generally located in the Northeast corridor of the United States. Although the Bank has a diversified loan portfolio, its debtors' ability to honor their contracts is influenced by the region's economy. At September 30, 2005, approximately 30% of the Bank's commercial loan portfolio was concentrated in loans made to religious organizations. From inception, the Bank has received support in the form of investments and deposits and has developed strong relationships with the Philadelphia region's religious community. Loans made to these organizations were primarily for expansion and repair of church facilities. Investment Securities and Other Short-term Investments Investment securities, including Federal Funds Sold, increased on average by $1.2 million, or 7%, during the quarter ended September 30, 2005. This increase is due to an increase in average funds available for investment because of an increase in average deposit balances (Refer to the discussion on Deposits below.). The Bank's current investment portfolio primarily consists of mortgage-backed pass-through agency securities (55.6%), and other government-sponsored agency securities (44.4%). The Bank does not invest in high-risk securities or complex structured notes. The yield on the portfolio was 4.37% at September 30, 2005 compared to 4.28% one year ago. The increase in the yield is primarily a result of some of the Bank's floating rate mortgage-backed securities that have Treasury and LIBOR indices that repriced in 2005 in a higher interest rate environment. The average duration of the portfolio at September 30, 2005 is 2.96 years compared to 3.15 years at June 30, 2005. The shortening of the duration during the quarter can be attributed to the shortening of duration on the mortgage-backed portion of the portfolio. The constant one year prepayment rate (CPR), prepayment speed at which mortgage-backed securities pay, increased slightly from 19.76% at June 30, 2005 to 20.62% at September 30, 2005. This translates into 20.62% of the mortgage pool repaying on an annual basis compared to 19.76% at June 30, 2005 resulting in increased cashflow. Management will continue to monitor and take appropriate action to control the optionality in the portfolio to ensure the appropriate level of funds are available to meet liquidity needs. 15 Deposits The Bank has a stable core deposit base representing 80% of total deposits. While the Bank has $13 million in certificates of deposit with balances of $100,000 or more, approximately $9 million, or 69%, of the these deposits are with governmental or quasi-governmental entities that have a long history with the Bank and are considered stable. During the quarter ended September 30, 2005, average deposits increased $671 thousand, or 1.06%. The increase was primarily in the categories of interest-bearing demand deposit accounts that increased $622 thousand, or 7.47% and noninterest-bearing checking accounts that increased $431 thousand, or 3.08%. The Bank successfully attracted additional accounts of local institutional customers. Management has been requesting institutional customers to establish money market accounts rather than jumbo certificates of deposit that are more costly and have definitive maturity dates. This strategy is working for it allows the Bank to have a higher level of core deposits without the stress of managing certificates of deposit that are more expensive and volatile. In addition, more emphasis is being placed on private funds rather than governmental funds that require collateralization. Growth in this area was somewhat offset by a $231 thousand, or 1.32%, decline in average savings deposit balances. In July 2004, the Bank closed its 2 Penn Center Office located in Center City Philadelphia. The closure of this branch resulted in some savings passbook account attrition. electronic banking alternatives including ATMs and e-banking could not be used to help retain the savings account deposits because passbook customers must physically enter the branch to complete transactions. With its re-capitalization, the Bank is positioned for deposit growth. Current capital levels allow for approximately $27 million in deposit growth and still remain compliant with mandatory capital requirements outlined in its Written Agreement with its regulators (See Regulatory Matters below). New business development strategies have been implemented that include leveraging the strategic partnerships/alliances the Bank has developed to cross-sell its products and services. In addition, the Bank's retail staff is challenged with increasing deposit levels in the communities where the branches are located. New deposits will continue to be sought to ensure the availability of funding anticipated increased loan volume. Other Borrowed Funds The Bank did not borrow funds during the quarter ended September 30, 2005. Generally, the level of other borrowed funds is dependent on many items such as loan growth, deposit growth, customer collateral/security requirements and interest rates paid for these funds. The Bank's liquidity has been enhanced by loan paydowns/payoffs--thereby, eliminating the need to borrow. Commitments and Lines of Credit The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and letters of credit, which are conditional commitments issued by the Bank to guarantee the performance of an obligation of a customer to a third party. Both arrangements have credit risk essentially the same as that involved in extending loans, and are subject to the Bank's normal credit policies. Collateral may be obtained based on management's assessment of the customer. The Bank's exposure to credit loss in the event of nonperformance by the other party to the financial instruments is represented by the contractual amount of those instruments. The Bank's financial instrument commitments at September 30, 2005 are summarized below: Commitments to extend credit $14,453,000 There were no outstanding letters of credit at September 30, 2005. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Approximately $9.9 million of the unused commitments represent the Bank's portion of syndicated national credits where no usage is projected. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Management believes the Bank has adequate liquidity to support the funding of unused commitments. 16 Liquidity and Interest Rate Sensitivity Management The primary functions of asset/liability management are to assure adequate liquidity and maintain appropriate balance between interest-sensitive earning assets and interest-bearing liabilities. Liquidity management involves the ability to meet cash flow requirements of customers who may be either depositors wanting to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. Interest rate sensitivity management seeks to avoid fluctuating net interest margins and to enhance consistent growth of net interest income through periods of changing interest rates. The Bank is required to maintain minimum levels of liquid assets as defined by Federal Reserve Board (the "FRB") regulations. This requirement is evaluated in relation to the composition and stability of deposits; the degree and trend of reliance on short-term, volatile sources of funds, including any undue reliance on particular segments of the money market or brokered deposits; any difficulty in obtaining funds; and the liquidity provided by securities and other assets. In addition, consideration is given to the nature, volume and anticipated use of commitments; the adequacy of liquidity and funding policies and practices, including the provision for alternate sources of funds; and the nature and trend of off-balance-sheet activities. At September 30, 2005, management believes the Bank's liquidity is satisfactory and in compliance with the FRB regulations The Bank's principal sources of asset liquidity include investment securities consisting principally of U.S. Government and agency issues, particularly those of shorter maturities, and mortgage-backed securities with monthly repayments of principal and interest. Other types of assets such as federal funds sold, as well as maturing loans, are also sources of liquidity. Approximately $8.8 million in loans are scheduled to mature within one year. By policy, the Bank's minimum level of liquidity is 6.00% of total assets. At September 30, 2005, the Bank had total short-term liquidity, including cash and federal funds sold, of $9 million, or 12.38% of total assets. Additional liquidity of approximately $3.8 million is provided by the portion of the Bank's investment portfolio classified as available-for-sale. However, a significant portion of these securities is used as collateral for governmental/quasi-governmental agencies and are therefore restricted from use to fund loans or to meet other liquidity requirements. The Bank's overall liquidity continues to be enhanced by a significant level of core deposits which management has determined are less sensitive to interest rate movements. The Bank continues to avoid reliance on large denomination time deposits as well as brokered deposits. The Bank has one $5 million deposit with a governmental agency that matures in March 2006 and a series of laddered certificates of deposit (maturities ranging from 3 months to 12 months) totaling $4 million from another quasi-governmental agency. While these are short-term renewals, based on discussions with representatives of these agencies, management does not anticipate the removal of these deposits from the Bank in the near future. The following is a summary of the remaining maturities of time deposits of $100,000 or more outstanding at September 30, 2005: (Thousands of dollars) ---------------------- 3 months or less $ 2,827 Over 3 through 12 months 10,096 Over 1 through three years 100 Over three years -- ------- Total $13,023 ======= 17 Capital Resources Total shareholders' equity increased approximately $69 thousand for the nine months ended September 30, 2005. The increase in equity was primarily due to net income of $98 thousand during nine months ended less a $29 thousand decrease in other comprehensive income (FAS 115 unrealized losses on available-for-sale securities) because of interest rate changes that decreased the value of the investment portfolio. The Board and management continue to explore strategies for the infusion of new capital into the organization. The most productive way is to continue to increase capital through sustained core earnings. The Bank's plan projects this occurrence in 2005. FRB standards for measuring capital adequacy for U.S. Banking organizations requires that banks maintain capital based on "risk-adjusted" assets so that categories of assets with potentially higher risk will require more capital backing than assets with lower risk. In addition, banks are required to maintain capital to support, on a risk-adjusted basis, certain off-balance-sheet activities such as loan commitments. The FRB standards classify capital into two tiers, referred to as Tier 1 and Tier 2. Tier 1 consists of common shareholders' equity, non-cumulative and cumulative perpetual preferred stock, and minority interests less all intangibles. Tier 2 capital consists of allowance for loan losses, hybrid capital instruments, term-subordinated debt, and intermediate-term preferred stock. Banks are required to meet a minimum ratio of 8% of qualifying capital to risk-adjusted total assets with at least 4% Tier 1 capital and a Tier I Leverage ratio of at least 6%. Capital that qualifies as Tier 2 capital is limited to 100% of Tier 1 capital. As indicated in the table below, the Company's risk-based capital ratios are above the minimum requirements. Management continues the objective of raising additional capital by seeking to offer additional stock (preferred and common) for sale in a private offering as well as increasing the rate of internal capital growth as a means of maintaining the required capital ratios. However, significant asset growth and the need for additional provisions to the allowance for loan losses could have an adverse effect on its capital ratios. The Company and the Bank do not anticipate paying dividends in the near future.
(thousands of dollars, Company Company Company Company except percentages) September 30, June 30, March 31, December 31, ------------- -------- --------- ------------ 2005 2005 2005 2004 ---- ---- ---- ---- Total Capital $ 8,880 $ 8,854 $ 8,791 $ 8,812 Less: Intangible Asset/Net unrealized gains (losses) on available for sale portfolio (1,415) (1,470) (1,503) (1,578) ------- ------- ------- ------- Tier 1 Capital 7,465 7,384 7,288 7,234 ------- ------- ------- ------- Tier 2 Capital 583 557 562 544 ------- ------- ------- ------- Total Qualifying Capital $ 8,048 $ 7,941 $ 7,850 $ 7,778 ======= ======= ======= ======= Risk Adjusted Total Assets (including off- Balance sheet exposures) $46,398 $44,548 $44,914 $43,436 Tier 1 Risk-Based Capital Ratio 16.09% 16.57% 16.23% 16.65% Tier 2 Risk-Based Capital Ratio 17.34% 17.82% 17.48% 17.91% Leverage Ratio 10.26% 10.36% 10.25% 9.89% Bank Bank Bank Bank ------- ------- ------- ------- Total Capital $ 8,591 $ 8,565 $ 8,503 $ 8,524 Less: Intangible Asset/Net unrealized gains (losses) on available for sale portfolio (1,415) (1,470) (1,503) (1,578) ------- ------- ------- ------- Tier 1 Capital 7,176 7,095 7,000 6,946 ------- ------- ------- ------- Tier 2 Capital 583 557 562 544 ------- ------- ------- ------- Total Qualifying Capital $ 7,759 $ 7,652 $ 7,562 $ 7,490 ======= ======= ======= ======= Risk Adjusted Total Assets (including off- Balance sheet exposures) $46,398 $44,548 $44,914 $43,436 Tier 1 Risk-Based Capital Ratio 15.47% 15.93% 15.59% 15.99% Tier 2 Risk-Based Capital Ratio 16.72% 17.18% 16.84% 17.24% Leverage Ratio 9.86% 9.96% 9.84% 9.49%
18 Results of Operations Summary The Bank had net income of approximately $37 thousand ($0.03 per common share) for the quarter ended September 30, 2005 compared to a net income of $1.5 million ($1.39 per common share) for the quarter ended September 30, 2004. The Bank had net income of approximately $98 thousand ($0.09 per common share) for the nine months ended September 30, 2005 compared to a net income of $1.7 million ($1.64 per common share) for the nine months ended September 30, 2004. The financial results for 2004 included a non-recurring $1.9 million gain on the sale of the Bank's corporate headquarters and remote parking facility owned by the Bank. Management continues the implementation of a plan to restore core profitability to the Bank. It includes among other things staff consolidation, reduction in branch operating hours, continued elimination of director fees, and the reduction of other operating expenses. Also, as part of the Bank's profit restoration plan, upon expiration of the lease in July 2004, the Bank's Two Penn Center branch was closed and consolidated with other branches in the network to further reduce occupancy, personnel, and other operating cost. While expense reductions continue to be achieved, management believes that a greater impact on net income will be realized by further leveraging the balance sheet. With its current capital levels, the Bank can grow its assets to $100 million and still be considered adequately capitalized. This growth will allow the Bank to take advantage of economies of scale and increase its core earnings stream. Management will seek to increase loan originations to ensure that the Bank's loan-to-deposit ratio remains close to 75%. Generally, increased loan volume results in a higher net interest margin and therefore increased revenues. Thus, while continuing to control expenses, management will place more focus on the implementation of business development strategies to increase the level of deposits and loans to increase its earnings. Also, revenue enhancement strategies have been employed for fee income opportunities through the implementation of products and services including corporate loan syndications where the Bank serves in the role of arranger and/or administrative agent. Management continues to market this service to local corporations in effort to expand this niche business that serves as a source of fee income. A more detailed explanation for each component of earnings is included in the sections below. Net Interest Income Average Balances, Rates, and Interest Income and Expense Summary
Three months Three months ended ended September 30, September 30, 2005 2004 ------------ ------------ Average Average (Dollars in thousands) Balance Interest Yield/Rate Balance Interest Yield/Rate ---------------------- ------- -------- ---------- ------- -------- ---------- Assets: Interest-earning assets: Loans $48,099 $ 886 7.37% $46,359 $ 784 6.77% Investment securities-HTM 8,602 87 4.02 6,724 71 4.25 Investments securities-AFS 4,001 45 4.49 4,545 52 4.58 Federal funds sold 6,359 55 3.45 6,920 25 1.43 Interest bearing balances with other banks 290 2 2.79 878 15 6.65 ------- ------ ---- ------- ----- ---- Total interest-earning assets 67,351 1,074 6.38 65,426 947 5.54 Interest-bearing liabilities Demand deposits 8,945 19 0.84 15,443 12 0.30 Savings deposits 17,274 14 0.33 18,396 15 0.34 Time deposits 23,526 124 2.12 20,258 67 1.33 ------- ------ ---- ------- ----- ---- Total interest-bearing liabilities 49,745 157 1.27 54,097 94 0.70 Net interest earnings $ 917 $ 853 Net yield on interest-earning assets 5.45% 5.21%
19 Net interest income is an effective measure of how well management has balanced the Bank's interest rate sensitive assets and liabilities. Net interest income, the difference between (a) interest and fees on interest earning assets and interest paid on interest-bearing liabilities, is a significant component of the earnings of the Bank. Changes in net interest income result primarily from increases or decreases in the average balances of interest earning assets, the availability of particular sources of funds and changes in prevailing interest rates. Net interest income increased $64 thousand, or 7.51%, and $232 thousand, or 9.45%, for the quarter and nine months ended September 30, 2005 compared to September 30, 2004, respectively. The increase is primarily attributed to an increase in average loans outstanding as well as a 325 basis point increase in the prime rate and federal funds sold rate since June 2004. As a result, the yield on average earning assets increased from 5.54% for the quarter ended September 30, 2004 to 6.38% for the quarter ended September 30, 2005. Although the Bank's cost of funds increased to 1.27% for the quarter ending September 30, 2005 from 0.70% for the same quarter in 2004, the cost of funds is still considered low when compared to the Bank's peer group of 1.55%. The low cost of funds is attributed to the Bank's core deposit base of checking and savings accounts that are less sensitive to changes in interest rate. Typically, the rates on these types of deposits lag market changes. The net interest margin of the Bank was 5.45% for the quarter ended September 30, 2005 compared to 5.21% for the same quarter in 2004. Management actively manages its exposure to interest rate changes. The increase in margin is attributed to the increase in prime, the Bank's continued low cost of funds and an increase in average loan balances. Provision for Loan Losses The provision is based on management's estimate of the amount needed to maintain an adequate allowance for loan losses. This estimate is based on the review of the loan portfolio, the level of net credit losses, past loan loss experience, the general economic outlook and other factors management feels are appropriate. The Bank made provisions totaling $50 thousand for the quarter ending September 30, 2005 compared to $36 thousand for the same quarter in 2004. For the nine months ended September 30, 2005, the Bank made provisions totaling $160 thousand compared to $6 thousand for the nine months ended September 30, 2004. The increase in the provisions is due to a review and analysis of the Bank's loan portfolio and an increase in the level of classified loans. Provisions are made to the allowance to cover loans for which full collection is uncertain in accordance with the Bank's Allowance for Loan Loss policies and procedures. (Refer to Allowance for Loan Losses above for discussion on classified loans and specific reserves.) Management continues to closely monitor the portfolio for signs of weakness and will proactively make provisions to cover potential losses. Systematic provisions are made to the allowance to cover potential losses related to the Bank's classified loans. Management believes the level of the allowance for loan losses is adequate as of September 30, 2005. Noninterest Income The amount of the Bank's noninterest income generally reflects the volume of the transactional and other accounts handled by the Bank and includes such fees and charges as low balance account charge, overdrafts, account analysis, and other customer service fees. Noninterest income declined $1.5 million, or 80.97%, and $2.1 million, or 63.31%, for the quarter and nine months ending September 30, 2005, compared to 2004, respectively. In 2004, the Bank recognized a non-recurring gain of $1.9 million on the sale of its corporate headquarters at 300 North 3rd Street, Philadelphia, PA, and a related bank-owned parking facility. 20 Customer service fees declined by $37 thousand, or 17.56%, and $148 thousand, or 22.32%, for the quarter and nine months ended September 30, 2005, compared to 2004, respectively. The decline came as a result of less activity fees on deposits. Because the Bank escheated many of its dormant/inactive accounts in 2003 and 2004 in accordance with the requirements of the Commonwealth of Pennsylvania, there was a significant decline in activity/dormant account service charges. ATM fees declined by $7 thousand, or 4.62%, and $24 thousand, or 5.13%, for the quarter and nine months ending September 30, 2005, compared to 2004, respectively. Some of the Bank's ATMs have experienced a drop in volume as competitors placed machines in close proximity to existing high volume ATMs of the Bank and several of the Bank's high volume ATM's were replaced with those of competitors that paid significantly higher fees to site owners. In addition, one of the Bank's high volume machines has been out of service since February 2005 because of a fire in the building in which it is located and another was temporarily out-of-service due to construction/demolition of the building in which it was housed. In July 2005, both machines were placed back in service. Management continues the process of identifying potentially high volume locations to place machines. The Bank serves as arranger/agent for loan syndications for major corporations throughout the country. The Bank was selected to syndicate four significant back-up lines/letters of credit with other minority banks throughout the country for major corporations. Fees recognized on these credit facilities totaled $20 thousand and $142 thousand during the quarter and nine months ended September 2005, respectively compared to $25 thousand and $128 thousand, respectively, for the same periods in 2004. Fees for this service are projected to exceed $180 thousand for 2005. These fees will be received annually for the administration of the credit facilities. Management plans to continue to develop this core line of business to generate additional fee income to support the Bank's profitability goals. Noninterest Expense Salaries and benefits increased $29 thousand, or 6.91%, during the quarter ended September 30, 2005 compared to 2004 but decreased $80 thousand, or 5.49%, for the nine months ended September 30, 2005 compared to 2004. As part of the Bank's continued implementation of its profit restoration plan, there were strategic reductions in staff, job consolidations, and a reduction in salaries for certain employees to lower the level of personnel expense. In July 2004, the Bank closed and consolidated the services of its Two Penn Center financial service center with other branches in the network. This action resulted in further staff reductions. However, the increase in salaries and benefits expense for the quarter ended September 2005 is a result of the hiring of additional business development staff and incentive compensation paid to staff for business referrals. Management continues its review to ensure the Bank is operating with the most efficient organizational structure. Data processing expenses are a result of the management decision of the Bank to outsource a majority of its data processing operations to third party processors. Such expenses are reflective of the high level of accounts being serviced for which the Bank is charged a per account charge by processors. In addition, the Bank uses outside loan servicing companies to service its mortgage, credit card, and student loan portfolios. Data processing expenses decreased approximately $39 thousand, or 27.11%, and $99 thousand, or 23.53%, during the quarter ended and nine months ended September 30, 2005 compared to 2004, respectively. The reduction is primarily a result of a decline in processing costs associated with the Bank's automated teller machine network because of fewer machines in service as well as a contract re-negotiation with its service provider. The Bank continues to study methods by which it may further reduce its data processing cost. Occupancy expense decreased approximately $1 thousand, or 0.31%, and $113 thousand, or 13%, during the quarter and nine months ended September 30, 2005 compared to 2004, respectively. The decrease is primarily attributable to the closure/consolidation of the Two Penn Center financial service center in July 2004. The cost of the lease was scheduled to double at expiration. As part of the Bank's profit restoration plan, upon expiration of the lease, this branch was closed and consolidated with other branches in the network to further reduce operating costs. All of the leasehold improvements and furniture associated with this branch became fully depreciated at the time of lease expiration in 2004. 21 Also contributing to the reduction in occupancy expense was the sale of the Bank's corporate headquarters in July 2004. This building was sold to generate gains as part of the Bank's re-capitalization plan. The sale of the building resulted in a reduction in property taxes, insurance, repairs and maintenance, and depreciation expense on leasehold improvements associated with the building. In February 2005, the Bank began the lease of its new corporate headquarters on a 10,000 square foot floor of a full service high rise office building located in center city Philadelphia. Marketing and public relations expense increased approximately $1 thousand, or 5.58%, and $9 thousand, or 18%, for the quarter and nine months ended September 30, 2005 compared to 2004, respectively. In April 2005, the Bank engaged a public relations firm to assist with re-acquainting the services of the Bank with leaders in the Philadelphia region in effort to stimulate business development activity. Activities of this firm have yielded additional loan and deposit business. Professional services expense increased approximately $2 thousand, or 3.61%, and increased $8 thousand, or 4.50%, for the quarter and nine months ended September 30, 2005 compared to 2004, respectively. This increase during the quarter is primarily related to legal fees associated with the collection of delinquent loans. Office operations and supplies expense decreased $26 thousand, or 24.69%, and $59 thousand, or 18.50%, for the quarter and nine months ended September 30, 2005 compared to 2004, respectively. In conjunction with the closure/consolidation of the Bank's Two Penn Center financial service center, the Bank experienced reductions in this category of expense including security guards and other costs associated with branch operations. FDIC insurance premiums decreased $1 thousand, or 3.36%, for the quarter ended September 30, 2005 compared to 2004 but increased $41 thousand, or 94.16%, for the nine months ended September 30, 2005 compared to 2004, respectively. FDIC insurance premiums are applied to all financial institutions based on a risk based premium assessment system. Under this system, bank strength is based on three factors: 1) asset quality, 2) capital strength, and 3) management. Premium assessments are then assigned based on the institution's overall rating, with the stronger institutions paying lower rates. The Bank's assessment was based on 1.96 basis points for BIF (Bank Insurance Fund) assessable deposits and SAIF (Savings Insurance Fund) assessable deposits. While the Bank is well capitalized, the increase during 2005, is a result of the perceived risk associated with the Bank's operating losses in prior years. All other expenses are reflective of the general cost to do business and compete in the current regulatory environment and maintenance of adequate insurance coverage. Regulatory Matters In February 2000, as a result of a regulatory examination completed in December 1999, the Bank entered into a Written Agreement ("Agreement") with its primary regulators with regard to, among other things, achievement of agreed-upon capital levels, implementation of a viable earnings/strategic plan, adequate funding of the allowance for loan losses, the completion of a management review and succession plan, and improvement in internal controls. The current Agreement requires the Bank maintain a minimum Tier 1 leverage capital ratio of 7.00%. As of December 31, 2002, the Bank had met the required ratios by continuing to implement strategies that included: increasing profitability, consolidating branches, and soliciting new and additional sources of capital. Management continues to address all matters outlined in the Agreement. Failure to comply could result in additional regulatory supervision and/or actions. At December 31, 2003, the Bank's tier one leverage capital ratio fell to 6.81%, below the 7% minimum capital ratio required by the Agreement. However, during 2004 management implemented re-capitalization strategies including the sale of bank-owned assets that generated gains of approximately $1.9 million. As a result, at December 31, 2004, the Bank's tier one leverage ratio had improved to 9.49%. At September 30, 2005, the tier one leverage ratio had further improved to 9.86% as a result of net income of $98 thousand for the nine months ended. Management continues to review and revise its capital plan to address the development of new equity. The most productive of which is to continue to increase capital through sustained core earnings. The Bank's strategic plan projects this occurrence in 2005. 22 At September 30, 2005, management believes that the Bank is "substantially" in compliance with the Agreement's terms and conditions. Failure to comply could result in additional regulatory supervision and/or actions. Dividend Restrictions UBS has never declared or paid any cash or stock dividends. The Pennsylvania Banking Code of 1965, as amended, provides that cash dividends may be declared and paid only from accumulated net earnings and that, prior to the declaration of any dividend, if the surplus of a bank is less than the amount of its capital, the bank shall, until surplus is equal to such amount, transfer to surplus an amount which is at least ten percent of the net earnings of the bank for the period since the end of the last fiscal year or any shorter period since the declaration of a dividend. If the surplus of a bank is less than 50% of the amount of its capital, no dividend may be declared or paid by the Bank without the prior approval of the Pennsylvania Department of Banking. Under the Federal Reserve Act, if a bank has sustained losses equal to or exceeding its undivided profits then on hand, no dividend shall be paid, and no dividends can ever be paid in an amount greater than such bank's net profits less losses and bad debts. Cash dividends must be approved by the Board if the total of all cash dividends declared by a bank in any calendar year, including the proposed cash dividend, exceeds the total of the Bank's net profits for that year plus its retained net profits from the preceding two years less any required transfers to surplus or to a fund for the retirement of preferred stock. Under the Federal Reserve Act, the Federal Reserve Board has the power to prohibit the payment of cash dividends by a bank if it determines that such a payment would be an unsafe or unsound banking practice. As a result of these laws and regulations, the Bank, and therefore UBS, whose only source of income is dividends from the Bank, will be unable to pay any dividends while an accumulated deficit exists. UBS does not anticipate that dividends will be paid for the foreseeable future. The FDIC generally prohibits all payments of dividends by a bank that is in default of any assessment to the FDIC. (See "Regulatory Matters" above) Recent Accounting Pronouncements In May 2005, the Financial Accounting Standards Board ("FASB") issued Statement No. 154, ("SFAS No. 154") "Accounting Changes and Error Corrections - A Replacement of APB Opinion No. 20 and FASB Statement No. 3." This new standard replaces Accounting Principles Board ("APB") Opinion No. 20, "Accounting Changes", and FASB Statement No. 3, "Reporting Accounting Changes in Interim Financial Statements." Among other changes, SFAS No. 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. SFAS No. 154 also provides that (1) a change in method of depreciating or amortizing a long-lived nonfinancial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle, and (2) correction of errors in previously issued financial statements should be termed a "restatement. " The new standard is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. UBS does not anticipate this revision will have a material effect on its financial statements. In December 2004, the FASB issued Statement No. 123 (Revised 2004) ("SFAS No. 123R") "Share-Based Payment," which requires that the compensation cost relating to share-based payment transactions be recognized in financial statements. SFAS No. 123R replaces SFAS No. 123, "Accounting for Stock-Based Compensation," and supersedes APB Opinion No. 25, "Accounting for Stock Issued to Employees." Share-based compensation arrangements include share options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. SFAS No. 123R requires all share-based payments to employees be valued using a fair valued method on the date of grant and expensed based on that fair value over the applicable vesting period. UBS adopted the cost recognition provision of SFAS No. 123 in 1995 and has been expensing compensation cost related to options. SFAS No. 123R also amends SFAS No. 95 "Statement of Cash Flows," requiring the benefits of tax deductions in excess of recognized compensation cost be reported as financing instead of operating cash 23 flows. The Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 107, ("SAB No. 107") which expresses the SEC's views regarding the interaction between SFAS No. 123R and certain SEC rules and regulations. Additionally, SAB No. 107 provides guidance related to share-based payment transactions for public companies. UBS will be required to apply SFAS No. 123R as of the annual reporting period that begins after June 15, 2005. UBS does not anticipate this revision will have a material effect on its financial statements. In November 2004, the Emerging Issues Task Force ("EITF") published Issue 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." The Task Force discussed the meaning of other-than-temporary impairment and its application to certain investments carried at cost. The Task Force requested that the FASB staff consider other impairment models within U.S. Generally Accepted Accounting Principles ("GAAP") when developing its views. The Task Force also requested that the scope of the impairment issue be expanded to include equity investments and investments subject to FASB Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and that the issue be addressed by the Task Force as a separate EITF issue. At the EITF meeting, the Task Force reached a consensus on one issue that certain quantitative and qualitative disclosures should be required for securities accounted for under Statement 115 that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. The APB ratified the consensus on that one issue at its November 25, 2004 meeting. In September 2004, the Financial Accounting Standards Board ("FASB") directed the FASB staff to issue two proposed FASB Staff Positions ("FSP"): Proposed FSP EITF Issue 03-1-a, which provides guidance for the application of paragraph 16 of EITF Issue 03-1 to debt securities that are impaired because of interest rate and/or sector spread increases, and Proposed FSP EITF Issue 03-1-b, which delays the effective date of Issue 03-1 for debt securities that are impaired because of interest rate and/or sector spread increases. In June 2005, the FASB reached a decision whereby they declined to provide additional guidance on the meaning of other-than-temporary impairment. The Board directed the FASB staff to issue EITF 03-1a as final and to draft a new FSP that will replace EITF 03-01. The final FSP (retitled FAS 115-1, "The Meaning of Other-Than-Temporary Impairment and it Application to Certain Investments") would be effective for other-than-temporary impairment analysis conducted in periods beginning after September 15, 2005. UBS does not anticipate this revision will have a material effect on its financial statements. Item 3. Quantitative and Qualitative Disclosures about Market Risk Interest rate sensitivity varies with different types of interest-earning assets and interest-bearing liabilities. Overnight federal funds on which rates change daily and loans which are tied to prime or other short term indices differ considerably from long-term investment securities and fixed-rate loans. Similarly, time deposits are much more interest sensitive than passbook savings accounts. The shorter-term interest rate sensitivities are key to measuring the interest sensitivity gap, or excess earning assets over interest-bearing liabilities. Management of interest sensitivity involves matching repricing dates of interest-earning assets with interest-bearing liabilities in a manner designed to optimize net interest income within the limits imposed by regulatory authorities, liquidity determinations and capital considerations. 24 At September 30, 2005, an asset sensitive position is maintained on a cumulative basis through 1 year of 3% that is within the Bank's policy guidelines of +/- 15% on a cumulative 1-year basis. The current gap position is primarily due to the level of loans and investments maturing and repricing in one year or less. Generally, because of the positive gap position of the Bank in shorter time frames, the Bank can anticipate that increases in market rates will have a positive impact on the net interest income, while decreases will have the opposite effect. While using the interest sensitivity gap analysis is a useful management tool as it considers the quantity of assets and liabilities subject to repricing in a given time period, it does not consider the relative sensitivity to market interest rate changes that are characteristic of various interest rate-sensitive assets and liabilities. Consequently, although the Bank currently has a negative gap position because of unequal sensitivity of these assets and liabilities, management believes this position will not materially impact earnings in a changing rate environment. For example, changes in the prime rate on variable commercial loans may not result in an equal change in the rate of money market deposits or short-term certificates of deposit. A simulation model is therefore used to estimate the impact of various changes, both upward and downward, in market interest rates and volumes of assets and liabilities on the net income of the Bank. This model produces an interest rate exposure report that forecast changes in the market value of portfolio equity under alternative interest rate environments. The market value of portfolio equity is defined as the present value of the Company's existing assets, liabilities and off-balance-sheet instruments. The calculated estimates of changes in market value of equity at September 30, 2005 are as follows: Market value Market value risk Changes in rate of equity (% Change) --------------- ------------ ---------- (Dollars in thousands) +200 basis points $ 5,860 (24.3) % +150 basis points 6,347 (18.1) +100 basis points 6,818 (12.0) + 50 basis points 7,305 (5.7) Flat rate 7,746 - - 50 basis points 8,138 5.1 -100 basis points 8,486 9.6 -150 basis points 8,807 13.7 -200 basis points 9,107 17.6 The market value of equity may be impacted by the composition of the Bank's assets and liabilities. The declining market value of equity in a rising rate environment is a result of the high level of fixed rate loans and investments the Bank has on its balance sheet. Management will actively manage the level of variable versus fixed rate assets in order to reduce the volatility in the market value of equity. The assumptions used in evaluating the vulnerability of the Company's earnings and capital to changes in interest rates are based on management's consideration of past experience, current position and anticipated future economic conditions. The interest sensitivity of the Company's assets and liabilities, as well as the estimated effect of changes in interest rates on the market value of portfolio equity, could vary substantially if different assumptions are used or actual experience differs from the assumptions on which the calculations were based. 25 The Board of Directors of the Bank and management consider all of the relevant factors and conditions in the asset/liability planning process. Interest-rate exposure is not considered significant and is within the policy limits of the Bank at September 30, 2005. However, if significant interest rate risk arises, the Board of Directors and management may take (but are not limited to) one or all of the following steps to reposition the balance sheet as appropriate: 1. Limit jumbo certificates of deposit (CDs) and movement into money market deposit accounts and short-term CDs through pricing and other marketing strategies. 2. Purchase quality loan participations with appropriate interest rate/gap match for the balance sheet of the Bank. 3. Restructure the investment portfolio of the Bank. The Board of Directors has determined that active supervision of the interest-rate spread between yield on earnings assets and cost of funds will decrease the vulnerability of the Bank to interest-rate cycles. Item 4. Controls and Procedures As of the end of the period covered by the report, the Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer, Evelyn F. Smalls, and Chief Financial Officer, Brenda M. Hudson-Nelson, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to Exchange Act Rules 13a-15(e) and 15d-15(e). Based upon the evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's periodic SEC filings. As of the date of this report, there have not been any significant changes in the Company's internal controls or in any other factors that could significantly affect those controls subsequent to the date of the evaluation. 26 PART II - OTHER INFORMATION Item 1. Legal Proceedings. No material claims have been instituted or threatened by or against the Company or its affiliates other than in the ordinary course of business. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds. None Item 3. Defaults Upon Senior Securities. None Item 4. Submission of Matters to a Vote of Security Holders. None Item 5. Other Information. None Item 6. Exhibits a) Exhibits. Exhibit 31.1 Certification of the Chief Executive Officer Pursuant to Exchange Act Rule 13a-14(a) or Rule 15d-14(a) Exhibit 31.2 Certification of the Chief Financial Officer Pursuant to Exchange Act Rule 13a-14(a) or Rule 15d-14(a) Exhibit 32.1 Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Exhibit 32.2 Certification of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 27 Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. UNITED BANCSHARES, INC. Date: November 14, 2005 /s/ Evelyn F. Smalls --------------------------------- Evelyn F. Smalls President & Chief Executive Officer Date: November 14, 2005 /s/ Brenda M. Hudson-Nelson ---------------------------------- Brenda Hudson-Nelson Executive Vice President/ Chief Financial Officer 28 Index to Exhibits ---------- FORM 10Q Exhibit 31.1 Certification of the Chief Executive Officer Pursuant to Exchange Act Rule 13a-14(a) or Rule 15d-14(a) Exhibit 31.2 Certification of the Chief Financial Officer Pursuant to Exchange Act Rule 13a-14(a) or Rule 15d-14(a) Exhibit 32.1 Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1 350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Exhibit 32.2 Certification of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 29