cbna10q3rdqtr2009.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549

FORM 10-Q

   x  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934    
For the quarterly period ended September 30, 2009
 
o  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                   to                   .
Commission File Number 001-13695
 
 
       COMMUNITY BANK SYSTEM, INC.  
   (Exact name of registrant as specified in its charter)  
 


 
 Delaware   16-1213679 
 (State or other jurisdiction of incorporation or organization)    (I.R.S. Employer Identification No.)
     
 5790 Widewaters Parkway, DeWitt, New York   13214-1883 
 (Address of principal executive offices)    (Zip Code)
                                                                                                                                                             
 
 
 (315) 445-2282
(Registrant's telephone number, including area code) 
 
 NONE
 (Former name, former address and former fiscal year, if changed since last report)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes   x    No  o.

Indicate by check mark whether the registrant has submitted electronically and posted to its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes   o   No o .

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
 Large accelerated filer o  Accelerated filer  x  Non-accelerated filer   o  Smaller reporting company   o.
     (Do not check if a smaller reporting company)  
 

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


Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.        
32,742,778 shares of Common Stock, $1.00 par value, were outstanding on October 31, 2009.


 

 


TABLE OF CONTENTS
 
 
           Page
           
 Part I.       Financial Information    
           
 Item 1.   Financial Statements (Unaudited)    
           
       Consolidated Statements of Condition    
       September 30, 2009 and December 31, 2008_____________________________________________________________________________________    3
           
       Consolidated Statements of Income    
       Three and nine months ended September 30, 2009 and 2008________________________________________________________________________    4
           
       Consolidated Statement of Changes in Shareholders’ Equity    
       Nine months ended September 30, 2009_______________________________________________________________________________________    5
           
       Consolidated Statements of Comprehensive Income    
       Three and nine months ended September 30, 2009 and 2008________________________________________________________________________    6
           
       Consolidated Statements of Cash Flows    
       Nine months ended September 30, 2009 and 2008________________________________________________________________________________    7
           
       Notes to the Consolidated Financial Statements    
       September 30, 2009______________________________________________________________________________________________________    8
           
 Item 2.    Management's Discussion and Analysis of Financial Condition and Results of Operations___________________________________________________    22
           
 Item 3.    Quantitative and Qualitative Disclosures about Market Risk__________________________________________________________________________    39
           
 Item 4.    Controls and Procedures_____________________________________________________________________________________________________    40
           
 Part II.      Other Information    
           
 Item 1.    Legal Proceedings__________________________________________________________________________________________________________    40
           
 Item 1A.    Risk Factors______________________________________________________________________________________________________________    40
           
 Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds__________________________________________________________________________    41
           
 Item 3.    Defaults Upon Senior Securities_______________________________________________________________________________________________    41
           
 Item 4.     Submission of Matters to a Vote of Securities Holders______________________________________________________________________________    41
           
 Item 5.    Other Information__________________________________________________________________________________________________________    41
           
 Item 6.    Exhibits__________________________________________________________________________________________________________________    41
 
 
 
 
2

 

Part I.   Financial Information
Item 1. Financial Statements

COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF CONDITION (Unaudited)
(In Thousands, Except Share Data)


     
 
September 30,
December 31,
 
2009
2008
   Cash and cash equivalents
$361,734
$213,753
     
   Available-for-sale investment securities, at fair value
1,214,521
1,317,217
   Held-to-maturity investment securities
283,305
77,794
     Total investment securities (fair value of $1,506,677 and $1,397,589, respectively)
1,497,826
1,395,011
     
   Loans held for sale
519
     
   Loans
3,087,093
3,136,140
   Allowance for loan losses
(41,072)
(39,575)
     Net loans
3,046,021
3,096,565
     
   Goodwill
300,758
301,149
   Core deposit intangibles, net
17,603
22,340
   Other intangibles, net
4,300
5,135
     Intangible assets, net
322,661
328,624
     
   Premises and equipment, net
74,654
73,294
   Accrued interest receivable
26,472
26,077
   Other assets
48,208
41,228
     Total assets
$5,378,095
$5,174,552
     
Liabilities:
   
   Noninterest-bearing deposits
$708,051
$638,558
   Interest-bearing deposits
3,180,194
3,062,254
      Total deposits
3,888,245
3,700,812
     
  Borrowings
756,442
760,558
  Subordinated debt held by unconsolidated subsidiary trusts
101,993
101,975
  Accrued interest and other liabilities
65,515
66,556
     Total liabilities
4,812,195
4,629,901
     
Commitments and contingencies (See Note I)
   
     
Shareholders' equity:
   
  Preferred stock $1.00 par value, 500,000 shares authorized, 0 shares issued
-
-
  Common stock, $1.00 par value, 50,000,000 shares authorized;
33,575
33,468
     33,574,989 and 33,468,215 shares issued at September 30, 2009 and December 31, 2008, respectively
   
  Additional paid-in capital
214,977
212,400
  Retained earnings
340,380
329,914
  Accumulated other comprehensive loss
(4,765)
(12,864)
  Treasury stock, at cost (834,811 shares)
(18,267)
(18,267)
     Total shareholders' equity
565,900
544,651
     
     Total liabilities and shareholders' equity
$5,378,095
$5,174,552

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

 
3

 

COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(In Thousands, Except Per-Share Data)

   
Three Months Ended
 
Nine Months Ended
   
September 30,
 
September 30,
   
2009
2008
 
2009
2008
Interest income:
         
 
Interest and fees on loans
$46,067
$46,731
 
$138,992
$138,937
 
Interest and dividends on taxable investments
9,849
9,539
 
30,082
29,888
 
Interest and dividends on nontaxable investments
5,972
5,544
 
17,868
17,210
 
     Total interest income
61,888
61,814
 
186,942
186,035
 
 
         
Interest expense:
         
 
Interest on deposits
10,612
14,761
 
36,269
48,495
 
Interest on borrowings
7,899
8,302
 
23,471
24,224
 
Interest on subordinated debt held by unconsolidated subsidiary trusts
1,525
1,678
 
4,650
5,205
 
     Total interest expense
20,036
24,741
 
64,390
77,924
             
Net interest income
41,852
37,073
 
122,552
108,111
Less:  provision for loan losses
2,375
1,985
 
7,200
4,335
Net interest income after provision for loan losses
39,477
35,088
 
115,352
103,776
             
Noninterest income:
         
 
Deposit service fees
10,991
9,039
 
30,247
26,205
 
Mortgage banking and other services
895
1,179
 
4,738
2,318
 
Benefit plan administration, consulting and actuarial fees
6,969
6,931
 
20,575
19,176
 
Trust, investment and asset management fees
1,951
2,234
 
6,251
6,721
 
Gain on investment securities
7
0
 
7
230
Total noninterest income
20,813
19,383
 
61,818
54,650
             
Operating expenses:
         
 
Salaries and employee benefits
23,166
21,130
 
69,282
61,288
 
Occupancy and equipment
5,533
5,305
 
17,448
16,067
 
Data processing and communications
5,328
4,284
 
15,349
12,369
 
Amortization of intangible assets
2,026
1,727
 
6,234
4,903
 
Legal and professional fees
1,367
1,095
 
3,969
3,295
 
Office supplies and postage
1,245
1,260
 
4,092
3,775
 
Business development and marketing
1,469
1,174
 
4,818
4,003
 
FDIC insurance premiums
1,670
665
 
7,066
1,051
 
Other
2,307
2,616
 
7,737
7,834
 
     Total operating expenses
44,111
39,256
 
135,995
114,585
             
Income before income taxes
16,179
15,215
 
41,175
43,841
Income taxes
3,724
3,429
 
9,100
9,870
Net income
$12,455
$11,786
 
$32,075
$33,971
             
Basic earnings per share
$0.38
$0.39
 
$0.98
$1.13
Diluted earnings per share
$0.38
$0.39
 
$0.97
$1.12
Dividends declared per share
$0.22
$0.22
 
$0.66
$0.64
             
The accompanying notes are an integral part of the consolidated financial statements.
         

 
4

 

COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited)
Nine Months Ended September 30, 2009
(In Thousands, Except Share Data)


         
Accumulated
   
 
Common Stock
Additional
 
Other
   
 
Shares
Amount
Paid-In
Retained
Comprehensive
Treasury
 
 
Outstanding
Issued
Capital
Earnings
Loss
Stock
Total
               
Balance at December 31, 2008
32,633,404
$33,468
$212,400
$329,914
($12,864)
($18,267)
$544,651
               
Net income
     
32,075
   
32,075
               
Other comprehensive income, net of tax
       
8,099
 
8,099
               
Dividends declared:
             
Common, $0.66 per share
     
(21,609)
   
(21,609)
               
Common stock issued under
             
Stock plan, including
             
tax benefits of $82
106,774
107
1,070
     
1,177
               
Stock options earned
   
1,507
     
1,507
               
Balance at September 30, 2009
32,740,178
$33,575
$214,977
$340,380
($4,765)
($18,267)
$565,900


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

 
5

 

COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
(In Thousands)


   
Three Months Ended
 
Nine Months Ended
   
September 30,
 
September 30,
   
2009
2008
 
2009
2008
             
Other comprehensive income (loss), before tax:
           
Change in pension liabilities
 
$3
$200
 
$1,779
$254
Change in unrealized gains (losses) on derivative instruments used in cash flow hedges
(112)
(305)
 
1,069
(231)
Unrealized (losses) gains on securities:
           
     Unrealized holding gains (losses) arising during period
 
14,388
(15,185)
 
9,786
(32,186)
     Reclassification adjustment for gains included in net income
 
(7)
0
 
(7)
(230)
Other comprehensive income (loss), before tax:
 
14,272
(15,290)
 
12,627
(32,393)
Income tax (expense) benefit related to other comprehensive (loss) income
 
(4,846)
5,754
 
(4,528)
12,234
Other comprehensive income (loss), net of tax:
 
9,426
(9,536)
 
8,099
(20,159)
Net income
 
12,455
11,786
 
32,075
33,971
Comprehensive income
 
$21,881
$2,250
 
$40,174
$13,812

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

 
6

 

COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(In Thousands)

 
Nine Months Ended
September 30, 
 
2009
2008
Operating activities:
   
  Net income
$32,075
$33,971
  Adjustments to reconcile net income to net cash provided by operating activities:
   
     Depreciation
7,696
7,023
     Amortization of intangible assets
6,234
4,903
     Net accretion of premiums and discounts on securities, loans and borrowings
1,020
(498)
     Stock-based compensation
2,298
2,000
     Provision for loan losses
7,200
4,335
     Provision for deferred taxes
4,143
3,343
     Amortization of mortgage servicing rights
547
521
     Bank-owned life insurance income
(348)
(364)
     Gain on investment securities and debt extinguishments
(7)
(230)
     Net gain on sale of other assets
(950)
(4)
     Net change in loans originated for sale
(519)
0
     Change in other operating assets and liabilities
(13,510)
(21,245)
Net cash provided by operating activities
45,879
33,755
Investing activities:
   
  Proceeds from sales of available-for-sale investment securities
216
43,678
  Proceeds from maturities of held-to-maturity investment securities
72,735
43,214
  Proceeds from maturities of available-for-sale investment securities
199,631
257,608
  Purchases of held-to-maturity investment securities
(279,358)
(8,640)
  Purchases of available-for-sale investment securities
(87,256)
(259,438)
  Net decrease (increase) in loans outstanding
43,345
(186,321)
  Cash paid for acquisition (net of cash acquired of  $0 and $200)
(332)
(5,558)
  Expenditures for intangibles
0
(322)
  Capital expenditures
(9,079)
(7,143)
Net cash used in investing activities
(60,098)
(122,922)
Financing activities:
   
  Net change in non-interest checking, interest checking and savings accounts
358,811
107,161
  Net change in time deposits
(171,378)
(109,232)
  Net change in short-term borrowings
(3,873)
90,642
  Change in long-term borrowings (including payments of $243 and $601)
(243)
9,399
  Payment on subordinated debt held by unconsolidated subsidiary trusts
0
(25,773)
  Issuance of common stock
386
7,606
  Cash dividends paid
(21,585)
(18,776)
  Tax benefits from share-based payment arrangements
82
912
Net cash provided by financing activities
162,200
61,939
Change in cash and cash equivalents
147,981
(27,228)
  Cash and cash equivalents at beginning of period
213,753
130,823
Cash and cash equivalents at end of period
$361,734
$103,595
Supplemental disclosures of cash flow information:
   
  Cash paid for interest
$64,824
$78,431
  Cash paid for income taxes
2,085
9,381
Supplemental disclosures of noncash financing and investing activities:
   
  Dividends declared and unpaid
7,203
6,590
  Transfers from loans to other real estate
1,599
764

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

 
7

 

COMMUNITY BANK SYSTEM, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
September 30, 2009


NOTE A:  BASIS OF PRESENTATION

The interim financial data as of September 30, 2009 and for the three and nine months ended September 30, 2009 and 2008 is unaudited; however, in the opinion of the Company, the interim data includes all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the results for the interim periods.  The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the full year or any other interim period.

NOTE B:  ACQUISITION AND OTHER MATTERS

Citizens Branches Acquisition
On November 7, 2008, the Company acquired 18 branch-banking centers in northern New York from Citizens Financial Group, Inc. (“Citizens”) in an all cash transaction.  The Company acquired approximately $109 million in loans and $565 million in deposits at a blended deposit premium of 13%.  The results of operations for the 18 branches acquired from Citizens have been included in the consolidated financial statements since that date.  In support of the transaction, the Company issued approximately $50 million of equity capital in the form of common stock in October 2008.

Alliance Benefit Group MidAtlantic
On July 7, 2008, Benefit Plans Administrative Services, Inc. (“BPAS”), a wholly owned subsidiary of the Company, acquired the Philadelphia division of Alliance Benefit Group MidAtlantic (“ABG”) from BenefitStreet, Inc. in an all cash transaction.  ABG provides retirement plan consulting, daily valuation administration, actuarial and ancillary support services.  The results of ABG’s operations have been included in the consolidated financial statements since that date.

The estimated purchase price allocation of the assets acquired and liabilities assumed in the purchase of Citizens and ABG, collectively, including capitalized acquisition costs, is as follows:

(000’s omitted)
 
Cash and cash equivalents
$   2,610
Loans, net of allowance for loan losses
108,633
Premises and equipment, net
2,717
Other assets
1,091
Core deposit intangibles
9,209
Customer list intangible
3,592
Goodwill
67,493
  Total assets acquired
195,345
Deposits
565,045
Borrowings
14
Other liabilities
938
  Total liabilities assumed
565,997
     Net liabilities assumed
$  370,652

Stock Repurchase Program
On July 22, 2009, the Company announced an authorization to repurchase up to 1,000,000 of its outstanding shares in open market transactions or privately negotiated transactions in accordance with securities laws and regulations through December 31, 2011.  Any repurchased shares will be used for general corporate purposes, including those related to stock plan activities.  The timing and extent of repurchases will depend on market conditions and other corporate considerations as determined at the Company’s discretion.  There were no treasury stock purchases during the first nine months of 2009.

 
8

 

NOTE C:  ACCOUNTING POLICIES

Critical Accounting Policies

Allowance for Loan Losses
Management continually evaluates the credit quality of the Company’s loan portfolio and performs a formal review of the adequacy of the allowance for loan losses on a quarterly basis.  The allowance reflects management’s best estimate of probable losses inherent in the loan portfolio.  Determination of the allowance is subjective in nature and requires significant estimates.   The Company’s allowance methodology consists of two broad components - general and specific loan loss allocations.

The general loan loss allocation is composed of two calculations that are computed on five main loan categories: commercial, consumer direct, consumer indirect, home equity and residential real estate.  The first calculation determines an allowance level based on the latest seven years of historical net charge-off data for each loan category (commercial loans exclude balances with specific loan loss allocations).  The second calculation is qualitative and takes into consideration eight qualitative environmental factors:  levels and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards, and other changes in lending policies, procedure, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry condition; and effects of changes in credit concentrations.  These two calculations are added together to determine the general loan loss allocation.  The specific loan loss allocation relates to individual commercial loans that are both greater than $0.5 million and in a nonaccruing status with respect to interest.  Specific losses are based on discounted estimated cash flows, including any cash flows resulting from the conversion of collateral or collateral shortfalls.  The allowance levels computed from the specific and general loan loss allocation methods are combined with unallocated reserves, if any, to derive the required allowance for loan loss to be reflected on the Consolidated Statement of Condition.

Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance.  A provision for loan loss is charged to operations based on management’s periodic evaluation of the factors previously mentioned.

Investment Securities
The Company has classified its investments in debt and equity securities as held-to-maturity or available-for-sale.  Held-to-maturity securities are those for which the Company has the positive intent and ability to hold to maturity, and are reported at cost, which is adjusted for amortization of premiums and accretion of discounts.  Securities not classified as held-to-maturity are classified as available-for-sale and are reported at fair market value with net unrealized gains and losses reflected as a separate component of shareholders' equity, net of applicable income taxes.  None of the Company's investment securities have been classified as trading securities at September 30, 2009.  Certain equity securities are stated at cost and include restricted stock of the Federal Reserve Bank of New York and Federal Home Loan Bank of New York.

Fair values for investment securities are based on quoted market prices, where available.  If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments, or a discounted cash flow model using market estimates of interest rates and volatility.

Investment securities are reviewed regularly for other-than-temporary impairment.  An unrealized loss is generally deemed to be other-than-temporary and a credit loss is deemed to exist if the present value of the expected future cash flows is less than the amortized cost basis of the debt security.  The credit loss component of an other-than-temporary impairment write-down is recorded in earnings, while the remaining portion of the impairment loss is recognized in other comprehensive income (loss), provided the Company does not intend to sell the underlying debt security and it is more likely than not that the Company will not be required to sell the debt security prior to recovery.    In determining whether a credit loss exists and the period over which the fair value of the debt security is expected to recover management considers the following factors: the length of time and extent that fair value has been less than cost, the financial condition and near term prospects of the issuer, any external credit ratings, the level of excess cash flows generated from the underlying collateral supporting the principal and interest payments of the debt securities, the level of credit enhancement provided by the structure and the Company’s ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value.

The specific identification method is used in determining the realized gains and losses on sales of investment securities and other-than-temporary impairment charges.  Premiums and discounts on securities are amortized and accreted, respectively, on a systematic basis over the period to maturity or estimated life of the related security.  Purchases and sales of securities are recognized on a trade date basis.

Income Taxes
Provisions for income taxes are based on taxes currently payable or refundable, and deferred taxes which are based on temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements.  Deferred tax assets and liabilities are reported in the financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets and liabilities are expected to be realized or settled.
 
9

 
Intangible Assets
Intangible assets include core deposit intangibles, customer relationship intangibles and goodwill arising from acquisitions.  Core deposit intangibles and customer relationship intangibles are amortized on either an accelerated or straight-line basis over periods ranging from 8 to 20 years.  The carrying value of goodwill and other intangible assets is based upon discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows.  It also requires use of a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, required equity market premiums, and company-specific risk indicators.

The Company evaluates goodwill for impairment on an annual basis, or more often if events or circumstances indicate there may be impairment.  The fair value of each reporting unit is compared to the carrying amount of that reporting unit in order to determine if impairment is indicated.  If so, the implied fair value of the reporting units’ goodwill is compared to its carrying amount and the impairment loss is measured by the excess of the carrying value over fair value.

Retirement Benefits
The Company provides defined benefit pension benefits and post-retirement health and life insurance benefits to eligible employees.  The Company also provides deferred compensation and supplemental executive retirement plans for selected current and former employees and officers.  Expense under these plans is charged to current operations and consists of several components of net periodic benefit cost based on various actuarial assumptions regarding future experience under the plans, including, but not limited to, discount rate, rate of future compensation increases and expected return on plan assets.

Subsequent Events
Companies are required to evaluate events and transactions that occur after the balance sheet date but before the date the financial statements are issued, or available to be issued in the case of non-public entities.  They must recognize in the financial statements the effect of all events or transactions that provide additional evidence of conditions that existed at the balance sheet date, including the estimates inherent in the financial preparation process.  Entities shall not recognize the impact of events or transactions that provide evidence about conditions that did not exist at the balance sheet date but arose after that date.  The Company has evaluated subsequent events through the time of filing these financial statements with the SEC on November 5, 2009

New Accounting Pronouncements

In June 2009, the FASB issued new guidance related to the accounting and disclosures for transfers of financial assets.  It established a new “participating interest” definition that must be met for transfers of portions of financial assets to be eligible for sale accounting, clarifies and amends the derecognition criteria for a transfer to be accounted for as a sale, and changes the amount that can be recognized as a gain or loss on a transfer accounted for as a sale when beneficial interests are received by the transferor. Enhanced disclosures are also required to provide information about transfers of financial assets and a transferor’s continuing involvement with transferred financial assets. The guidance must be applied as of the beginning of an entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. Earlier application is prohibited. The Company is currently evaluating this new guidance.

In June 2009, the FASB issued guidance related to financial companies involved with variable interest entities.  Companies are now required to qualitatively assess the determination of the primary beneficiary of a variable interest entity (“VIE”) based on whether the entity (1) has the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and (2) has the obligation to absorb losses of the entity or the right to receive benefits from the entity that could potentially be significant to the VIE. Also required is an ongoing reconsideration of the primary beneficiary, as well as amendments regarding the events that trigger a reassessment of whether an entity is a VIE. Enhanced disclosures are also required to provide information about an enterprise’s involvement in a VIE. The guidance shall be effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. Earlier application is prohibited. The Company is currently evaluating this new guidance.

In December 2008, the FASB issued changes to employers’ disclosures regarding postretirement benefit plan assets.  The guidance effects an employer’s disclosures about plan assets of a defined benefit pension or other postretirement plan on investment policies and strategies, major categories of plan assets, inputs and valuation techniques used to measure the fair value of plan assets and significant concentrations of risk within plan assets. This guidance shall be effective for fiscal years ending after December 15, 2009, with earlier application permitted. Upon initial application, the provisions of this guidance are not required for earlier periods that are presented for comparative purposes. The Company is currently evaluating the disclosure requirements of this new guidance.

In August 2009, the FASB issued new accounting guidance to provide clarification on measuring liabilities at fair value when a quoted price in an active market is not available.  This guidance became effective as of October 1, 2009.  It had no material impact on our consolidated financial statements.
 
10


NOTE D:  INVESTMENT SECURITIES

The amortized cost and estimated fair value of investment securities as of September 30, 2009 and December 31, 2008 are as follows:

 
September 30, 2009
 
December 31, 2008
   
Gross
Gross
Estimated
   
Gross
Gross
Estimated
 
Amortized
Unrealized
Unrealized
Fair
 
Amortized
Unrealized
Unrealized
Fair
(000's omitted)
Cost
Gains
Losses
Value
 
Cost
Gains
Losses
Value
Held-to-Maturity Portfolio:
                 
U.S. Treasury and agency securities
     $70,315
     $2,675
           $0
     $72,990
 
$61,910
$2,358
$0
$64,268
Obligations of state and political subdivisions
69,910
3,679
0
73,589
 
15,784
220
0
16,004
Government guaranteed mortgage-backed securities
143,000
2,497
0
145,497
 
0
0
0
0
Other securities
80
0
0
80
 
100
0
0
100
Total held-to-maturity portfolio
     283,305
     $8,851
         $0
     292,156
 
77,794
$2,578
$0
80,372
                   
Available-for-Sale Portfolio:
                 
U.S. Treasury and agency securities
      312,429
$25,108
$13
337,524
 
382,301
     $29,482
$0
411,783
Obligations of state and political subdivisions
       499,050
22,588
834
520,804
 
538,008
13,537
3,606
547,939
Corporate debt securities
        35,569
1,711
0
37,280
 
35,596
333
777
35,152
Collateralized mortgage obligations
        11,214
548
0
11,762
 
25,464
236
0
25,700
Pooled trust preferred securities
        71,377
               0
  25,957
45,420
 
72,535
0
22,670
49,865
Government guaranteed mortgage-backed securities
     199,974
7,131
468
206,637
 
188,560
        4,234
740
192,054
  Subtotal
   1,129,613
57,086
  27,272
1,159,427
 
1,242,464
47,822
27,793
1,262,493
Federal Home Loan Bank of NY stock
        38,491
0
0
38,491
 
38,056
0
0
38,056
Federal Reserve Bank stock
        12,378
0
0
12,378
 
12,383
0
0
12,383
Other equity securities
          4,231
1
7
4,225
 
4,285
0
0
4,285
Total available-for-sale portfolio
    1,184,713
$57,087
$27,279
1,214,521
 
1,297,188
$47,822
$27,793
1,317,217
                   
Net unrealized gain on
   available-for-sale portfolio
         29,808
   
0
 
20,029
   
0
     Total
 $ 1,497,826
   
$1,506,677
 
$1,395,011
   
$1,397,589


 
11

 

A summary of investment securities that have been in a continuous unrealized loss position for less than or greater than twelve months is as follows:

As of September 30, 2009
   
Less than 12 Months
 
12 Months or Longer
 
Total
     
Gross
   
Gross
   
Gross
   
Fair
Unrealized
 
Fair
Unrealized
 
Fair
Unrealized
(000's omitted)
 
Value
Losses
 
Value
Losses
 
Value
Losses
                   
Available-for-Sale Portfolio:
                 
U.S. Treasury and agency securities
 
$989
$13
 
$0
$0
 
$989
$13
Obligations of state and political subdivisions
 
15,552
166
 
6,673
302
 
22,225
468
Pooled trust preferred securities
 
0
0
 
45,420
25,957
 
45,420
25,957
Government guaranteed mortgage-backed securities
 
5,166
23
 
4,223
811
 
9,389
834
Other equity securities
 
10
7
 
0
0
 
10
7
    Total available-for-sale portfolio
 
$21,717
$209
 
$56,316
$27,070
 
$78,033
$27,279

As of December 31, 2008
    Less than 12 Months   12 Months or Longer   Total
     
Gross
   
Gross
   
Gross
   
Fair
Unrealized
 
Fair
Unrealized
 
Fair
Unrealized
(000's omitted)
 
Value
Losses
 
Value
Losses
 
Value
Losses
                   
Available-for-Sale Portfolio:
                 
  Obligations of state and political subdivisions
 
$61,879
$3,127
 
$7,419
$479
 
$69,298
$3,606
  Corporate debt securities
 
10,897
680
 
1,903
97
 
12,800
777
  Pooled trust preferred securities
 
0
0
 
49,865
22,670
 
49,865
22,670
  Government guaranteed mortgage-backed securities
 
24,897
738
 
338
2
 
25,235
740
    Total available-for-sale portfolio
 
$97,673
$4,545
 
$59,525
$23,248
 
$157,198
$27,793

Included in the available for sale portfolio are pooled trust preferred, class A-1 securities with a current par value of $73.1 million and unrealized losses of $26.0 million at September 30, 2009.  The underlying collateral of these assets are principally trust-preferred securities of smaller regional banks and insurance companies.  The Company’s securities are in the super-senior cash flow tranche of the investment pools.  All other tranches in these pools will incur losses before this tranche is impacted.  An additional 38% - 43% of the underlying collateral would have to be in deferral or default concurrently to result in an expectation of non-receipt of contractual cash flows.  The market for these securities at September 30, 2009 is not active and markets for similar securities are also not active.  The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which these securities trade and then by a significant decrease in the volume of trades relative to historical levels.  The fair value of these securities was determined using a discounted cash flow model that incorporated market estimates of interest rates and volatility, as well as, observable quoted prices for similar assets in markets that have not been active.  These assumptions have a significant effect on the reported fair values.  The use of different assumptions, as well as changes in market conditions, could result in materially different fair values.  The Company does not intend to sell the underlying security.  It is not more likely than not that the Company will be required to sell the debt security prior to recovery and does not consider these investments to be other-than-temporarily impaired as of September 30, 2009.  In determining if unrealized losses are other-than-temporary, management considers the following factors: the length of time and extent that fair value has been less than cost, the financial condition and near term prospects of the issuers, any external credit ratings, the level of excess cash flows generated from the underlying collateral supporting the principal and interest payments of the debt securities, the level of credit enhancement provided by the structure, and the Company’s ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value.  To date, the Company has received all scheduled principal and interest payments and expects to fully collect all future contractual principal and interest payments.  Subsequent changes in market or credit conditions could change those evaluations.

Management does not believe any individual unrealized loss as of September 30, 2009 represents an other-than-temporary impairment.  The unrealized losses reported pertaining to government guaranteed mortgage-backed securities relate primarily to securities issued by GNMA, FNMA and FHLMC, who are currently rated AAA by Moody’s Investor Services and Standard & Poor’s and are guaranteed by the U.S. government.  The obligations of state and political subdivisions are general purpose debt obligations of various states and political subdivisions.  The unrealized losses in the portfolios are primarily attributable to changes in interest rates.  The Company does not intend to sell these securities, nor is it more likely than not that the Company will be required to sell these securities prior to recovery of the amortized cost.
 
12

 
The amortized cost and estimated fair value of debt securities at September 30, 2009, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

   
Held-to-Maturity
 
Available-for-Sale
   
Carrying
Fair
 
Carrying
Fair
(000's omitted)
 
Value
Value
 
Value
Value
Due in one year or less
 
 $16,666
$16,821
 
        $54,637
         $55,466
Due after one through five years
 
           48,896
          50,250
 
  234,260
       247,953
Due after five years through ten years
 
          23,087
         24,526
 
        354,677
       377,875
Due after ten years
 
           51,576
         54,982
 
         274,851
  259,733
     Subtotal
 
         140,225
         146,579
 
         918,425
       941,027
Collateralized mortgage obligations
 
0
                   0
 
           11,214
         11,762
Mortgage-backed securities
 
         143,080
       145,577
 
      199,974
       206,637
     Total
 
       $283,305
     $292,156
 
$1,129,613
    $1,159,426

Cash flow information on investment securities for the nine months ended September 30 is as follows:

(000's omitted)
2009
2008
Proceeds from the sales of available-for-sale investment securities
$216
$43,678
Gross gains on sales of investment securities
 7
550
Gross losses on sales of investment securities
 0
320

NOTE E:  INTANGIBLE ASSETS

The gross carrying amount and accumulated amortization for each type of intangible asset are as follows:

   
As of September 30, 2009
 
As of December 31, 2008
   
Gross
 
Net
 
Gross
 
Net
   
Carrying
Accumulated
Carrying
 
Carrying
Accumulated
Carrying
(000's omitted)
 
Amount
Amortization
Amount
 
Amount
Amortization
Amount
Amortizing intangible assets:
               
  Core deposit intangibles
 
$60,595
($42,992)
$17,603
 
$59,933
($37,593)
$22,340
  Other intangibles
 
7,882
(3,582)
4,300
 
7,882
(2,747)
5,135
     Total amortizing intangibles
 
68,477
(46,574)
21,903
 
67,815
(40,340)
27,475
Non-amortizing intangible assets:
               
  Goodwill
 
300,758
0
300,758
 
301,149
0
301,149
     Total intangible assets, net
 
$369,235
($46,574)
$322,661
 
$368,964
($40,340)
$328,624

No goodwill impairment adjustment was recognized in the third quarter of 2009. The estimated aggregate amortization expense for each of the succeeding fiscal years ended December 31 is as follows:

(000's omitted)
 
Amount
Oct-Dec 2009
 
$1,936
2010
 
5,955
2011
 
3,485
2012
 
2,899
2013
 
2,259
Thereafter
 
5,369
Total
 
$21,903


 
13

 

NOTE F:  MANDATORILY REDEEMABLE PREFERRED SECURITIES

The Company sponsors two business trusts, Community Statutory Trust III and Community Capital Trust IV (“Trust IV”), of which 100% of the common stock is owned by the Company.  The trusts were formed for the purpose of issuing company-obligated mandatorily redeemable preferred securities to third-party investors and investing the proceeds from the sale of such preferred securities solely in junior subordinated debt securities of the Company.  The debentures held by each trust are the sole assets of that trust.  Distributions on the preferred securities issued by each trust are payable quarterly at a rate per annum equal to the interest rate being earned by the trust on the debentures held by that trust and are recorded as interest expense in the consolidated financial statements.  The preferred securities are subject to mandatory redemption, in whole or in part, upon repayment of the debentures.  The Company has entered into agreements which, taken collectively, fully and unconditionally guarantee the preferred securities subject to the terms of each of the guarantees.  The terms of the preferred securities of each trust are as follows:

 
Issuance
Par
 
Maturity
   
Trust
Date
Amount
Interest Rate
Date
Call Provision
Call Price
III
7/31/2001
$24.5 million
3 month LIBOR plus 3.58% (4.07%)
7/31/2031
  5 year beginning 2006
103.00% declining to par in 2011
IV
12/8/2006
$75 million
3 month LIBOR plus 1.65% (1.95%)
12/15/2036
5 year beginning 2012
Par

Upon the issuance of Trust IV, the Company entered into an interest rate swap agreement to convert the variable rate trust preferred securities into a fixed rate security for a term of five years at a fixed rate of 6.43%.  Additional interest expense of $806,000 and $2,035,000 was recognized based on the interest rate swap agreement for the three and nine months ended September 30, 2009, respectively, compared to $382,000 and $760,000 for the three and nine months ended September 30, 2008.

NOTE G:  BENEFIT PLANS

The Company provides defined benefit pension benefits and post-retirement health and life insurance benefits to eligible employees. The Company also provides supplemental pension retirement benefits for several current and former key employees.  During the first quarter, the Company made a contribution to its defined benefit pension plan of $15.0 million.  No other contributions are required in 2009.  The Company accrues for the estimated cost of these benefits through charges to expense during the years that employees earn these benefits.  The net periodic benefit cost for the three and nine months ended September 30 is as follows:

  Pension Benefits   Post-retirement Benefits
 
Three Months Ended
 
Nine Months Ended
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
September 30,
 
September 30,
(000's omitted)
2009
2008
 
2009
2008
 
2009
2008
 
2009
2008
Service cost
$878
$780
 
$2,622
$2,339
 
$111
$174
 
$510
$524
Interest cost
905
819
 
2,741
2,457
 
105
150
 
413
450
Expected return on plan assets
(1,172)
(1,117)
 
(3,515)
(3,352)
 
0
0
 
0
0
Amortization of unrecognized net loss
682
164
 
2,059
494
 
(9)
25
 
21
75
Amortization of prior service cost
(27)
(27)
 
(88)
(82)
 
13
27
 
40
82
Amortization of transition obligation
0
0
 
0
0
 
10
11
 
31
31
Net periodic benefit cost
$1,266
$619
 
$3,819
$1,856
 
$230
$387
 
$1,015
$1,162

NOTE H:  EARNINGS PER SHARE

Basic earnings per share are computed based on the weighted-average common shares outstanding for the period.  Diluted earnings per share are based on the weighted-average shares outstanding adjusted for the dilutive effect of restricted stock and the assumed exercise of stock options during the year.  The dilutive effect of options is calculated using the treasury stock method of accounting.  The treasury stock method determines the number of common shares that would be outstanding if all the dilutive options (those where the average market price is greater than the exercise price) were exercised and the proceeds were used to repurchase common shares in the open market at the average market price for the applicable time period.  There were approximately 2.5 million weighted-average anti-dilutive stock options outstanding at September 30, 2009 compared to approximately 1.1 million weighted-average anti-dilutive stock options outstanding at September 30, 2008 that were not included in the computation below.  The following is a reconciliation of basic to diluted earnings per share for the three and nine months ended September 30, 2009 and 2008.

 
14

 


 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
(000's omitted, except per share data)
2009
2008
 
2009
2008
Net income
$12,455
$11,786
 
$32,075
$33,971
Income attributable to unvested stock-based compensation awards
 (67)
(48)
 
(165)
(133)
Income available to common shareholders
$12,388
11,738
 
$31,910
$33,838
           
Weighted-average common shares outstanding –basic
32,674
29,924
 
32,663
29,843
Basic earnings per share
$0.38 
$0.39
 
$0.98
$1.13
           
Net income
$12,455
$11,786
 
$32,075
$33,971
Income attributable to unvested stock-based compensation awards
 (67)
(48)
 
(165)
(133)
Income available to common shareholders
$12,388
$11,738
 
$31,910
$33,838
           
Weighted-average common shares outstanding
32,674
29,924
 
32,663
29,843
Assumed exercise of stock options
147
330
 
122
336
Weighted-average shares – diluted
 32,821
30,254
 
32,785
30,179
Diluted earnings per share
$0.38
$0.39
 
$0.97
$1.12

NOTE I:  COMMITMENTS, CONTINGENT LIABILITIES AND RESTRICTIONS

The Company 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 consist primarily of commitments to extend credit and standby letters of credit.  Commitments to extend credit are agreements to lend to customers, generally having fixed expiration dates or other termination clauses that may require payment of a fee.  These commitments consist principally of unused commercial and consumer credit lines.  Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of an underlying contract with a third party.  The credit risks associated with commitments to extend credit and standby letters of credit are essentially the same as that involved with extending loans to customers and are subject to normal credit policies.  Collateral may be obtained based on management’s assessment of the customer’s creditworthiness.

The contract amount of commitments and contingencies are as follows:

(000's omitted)
September 30,
 2009
December 31,
2008
Commitments to extend credit
$556,510
$523,017
Standby letters of credit
19,763
13,209
     Total
$576,273
$536,226

NOTE J:  FAIR VALUE

Accounting literature allows entities an irrevocable option to measure certain financial assets and financial liabilities at fair value.  Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings.  The Company has elected to value loans held for sale at fair value in order to more closely match the gains and losses associated with loans held for sale with the gains and losses on forward sales contracts.  Accordingly the impact on the valuation will be recognized in the Company’s consolidated statement of income.  All mortgage loans held for sale are current and in performing status.

Fair value, establishes a framework for measuring fair value and expands disclosure about such fair value instruments.  It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price).  Inputs used to measure fair value are classified into the following hierarchy:
 
 ·  Level 1 – Quoted prices in active markets for identical assets or liabilities.
 ·  Level 2 – Quoted prices in active markets for similar assets or liabilities, or quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability.
 ·  Level 3 – Significant valuation assumptions not readily observable in a market.
 
 
15

 
A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.    The following tables set forth the Company’s financial assets and liabilities that were accounted for at fair value on a recurring basis:

 
September 30, 2009
(000's omitted)
Level 1
Level 2
Level 3
Total Fair Value
Available-for-sale investment securities:
       
  U.S. Treasury and agency securities
$989
$336,535
$0
$337,524
  Obligations of state and political subdivisions
0
520,804
0
520,804
  Government guaranteed mortgage-backed securities
0
206,619
0
206,619
  Corporate debt securities
0
37,280
0
37,280
  Collateralized mortgage obligations
0
11,762
0
11,762
  Pooled trust preferred securities
0
0
45,420
45,420
  Other equity securities
28
0
4,215
4,243
   Total available-for-sale investment securities
1,017
1,113,000
49,635
1,163,652
Forward sales contracts
0
(73)
0
(73)
Commitments to originate real estate loans for sale
0
0
180
180
Mortgage loans held for sale
0
519
0
519
Interest rate swap
0
(5,652)  
0
(5,652)  
   Total
$1,017
$1,107,794
$49,815
$1,158,626

 
December 31, 2008
(000's omitted)
Level 1
Level 2
Level 3
Total Fair Value
Available-for-sale investment securities:
       
  U.S. Treasury and agency securities
$1,007
$410,776
$0
$411,783
  Obligations of state and political subdivisions
0
547,939
0
547,939
  Government guaranteed mortgage-backed securities
0
192,054
0
192,054
  Corporate debt securities
0
35,152
0
35,152
  Collateralized mortgage obligations
0
25,700
0
25,700
  Pooled trust preferred securities
0
0
49,865
49,865
  Other equity securities
28
0
4,257
4,285
   Total available-for-sale investment securities
1,035
1,211,621
54,122
1,266,778
Interest rate swap
0
(6,721)
0
(6,721)
   Total
$1,035
$1,204,900
$54,122
$1,260,057
 
The valuation techniques used to measure fair value for the items in the table above are as follows:
·  
Available for sale investment securities – The fair value of available-for-sale investment securities is based upon quoted prices, if available.  If quoted prices are not available, fair values are measured using quoted market prices for similar securities or model-based valuation techniques.  Level 1 securities include U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets.  Level 2 securities include U.S. agency securities, mortgage-backed securities issued by government-sponsored entities, municipal securities and corporate debt securities that are valued by reference to prices for similar securities or through model-based techniques in which all significant inputs are observable.  Securities classified as Level 3 include pooled trust preferred securities in less liquid markets.  The value of these instruments is determined using pricing models or similar techniques as well as significant judgment or estimation.
·  
Mortgage loans held for sale – Mortgage loans held for sale are carried at fair value, which is determined using quoted secondary-market prices of loans with similar characteristics and, as such, have been classified as a Level 2 valuation.  The unpaid principal value of mortgage loans held for sale at September 30, 2009 is $0.5 million.  The unrealized gain on mortgage loans held for sale of $14,000 was recognized in mortgage banking and other income in the consolidated statement of income for the quarter ended September 30, 2009.


 
16

 

·  
Forward sales contracts – The Company enters into forward sales contracts to sell certain residential real estate loans.  Such commitments are considered to be derivative financial instruments and, therefore, are carried at estimated fair value in the other asset or other liability section of the consolidated balance sheet.  The fair value of these forward sales contracts is primarily measured by obtaining pricing from certain government-sponsored entities.  The pricing is derived from market observable inputs that can generally be verified and do not typically involve significant judgment by the Company and, therefore, are classified as Level 2 in the fair value hierarchy.
·  
Commitments to originate real estate loans for sale – The Company enters into various commitments to originate residential real estate loans for sale.  Such commitments are considered to be derivative financial instruments and, therefore, are carried at estimated fair value in the other asset or other liability section of the consolidated balance sheet.  The estimated fair value of these commitments is determined using quoted secondary market prices obtained from certain government-sponsored entities.  Additionally, accounting guidance requires the expected net future cash flows related to the associated servicing of the loan to be included in the fair value measurement of the derivative.  The expected net future cash flows are based on a valuation model that calculates the present value of estimated net servicing income.  The valuation model incorporates assumptions that market participants would use in estimating future net servicing income.  Such assumptions include estimates of the cost of servicing loans, appropriate discount rate and prepayment speeds.  The determination of expected net cash flows is considered a significant unobservable input contributing to the Level 3 classification of commitments to originate real estate loans for sale.
·  
Interest rate swap – The Company utilizes interest rate swap agreements to modify the repricing characteristics of certain of its interest-bearing liabilities.  The fair value of these interest rate swaps traded in over-the-counter markets where quoted market prices are not readily available, are measured using models for which the significant assumptions such as yield curves and option volatilities are market observable and, therefore, classified as Level 2 in the fair value hierarchy.

  The changes in Level 3 assets measured at fair value on a recurring basis are summarized in the following tables:
 
 
 
 
Three Months Ended September 30,
 
2009
 
2008
(000's omitted)
Pooled trust preferred  
securities
Other equity securities
Commitments to originate
real estate 
loans for sale
Total
 
Pooled trust preferred 
 securities
Other equity securities
Commitments to originate real estate  
loans for sale
Total
Beginning balance
$54,561
$4,245
$142
$58,948
 
$61,982
$4,258
$0
$66,240
Total gains included in earnings
28
0
0
28
 
20
0
0
20
Total losses included in other comprehensive income
(8,705)
0
0
(8,705)
 
(11,503)
0
0
(11,503)
Purchases
0
12
0
12
 
0
0
0
0
Sales/calls/principal reductions
(464)
(42)
0
(506)
 
(174)
(2)
0
(176)
Commitments to originate real estate loans held for sale, net
0
0
38
38
 
0
0
0
0
Ending balance
$45,420
$4,215
$180
$49,815
 
$50,325
$4,256
$0
$54,581

 
Nine Months Ended September 30,
 
2009
 
2008
(000's omitted)
Pooled trust preferred 
securities
Other equity securities
Commitments
to originate
real estate
loans for sale
Total
 
Pooled trust preferred
securities
Other equity securities
Commitments
to originate
real estate
loans for sale
Total
Beginning balance
$49,865
$4,261
$0
$54,126
 
$72,300
$5,054
$0
$77,354
Total gains (losses) included in earnings
81
0
0
81
 
58
(14)
0
44
Total losses included in other comprehensive income
(3,286)
0
0
(3,286)
 
(21,652)
0
0
(21,652)
Purchases
0
54
0
54
 
0
34
0
34
Sales/calls/principal reductions
(1,240)
(100)
0
(1,340)
 
(381)
(818)
0
(1,199)
Commitments to originate real estate loans held for sale, net
0
0
180
180
 
0
0
0
0
Ending balance
$45,420
$4,215
$180
$49,815
 
$50,325
4,256
$0
$54,581


 
17

 

Assets and liabilities measured on a non-recurring basis:
 
September 30, 2009
 
December 31, 2008
(000's omitted)
Level 1
Level 2
Level 3
Total Fair Value
 
Level 1
Level 2
Level 3
Total Fair Value
Impaired loans
$0
$0
$2,650
$2,650
 
$0
$0
$850
$850
Goodwill
n/a
n/a
n/a
n/a
 
0
0
5,579
5,579
Mortgage servicing rights
0
0
1,376
1,376
 
n/a
n/a
n/a
n/a
   Total
$0
$0
$4,026
$4,026
 
$0
$0
$6,429
$6,429

Originated mortgage servicing rights are recorded at their fair value at the time of sale of the underlying loan, and are amortized in proportion to and over the period of estimated net servicing income.  In accordance with GAAP, the Company must record impairment charges, on a nonrecurring basis, when the carrying value of certain strata exceed their estimated fair value.  The fair value of mortgage servicing rights is based on a valuation model incorporating inputs that market participants would use in estimating future net servicing income.  Such inputs include estimates of the cost of servicing loans, appropriate discount rate and prepayment speeds.  The amount of impairment recognized is the amount by which the carrying value of the capitalized servicing rights for a stratum exceed estimated fair value.  Impairment is recognized through a valuation allowance.  Due primarily to an increase in the cost of servicing and an increase in the expected prepayment speed of the Company’s sold loan portfolio with servicing retained, the fair value of the Company’s mortgage servicing rights declined during the three quarters of 2009.  As a result of this decline, the Company established a valuation allowance of $0.3 million at September 30, 2009.    These inputs are considered to be unobservable and contribute to the Level 3 classification of mortgage servicing rights.

 
Loans are generally not recorded at fair value on a recurring basis.  Periodically, the Company records nonrecurring adjustment to the carrying value of loans based on fair value measurements for partial charge-offs of the uncollectible portions of those loans.  Nonrecurring adjustments also include certain impairment amounts for collateral-dependent loans calculated when establishing the allowance for credit losses. Such amounts are generally based on the fair value of the underlying collateral supporting the loan and, as a result, the carrying value of the loan less the calculated valuation amount does not necessarily represent the fair value of the loan. Real estate collateral is typically valued using independent appraisals or other indications of value based on recent comparable sales of similar properties or assumptions generally observable in the marketplace, adjusted based on non-observable inputs and the related nonrecurring fair value measurement adjustments and have generally been classified as Level 3. Estimates of fair value used for other collateral supporting commercial loans generally are based on assumptions not observable in the marketplace and, therefore, such valuations have been classified as Level 3.

The Company evaluates goodwill for impairment on an annual basis, or more often if events or circumstances indicate there may be impairment.  The fair value of each reporting unit is compared to the carrying amount of that reporting unit in order to determine if impairment is indicated.  If so, the implied fair value of the reporting units’ goodwill is compared to its carrying amount and the impairment loss is measured by the excess of the carrying value of the goodwill over fair value of the goodwill.  In such situations, the Company performs a discounted cash flow modeling technique that requires management to make estimates regarding the amount and timing of expected future cash flows of the assets and liabilities of the reporting unit that enable the Company to calculate the implied fair value of the goodwill.  It also requires use of a discount rate that reflects the current return requirement of the market in relation to present risk-free interest rates, required equity market premiums and company-specific risk indicators.  As a result of the significant declines the equity markets experienced in 2008, management determined a triggering event had occurred and the goodwill associated with Nottingham Advisors, one of the Company’s wealth management businesses, was tested for impairment during the fourth quarter of 2008.  Based on the goodwill valuation performed in the fourth quarter of 2008 using Level 3 inputs, the Company recognized an impairment charge and wrote down the carrying value of the goodwill by $1.7 million to $5.6 million.

The Company determines fair values based on quoted market values where available or on estimates using present values or other valuation techniques.  Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows.  In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument.  Certain financial instruments and all nonfinancial instruments are excluded from fair value disclosure requirements.  Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.  The fair value of investment securities has been disclosed in footnote D.  The carrying amounts and estimated fair values of the Company’s other financial instruments at September 30, 2009 and December 31, 2008 are as follows:
 
 

 
18

 


   
September 30, 2009
 
December 31, 2008
   
Carrying
Fair
 
Carrying
Fair
(000's omitted)
 
Value
Value
 
Value
Value
Financial assets:
           
   Net loans
 
$3,046,021
$3,075,321
 
$3,096,565
$3,135,832
Financial liabilities:
           
   Deposits
 
3,888,245
3,905,998
 
3,700,812
3,719,557
   Borrowings
 
756,442
838,745
 
760,558
869,162
   Subordinated debt held by unconsolidated subsidiary trusts
 
101,993
76,486
 
101,975
61,409
          
The following is a further description of the principal valuation methods used by the Company to estimate the fair values of its financial instruments.
 
 
Loans – Fair values for variable rate loans that reprice frequently are based on carrying values.  Fair values for fixed rate loans are estimated using discounted cash flows and interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.  The allowance for loan losses is considered a reasonable discount for credit risk.

Deposits – The fair value of demand deposits, interest-bearing checking deposits, savings accounts and money market deposits is the amount payable on demand at the reporting date.  The fair value of time deposit obligations are based on current market rates for similar products.

Borrowings - Fair values for long-term borrowings are estimated using discounted cash flows and interest rates currently being offered on similar borrowings.

Subordinated debt held by unconsolidated subsidiary trusts - The fair value of subordinated debt held by unconsolidated subsidiary trusts are estimated using discounted cash flows and interest rates currently being offered on similar securities.

Other financial assets and liabilities – Cash and cash equivalents, accrued interest receivable and accrued interest payable have fair values which approximate the respective carrying values because the instruments are payable on demand or have short-term maturities and present relatively low credit risk and interest rate risk.

NOTE K:  SEGMENT INFORMATION

Operating segments are components of an enterprise, which are evaluated regularly by the chief operating decision maker in deciding how to allocate resources and assess performance.  The Company’s chief operating decision maker is the President and Chief Executive Officer of the Company. The Company has identified “Banking” as its reportable operating business segment.  The Banking segment provides full-service banking to consumers, businesses and governmental units in northern, central and western New York as well as northeastern Pennsylvania.

Immaterial operating segments of the Company’s operations, which do not have similar characteristics to the banking segment and do not meet the quantitative thresholds requiring disclosure, are included in the “Other” category.  Revenues derived from these segments includes administration, consulting and actuarial services provided to sponsors of employee benefit plans, broker-dealer and investment advisory services, asset management services to individuals, corporate pension and profit sharing plans, trust services and insurance commissions from various insurance related products and services.  The accounting policies used in the disclosure of business segments are the same as those described in the summary of significant accounting policies (See Note A, Summary of Significant Accounting Policies of the most recent Form 10-K for the year ended December 31, 2008 filed with the SEC on March 13, 2009).


 
19

 

Information about reportable segments and reconciliation of the information to the consolidated financial statements follows:

 
For the Three Months Ended
 
September 30, 2009
 
September 30, 2008
(000's omitted) 
Banking
Other
Consolidated
Total
 
Banking
Other
Consolidated
Total
               
Net interest income
$41,825
$27
$41,852
 
$37,022
$51
$37,073
Provision for loan losses
2,375
0
2,375
 
1,985
0
1,985
Noninterest income excluding gain on investment securities and debt extinguishments
11,567
9,239
20,806
 
9,775
9,608
19,383
Gain on investment securities
7
0
7
 
0
0
0
Amortization of intangible assets
1,787
239
2,026
 
1,438
289
1,727
Other operating expenses
34,143
7,942
42,085
 
30,051
7,478
37,529
Income before income taxes
$15,094
$1,085
$16,179
 
$13,323
$1,892
$15,215
 
 
 
For the Nine Months Ended
 
September 30, 2009
 
September 30, 2008
 
Banking
Other
Consolidated
Total
 
Banking
Other
Consolidated
Total
Net interest income
$122,499
$53
$122,552
 
$107,930
$181
$108,111
Provision for loan losses
7,200
0
7,200
 
4,335
0
4,335
Noninterest income excluding gain on investment securities and debt extinguishments
34,000
27,811
61,811
 
27,158
27,262
54,420
Gain on investment securities
7
0
7
 
230
0
230
Amortization of intangible assets
5,479
755
6,234
 
4,394
509
4,903
Other operating expenses
105,625
24,136
129,761
 
88,507
21,175
109,682
Income before income taxes
$38,202
$2,973
$  41,175
 
$38,082
$5,759
$  43,841
               
Assets
$5,337,472
$40,623
$5,378,095
 
$4,722,300
$44,219
$4,766,519
Goodwill
$287,411
$13,347
$300,758
 
$221,361
$14,362
$235,723
 
 
NOTE L:  DERIVATIVE INSTRUMENTS

The Company is party to derivative financial instruments in the normal course of its business to meet the financing needs of its customers and to manage its own exposure to fluctuations in interest rates.  These financial instruments have been limited to interest rate swap agreements, commitments to originate real estate loans held for sale and forward sales commitments.  The Company does not hold or issue derivative financial instruments for trading or other speculative purposes.

The Company enters into forward sales commitments for the future delivery of residential mortgage loans, and interest rate lock commitments to fund loans at a specified interest rate.  The forward sales commitments are utilized to reduce interest rate risk associated with interest rate lock commitments and loans held for sale.  Changes in the estimated fair value of the forward sales commitments and interest rate lock commitments subsequent to inception are based on changes in the fair value of the underlying loan resulting from the fulfillment of the commitment and changes in the probability that the loan will fund within the terms of the commitment, which is affected primarily by changes in interest rates and the passage of time.  At inception and during the life of the interest rate lock commitment, the Company includes the expected net future cash flows related to the associated servicing of the loan as part of the fair value measurement of the interest rate lock commitments.  These derivatives are recorded at fair value.

The Company utilizes interest rate swap agreements as part of the management of interest rate risk to modify the repricing characteristics of certain of its borrowings.  The interest rate swap has been designated as a qualifying cash flow hedge.  See further details of interest rate swap agreements in Note H to the consolidated financial statements as of December 31, 2008.


 
20

 

The following table presents the Company’s derivative financial instruments, their estimated fair values, and balance sheet location as of September 30, 2009:

 
As of September 30, 2009
 
 
Asset Derivatives
 
Liability Derivatives
 
(000's omitted)
Location
Notional
Fair Value
 
Location
Notional
Fair Value
 
Derivatives designated as hedging instruments:
               
   Interest rate swap agreement
       
Other liabilities
($75,000)
($5,652)
 
Derivatives not designated as hedging instruments:
               
   Commitments to originate real estate loans for sale
Other assets
$8,004
$180
         
   Forward sales contracts
       
Other liabilities
($5,886)
(73)
 
Total derivatives
   
$180
     
($5,725)
 

The following table presents the Company’s derivative financial instruments and the location of the net gain or loss recognized in the statement of income for the three and nine months ended September 30, 2009:

     
Gain/(Loss) Recognized in the Statement of Income
(000's omitted)
Location
 
Three Months Ending September 30, 2009
 
Nine Months Ending September 30, 2009
Interest rate swap agreement
Interest on subordinated debt held by unconsolidated subsidiary trusts
 
($806)
 
($2,035)
Interest rate lock commitments
Mortgage banking and other services
 
38
 
180
Forward sales commitments
Mortgage banking and other services
 
(247)
 
(73)
Total
   
($1,015)
 
($1,928)

The amount of gain (loss) recognized during the three and nine months ended September 30, 2009 in other comprehensive income related to the interest rate swap accounted for as a hedging instrument was approximately ($69,000) and $658,000, respectively.  The amount of loss reclassified from accumulated other comprehensive income into income (effective portion) amounted to $806,000 and $2,035,000 for the three and nine months ending September 30, 2009, respectively, and is located in interest expense on subordinated debt held by unconsolidated trusts.

 
21

 

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

Introduction

This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) primarily reviews the financial condition and results of operations of Community Bank System, Inc. (the “Company” or “CBSI”) as of and for the three and nine months ended September 30, 2009 and 2008, although in some circumstances the second quarter of 2009 is also discussed in order to more fully explain recent trends.  The following discussion and analysis should be read in conjunction with the Company's Consolidated Financial Statements and related notes that appear on pages 3 through 21.  All references in the discussion to the financial condition and results of operations are to those of the Company and its subsidiaries taken as a whole.

Unless otherwise noted, the term “this year” refers to results in calendar year 2009, “third quarter” refers to the quarter ended September 30, 2009, earnings per share (“EPS”) figures refer to diluted EPS, and net interest income and net interest margin are presented on a fully tax-equivalent (“FTE”) basis.
 
 
This MD&A contains certain forward-looking statements with respect to the financial condition, results of operations and business of the Company.  These forward-looking statements involve certain risks and uncertainties.  Factors that may cause actual results to differ materially from those proposed by such forward-looking statements are set herein under the caption, “Forward-Looking Statements,” on page 38.

Critical Accounting Policies

As a result of the complex and dynamic nature of the Company’s business, management must exercise judgment in selecting and applying the most appropriate accounting policies for its various areas of operations.  The policy decision process not only ensures compliance with the latest generally accepted accounting principles (“GAAP”), but also reflects management’s discretion with regard to choosing the most suitable methodology for reporting the Company’s financial performance.  It is management’s opinion that the accounting estimates covering certain aspects of the business have more significance than others due to the relative importance of those areas to overall performance, or the level of subjectivity in the selection process.  These estimates affect the reported amounts of assets and liabilities and disclosures of revenues and expenses during the reporting period.  Actual results could differ from those estimates.  Management believes that critical accounting estimates include:

·  
Allowance for loan losses - The allowance for loan losses reflects management’s best estimate of probable losses inherent in the loan portfolio.  Determination of the allowance is inherently subjective.  It requires significant estimates including the amounts and timing of expected future cash flows on impaired loans and the amount of estimated losses on pools of homogeneous loans which is based on historical loss experience and consideration of current economic and portfolio trends, all of which may be susceptible to significant change.
 
·  
Investment securities - Investment securities are classified as held-to-maturity, available-for-sale, or trading.  The appropriate classification is based partially on the Company’s ability to hold the securities to maturity and largely on management’s intentions with respect to either holding or selling the securities.  The classification of investment securities is significant since it directly impacts the accounting for unrealized gains and losses on securities.  Unrealized gains and losses on available-for-sale securities are recorded in accumulated other comprehensive income or loss, as a separate component of shareholders’ equity and do not affect earnings until realized.  The fair values of the investment securities are generally determined by reference to quoted market prices, where available.  If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments, or a discounted cash flow model using market estimates of interest rates and volatility.  Investment securities with significant declines in fair value are evaluated to determine whether they should be considered other-than–temporarily impaired.  An unrealized loss is generally deemed to be other-than-temporary and a credit loss is deemed to exist if the present value of the expected future cash flows is less than the amortized cost basis of the debt security.  The credit loss component of an other-than-temporary impairment write-down is recorded in earnings, while the remaining portion of the impairment loss is recognized in other comprehensive income (loss), provided the Company does not intend to sell the underlying debt security and it is not more likely than not that the Company will be required to sell the debt security prior to recovery.

·  
Actuarial assumptions associated with pension, post-retirement and other employee benefit plans - These assumptions include discount rate, rate of future compensation increases and expected return on plan assets.

·  
Provision for income taxes - The Company is subject to examinations from various taxing authorities.  Such examinations may result in challenges to the tax return treatment applied by the Company to specific transactions.  Management believes that the assumptions and judgments used to record tax related assets or liabilities have been appropriate.  Should tax laws change or the taxing authorities determine that management’s assumptions were inappropriate, an adjustment may be required which could have a material effect on the Company’s results of operations.

·  
Carrying value of goodwill and other intangible assets - The carrying value of goodwill and other intangible assets is based upon discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows.  It also requires use of a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, required equity market premiums and company-specific risk indicators.

A summary of the accounting policies used by management is disclosed in Note A, “Summary of Significant Accounting Policies” on pages 49-54 of the most recent Form 10-K (fiscal year ended December 31, 2008) filed with the Securities and Exchange Commission on March 13, 2009.
 
22

 
Executive Summary

The Company’s business philosophy is to operate as a community bank with local decision-making, principally in non-metropolitan markets, providing a broad array of banking and financial services to retail, commercial and municipal customers.

The Company’s core operating objectives are: (i) grow the branch network, primarily through a disciplined acquisition strategy, and certain selective de novo expansions, (ii) build high-quality, profitable loan and deposit portfolios using both organic and acquisition strategies, (iii) increase the noninterest income component of total revenues through development of banking-related fee income, growth in existing financial services business units, and the acquisition of additional financial services and banking businesses, and (iv) utilize technology to deliver customer-responsive products and services and reduce operating costs.

Significant factors management reviews to evaluate achievement of the Company’s operating objectives and its operating results and financial condition include, but are not limited to: net income and earnings per share, return on assets and equity, net interest margins, noninterest income, operating expenses, asset quality, loan and deposit growth, capital management, performance of individual banking and financial services units, liquidity and interest rate sensitivity, enhancements to customer products and services, technology advancements, market share, peer comparisons, and the performance of acquisition and integration activities.

On November 7, 2008, the Company acquired 18 branch-banking centers in northern New York from Citizens Financial Group, Inc. (“Citizens”) in an all cash transaction.  The Company acquired approximately $109 million in loans and $565 million in deposits at a blended deposit premium of 13%.  The results of operations for the 18 branches acquired from Citizens have been included in the consolidated financial statements since that date.  In support of the transaction, the Company raised approximately $50 million of equity capital in the form of common stock in October 2008.

On July 7, 2008, Benefit Plans Administrative Services, Inc. (“BPAS”), a wholly owned subsidiary of the company, acquired the Philadelphia division of Alliance Benefit Group MidAtlantic (“ABG”) from BenefitStreet, Inc. in an all cash transaction.  ABG provides retirement plan consulting, daily valuation administration, actuarial and ancillary support services.  The results of ABG’s operations have been included in the consolidated financial statements since that date.

Third quarter and September year-to-date 2009 net income of $12.5 million and $32.1 million, respectively, was $0.7 million or 5.7% higher and $1.9 million or 5.6% lower than the respective prior year periods.  Earnings per share were $0.38 and $0.97 for the three and nine months ended September 30, 2009, respectively, a decrease of $0.01 and $0.15, from the equivalent prior year periods.  Higher operating expenses, principally from acquisitions completed in 2008, significantly higher FDIC insurance assessments, and higher loan loss provisions were partially offset by higher net interest income generated through organic and acquired growth of both loans and core deposits, and higher noninterest income.  Third quarter and year-to-date 2009 results included the incurrence of an additional $1.0 million and $6.0 million, respectively, of FDIC-insurance related assessments, or $0.02 and $0.14 per share, respectively, above the three and nine month periods of 2008.  Excluding these additional assessments, earnings per share for the quarter were $0.01 higher than the reported results from last year’s third quarter.

Asset quality in the third quarter of 2009 remained stable, and favorable as compared to peer financial organizations.  Loan charge-offs declined from both the third quarter of 2008, as well as the previous quarters of 2009.  Nonperforming loan and delinquency ratios and the provision for loan losses were up versus the third quarter of 2008, but they continue to be below long-term historical levels.  The Company experienced year-over-year loan growth in the consumer installment and business lending portfolios, due to organic and acquired growth.  The investment portfolio, including cash equivalents, increased as compared to both the third quarter of 2008 and June 30, 2009 due to the net liquidity created from the acquisition of Citizens in the fourth quarter of 2008 and organic deposit growth.  Average deposits increased in the third quarter of 2009 as compared to both the second quarter of 2009 and the third quarter of 2008, reflective of the Citizens acquisition and organic growth in core deposits.  External borrowings decreased from the third quarter of 2008 and remained consistent with the second quarter of 2009.
 
 

23

 

 
Net Income and Profitability
 
As shown in Table 1, net income for the third quarter of $12.5 million increased $0.7 million or 5.7% versus the third quarter of 2008.  September year-to-date net income of $32.1 million declined $1.9 million or 5.6% as compared to the first nine months of 2008.  Earnings per share for the third quarter and September year-to-date periods of $0.38 and $0.97, respectively, declined 2.6% and 13.4% versus the comparable periods of 2008.  As compared to the second quarter of 2009, net income increased $3.3 million or 36% and earnings per share increased $0.10 or 36%.

Third quarter net interest income of $41.9 million was up $4.8 million or 13% from the comparable prior year period and net interest income for the first nine months of 2009 increased $14.4 million or 13% over the first nine months of 2008.  The current quarter’s provision for loan losses increased $0.4 million as compared to the third quarter of 2008 and increased $2.9 million for the first nine months of 2009 as compared to the same period of 2008, reflective of a continued higher level of net charge-offs and the general deteriorating economic conditions.  Third quarter noninterest income, excluding securities gains and losses, was $20.8 million, up $1.4 million or 7.3% from the third quarter of 2008, while year-to-date noninterest income of $61.8 million increased $7.4 million or 14% from the prior year level.  Operating expenses of $44.1 million for the quarter and $136.0 million for the first nine months of 2009 were up $4.9 million or 12% and $21.4 million or 19%, respectively, from the comparable prior year periods.  A significant portion of the increase was attributable to the acquisitions of ABG and Citizens during the third and fourth quarters of 2008, as well as higher FDIC insurance assessments due to significant increases in premium rates and the special assessment in the second quarter of 2009, as well as an increase in pension costs.

As reflected in Table 1, the primary reasons for higher earnings in the quarter were higher noninterest income and net interest income partially offset by higher operating expenses and loan loss provision.  Earnings per share declined slightly due to the higher number of shares outstanding which was mostly driven by the equity offering in the fourth quarter of 2008.  For the nine months ended September 30, 2009, the primary reason for lower earnings were higher operating expenses and loan loss provision, partially offset by higher net interest income and noninterest income.  Net interest income for the third quarter and year-to-date period increased as compared to the comparable periods of 2008 as a result of acquired and organic loan growth and increased levels of investments including cash equivalents, partially offset by a lower net interest margin.  Excluding security gains and losses, noninterest income increased due to increased activity in the secondary mortgage banking business, growth in the Company’s employee benefits consulting and plan administration business, mostly as a result of the acquisition of ABG, as well as higher banking service fees and debit card related revenues from the acquired branches.  Higher net charge-offs and generally unfavorable economic trends were the primary reasons for the increase in loan loss provision.  Operating expenses increased for the quarter and year-to-date periods, primarily due to costs associated with the two acquisitions in the last year, as well as higher FDIC insurance assessments and higher pension costs related to the underlying asset performance in 2008.

A condensed income statement is as follows:

Table 1: Summary Income Statements

   
Three Months Ended
 
Nine Months Ended
   
September 30,
 
September 30,
(000's omitted, except per share data)
 
2009
2008
 
2009
2008
Net interest income
 
$41,852
$37,073
 
$122,552
$108,111
Provision for loan losses
 
2,375
1,985
 
7,200
4,335
Noninterest income excluding security gains/losses
 
20,806
19,383
 
61,811
54,420
Gain on sales of investment securities
 
7
0
 
7
230
Operating expenses
 
44,111
39,256
 
135,995
114,585
Income before taxes
 
16,179
15,215
 
41,175
43,841
Income taxes
 
3,724
3,429
 
9,100
9,870
Net income
 
$12,455
$11,786
 
$32,075
$33,971
             
Diluted earnings per share
 
$0.38
$0.39
 
$0.97
$1.12

 
24


Net Interest Income

Net interest income is the amount by which interest and fees on earning assets (loans, investments and cash) exceed the cost of funds, primarily interest paid to the Company's depositors and interest on external borrowings.  Net interest margin is the difference between the gross yield on earning assets and the cost of interest-bearing funds as a percentage of earning assets.

As shown in Table 2a, net interest income (with nontaxable income converted to a fully tax-equivalent basis) for the third quarter of 2009 was $45.8 million, a $5.1 million increase from the same period last year.  A $554 million increase in third quarter interest-earning assets versus the prior year had a greater impact than the $438 million increase in average interest-bearing liabilities and a four-basis point decrease in the net interest margin.  As reflected in Table 3, the volume increase from interest bearing assets and the rate decrease on interest bearing liabilities had a $15.5 million favorable impact on net interest income, while the volume increase from interest bearing liabilities and rate decrease on interest bearing assets had a $10.4 million unfavorable impact on net interest income.   The lower yields on interest bearing assets had a greater unfavorable impact on net interest margin than the decrease in the cost of funding.   September YTD net interest income of $134.4 million increased $15.0 million or 13% from the year-earlier period.  A $560 million increase in interest bearing assets more than offset a $462 million increase in interest bearing liabilities and a two-basis point decrease in the net interest margin.  The increase in interest earning assets and the lower rate on interest bearing liabilities had a $47.5 million favorable impact that was partially offset by a $32.5 million unfavorable impact from the decrease in the rate on interest bearing assets and the increase in interest-bearing liability balances.

Higher third quarter and September year-to-date average loan balances were attributable to $111 million of loans acquired in the Citizens acquisition and organic growth in the business lending and consumer installment portfolios.  As compared to the second quarter of 2009, average loans declined $22.8 million primarily from continued principal amortization in the Company’s consumer mortgage and home equity portfolios, combined with its decision to sell the majority of its longer-term, lower rate mortgage originations in the quarter and year-to-date periods.  Average investments and cash equivalents for the third quarter and YTD periods were $435 million and $336 million higher than the respective periods of 2008, reflective of the net liquidity generated from the Citizens acquisition and organic deposit growth.  In comparison to the prior year, total average deposits were up $624 million or 19% for the quarter primarily as a result of the November 2008 acquisition of Citizens, which included $565 million of deposits at the date of acquisition.  On an organic basis, average interest bearing deposits for the third quarter increased $59 million from the third quarter of 2008.  Organic growth in average noninterest bearing deposits was $47 million over the third quarter of 2008.  Quarterly average borrowings decreased $67.9 million as compared to the third quarter of 2008 as a portion of the net liquidity from the branch acquisition was used to eliminate short-term borrowings.

The net interest margin of 3.78% for both the third quarter and year-to-date periods decreased four basis points and two basis points, respectively, versus the same periods in the prior year.  The decline was primarily attributable to a 69-basis point decrease in the earning asset yield for both the quarter and year-to-date periods, as compared to the prior year periods.  The decrease in the earning asset yield is due to a 123-basis point and 108-basis point decline in the investment yields for the third quarter and YTD periods, respectively and a 35-basis point and 46-basis point decline in the loan yields for the third quarter and YTD periods, respectively, as compared to the like periods of 2008.   The change in the earning-asset yield is primarily a result of variable and adjustable-rate loans repricing downward and lower rates on fixed rate new loan volume due to the decline in interest rates to levels below those prevalent in prior years, as well as the Company’s increased holdings of lower yielding cash instruments as it maintains a liquid position in anticipation of improved investment opportunities in future periods.

Partially offsetting these declines was a 68-basis point and a 69-basis point decline in the cost of funds for the quarter and year-to-date periods, respectively, as compared to the same periods of 2008.  The third quarter cost of funds decreased 68 basis points versus the prior year quarter due to a 88-basis point decrease in interest-bearing deposit rates and a seven-basis point decrease in the average interest rate paid on external borrowings.  The decreased cost of funds was reflective of disciplined deposit pricing, whereby interest rates on selected categories of deposit accounts were lowered throughout 2008 and the first nine months of 2009 in response to market conditions.  Additionally, the proportion of customer deposits in higher cost time deposits has declined 7.0 percentage points over the last twelve months, while the percentage of deposits in non-interest bearing and lower cost checking accounts has increased.  The rate paid on long-term borrowings was impacted by the approximately 230 basis point decrease in the three-month LIBOR (London Interbank Offered Rates) over the last twelve months, from which the interest rate on $25 million of the mandatorily redeemable preferred securities is based.
 
25


Tables 2a and 2b below set forth information related to average interest-earning assets and interest-bearing liabilities and their associated yields and rates for the periods indicated.  Interest income and yields are on a fully tax-equivalent basis using marginal income tax rates of 38.46% in 2009 and 38.49% in 2008.  Average balances are computed by accumulating the daily ending balances in a period and dividing by the number of days in that period.  Loan yields and amounts earned include loan fees.  Average loan balances include nonaccrual loans and loans held for sale.

Table 2a: Quarterly Average Balance Sheet

 
Three Months Ended
 
Three Months Ended
 
September 30, 2009
 
September 30, 2008
     
Avg.
     
Avg.
 
Average
 
Yield/Rate
 
Average
 
Yield/Rate
 (000's omitted except yields and rates)
Balance
Interest
Paid
 
Balance
Interest
Paid
Interest-earning assets:
             
  Cash equivalents
$292,545
$200
0.27%
 
$4,320
$24
2.18%
  Taxable investment securities (1)
864,478
9,914
4.55%
 
766,582
9,811
5.09%
  Nontaxable investment securities (1)
560,615
9,532
6.75%
 
511,299
8,758
6.81%
  Loans (net of unearned discount)
3,082,495
46,183
5.94%
 
2,963,504
46,866
6.29%
     Total interest-earning assets
4,800,133
65,829
5.44%
 
4,245,705
65,459
6.13%
Noninterest-earning assets
549,629
     
466,718
   
     Total assets
$5,349,762
     
$4,712,423
   
               
Interest-bearing liabilities:
             
  Interest checking, savings and money market deposits
$1,873,536
2,702
0.57%
 
$1,348,288
2,691
0.79%
  Time deposits
1,290,860
7,910
2.43%
 
1,310,393
12,070
3.66%
  Short-term borrowings
593,385
6,415
4.29%
 
477,139
4,644
3.87%
  Long-term borrowings
265,120
3,009
4.50%
 
449,292
5,336
4.72%
     Total interest-bearing liabilities
4,022,901
20,036
1.98%
 
3,585,112
24,741
2.75%
Noninterest-bearing liabilities:
             
  Demand deposits
708,430
     
590,098
   
  Other liabilities
58,669
     
49,964
   
Shareholders' equity
559,762
     
487,249
   
     Total liabilities and shareholders' equity
$5,349,762
     
$4,712,423
   
               
Net interest earnings
 
$45,793
     
$40,718
 
Net interest spread
   
3.46%
     
3.38%
Net interest margin on interest-earnings assets
   
3.78%
     
3.82%
               
Fully tax-equivalent adjustment
 
$3,941
     
$3,645
 


(1) Averages for investment securities are based on historical cost basis and the yields do not give effect to changes in fair value that is reflected as a component of shareholders’ equity and deferred taxes.



 
26

 

Table 2b: Year-to-Date Average Balance Sheet

 
Nine Months Ended
 
Nine Months Ended
 
September 30, 2009
 
September 30, 2008
     
Avg.
     
Avg.
 
Average
 
Yield/Rate
 
Average
 
Yield/Rate
 (000's omitted except yields and rates)
Balance
Interest
Paid
 
Balance
Interest
Paid
Interest-earning assets:
             
  Cash equivalents
$254,935
$499
0.26%
 
$25,983
$482
2.48%
  Taxable investment securities (1)
833,708
30,445
4.88%
 
760,567
30,303
5.32%
  Nontaxable investment securities (1)
559,417
28,489
6.81%
 
525,530
27,154
6.90%
  Loans (net of unearned discount)
3,109,210
139,340
5.99%
 
2,885,267
139,375
6.45%
     Total interest-earning assets
4,757,270
198,773
5.59%
 
4,197,347
197,314
6.28%
Noninterest-earning assets
542,579
     
467,623
   
     Total assets
$5,299,849
     
$4,664,970
   
               
Interest-bearing liabilities:
             
  Interest checking, savings and money market deposits
$1,789,844
8,616
0.64%
 
$1,304,616
7,926
0.81%
  Time deposits
1,367,146
27,653
2.70%
 
1,356,937
40,569
3.99%
  Short-term borrowings
555,126
17,691
4.26%
 
441,347
13,321
4.03%
  Long-term borrowings
304,608
10,430
4.58%
 
451,971
16,108
4.76%
     Total interest-bearing liabilities
4,016,724
64,390
2.14%
 
3,554,871
77,924
2.93%
Noninterest-bearing liabilities:
             
  Demand deposits
677,323
     
569,764
   
  Other liabilities
53,753
     
53,851
   
Shareholders' equity
552,049
     
486,484
   
     Total liabilities and shareholders' equity
$5,299,849
     
$4,664,970
   
               
Net interest earnings
 
$134,383
     
$119,390
 
Net interest spread
   
3.45%
     
3.35%
Net interest margin on interest-earnings assets
   
3.78%
     
3.80%
               
Fully tax-equivalent adjustment
 
$11,831
     
$11,279
 

(1) Averages for investment securities are based on historical cost basis and the yields do not give effect to changes in fair value that is reflected as a component of shareholders’ equity and deferred taxes.


 
27

 

As discussed above and disclosed in Table 3 below, the quarterly change in net interest income (fully tax-equivalent basis) may be analyzed by segregating the volume and rate components of the changes in interest income and interest expense for each underlying category.
 
Table 3: Rate/Volume

 
3rd Quarter 2009 versus 3rd Quarter 2008
 
Nine Months Ended September 30, 2009 versus September 30, 2008
 
Increase (Decrease) Due to Change in (1)
 
Increase (Decrease) Due to Change in (1)
  Volume Rate Net Change   Volume Rate  Net Change
(000's omitted)
             
Interest earned on:
             
  Cash equivalents
$215
($39)
$176
 
$798
($781)
$17
  Taxable investment securities
1,181
(1,079)
102
 
2,783
(2,641)
142
  Nontaxable investment securities
840
(65)
775
 
1,729
(395)
1,334
  Loans (net of unearned discount)
1,839
(2,522)
(683)
 
10,413
(10,448)
(35)
Total interest-earning assets (2)
8,036
(7,666)
370
 
24,725
(23,267)
1,458
               
Interest paid on:
             
  Interest checking, savings and money market deposits
879
(868)
11
 
2,555
(1,865)
690
  Time deposits
(177)
(3,983)
(4,160)
 
303
(13,219)
(12,916)
  Short-term borrowings
1,217
554
1,771
 
3,593
777
4,370
  Long-term borrowings
(2,099)
(228)
(2,327)
 
(5,068)
(610)
(5,678)
Total interest-bearing liabilities (2)
2,765
(7,470)
(4,705)
 
9,237
(22,771)
(13,534)
               
Net interest earnings (2)
5,290
(215)
5,075
 
15,820
(828)
14,992

(1) The change in interest due to both rate and volume has been allocated in proportion to the relationship of the absolute dollar amounts of such change in each component.

(2) Changes due to volume and rate are computed from the respective changes in average balances and rates and are not a summation of the changes of  the components.





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Noninterest Income

The Company’s sources of noninterest income are of three primary types: 1) general banking services related to loans, deposits and other core customer activities typically provided through the branch network and electronic banking channels (performed by Community Bank, N.A. (“CBNA”) and First Liberty Bank and Trust); 2) employee benefit plan administration, actuarial and consulting services (performed by BPAS); and 3) wealth management services, comprised of trust services (performed by the trust unit within CBNA), investment and insurance products (performed by Community Investment Services, Inc. and CBNA Insurance Agency, Inc.) and asset management (performed by Nottingham Advisors or Nottingham).  Additionally, the Company has periodic transactions, most often net gains (losses) from the sale of investment securities and prepayment of debt instruments.

Table 4: Noninterest Income

   
Three Months Ended
 
Nine months Ended
   
September 30,
 
September 30,
(000's omitted)