cbna10q3rdqtr2010.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, 2010
   
 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 (Sec.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.       
 33,171,330 shares of Common Stock, $1.00 par value, were outstanding on October 31, 2010.


 
1

 


TABLE OF CONTENTS

 
 Part I.     Financial Information    Page
         
 Item 1.    Financial Statements (Unaudited)    
         
        Consolidated Statements of Condition    
        September 30, 2010 and December 31, 2009­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­................................................................................................................................................................................................    3
         
        Consolidated Statements of Income    
        Three and nine months ended September 30, 2010 and 2009..................................................................................................................................................................    4
         
        Consolidated Statement of Changes in Shareholders’ Equity    
        Nine months ended September 30, 2010.....................................................................................................................................................................................................    5
         
        Consolidated Statements of Comprehensive Income    
        Three and nine months ended September 30, 2010 and 2009..................................................................................................................................................................    6
         
        Consolidated Statements of Cash Flows    
        Nine months ended September 30, 2010 and 2009.....................................................................................................................................................................................    7
         
        Notes to the Consolidated Financial Statements    
        September 30, 2010.........................................................................................................................................................................................................................................    8
         
 Item 2.    Management's Discussion and Analysis of Financial Condition and Results of Operations..............................................................................................................    21
         
 Item 3.     Quantitative and Qualitative Disclosures about Market Risk....................................................................................................................................................................    37
         
 Item 4.    Controls and Procedures..................................................................................................................................................................................................................................    38
         
 Part II.    Other Information    
         
 Item 1.    Legal Proceedings.............................................................................................................................................................................................................................................    38
         
 Item 1A.     Risk Factors........................................................................................................................................................................................................................................................    38
         
 Item 2.     Unregistered Sales of Equity Securities and Use of Proceeds...................................................................................................................................................................    38
         
 Item 3.    Defaults Upon Senior Securities.....................................................................................................................................................................................................................    38
         
 Item 4.    (Removed and Reserved).................................................................................................................................................................................................................................    39
         
 Item 5.    Other Information..............................................................................................................................................................................................................................................    39
         
 Item 6.    Exhibits................................................................................................................................................................................................................................................................    39
                
 
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,
 
2010
2009
Assets:
   
   Cash and cash equivalents
$179,556
$361,876
     
   Available-for-sale investment securities (cost of $1,075,896 and $1,083,811, respectively)
1,117,605
1,096,547
     
   Held-to-maturity investment securities (fair value of $645,856 and $340,932, respectively)
597,947
335,936
     
   Other securities, at cost
53,597
54,644
     
   Loans held for sale, at fair value
1,541
1,779
     
   Loans
3,080,397
3,099,485
   Allowance for loan losses
(42,610)
(41,910)
     Net loans
3,037,787
3,057,575
     
   Core deposit intangibles, net
11,659
15,933
   Goodwill
297,692
297,692
   Other intangibles, net
3,335
4,046
     Intangible assets, net
312,686
317,671
     
   Premises and equipment, net
80,219
76,896
   Accrued interest receivable
27,566
25,139
   Other assets
87,713
74,750
     
        Total assets
$5,496,217
$5,402,813
     
Liabilities:
   
   Noninterest-bearing deposits
$738,994
$736,816
   Interest-bearing deposits
3,227,341
3,187,670
      Total deposits
3,966,335
3,924,486
     
  Borrowings
729,508
754,779
  Subordinated debt held by unconsolidated subsidiary trusts
102,018
101,999
  Accrued interest and other liabilities
82,556
55,852
     Total liabilities
4,880,417
4,837,116
     
Commitments and contingencies (See Note H)
   
     
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; 33,989,515 and
33,990
33,631
     33,630,700 shares issued, respectively
   
  Additional paid-in capital
222,207
216,481
  Retained earnings
366,783
342,539
  Accumulated other comprehensive gain (loss)
10,920
(8,784)
  Treasury stock, at cost (827,183 and 830,392 shares, respectively)
(18,100)
(18,170)
     Total shareholders' equity
615,800
565,697
     
     Total liabilities and shareholders' equity
$5,496,217
$5,402,813





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,
   
2010
2009
 
2010
2009
Interest income:
         
 
Interest and fees on loans
$45,094
$46,067
 
$134,618
$138,992
 
Interest and dividends on taxable investments
11,928
9,849
 
35,029
30,082
 
Interest and dividends on nontaxable investments
5,575
5,972
 
16,625
17,868
 
     Total interest income
62,597
61,888
 
186,272
186,942
 
 
         
Interest expense:
         
 
Interest on deposits
7,296
10,612
 
23,646
36,269
 
Interest on borrowings
7,468
7,899
 
22,617
23,471
 
Interest on subordinated debt held by unconsolidated subsidiary trusts
1,509
1,525
 
4,458
4,650
 
     Total interest expense
16,273
20,036
 
50,721
64,390
             
Net interest income
46,324
41,852
 
135,551
122,552
Less:  provision for loan losses
1,400
2,375
 
5,270
7,200
         Net interest income after provision for loan losses
44,924
39,477
 
130,281
115,352
             
Noninterest income:
         
 
Deposit service fees
11,180
10,991
 
33,036
30,247
 
Mortgage banking and other services
2,078
895
 
4,116
4,738
 
Benefit plan administration, consulting and actuarial fees
7,256
6,969
 
22,415
20,575
 
Trust, investment and asset management fees
2,400
1,951
 
7,442
6,251
 
Gain on investment securities & debt extinguishments
-
7
 
-
7
         Total noninterest income
22,914
20,813
 
67,009
61,818
             
Operating expenses:
         
 
Salaries and employee benefits
23,056
23,166
 
68,501
69,282
 
Occupancy and equipment
5,575
5,533
 
17,414
17,448
 
Data processing and communications
5,430
5,328
 
15,853
15,349
 
Amortization of intangible assets
1,277
2,026
 
4,985
6,234
 
Legal and professional fees
1,014
1,367
 
3,819
3,969
 
Office supplies and postage
1,382
1,245
 
3,942
4,092
 
Business development and marketing
1,250
1,469
 
3,995
4,818
 
FDIC insurance premiums
1,599
1,670
 
4,656
7,066
 
Other
3,769
2,307
 
9,600
7,737
 
     Total operating expenses
44,352
44,111
 
132,765
135,995
             
Income before income taxes
23,486
16,179
 
64,525
41,175
Income taxes
6,224
3,724
 
17,099
9,100
Net income
$17,262
$12,455
 
$47,426
$32,075
             
Basic earnings per share
$0.52
$0.38
 
$1.43
$0.98
Diluted earnings per share
$0.51
$0.38
 
$1.42
$0.97
Dividends declared per share
$0.24
$0.22
 
$0.70
$0.66
           




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, 2010
(In Thousands, Except Share Data)


         
Accumulated
   
 
Common Stock
Additional
 
Other
   
 
Shares
Amount
Paid-In
Retained
Comprehensive
Treasury
 
 
Outstanding
Issued
Capital
Earnings
(Loss)Income
Stock
Total
               
Balance at December 31, 2009
          32,800,308
$33,631
$216,481
$342,539
($8,784)
($18,170)
$565,697
               
Net income
     
47,426
   
47,426
               
Other comprehensive income, net of tax
       
19,704
 
19,704
               
Dividends declared:
             
  Common, $0.70 per share
     
(23,182)
   
(23,182)
               
Common stock issued under Stock Plan,
             
  including tax benefits of $584
362,024
359
2,959
   
 70
3,388
 
             
Stock-based compensation
   
2,767
     
2,767
               
Balance at September 30, 2010
33,162,332
$33,990
$222,207
$366,783
$10,920
($18,100)
$615,800

 

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,
   
2010
2009
 
2010
2009
             
Other comprehensive income, before tax:
           
Change in pension liabilities
 
$298
$3
 
$894
$1,779
Change in unrealized losses on derivative instruments used in cash flow hedges
 
401
(112)
 
1,045
1,069
Unrealized gains on securities:
           
     Unrealized holding gains arising during period
 
7,920
14,388
 
28,972
9,786
     Reclassification adjustment for gains included in net income
 
0
(7)
 
0
(7)
Other comprehensive income, before tax:
 
8,619
14,272
 
30,911
12,627
Income tax expense related to other comprehensive (loss) income
 
(3,034)
(4,846)
 
(11,207)
(4,528)
Other comprehensive income (loss), net of tax:
 
5,585
9,426
 
19,704
8,099
Net income
 
17,262
12,455
 
47,426
32,075
Comprehensive income
 
$22,847
$21,881
 
$67,130
$40,174

 



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,
 
2010
2009
Operating activities:
   
  Net income
$47,426
$32,075
  Adjustments to reconcile net income to net cash provided by operating activities:
   
     Depreciation
7,447
7,696
     Amortization of intangible assets
4,985
6,234
     Net gain on sale of investment securities
0
(7)
     Net amortization (accretion) of premiums & discounts on securities, loans and borrowings
1,957
1,020
     Stock-based compensation
2,767
2,298
     Provision for loan losses
5,270
7,200
     Amortization of mortgage servicing rights
574
547
     Appreciation of bank-owned life insurance policies
(356)
(348)
 Net gain on sale of loans and other assets
(46)
(950)
     Net change in loans held for sale
1,011
(519)
     Change in other assets and liabilities
495
(9,367)
       Net cash provided by operating activities
71,530
45,879
Investing activities:
   
  Proceeds from sales of available-for-sale investment securities
0
27
  Proceeds from maturities of held-to-maturity investment securities
60,039
72,735
  Proceeds from maturities of available-for-sale investment securities
116,889
199,555
  Purchases of held-to-maturity investment securities
(323,745)
(279,358)
  Purchases of available-for-sale investment securities
(109,227)
(86,601)
  Sales of other securities
1,061
46
  Purchases of other securities
(5)
(436)
  Net decrease in loans
14,519
43,345
  Cash paid for acquisition
0
(332)
  Capital expenditures
(11,497)
(9,079)
       Net cash used in investing activities
(251,966)
(60,098)
Financing activities:
   
  Net change in deposits
41,849
187,433
  Net change in borrowings
(25,271)
(4,116)
  Issuance of common stock
3,388
386
  Cash dividends paid
(22,434)
(21,585)
  Excess tax benefits from stock-based compensation
584
82
       Net cash (used in)/provided by financing activities
(1,884)
162,200
Change in cash and cash equivalents
(182,320)
147,981
Cash and cash equivalents at beginning of period
361,876
213,753
Cash and cash equivalents at end of period
$179,556
$361,734
Supplemental disclosures of cash flow information:
   
  Cash paid for interest
$51,145
$64,824
  Cash paid for income taxes
6,050
2,085
Supplemental disclosures of noncash financing and investing activities:
   
  Dividends declared and unpaid
7,959
7,203
  Transfers from loans to other real estate
3,639
1,599










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, 2010

NOTE A:  BASIS OF PRESENTATION

The interim financial data as of September 30, 2010 and for the three and nine months ended September 30, 2010 and 2009 is unaudited; however, in the opinion of Community Bank System, Inc. (“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.  Certain prior year amounts in the consolidated financial statements and notes thereto have been reclassified to conform to the current year’s presentation.

NOTE B:  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 incurred 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 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 allowances, if any, to derive the required allowance for loan losses to be reflected on the Consolidated Statement of Condition.  As it has in prior periods, the Company strives to refine and enhance its loss evaluation and estimation processes continually.  In 2009, the Company developed and utilized more granular historical loss factors on a portfolio specific basis, as well as enhanced its use of both Company specific and macro economic qualitative factors.  These enhancements did not result in a significant change to the determined allowance levels.

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 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, 2010.

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

The Company conducts an assessment of all securities in an unrealized loss position to determine if other-than-temporary impairment (“OTTI”) exists on a monthly basis. An unrealized loss exists when the current fair value of an individual security is less than its amortized cost basis.  The OTTI assessment considers the security structure, recent security collateral performance metrics if applicable, external credit ratings, failure of the issuer to make scheduled interest or principal payments, judgment and expectations of future performance, and relevant independent industry research, analysis and forecasts. The severity of the impairment and the length of time the security has been impaired is also considered in the assessment.  The assessment of whether an OTTI decline exists is performed on each security, regardless of the classification of the security as available-for-sale or held-to-maturity and involves a high degree of subjectivity and judgment that is based on the information available to management at a point in time.
 
 
8

 
 
An OTTI loss must be recognized for a debt security in an unrealized loss position if there is an intent to sell the security or it is more likely than not the Company will be required to sell the security prior to recovery of its amortized cost basis. In this situation, the amount of loss recognized in income is equal to the difference between the fair value and the amortized cost basis of the security. Even if it is not expected that the security will be sold, an evaluation of the expected cash flows to be received is performed to determine if a credit loss has occurred. For debt securities, a critical component of the evaluation for OTTI is the identification of credit-impaired securities, where the Company does not expect to receive cash flows sufficient to recover the entire amortized cost basis of the security.  In the event of a credit loss, only the amount of impairment associated with the credit loss would be recognized in income. The portion of the unrealized loss relating to other factors, such as liquidity conditions in the market or changes in market interest rates, is recorded in accumulated other comprehensive loss.

Equity securities are also evaluated to determine whether the unrealized loss is expected to be recoverable based on whether evidence exists to support a realizable value equal to or greater than the amortized cost basis. If it is probable that the amortized cost basis will not be recovered, taking into consideration the estimated recovery period and the ability to hold the equity security until recovery, OTTI is recognized in earnings equal to the difference between the fair value and the amortized cost basis of the security.
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
The Company and its subsidiaries file a consolidated federal income tax return.  Provisions for income taxes are based on taxes currently payable or refundable as well as deferred taxes that 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.

Benefits from tax positions should be recognized in the financial statements only when it is more likely than not that the tax position will be sustained upon examination by the appropriate taxing authority having full knowledge of all relevant information. A tax position meeting the more-likely-than-not recognition threshold should be measured at the largest amount of benefit for which the likelihood of realization upon ultimate settlement exceeds 50 percent.

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 initial and ongoing 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 discount rate, rate of future compensation increases and expected return on plan assets.

Subsequent Events
On October 25, 2010, the Company announced that it has entered into a definitive agreement to acquire The Wilber Corporation, (“Wilber”) parent company of the Wilber National Bank in Oneonta, NY, for $101.8 million in stock and cash.  The acquisition will extend the Company’s Central New York service area to the contiguous Central Leatherstocking, Greater Capital District, and Catskills regions of Upstate New York.  The acquisition is expected to close during the second quarter of 2011, pending both customary regulatory and Wilber shareholder approval.  Upon the completion of the merger, Community Bank will add 22 branch locations in eight counties, and deposits of approximately $775 million.


 
9

 

On November 4, 2010 the Company was served with a complaint naming the Company, The Wilber Corporation, and the Wilber directors in a class action lawsuit filed with the New York State Supreme Court in Otsego County, New York.  The complaint alleges that CBSI aided and abetted various purported breaches of fiduciary duties by Wilber and its directors involving the appropriateness of the sale process conducted by Wilber and fairness of the merger consideration and terms in connection with the proposed merger agreement.  The Company believes that the allegations are without merit and intends to vigorously defend the complaint.

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.    

 New Accounting Pronouncements
In January 2010, the Financial Accounting Standards Board (“FASB”) issued ASU 2010-6, Fair Value Measurements and Disclosures (Topic 820), Improving Disclosures About Fair Value Measurements. This guidance requires new disclosures as follows: 1) transfers in and out of Levels 1 and 2 and the reasons for the transfers, 2) additional breakout of asset and liability categories and 3) purchases, sales, issuances and settlements to be reported separately in the Level 3 rollforward. This guidance was effective for the Company for first quarter 2010 reporting, with the exception of item 3, which is effective beginning with first quarter 2011 reporting, and did not impact the Company’s consolidated financial statements.

In July 2010, the FASB issued ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.  This guidance requires entities to provide enhanced disclosures in the financial statements about their loans including credit risk exposures and the allowance for loan losses.  While some of the required disclosures are already included in the Management Discussion and Analysis section of the interim and annual filings, the new guidance will require enhanced disclosure to be included in the notes to the financial statements.  The adoption of this guidance is not expected to have a material impact on the Company’s consolidated financial statements.

NOTE C:  INVESTMENT SECURITIES

The amortized cost and estimated fair value of investment securities as of September 30, 2010 and December 31, 2009 are as follows:

 
September 30, 2010
 
December 31, 2009
   
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
$463,171
$41,732
$0
$504,903
 
$153,761
$2,185
$538
$155,408
Government agency mortgage-backed securities
69,775
3,325
0
73,100
 
112,162
1,963
0
114,125
Obligations of state and political subdivisions
64,943
2,852
0
67,795
 
69,939
1,496
110
71,325
Other securities
58
0
0
58
 
74
0
0
74
Total held-to-maturity portfolio
$597,947
$47,909
$0
$645,856
 
$335,936
$5,644
$648
$340,932
                   
Available-for-Sale Portfolio:
                 
U.S. Treasury and agency securities
$289,219
$31,770
$0
$320,989
 
$302,430
$19,339
$29
$321,740
Obligations of state and political subdivisions
500,701
21,383
348
521,736
 
462,161
15,132
1,883
475,410
Government agency mortgage-backed securities
180,026
11,731
28
191,729
 
201,361
6,088
1,042
206,407
Pooled trust preferred securities
69,908
0
25,613
44,295
 
71,002
0
26,988
44,014
Corporate debt securities
25,533
2,294
0
27,827
 
35,561
1,556
0
37,117
Government agency collateralized mortgage obligations
10,129
592
0
10,721
 
10,917
567
0
11,484
Marketable equity securities
380
0
72
308
 
379
2
6
375
Total available-for-sale portfolio
$1,075,896
$67,770
$26,061
$1,117,605
 
$1,083,811
$42,684
$29,948
$1,096,547


 
10

 

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, 2010
   
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
 
$9,710
$146
 
$4,309
$202
 
$14,019
$348
 Government agency mortgage-backed securities
 
2,577
28
 
0
0
 
2,577
28
 Pooled trust preferred securities
 
0
0
 
44,296
25,612
 
44,296
25,612
 Marketable equity securities
 
380
72
 
0
0
 
380
72
   Total available-for-sale portfolio/
     Total investment portfolio
 
$12,667
$246
 
$48,605
$25,814
 
$61,272
$26,060

As of December 31, 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
                   
Held-to-Maturity Portfolio:
                 
  U.S. Treasury and agency securities
 
$67,435
$538
 
$0
$0
 
$67,435
$538
  Obligations of state and political subdivisions
 
10,408
110
 
0
0
 
10,408
110
     Total held-to-maturity portfolio
 
77,843
648
 
0
0
 
77,843
648
                   
Available-for-Sale Portfolio:
                 
 Obligations of state and political subdivisions
 
31,179
854
 
4,074
1,029
 
35,253
1,883
 U.S. Treasury and agency securities
 
973
29
 
0
0
 
973
29
 Pooled trust preferred securities
 
0
0
 
44,014
26,988
 
44,014
26,988
 Government agency mortgage-backed securities
 
32,636
522
 
6,403
520
 
39,039
1,042
 Marketable equity securities
 
19
6
 
0
0
 
19
6
   Total available-for-sale portfolio
 
64,807
1,411
 
54,491
28,537
 
119,298
29,948
                   
    Total investment portfolio
 
$142,650
$2,059
 
$54,491
$28,537
 
$197,141
$30,596

Included in the available-for-sale portfolio are pooled trust preferred, class A-1 securities with a current par value of $71.6 million and unrealized losses of $25.6 million at September 30, 2010.  The underlying collateral of these assets is 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 the super senior tranche is impacted.  As of September 30, 2010, an additional 32% - 38% of the underlying collateral in these securities would have to be in deferral or default concurrently to result in an expectation of non-receipt of contractual cash flows.

A detailed review of the pooled trust preferred securities was completed for the quarter ended September 30, 2010.  This review included an analysis of collateral reports, a cash flow analysis, including varying degrees of projected deferral/default scenarios, and a review of various financial ratios of the underlying banks and insurance companies that make up the collateral pool.  Based on the analysis performed, significant further deferral/defaults and further erosion in other underlying performance conditions would have to exist before the Company would incur a loss.  Therefore, the Company determined an other-than-temporary impairment did not exist at September 30, 2010.  To date, the Company has received all scheduled principal and interest payments and expects to fully collect all future contractual principal and interest payments. The Company does not intend to sell and it is not more likely than not that the Company will be required to sell the underlying securities.   Subsequent changes in market or credit conditions could change those evaluations.


 
11

 

Management does not believe any individual unrealized loss as of September 30, 2010 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.
 
 
The amortized cost and estimated fair value of debt securities at September 30, 2010, 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.  Securities not due at a single maturity date are shown separately.

   
Held-to-Maturity
 
Available-for-Sale
   
Amortized
Fair
 
Amortized
Fair
(000's omitted)
 
Cost
Value
 
Cost
Value
Due in one year or less
 
$9,629
$9,693
 
$47,407
$48,328
Due after one through five years
 
63,547
68,005
 
208,642
221,232
Due after five years through ten years
 
401,852
439,273
 
306,407
335,220
Due after ten years
 
53,086
55,727
 
322,905
310,068
     Subtotal
 
528,114
572,698
 
885,361
914,848
Government agency collateralized mortgage obligations
 
0
0
 
10,129
10,720
Government agency mortgage-backed securities
 
69,833
73,158
 
180,026
191,729
     Total
 
$597,947
$645,856
 
$1,075,516
$1,117,297

NOTE D:  INTANGIBLE ASSETS

The gross carrying amount and accumulated amortization for each type of identifiable intangible asset are as follows:
 
   
As of September 30, 2010
 
As of December 31, 2009
   
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
($48,936)
$11,659
 
$60,595
($44,662)
$15,933
  Other intangibles
 
7,894
(4,559)
3,335
 
7,894
(3,848)
4,046
 Total amortizing intangibles
 
$68,489
($53,495)
$14,994
 
$68,489
($48,510)
$19,979

The estimated aggregate amortization expense for each of the five succeeding fiscal years ended December 31 is as follows:

Oct-Dec 2010
$972
2011
3,488
2012
2,901
2013
2,260
2014
1,703
Thereafter
3,670
Total
$14,994

Shown below are the components of the Company’s goodwill at September 30, 2010:

(000’s omitted)
December 31, 2009
Activity
September 30, 2010
Goodwill
$302,516
$0
$302,516
Accumulated impairment
(4,824)
0
(4,824)
Goodwill, net
$297,692
$0
$297,692

During the first quarter, the Company performed its annual internal valuation of goodwill for impairment by comparing the fair value of each reporting unit to its carrying value.  Results of the valuations indicate there was no goodwill impairment.  As a result of the significant declines the equity markets experienced in 2009, management determined a triggering event had occurred and the goodwill associated with Nottingham Advisors Inc. (“Nottingham”), one of the Company’s wealth management businesses, was tested for impairment during the fourth quarter of 2009.   As a result the Company recognized an impairment charge of $3.1 million on the carrying value of the goodwill associated with Nottingham.  Additional declines in Nottingham’s projected operating results may cause future impairment to its remaining goodwill balance of $2.5 million. See further details of the evaluation of goodwill for impairment in Note I.
 
 
 
12

 
 
NOTE E:  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% (4.04%)
7/31/2031
  5 year beginning 2006
101.5% declining to par in 2011
IV
12/8/2006
$75 million
3 month LIBOR plus 1.65% (1.94%)
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 $821,000 and $2,517,000 was recognized based on the interest rate swap agreement for the three and nine months ended September 30, 2010, respectively, compared to $806,000 and $2,035,000, respectively, for the three and nine months ended September 30, 2009.

NOTE F:  BENEFIT PLANS

The Company provides a qualified defined benefit pension plan and other post-retirement health and life insurance benefits to qualified employees and retirees, an unfunded supplemental pension plan for certain key executives, and an unfunded stock balance plan for certain of its nonemployee directors which was frozen effective December 31, 2009.  The Company terminated its post-retirement medical program for current and future employees effective December 31, 2009.  Remaining plan participants will include only existing retirees, or those active and eligible employees who retire prior to December 31, 2010.  During the first quarter of 2010, the Company made a contribution to its defined benefit pension plan of $15.0 million.  No other contributions are required in 2010.  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)
2010
2009
 
2010
2009
 
2010
2009
 
2010
2009
Service cost
$666
$874
 
$1,997
$2,622
 
$0
$111
 
$0
$510
Interest cost
944
919
 
2,831
2,757
 
49
105
 
147
413
Expected return on plan assets
(1,618)
(1,171)
 
(4,853)
(3,515)
 
0
0
 
0
0
Amortization of unrecognized net loss
583
690
 
1,749
2,072
 
4
(9)
 
13
21
Amortization of prior service cost
(47)
(31)
 
(141)
(92)
 
(264)
13
 
(793)
40
Amortization of transition obligation
0
0
 
0
0
 
0
10
 
0
31
Net periodic benefit cost
$528
$1,281
 
$1,583
$3,844
 
($211)
$230
 
($633)
$1,015



 
13

 

NOTE G:  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 1.7 million weighted-average anti-dilutive stock options outstanding at September 30, 2010 compared to approximately 2.5 million weighted-average anti-dilutive stock options outstanding at September 30, 2009 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, 2010 and 2009.

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
(000's omitted, except per share data)
2010
2009
 
2010
2009
Net income
$17,262
$12,455
 
$47,426
$32,075
Income attributable to unvested stock-based compensation awards
 (150)
(67)
 
 (405)
(165)
Income available to common shareholders
17,112
12,388
 
47,021
31,910
           
Weighted-average common shares outstanding - basic
32,987
32,674
 
32,920
32,663
Basic earnings per share
$0.52 
$0.38
 
$1.43 
$0.98
           
Net income
$17,262
$12,455
 
$47,426
$32,075
Income attributable to unvested stock-based compensation awards
 (150)
(67)
 
 (405)
(165)
Income available to common shareholders
17,112
12,388
 
47,021
31,910
           
Weighted-average common shares outstanding
32,987
32,674
 
32,920
32,663
Assumed exercise of stock options
330
147
 
273
122
Weighted-average shares – diluted
 33,317
32,821
 
 33,193
32,785
Diluted earnings per share
$0.51
$0.38
 
$1.42
$0.97

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 2010.

NOTE H:  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 the Company’s 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,
 2010
December 31,
2009
Commitments to extend credit
$504,754
$573,179
Standby letters of credit
18,523
19,121
     Total
$523,277
$592,300


 
14

 

NOTE I:  FAIR VALUE

Accounting standards allow 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.

Accounting standards establish a framework for measuring fair value and require certain disclosures 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.
 
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.   There were no transfers between Level 1 and Level 2 for any of the periods presented.
 
 
September 30, 2010
(000's omitted)
Level 1
Level 2
Level 3
Total Fair Value
Available-for-sale investment securities:
       
U.S. Treasury and agency securities
$1,063
$319,926
$0
$320,989
Obligations of state and political subdivisions
0
521,736
0
521,736
Government agency mortgage-backed securities
0
191,729
0
191,729
Corporate debt securities
0
27,827
0
27,827
Government agency collateralized mortgage obligations
0
10,721
0
10,721
Pooled trust preferred securities
0
0
44,295
44,295
Marketable equity securities
308
0
0
308
   Total available-for-sale investment securities
1,371
1,071,939
44,295
1,117,605
Forward sales contracts
0
(193)
0
(193)
Commitments to originate real estate loans for sale
0
0
917
917
Mortgage loans held for sale
0
1,541
0
1,541
Interest rate swap
0
(4,048)
0
(4,048)
   Total
$1,371
$1,069,239
$45,212
$1,115,822

 
December 31, 2009
(000's omitted)
Level 1
Level 2
Level 3
Total Fair Value
Available-for-sale investment securities:
       
U.S. Treasury and agency securities
$973
$320,767
$0
$321,740
Obligations of state and political subdivisions
0
475,410
0
475,410
Government agency mortgage-backed securities
0
206,407
0
206,407
Corporate debt securities
0
37,117
0
37,117
Government agency collateralized mortgage obligations
0
11,484
0
11,484
Pooled trust preferred securities
0
0
44,014
44,014
Marketable equity securities
375
0
0
375
   Total available-for-sale investment securities
1,348
1,051,185
44,014
1,096,547
Forward sales contracts
0
119
0
119
Commitments to originate real estate loans for sale
0
0
31
31
Mortgage loans held for sale
0
1,779
0
1,779
Interest rate swap
0
(5,093)
0
(5,093)
   Total
$1,348
$1,047,990
$44,045
$1,093,383

 
 
15

 
 
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 obligations and marketable equity 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, such as dealer quotes, reported trades, trade execution data, LIBOR swap yield curve, market prepayment speeds, credit information, market spreads, and security’s terms and conditions, are observable.  Securities classified as Level 3 include pooled trust preferred securities in less liquid markets.  The value of these instruments is determined using multiple pricing models or similar techniques as well as significant unobservable inputs such as judgment or estimation by the Company in the weighting of the models.
 
 
·
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, 2010 is $1.5 million.  The unrealized gain on mortgage loans held for sale of $56,000 was recognized in mortgage banking and other income in the consolidated statement of income for the quarter ended September 30, 2010.
 
 
·
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 and reflects the underlying price the entity would pay the Company for an immediate sale on these mortgages.  These instruments 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 realization rate, 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, which are 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,
 
2010
 
2009
(000's omitted)
Pooled trust preferred securities
Commitments to originate real estate loans
 for sale
Total
 
Pooled trust preferred securities
Commitments to originate real estate loans
 for sale
Total
Beginning balance
$47,343
$367
$47,710  
 
$54,561
$142 
$54,703 
Total gains (losses) included in earnings (1)
24
(367)
(343)  
 
28
(142)
(114)
Total losses included in other comprehensive income
(2,661)
0
(2,661)
 
(8,705)
0
(8,705)  
Sales/calls/principal reductions
(411)
0
(411)  
 
(464)
0  
(464)  
Commitments to originate real estate loans held for sale, net
0
917
917  
 
0
180  
180 
Ending balance
$44,295
$917
$45,212  
 
$45,420
$180  
$45,600 
(1) Amounts included in earnings associated with the pooled trust preferred securities relate to accretion of related discount.


 
16

 


 
Nine Months Ended September 30,
 
2010
 
2009
(000's omitted)
Pooled trust preferred securities
Commitments to originate real estate loans for sale
Total
 
Pooled trust preferred securities
Commitments to originate real estate loans for sale
Total
Beginning balance
$44,014
$31
$44,045
 
$49,865
$0
$49,865
Total gains (losses) included in earnings (1)
73
(31)
42
 
81
0
81
Total gains (losses) included in other comprehensive income
1,376
0
1,376
 
(3,286)
0
(3,286)
Sales/calls/principal reductions
(1,168)
0
(1,168)
 
(1,240)
0
(1,240)
Commitments to originate real estate loans held for sale, net
0
917
917
 
0
180
180
Ending balance
$44,295
$917
$45,212
 
$45,420
$180
$45,600
(1) Amounts included in earnings associated with the pooled trust preferred securities relate to accretion of related discount.

Assets and liabilities measured on a non-recurring basis:

 
September 30, 2010
 
December 31, 2009
(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
$394
$394
 
$0
$0
$5,771
$5,771
Impaired goodwill
N/A
N/A
N/A
N/A
 
0
0
2,500
2,500
Mortgage servicing rights
0
0
1,531
1,531
 
0
0
1,608
1,608
   Total
$0
$0
$1,925
$1,925
 
$0
$0
$9,879
$9,879

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 estimated period of net servicing income.  In accordance with generally accepted accounting principles, the Company must record impairment charges, on a nonrecurring basis, when the carrying value of certain strata exceeds 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 and are considered to be unobservable and contribute to the Level 3 classification of mortgage servicing rights.  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.  There is a valuation allowance of approximately $271,000 at September 30, 2010.

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.  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 2009, management determined a triggering event had occurred and the goodwill associated with Nottingham, one of the Company’s wealth management businesses, was tested for impairment during the fourth quarter of 2009.  Based on the goodwill valuation performed in the fourth quarter of 2009 using Level 3 inputs, the Company recognized an impairment charge and wrote down the carrying value of the goodwill by $3.1 million.


 
17

 

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, but not limited to, 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 Note C.  The carrying amounts and estimated fair values of the Company’s other financial instruments that are not accounted for at fair value at September 30, 2010 and December 31, 2009 are as follows:

   
September 30, 2010
 
December 31, 2009
   
Carrying
Fair
 
Carrying
Fair
(000's omitted)
 
Value
Value
 
Value
Value
Financial assets:
           
   Loans
 
$3,080,397
$3,126,825
 
$3,099,485
$3,089,287
Financial liabilities:
           
   Deposits
 
3,966,335
3,981,035
 
3,924,486
3,939,951
   Borrowings
 
729,508
833,913
 
754,779
821,987
   Subordinated debt held by unconsolidated subsidiary trusts
 
102,018
75,202
 
101,999
84,431

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.

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 values 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 J:  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 E.


 
18

 

The following table presents the Company’s derivative financial instruments, their estimated fair values, and balance sheet location as of September 30, 2010:

 
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
$4,048
Derivatives not designated as hedging instruments:
             
   Commitments to originate real estate loans for sale
Other assets
$58,319
$917
       
   Forward sales commitments
       
Other liabilities
$45,491
193
Total derivatives
   
$917
     
$4,241

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, 2010:

     
Gain/(loss) recognized in the Statement of Income
(000's omitted)
Location
 
Three Months Ending
September 30, 2010
Nine Months Ending
September 30, 2010
Interest rate swap agreement
Interest on subordinated debt held by unconsolidated subsidiary trusts
 
($821)
($2,517)
Interest rate lock commitments
Mortgage banking and other services
 
550
917
Forward sales commitments
Mortgage banking and other services
 
(59)
(193)
Total
   
($330)
($1,793)

The amount of gain recognized during the three and nine months ended September 30, 2010 in other comprehensive income related to the interest rate swap accounted for as a hedging instrument was approximately $247,000 and $643,000, respectively.  The amount of loss reclassified from accumulated other comprehensive income into income (effective portion) amounted to approximately $821,000 and $2,517,000 for the three and nine months ended September 30, 2010, respectively, and is located in interest expense on subordinated debt held by unconsolidated trusts.

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 Northern 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 include administration, consulting and actuarial services 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, 2009 filed with the SEC on March 11, 2010).


 
19

 

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

 
(000's omitted) 
Banking
Other
Eliminations
Consolidated
Total
Three Months Ended September 30, 2010
       
Net interest income
$46,296
$28
$0
$46,324
Provision for loan losses
1,400
0
0
1,400
Noninterest income
13,282
10,009
(377)
22,914
Amortization of intangible assets
1,067
210
0
1,277
Other operating expenses
35,606
7,846
(377)
43,075
Income before income taxes
$21,505
$1,981
$0
$23,486
Assets
$5,472,394
$35,535
($11,712)
$5,496,217
Goodwill
$287,411
$10,281
$0
$297,692
         
Three Months Ended September 30, 2009
       
Net interest income
$41,825
$27
$0
$41,852
Provision for loan losses
2,375
0
0
2,375
Noninterest income
11,906
9,252
(345)
20,813
Amortization of intangible assets
1,787
239
0
2,026
Other operating expenses
34,489
7,941
(345)
42,085
Income before income taxes
$15,080
$1,099
($0)
$16,179
Assets
$5,351,473
$37,040
($10,418)
$5,378,095
Goodwill
$287,411
$13,347
$0
$300,758
         
Nine Months Ended September 30, 2010
       
Net interest income
$135,472
$79
$0
$135,551
Provision for loan losses
5,270
0
0
5,270
Noninterest income
37,205
30,948
(1,144)
67,009
Amortization of intangible assets
4,319
666
0
4,985
Other operating expenses
104,733
24,191
(1,144)
127,780
Income before income taxes
$58,355
$6,170
$0
$64,525
         
Nine Months Ended September 30, 2009
       
Net interest income
$122,500
$52
$0
$122,552
Provision for loan losses
7,200
0
0
7,200
Noninterest income
35,018
27,702
(902)
61,818
Amortization of intangible assets
5,480
754
0
6,234
Other operating expenses
106,526
24,137
(902)
129,761
Income before income taxes
$38,312
$2,863
($0)
$41,175
         

 
20

 

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, 2010 and 2009, although in some circumstances the second quarter of 2010 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 20.  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” and “YTD” refers to results in calendar year 2010, “third quarter” refers to the quarter ended September 30, 2010, and earnings per share (“EPS”) figures refer to diluted EPS.
 
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 36.

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 loan losses in the Company’s loan portfolio. Determination of the allowance for loan losses 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 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 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.

·
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, mortality rates, future health care costs 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.
 
 
21

 
 
·
Intangible assets – As a result of acquisitions, the Company has acquired goodwill and identifiable intangible assets.  Goodwill represents the cost of acquired companies in excess of the fair value of net assets at the acquisition date.  Goodwill is evaluated at least annually, or when business conditions suggest impairment may have occurred and will be reduced to its carrying value through a charge to earnings if impairment exists.  Core deposits and other identifiable intangible assets are amortized to expense over their estimated useful lives.  The determination of whether or not impairment exists 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 them to select 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, all of which are susceptible to change based on changes in economic conditions and other factors.  Future events or changes in the estimates used to determine the carrying value of goodwill and identifiable intangible assets could have a material impact on the Company’s results of operations.

A summary of the accounting policies used by management is disclosed in Note A, “Summary of Significant Accounting Policies” on pages 50-55 of the most recent Form 10-K (fiscal year ended December 31, 2009) filed with the Securities and Exchange Commission on March 11, 2010.

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.

Third quarter and September year-to-date 2010 net income of $17.3 million and $47.4 million, respectively, were $4.8 million or 39% and $15.4 million or 48% higher than the respective prior year periods.  Earnings per share were $0.51 and $1.42 for the three and nine months ended September 30, 2010, respectively, an increase of $0.13 and $0.45 from the comparable prior year periods.  The increase was due to higher revenue from both increased net interest income, as a result of earning asset growth and a higher net interest margin, and non-interest income.  Also contributing to higher net income was a lower year-to-date provision for loan losses and lower expenses as a result of general cost management initiatives.  These were partially offset by a higher effective income tax rate due to a higher proportional level of fully taxable income.

Asset quality in the third quarter of 2010 remained stable, and favorable as compared to averages for peer financial organizations.  Third quarter loan net charge-offs and the current quarter provision for loan losses were below those experienced in the third quarter of 2009 and the second quarter of 2010.  Nonperforming loans increased slightly from the third quarter of 2009 and were below nonperforming loans at June 30, 2010.  Delinquency ratios increased from both the third quarter of 2009 and the second quarter of 2010, but remain favorable compared to peer levels.  The Company experienced year-over-year growth in third quarter average interest-earning assets, including a small net increase in loan balances.  Average investment portfolio balances, including cash equivalents, increased as compared to the third quarter 2009 and decreased slightly from the second quarter 2010.  Average deposits increased in the third quarter of 2010 as compared to the third quarter of 2009, reflective of organic growth in core deposits.  Average external borrowings were down slightly from both the second quarter of 2010 and the third quarter of 2009.

On October 25, 2010, the Company announced that it has entered into a definitive agreement to acquire The Wilber Corporation, (“Wilber”) parent company of the Wilber National Bank in Oneonta, NY, for $101.8 million in stock and cash.  The acquisition will extend the Company’s Central New York service area to the contiguous Central Leatherstocking, Greater Capital District, and Catskills regions of Upstate New York.  The acquisition is expected to close during the second quarter of 2011, pending both customary regulatory and Wilber shareholder approval.  Upon the completion of the merger, Community Bank will add 22 branch locations in eight counties, and deposits in excess of $775 million.

On November 4, 2010 the Company was served with a complaint naming the Company, The Wilber Corporation, and the Wilber directors in a class action lawsuit filed with the New York State Supreme Court in Otsego County, New York.  The complaint alleges that CBSI aided and abetted various purported breaches of fiduciary duties by Wilber and its directors involving the appropriateness of the sale process conducted by Wilber and fairness of the merger consideration and terms in connection with the proposed merger agreement.  The Company believes that the allegations are without merit and intends to vigorously defend the complaint.
 
 
22

 
 
Net Income and Profitability
 
As shown in Table 1, net income for the third quarter and September YTD of $17.3 million and $47.4 million, respectively, increased 39% and 48% versus the comparable periods of 2009.  Earnings per share for the third quarter of $0.51 were $0.13 higher than the EPS generated in the third quarter of 2009, and earnings per share of $1.42 for the first nine months of 2010 increased $0.45 from the amount earned in the first nine months of 2009.

As reflected in Table 1, third quarter net interest income of $46.3 million was up $4.5 million, or 11%, from the comparable prior year period and net interest income for the first nine months of 2010 increased $13.0 million, or 11%, over the first nine months of 2009.  The current quarter’s provision for loan losses decreased $1.0 million as compared to the third quarter of 2009 and was $1.9 million lower than the first nine months of 2009, reflective of lower levels of net charge-offs and generally stable asset quality.  Third quarter noninterest income was $22.9 million, up $2.1 million, or 10.1%, from the third quarter of 2009, while year-to-date noninterest income of $67.0 million increased $5.2 million, or 8.4%, from the prior year level, despite a $0.9 million decline in mortgage-banking related revenue.  Contributing to the increase was higher deposit service fees and growth in the Company’s employee benefits consulting and plan administration business and wealth management revenues, a result of both new client and services generation and improving market conditions as compared to the first nine months of 2009.  Operating expenses of $44.4 million and $132.8 million for the third quarter and first nine months of 2010 increased $0.2 million or 0.5% as compared to the third quarter of 2009, and declined $3.2 million, or 2.4% as compared to the first nine months of 2009, reflective of solid cost management programs across all functional areas of the Company.
 
 
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)
 
2010
2009
 
2010
2009
Net interest income
 
$46,324
$41,852
 
$135,551
$122,552
Provision for loan losses
 
1,400
2,375
 
5,270
7,200
Noninterest income
 
22,914
20,806
 
67,009
61,811
Gain on sales of investment securities
 
0
7
 
0
7
Operating expenses
 
44,352
44,111
 
132,765
135,995
Income before taxes
 
23,486
16,179
 
64,525
41,175
Income taxes
 
6,224
3,724
 
17,099
9,100
Net income
 
$17,262
$12,455
 
$47,426
$32,075
             
Diluted earnings per share
 
$0.51
$0.38
 
$1.42
$0.97

Net Interest Income

Net interest income is the amount by which interest and fees on earning assets (loans, investments and cash equivalents) 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 2010 was $50.1 million, a $4.3 million increase from the same period last year.  A $71.8 million increase in third quarter interest-earning assets combined with a 30-basis point increase in net interest margin versus the prior year had a greater impact than the $27.5 million increase in average interest-bearing liabilities.  As reflected in Table 3, the volume increase from interest-bearing assets and the rate decrease on interest-bearing liabilities had a $4.9 million favorable impact on net interest income, while the volume increase from interest bearing liabilities and rate decrease on interest bearing assets had a $0.6 million unfavorable impact on net interest income.   The lower cost of funding had a greater favorable impact on net interest margin than the lower yields on interest-bearing assets.  September YTD net interest income of $146.9 million increased $12.5 million or 9.3% from the year earlier period.  A $107.6 million increase in interest bearing assets and a 26-basis point increase in net interest margin more than offset a $56.0 million increase in interest-bearing liabilities.  The increase in interest-earning assets and the lower rate on interest bearing liabilities had a $19.0 million favorable impact that was partially offset by a $6.5 million unfavorable impact from the decrease in rate on interest-bearing assets and the increase in interest-bearing liability balances.

 
23

 

Average investments for the third quarter and YTD periods were $307.8 million and $291.8 million higher than the respective periods of 2009, while overnight invested cash equivalents for the third quarter and YTD periods declined $242.1 million and $154.7 million from the respective prior year periods, reflective of deployment during the first quarter of 2010 of a portion of the company’s excess liquidity into intermediate-term U.S. Treasury securities.  Third quarter average loan balances increased $6.1 million while September year-to-date average loan balances declined $29.5 million, as compared to the comparable periods of 2009, primarily from continued declines in the consumer installment and business lending portfolios as a result of lower demand characteristics in response to current economic conditions, partially offset by strong consumer mortgage volume due to continued low long-term interest rates.  In comparison to the prior year, total average interest-bearing deposits were up $53.4 million or 1.7% for the quarter, reflective of organic growth in core deposits partially offset by a reduction in time deposits.  Quarterly average borrowings declined $25.9 million or 3.0% as compared to the third quarter of 2009 and reflect the maturity of $25 million of term borrowings in the second quarter of 2010.

The net interest margin of 4.08% for the third quarter and 4.04% for the year-to-date period increased 30 basis points and 26 basis points, respectively, versus the same periods in the prior year.  The improvement was primarily attributable to a 33-basis point and a 42-basis point decrease in the cost of funds for the quarter and year-to-date periods, respectively, as compared to the prior year periods, partially offset by a three-basis point and 16-basis point decrease in earning-asset yields, as compared to the prior year periods.  The decrease in the earning-asset yield was driven by a 13-basis point decline in the loan yields for both the third quarter and YTD periods, respectively, as compared to the like periods of 2009.  Partially offsetting this decrease for the third quarter was a 17-basis point increase in investment yield, including cash equivalents, due to a more productive deployment of net liquidity during 2010.  Investment yield, including cash equivalents, for the year-to-date period declined 13 basis points from the prior year period as yields on new purchases were lower than those earned on maturing securities.  The decline in loan yields is primarily a result of lower rates on fixed rate new loan volume due to the decline in interest rates to levels below those prevalent in prior years and certain adjustable-rate loans repricing downward.

The third quarter cost of funds decreased versus the prior year quarter due to a 43-basis point decrease in interest-bearing deposit rates, a higher proportion of funding being supplied from non-interest bearing deposits, and an eight-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 2009 and the first nine months of 2010 in response to market conditions.  Additionally, the proportion of customer deposits in higher cost time deposits has declined eight percentage points over the last twelve months, while the percentage of deposits in non-interest bearing and lower-cost checking and savings accounts increased three percentage points.

 
24

 


Table 2a and 2b below sets 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 a marginal income tax rate of 38.46% in 2010 and 2009.  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, 2010
 
September 30, 2009
     
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
$50,484
$34
0.27%
 
$292,545
$200
0.27%
   Taxable investment securities (1)
1,182,243
12,252
4.11%
 
864,478
9,914
4.55%
   Nontaxable investment securities (1)
550,660
8,873
6.39%
 
560,615
9,532
6.75%
   Loans (net of unearned discount)(2)
3,088,590
45,226
5.81%
 
3,082,495
46,183
5.94%
       Total interest-earning assets
4,871,977
66,385
5.41%
 
4,800,133
65,829
5.44%
Noninterest-earning assets
602,975
     
549,629
   
     Total assets
$5,474,952
     
$5,349,762
   
               
Interest-bearing liabilities:
             
   Interest checking, savings and money market deposits
$2,218,640
2,824
0.51%
 
$1,873,536
2,702
0.57%
   Time deposits
999,191
4,472
1.78%
 
1,290,860
7,910
2.43%
   Borrowings
832,568
8,977
4.28%
 
858,505
9,424
4.36%
     Total interest-bearing liabilities
4,050,399
16,273
1.59%
 
4,022,901
20,036
1.98%
Noninterest-bearing liabilities:
             
   Demand deposits
736,203
     
708,430
   
   Other liabilities
81,438
     
58,669
   
Shareholders' equity
606,912
     
559,762
   
     Total liabilities and shareholders' equity
$5,474,952
     
$5,349,762
   
               
Net interest earnings
 
$50,112
     
$45,793
 
Net interest spread
   
3.82%
     
3.46%
Net interest margin on interest-earning assets
   
4.08%
     
3.78%
               
Fully tax-equivalent adjustment
 
$3,788
     
$3,941
 
 
    (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.
          (2) The impact of interest and fees not recognized on nonaccrual loans was immaterial.

 
25

 




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


 
Nine Months Ended
 
Nine Months Ended
 
September 30, 2010
 
September 30, 2009
     
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
$100,248
$189
0.25%
 
$254,935
$499
0.26%
    Taxable investment securities (1)
1,153,321
35,885
4.16%
 
833,708
30,445
4.88%
    Nontaxable investment securities (1)
531,555
26,535
6.67%
 
559,417
28,489
6.81%
    Loans (net of unearned discount)(2)
3,079,738
134,999
5.86%
 
3,109,210
139,340
5.99%
       Total interest-earning assets
4,864,862
197,608
5.43%
 
4,757,270
198,773
5.59%
Noninterest-earning assets
586,677
     
542,579
   
     Total assets
$5,451,539
     
$5,299,849
   
               
Interest-bearing liabilities:
             
    Interest checking, savings and money market deposits
$2,169,083
8,518
0.53%
 
$1,789,844
8,616
0.64%
    Time deposits
1,061,551
15,128
1.91%
 
1,367,146
27,653
2.70%
    Borrowings
842,107
27,075
4.30%
 
859,734
28,121
4.37%
     Total interest-bearing liabilities
4,072,741
50,721
1.67%
 
4,016,724
64,390
2.14%
Noninterest-bearing liabilities:
             
    Demand deposits
723,256
     
677,323
   
    Other liabilities
67,861
     
53,753
   
Shareholders' equity
587,682
     
552,049
   
     Total liabilities and shareholders' equity
$5,451,540
     
$5,299,849
   
               
Net interest earnings
 
$146,887
     
$134,383
 
Net interest spread
   
3.76%
     
3.45%
Net interest margin on interest-earning assets
   
4.04%
     
3.78%
               
Fully tax-equivalent adjustment
 
$11,336
     
$11,831
 
 
    (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.
    (2) The impact of interest and fees not recognized on nonaccrual loans was immaterial.

 
26

 

 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 2010 Compared to 3rd Quarter 2009
 
Nine Months Ended September 30, 2010 Compared to September 30, 2009
 
Increase (Decrease) Due to Change in(1)
 
Increase (Decrease) Due to Change in(1)
(000's omitted)
Volume
Rate
Net Change
 
Volume
Rate
Net Change
               
Interest earned on:
             
  Cash equivalents
($165)
($1)
($166)
 
($293)
($17)
($310)
  Taxable investment securities
3,366
(1,028)
2,338
 
10,426
(4,986)
5,440
  Nontaxable investment securities
(167)
(492)
(659)
 
(1,399)
(555)
(1,954)
  Loans (net of unearned discount)
91
(1,048)
(957)
 
(1,312)
(3,029)
(4,341)
Total interest-earning assets (2)
980
(424)
556
 
4,439
(5,604)
(1,165)
               
Interest paid on:
             
  Interest checking, savings and money market deposits
462
(340)
122
 
1,646
(1,744)
(98)
  Time deposits
(1,567)
(1,871)
(3,438)
 
(5,395)
(7,130)
(12,525)
  Borrowings
(282)
(165)
(447)
 
(571)
(474)
(1,045)
Total interest-bearing liabilities (2)
136
(3,899)
(3,763)
 
886
(14,555)
(13,669)
               
Net interest earnings (2)
694
3,625
4,319
 
3,091
9,413
12,504

 
(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.

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 trust, administration, actuarial and consulting services (performed by Benefit Plans Administrative Services, Inc. (“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, Inc. or “Nottingham”).  Additionally, the Company has periodic transactions, most often net gains or 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)
 
2010
2009
 
2010
2009
Deposit service charges and fees
 
$11,180
$10,991
 
$33,036
$30,247
Benefit plan administration, consulting and actuarial fees
 
7,256
6,969
 
22,415
20,575
Trust, investment and asset management fees
 
2,400
1,951
 
7,442
6,251
Other banking services
 
863
669
 
1,826
1,536
Mortgage banking
 
1,215
226
 
2,290
3,202
     Subtotal
 
22,914
20,806
 
67,009
61,811
Gain on investment securities & debt prepayment
 
0
7
 
0
7
      Total noninterest income
 
$22,914
$20,813
 
$67,009
$61,818
             
Noninterest income/operating income (FTE)
 
31.4%
31.2%
 
31.3%
31.5%


 
27

 

As displayed in Table 4, noninterest income was $22.9 million in the third quarter and $67.0 million for the first nine months of 2010.  This represents an increase of $2.1 million, or 10.1%, for the quarter and $5.2 million, or 8.4%, for the YTD period in comparison to 2009.  General recurring banking fees of $12.0 million for the third quarter and $34.9 million for the first nine months of 2010 were up $0.4 million or 3.3% and $3.1 million, or 9.7%, respectively, as compared to the prior year periods, despite regulatory changes that have created downward pressure on certain product utilization.  The increase was driven by organic core deposit account growth, increased electronic banking activity and expanded debit-card usage.  Effective July 1, 2010, Regulation E (a Federal Reserve Board Regulation) prohibits financial institutions from charging consumers fees for paying overdrafts on ATM and debit card transactions, unless the customer consents.  To date, the majority of customer’s who have responded have consented to protecting their accounts from electronic transaction rejection.

Residential mortgage banking revenue increased $1.0 million for the quarter and declined $0.9 million for the nine months in comparison to the prior year periods, reflective of the robust secondary market activities experienced in the third quarter of 2010, similar to the first half of 2009.  Residential mortgage banking income totaled $1.2 million for the third quarter of 2010 and $2.3 million for the first nine months, as compared to $0.2 million in the third quarter of 2009 and $3.2 for the first nine months of 2009.  Residential mortgage banking income consists of realized gains or losses from the sale of residential mortgage loans and the origination of mortgage loan servicing rights, unrealized gains and losses on residential mortgage loans held for sale and related commitments, mortgage loan servicing fees and other mortgage loan-related fee income.  Included in the third quarter mortgage banking income is $0.8 million of unrealized gains on residential mortgage loans held for sale and the related commitments.   Also included in the third quarter of 2010 is a $0.3 million impairment charge for the fair value of the mortgage servicing rights due primarily to an increase in the expected prepayment speed of the Company’s sold loan portfolio with servicing retained.  Partially offsetting the third quarter impairment is a $0.1 million recovery of an impairment charge taken in a prior period.  Residential mortgage loans sold to investors, primarily Fannie Mae, totaled $52.6 million in the first nine months of 2010 as compared to $165.4 million for the comparable 2009 period.  Residential mortgage loans held for sale and recorded at fair value at September 30, 2010 totaled $1.5 million.  Realization of the unrealized gains on mortgage loans held for sale and the related commitments, as well as future revenue generation from mortgage banking activities will be dependent on market conditions and long-term interest rate trends.

Benefit trust, administration, consulting and actuarial fees increased $0.3 million and $1.8 million, respectively, for the three and nine months ended September 30, 2010 as compared to the prior year periods, driven by a combination of new client generation, expanded service offerings and increased asset-based revenue.  Wealth management services revenue increased $0.4 million, or 23%, for the third quarter and $1.2 million, or 19%, for the first nine months, reflective of favorable market valuation comparisons and generally improving demand characteristics.

The ratio of noninterest income to total income (FTE basis) was 31.4% for the quarter and 31.3% for the year-to-date period, versus 31.2% and 31.5% for the comparable periods of 2009.  The slight increase in the quarter is a function of noninterest income increasing at a faster rate than net interest income, primarily due to the high level of mortgage banking activity.  On a year-to-date basis, net interest income increased at a faster rate than noninterest income mostly as a result of the significant expansion of the net interest margin.

Operating Expenses
Table 5 below sets forth the quarterly results of the major operating expense categories for the current and prior year, as well as efficiency ratios (defined below), a standard measure of expense utilization effectiveness commonly used in the banking industry.

Table 5: Operating Expenses
 
 
     Three Months Ended    Nine Months Ended
     September 30,    September 30,
(000's omitted)
   2010  2009    2010  2009
Salaries and employee benefits
 
$23,056
$23,166
 
$68,501
$69,282
Occupancy and equipment
 
5,575
 5,533  
17,414
17,448
Data processing and communications
 
5,430
5,328
 
15,853
15,349
Amortization of intangible assets
 
1,277
2,026
 
4,985
6,234
Legal and professional fees
 
1,014
1,367
 
3,819
3,969
Office supplies and postage
 
1,382
1,245
 
3,942
4,092
Business development and marketing
 
1,250
 1,469  
3,995
4,818
FDIC insurance premiums
 
1,599
1,670
 
4,656
7,066
Other
 
3,769
2,307
 
9,600
7,737
 Total operating expenses  
$44,352
$44,111
 
$132,765
$135,995
             
Operating expenses/average assets
 
3.07%
3.12%
 
3.10%
3.20%
Efficiency ratio
 
57.9%
63.2%
 
59.1%
64.7%
 
 
28

 

As shown in Table 5, third quarter 2010 operating expenses were $44.4 million, an increase of $0.2 million or 0.5% from the prior year level.  Year-to-date operating expenses of $132.8 million declined $3.2 million or 2.4% as compared to the same period of 2009.  Excluding the $2.5 million FDIC special assessment incurred in the second quarter 2009, YTD operating expenses were down $0.7 million versus the equivalent prior year period.  Implementation of several expense reduction initiatives allowed the Company to report lower total operating expenses despite year-over-year increases in merit-based compensation, as well as higher technology and volume based processing costs.  The Company continued to dedicate significant resources to the conversion of its core banking system, which was completed in the third quarter 2010.

Salary expense increased $1.1 million and $2.5 million from the third quarter and first nine months of 2009, respectively, offset by a $1.0 million and $3.3 million decrease in employee benefit costs from the three and nine months ended September 30, 2010, respectively, as compared to the prior year periods.  This was primarily due to modifications made to the Company’s defined benefit pension plan, and the fourth quarter 2009 termination of its post-retirement medical program for certain current and all future employees, offset by a higher contribution to the Company’s 401(k) Employee Stock Ownership Plan (“401(k) Plan”).  The defined benefit pension plan was modified to a new plan design, which combines service credits in the Company’s Cash Balance Plan with additional contributions to be made to the 401(k) Plan.  Additionally, effective January 1, 2010, the Company increased its discretionary matching contribution to the 401(k) Plan for employee participants who contribute 6% of eligible compensation from a maximum of 3.5% to 4.5%.

Additional changes to operating expenses can be attributable to lower FDIC insurance premiums ($0.1 million for the quarter, $2.4 million YTD), lower business development and marketing expenses ($0.2 million for the quarter, $0.8 million YTD), and lower amortization of intangible assets ($0.7 million for the quarter, $1.2 million YTD), partially offset by higher volume-based data processing and communication costs ($0.1 million for the quarter, $0.5 million YTD) and higher property and other related writedowns ($0.6 million for the quarter and $1.0 million YTD).  In May 2009, the FDIC basic insurance coverage limit of $250,000 was extended through December 31, 2013, and subsequently made permanent as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act.  This change combined with a significant depletion of the general insurance fund due to a major increase in the number and magnitude of bank failures have resulted in significant increases in the FDIC assessment rates from pre-2009 periods, and are expected to remain at similar levels during the remainder of 2010.  The Company is also participating in the FDIC’s Transaction Account Guarantee Program (“TAGP”) that provides unlimited coverage for transaction deposit accounts and for which a supplemental 10-basis point premium is currently assessed.  In the second quarter of 2009, the FDIC assessed an emergency special assessment equal to five basis points on a bank’s assets less Tier 1 capital, which resulted in $2.5 million of additional premiums recognized in June 2009.  No additional special assessments were levied in 2009 and the first nine months of 2010.

The Company’s efficiency ratio (recurring operating expenses excluding intangible amortization, acquisition, core system conversion expenses and the special FDIC assessment divided by the sum of net interest income (FTE) and recurring noninterest income) was 57.9% for the third quarter, 5.3 percentage points below the comparable quarter of 2009.  This resulted from operating expenses (as described above) increasing 0.5%, while recurring operating income increased 9.6% due to a 9.4% increase in net interest income and a 10.1% increase in noninterest income year over year.  The efficiency ratio of 59.1% for the first nine months of 2010 was down 5.6 percentage points from a year earlier due to core operating expense decreasing 0.4% while recurring operating income increased 9.0%.  Operating expenses, excluding intangible amortization, acquisition and core system conversion expenses and the special FDIC assessment as a percentage of average assets decreased five basis points and 10 basis points for the quarter and year-to-date periods, respectively.  Operating expenses (as defined above) increased 0.5% for the quarter and decreased 0.4%, year-to-date, while average assets increased 2.3% and 2.9%, respectively, for the same time periods.

Income Taxes

The third quarter and YTD effective income tax rate was 26.5%, as compared to 23.0% and 22.1% effective tax rates for the respective periods of 2009.  The higher effective tax rate for 2010 was principally a result of a higher proportion of income being generated from fully taxable sources.

 
29

 

Investments

As reflected in Table 6 below, the carrying value of investments (including unrealized gains on available-for-sale securities) was $1.72 billion at the end of the third quarter, an increase of $283.1 million from December 31, 2009 and an increase of $272.5 million from September 30, 2009.  The book value (excluding unrealized gains) of investments increased $254.0 million from December 31, 2009 and $260.5 million from September 30, 2009.  Throughout 2009 cash equivalents remained above historical levels, as the Company maintained the liquidity provided by the 2008 Citizens branch acquisition and organic deposit growth in anticipation of improved investment opportunities in future periods.  A portion of the Company’s significant liquidity position was deployed during the first nine months of 2010 through the purchase of $317 million of intermediate-term U.S. Treasury Notes.  The overall mix of securities within the portfolio over the last year has changed, with an increase in the proportion of U.S. Treasury Notes and a decrease in the proportion of obligations of state and political subdivisions and mortgage-backed securities.  The change in the carrying value of investments is impacted by the amount of net unrealized gains in the available-for-sale portfolio at a point in time.  At September 30, 2010, the portfolio had a $41.7 million net unrealized gain, an increase of $29.0 million from the unrealized gain at December 31, 2009 and up $11.9 million from the unrealized gain at September 30, 2009.  This increase in the unrealized gain is indicative of favorable interest rate movements during the respective time periods and the changes in the size and composition of the portfolio.  Although not reflected in the financial results of the Company, the held-to-maturity portfolio had an additional $47.9 million of net unrealized gains as of September 30, 2010.

Table 6: Investments
   
September 30, 2010
 
December 31, 2009
 
September 30, 2009
   
Amortized
   
Amortized
   
Amortized
 
   
Cost/Book
Fair
 
Cost/Book
Fair
 
Cost/Book
Fair
(000's omitted)
 
Value
Value
 
Value
Value
 
Value
Value
Held-to-Maturity Portfolio:
                 
U.S. Treasury and agency securities
 
$463,171
$504,903
 
$153,761
$155,408
 
$70,315
$72,990
Government agency mortgage-backed securities
 
69,775
73,100
 
112,162
114,125
 
143,000
145,497
Obligations of state and political subdivisions
 
64,943
67,795
 
69,939
71,325
 
69,910
73,589
Other securities
 
58
58
 
74
74
 
80
80
     Total held-to-maturity portfolio
 
597,947
645,856
 
335,936
340,932
 
283,305
292,156
                   
Available-for-Sale Portfolio:
                 
U.S. Treasury and agency securities
 
289,219
320,989
 
302,430
321,740
 
312,429
337,524
Obligations of state and political subdivisions
 
500,701
521,736
 
462,161
475,410
 
499,050
520,804
Government agency mortgage-backed securities
 
180,026
191,729
 
201,361
206,407
 
199,967
206,630
Pooled trust preferred securities
 
69,908
44,296
 
71,002
44,014
 
71,377
45,420
Corporate debt securities
 
25,533
27,827
 
35,561
37,117
 
35,569
37,280
Government agency collateralized mortgage obligations
 
10,129
10,720
 
10,917
11,484
 
11,214
11,762
Marketable equity securities
 
380
308
 
379
375
 
374
374
     Available-for-sale portfolio
 
1,075,896
1,117,605
 
1,083,811
1,096,547
 
1,129,980
1,159,794
Net unrealized gain on available-for-sale portfolio
 
41,709
0
 
12,736
0
 
29,808
0
     Total available-for-sale portfolio
 
1,117,605
1,117,605
 
1,096,547
1,096,547
 
1,159,788
1,159,794
                   
Total investments
 
$1,715,552
$1,763,461
 
$1,432,483
$1,437,479
 
$1,443,093
$1,451,950

Included in the available-for-sale portfolio, as detailed in Table 7, are pooled trust preferred, class A-1 securities with a current par value of $71.6 million and unrealized losses of $25.6 million at September 30, 2010.  The underlying collateral of these assets is 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.  As of September 30, 2010, an additional 32% - 38% of the underlying collateral would have to be in deferral or default concurrently to result in the potential non-receipt of contractual cash flows.  The market for these securities at September 30, 2010 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 by external pricing sources 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 may 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.
 
 
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A detailed review of the pooled trust preferred securities was completed for the quarter ended September 30, 2010.  This review included an analysis of collateral reports, a cash flow analysis, including varying degrees of projected deferral/default scenarios, and a review of various financial ratios of the underlying issuers.  Based on the analysis performed, significant further deferral/defaults and further erosion in other underlying performance conditions would have to exist before the Company would incur a loss.  Based on the analysis performed, the Company determined an other-than-temporary impairment did not exist at September 30, 2010.  To date, the Company has received all scheduled principal and interest payments and expects to fully collect all future contractual principal and interest payments.  The Company does not intend to sell the underlying securities.  These securities represent less than 1% of the Company’s earning-assets as of September 30, 2010 and, thus, are not relied upon for meeting the daily liquidity needs of the Company.  Subsequent changes in market or credit conditions could change those evaluations.

Table 7: Pooled Trust Preferred Securities as of September 30, 2010

(000’s omitted)
 
PreTSL XXVI
 
PreTSL XXVII
 
PreTSL XXVIII
             
Single issuer or pooled
 
Pooled
 
Pooled
 
Pooled
Class
 
A-1
 
A-1
 
A-1
Book value at 9/30/10
 
$22,550
 
$23,329
 
$24,029
Fair value at 9/30/10
 
13,567
 
15,000
 
15,728
Unrealized loss at 9/30/10
 
$8,983
 
$8,329
 
$8,300
Rating (Moody’s/Fitch/S&P)
 
(Ba1/BB/CCC)
 
(A3/BB/CCC+)
 
(A3/BB/CCC)
Number of depository institutions/companies in issuance
 
64/74
 
42/49
 
45/56
Deferrals and defaults as a percentage of collateral
 
30.4%
 
29.4%
 
22.6%
Excess subordination
 
26.3%
 
28.7%
 
34.5%

Loans

As shown in Table 8, loans ended the third quarter at $3.08 billion, down $19.1 million (0.6%) from year-end 2009 and down $6.7 million (0.2%) from one year earlier.  During the third quarter of 2010, the loan portfolio declined $10.8 million or 0.3% from June 30, 2010.  The decline came from the business lending portfolio ($17.8 million), partially offset by an increase in the consumer installment portfolio ($7.4 million).  The consumer mortgage portfolio remained consistent with the second quarter despite the sale of $30.1 million of mortgage loans in the secondary market during the third quarter.

Table 8: Loans
 
(000's omitted)  
September 30, 2010
 
December 31, 2009
 
September 30, 2009
 
Business lending
 
$1,043,211
33.9%
 
$1,066,730
34.4%
 
$1,052,615
34.1%
 
Consumer mortgage
 
1,065,297
34.6%
 
1,044,589
33.7%
 
1,032,807
33.5%
 
Consumer installment
 
971,889
31.5%
 
988,166
31.9%
 
1,001,671
32.4%
 
  Total loans
 
$3,080,397
100.0%
 
$3,099,485
100.0%
 
$3,087,093
100.0%
 

The combined total of general-purpose business lending, including commercial and industrial and mortgages on commercial property is characterized as the Company’s business lending activity.  The business lending portfolio decreased $23.5 million in the first nine months of 2010 and decreased $9.4 million versus one year ago.  Customer demand has remained soft due primarily to economic conditions.  The Company maintains its commitment to generating growth in its business portfolio in a manner that adheres to its twin goals of maintaining strong asset quality and producing profitable margins.  The Company has invested in additional personnel, technology and business development resources over the past few years to further strengthen its capabilities in this key business area.

Consumer mortgages increased $32.5 million year-over-year and $20.7 million in the first nine months of 2010.  During the first nine months of 2010, the Company originated and sold $52.6 million of residential mortgages, principally to Fannie Mae, as compared to $165.4 million in the first nine months of 2009.  Consumer mortgage volume has been relatively strong over the last year due to continued low long-term interest rates and comparatively stable real estate valuations in the Company’s primary markets.  The consumer real estate portfolio does not include exposure to subprime, Alt-A, or other higher-risk mortgage products.  The Company’s solid performance during a tumultuous period in the overall industry is a testament to the stable, low-risk profile of its portfolio and its ability to successfully meet customer needs at a time when some national mortgage lenders are restricting their lending activities in many of the Company’s markets.  Interest rates and expected duration continue to be the most significant factors in determining whether the Company chooses to retain, versus sell and service, portions of its new mortgage production.


 
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Consumer installment loans, both those originated directly (such as personal installment and home equity loans and lines of credit), and indirectly (originated predominantly in automobile, marine and recreational vehicle dealerships), declined $16.3 million in the first nine months of 2010 and decreased $29.8 million on a year-over-year basis.  The origination and utilization of consumer installment and home equity loans has faced somewhat softer demand over the past year due to lower consumer spending and deleveraging activities, as well as historically low mortgage interest rates in response to weaker economic conditions.  Declines in both new and used vehicle sales in 2009 and the first nine months of 2010 adversely impacted the Company’s ability to generate the same level of new loan volume it has in previous years.  The Company is focused on maintaining the solid profitability produced by its in-market and contiguous market indirect portfolio, while continuing to pursue its disciplined, long-term approach to expanding its dealer network.  It is expected that improved economic conditions in the future will create the opportunity for the Company to produce indirect loan growth more in line with its longer-term historical experience.

Asset Quality