cbna201210q1stqtr.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 March 31, 2012
   
   OR
   
 o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   For the transition period from                              to                                .
   Commission File Number: 001-13695
 
 
 
 COMMUNITY BANK SYSTEM, INC.
(Exact name of registrant as specified in its charter)
 
 
         Delaware                                16-1213679                 
 (State or other jurisdiction of incorporation or organization)      (I.R.S. Employer Identification No.)
     
         5790 Widewaters Parkway, DeWitt, New York                                  13214-1883                  
 (Address of principal executive offices)    (Zip Code)
   (315) 445-2282  
(Registrant's telephone number, including area code)
     
   NONE  
(Former name, former address and former fiscal year, if changed since last report)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes   x    No  o.

Indicate by check mark whether the registrant has submitted electronically and posted to its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  x    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   x  Accelerated filer   o  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.        
39,446,227 shares of Common Stock, $1.00 par value, were outstanding on April 30, 2012.


 
1

 


TABLE OF CONTENTS



Part I.
   Financial Information
Page
     
Item 1.
Financial Statements (Unaudited)
 
     
 
Consolidated Statements of Condition
 
 
March 31, 2012 and December 31, 2011­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­                                                                                                                                                                                                                              
3
     
 
Consolidated Statements of Income
 
 
Three months ended March 31, 2012 and 2011                                                                                                                                                                                                                 
4
     
 
Consolidated Statements of Comprehensive Income
 
 
Three months ended March 31, 2012 and 2011                                                                                                                                                                                                              
5
     
 
Consolidated Statement of Changes in Shareholders’ Equity
 
 
Three months ended March 31, 2012                                                                                                                                                                                                                               
6
     
 
Consolidated Statements of Cash Flows
 
 
Three months ended March 31, 2012 and 2011                                                                                                                                                                                                                 
7
     
 
Notes to the Consolidated Financial Statements
 
 
March 31, 2012                                                                                                                                                                                                                                                                       
8
     
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations                                                                                                                                  
24
     
Item 3.
Quantitative and Qualitative Disclosures about Market Risk                                                                                                                                                                                        
39
     
Item 4.
Controls and Procedures                                                                                                                                                                                                                                                      
40
     
Part II.
   Other Information
 
     
Item 1.
Legal Proceedings                                                                                                                                                                                                                                                              
40
     
Item 1A.
Risk Factors                                                                                                                                                                                                                                                                            
40
     
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds                                                                                                                                                                                       
40
     
Item 3.
Defaults Upon Senior Securities                                                                                                                                                                                                                                         
40
     
Item 4.
Mine Safety Disclosures                                                                                                                                                                                                                                                      
40
     
Item 5.
Other Information                                                                                                                                                                                                                                                                  
40
          
Item 6.
Exhibits                                                                                                                                                                                                                                                                                    
41


 
2

 

Part I.   Financial Information
Item 1. Financial Statements

COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF CONDITION (Unaudited)
(In Thousands, Except Share Data)
 
March 31,
December 31,
 
2012
2011
Assets:
   
   Cash and cash equivalents
$132,055
$324,878
     
   Available-for-sale investment securities (cost of $1,966,877 and $1,453,461, respectively)
2,045,380
1,538,973
     
   Held-to-maturity investment securities (fair value of $708,013 and $617,835, respectively)
652,673
553,495
     
   Other securities, at cost
67,092
58,902
     
   Loans held for sale, at fair value
-
532
     
   Loans
3,460,739
3,471,025
   Allowance for loan losses
(41,809)
(42,213)
     Net loans
3,418,930
3,428,812
     
   Goodwill
345,050
345,050
   Core deposit intangibles, net
10,715
11,519
   Other intangibles, net
3,715
3,995
     Intangible assets, net
359,480
360,564
     
   Premises and equipment, net
83,848
85,956
   Accrued interest receivable
27,944
28,579
   Other assets
125,056
107,584
     
        Total assets
$6,912,458
$6,488,275
     
Liabilities:
   
   Noninterest-bearing deposits
$911,131
$894,464
   Interest-bearing deposits
4,040,876
3,900,781
      Total deposits
4,952,007
4,795,245
     
  Borrowings
910,427
728,281
  Subordinated debt held by unconsolidated subsidiary trusts
102,054
102,048
  Accrued interest and other liabilities
107,297
88,118
     Total liabilities
6,071,785
5,713,692
     
Commitments and contingencies (See Note J)
   
     
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; 40,240,332 and
   
    37,794,532 shares issued, respectively
40,240
37,795
  Additional paid-in capital
372,554
313,501
  Retained earnings
420,415
411,805
  Accumulated other comprehensive income
24,997
29,165
  Treasury stock, at cost (801,260 and 808,123 shares, respectively)
(17,533)
(17,683)
     Total shareholders' equity
840,673
774,583
     
     Total liabilities and shareholders' equity
$6,912,458
$6,488,275





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
   
March 31,
   
2012
2011
Interest income:
   
 
Interest and fees on loans
$47,638
$42,297
 
Interest and dividends on taxable investments
14,275
12,229
 
Interest and dividends on nontaxable investments
5,598
5,761
 
     Total interest income
67,511
60,287
 
 
   
Interest expense:
   
 
Interest on deposits
5,509
6,006
 
Interest on borrowings
7,400
7,291
 
Interest on subordinated debt held by unconsolidated subsidiary trusts
693
1,467
 
     Total interest expense
13,602
14,764
       
Net interest income
53,909
45,523
Less:  provision for loan losses
1,644
1,050
Net interest income after provision for loan losses
52,265
44,473
       
Noninterest income:
   
 
Deposit service fees
10,369
9,685
 
Other banking services
994
794
 
Benefit trust, administration, consulting and actuarial fees
8,973
8,183
 
Wealth management services
3,132
2,180
Total noninterest income
23,468
20,842
       
Noninterest expenses:
   
 
Salaries and employee benefits
27,425
23,111
 
Occupancy and equipment
6,463
6,057
 
Data processing and communications
5,583
4,771
 
Amortization of intangible assets
1,086
901
 
Legal and professional fees
2,208
1,339
 
Office supplies and postage
1,468
1,196
 
Business development and marketing
1,172
1,254
 
FDIC insurance premiums
906
1,361
 
Acquisition expenses
260
691
 
Other
2,832
2,635
 
     Total noninterest expenses
49,403
43,316
       
Income before income taxes
26,330
21,999
Income taxes
7,504
5,839
Net income
$18,826
$16,160
       
Basic earnings per share
$0.49
$0.48
Diluted earnings per share
$0.48
$0.48
Dividends declared per share
$0.26
$0.24
     




The accompanying notes are an integral part of the consolidated financial statements.
 
 
4

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


 
Three Months Ended
 
March 31,
 
2012
2011
     
Other comprehensive income, before tax:
   
Change in accumulated unrealized gain or loss for pension and other post retirement obligations
$682
$174
Change in unrealized losses on derivative instruments used in cash flow hedging relationships
-
788
Unrealized holding (losses) gains arising during period
(7,010)
8,977
Other comprehensive (loss) gain, before tax:
(6,328)
9,939
Income tax benefit (expense) related to other comprehensive income
2,160
(3,821)
Other comprehensive (loss) gain, net of tax:
(4,168)
6,118
Net income
18,826
16,160
Comprehensive income
$14,658
$22,278

Tax Effect Allocated To Each Component Of Comprehensive Income:
   
     
Tax effect of unrealized loss for pension and other postretirement obligations
($264)
    ($68)
     
Tax effect of unrealized losses on derivative instruments used in cash flow hedging relationships
-
(303)
     
Tax effect of unrealized gains and losses on available-for-sale securities arising during period
2,424
(3,450)
     
Income tax benefit (expense) related to other comprehensive loss
$2,160
($3,821)
     
Accumulated Other Comprehensive Income By Component:
   
     
Unrealized loss for pension and other postretirement obligations
($39,795)
($23,090)
Tax effect
15,339
8,904
Net unrealized loss for pension and other postretirement obligations
(24,456)
(14,186)
     
Unrealized losses on derivative instruments used in cash flow hedging relationships
-
(2,445)
Tax effect
-
949
Net unrealized losses on derivative instruments used in cash flow hedging relationships
-
(1,496)
     
Unrealized gain on available-for-sale securities
78,503
18,910
Tax effect
(29,050)
(6,451)
Net unrealized gain on available-for-sale securities
49,453
12,459
     
Accumulated other comprehensive income (loss)
$24,997
($3,223)














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

 
5

 

COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited)
Three months ended March 31, 2012
(In Thousands, Except Share Data)


         
Accumulated
   
 
Common Stock
Additional
 
Other
   
 
Shares
Amount
Paid-In
Retained
Comprehensive
Treasury
 
 
Outstanding
Issued
Capital
Earnings
Income(Loss)
Stock
Total
               
Balance at December 31, 2011
          36,986,409
$37,795
$313,501
$411,805
$29,165
($17,683)
$774,583
               
Net income
     
18,826
   
18,826 
               
Other comprehensive loss, net of tax
       
(4,168)
 
(4,168)
               
Dividends declared:
             
Common, $0.26 per share
     
(10,216)
   
(10,216)
               
Common stock issued under employee
             
  stock plan, including tax benefits of $660
322,863
315
5,043
   
150
5,508
               
Stock-based compensation
   
1,223
     
1,223
 
             
Common stock issuance
2,129,800
2,130
52,787
     
54,917
               
Balance at March 31, 2012
39,439,072
$40,240
$372,554
$420,415
$24,997
($17,533)
$840,673































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)
 
Three Months Ended March 31,
 
2012
2011
Operating activities:
   
  Net income
$18,826
$16,160
  Adjustments to reconcile net income to net cash provided by operating activities:
   
     Depreciation
2,809
2,739
     Amortization of intangible assets
1,086
901
     Net accretion of premiums & discounts on securities, loans and borrowings
(998)
(314)
     Stock-based compensation
1,223
1,262
     Provision for loan losses
1,644
1,050
     Amortization of mortgage servicing rights
188
224
     Income from bank-owned life insurance policies
(271)
(113)
     Net gain from sale of loans and other assets
(171)
(388)
     Net change in loans held for sale
562
3,976
     Change in other assets and liabilities
3,997
(2,416)
       Net cash provided by operating activities
28,895
23,081
Investing activities:
   
  Proceeds from maturities of held-to-maturity investment securities
4,555
11,703
  Proceeds from maturities of available-for-sale investment securities
36,742
36,760
  Purchases of held-to-maturity investment securities
(103,633)
(2,299)
  Purchases of available-for-sale investment securities
(549,254)
(86,795)
  Net change in other securities
(8,190)
7
  Net decrease in loans
8,238
24,506
  Cash paid for acquisition
0
(270)
  Purchases of premises and equipment
(560)
(2,137)
       Net cash used in investing activities
(612,102)
(18,525)
Financing activities:
   
  Net increase in deposits
156,762
86,986
  Net change in borrowings
182,146
(75)
  Issuance of common stock
60,425
1,324
  Cash dividends paid
(9,609)
(7,976)
  Tax benefits from share-based payment arrangements
660
286
       Net cash provided by financing activities
390,384
80,545
Change in cash and cash equivalents
(192,823)
85,101
Cash and cash equivalents at beginning of period
324,878
211,837
Cash and cash equivalents at end of period
$132,055
$296,938
Supplemental disclosures of cash flow information:
   
  Cash paid for interest
$13,824
$14,882
  Cash paid for income taxes
3,091
124
Supplemental disclosures of noncash financing and investing activities:
   
  Dividends declared and unpaid
10,216
8,022
  Transfers from loans to other real estate
739
912













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

 
7

 

COMMUNITY BANK SYSTEM, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
March 31, 2012

NOTE A:  BASIS OF PRESENTATION

The interim financial data as of and for the three months ended March 31, 2012 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 in accordance with generally accepted accounting principles (“GAAP”).  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:  ACQUISITIONS

On January 19, 2012, Community Bank, N.A. (”the Bank”), the wholly-owned banking subsidiary of the Company, entered into an Assignment, Purchase and Assumption Agreement (the “HSBC Branch Agreement”) and a Purchase and Assumption Agreement (the “First Niagara Branch Agreement”) (collectively, the “Agreements”) with First Niagara Bank, N.A. (“First Niagara”).  Under the Agreements, the Bank will acquire 19 branches in Central, Northern, and Western New York, consisting of three branches purchased directly from First Niagara and 16 branches which are currently owned by HSBC Bank USA, National Association (“HSBC”). First Niagara is assigning its rights to the HSBC branches in connection with its pending acquisition of HSBC’s Upstate New York banking franchise. Under the terms of the Agreements, the Bank will acquire approximately $218 million in loans and $955 million in deposits at a blended deposit premium of 3.22%.  The branch acquisitions are expected to close during the third quarter of 2012, subject to regulatory review and approval and customary closing conditions.
 
The Company completed a public stock offering in late January 2012.  The offering raised $57.5 million through the issuance of 2.13 million shares.  The net proceeds of the offering were approximately $54.9 million.  The Company intends to use the capital raised in this offering to support the HSBC and First Niagara branch acquisitions.

On November 30, 2011, the Company, through its Benefit Plans Administrative Services, Inc. (“BPAS”) subsidiary, acquired certain assets and liabilities of CAI Benefits, Inc. (“CAI”), a provider of actuarial, consulting and retirement plan administration services, with offices in New York City and Northern New Jersey.  The results of CAI’s operations have been included in the consolidated financial statements since that date.  The transaction adds valuable service capacity and enhances distribution prospects in support of the Company’s broader-based employee benefits business, including daily valuation plan and collective investment fund administration.

On April 8, 2011, the Company acquired The Wilber Corporation (“Wilber”), parent company of Wilber National Bank, for approximately $103 million in stock and cash, comprised of $20.4 million in cash and the issuance of 3.35 million additional shares of the Company’s common stock.  Based in Oneonta, New York, Wilber operated 22 branches in the Central, Greater Capital District, and Catskill regions of Upstate New York.  Wilber was merged into the Company and Wilber National Bank was merged into the Bank.  The results of Wilber’s operations have been included in the Company’s financial statements since that date.

The assets and liabilities assumed in the acquisitions were recorded at their estimated fair values based on management's best estimates using information available at the dates of acquisition.  The following table summarizes the estimated fair value of the assumed assets and liabilities.
 
(000s omitted)
Consideration paid:
 
Community Bank System, Inc. common stock
$82,580 
Cash
21,885 
   Total consideration paid
104,465 
Recognized amounts of identifiable assets acquired and liabilities assumed:
 
Cash and cash equivalents
26,901 
Investment securities
297,573 
Loans
462,334 
Premises and equipment
6,353 
Accrued interest receivable
2,615 
Other assets and liabilities, net
46,942 
Core deposit intangibles
4,016 
Other intangibles
1,595 
Deposits
(771,554) 
Borrowings
(19,668) 
  Total identifiable assets
57,107 
     Goodwill
$  47,358 
 
 
8

 
 
Acquired loans that have evidence of deterioration in credit quality since origination and for which it is probable, at acquisition, that the Company will be unable to collect all contractually required payments were aggregated by comparable characteristics and  recorded at fair value without a carryover of the related allowance for loan losses.  Cash flows for each pool were determined using an estimate of future credit losses and an estimated rate of prepayments.  Projected monthly cash flows were then discounted to present value using a market-based discount rate.  The excess of the undiscounted expected cash flows over the estimated fair value is referred to as the “accretable yield” and is recognized into interest income over the remaining lives of the acquired loans.

The following is a summary of the loans acquired in the Wilber acquisition:
 
(000’s omitted)
Acquired Impaired Loans
     Acquired      
Non-Impaired Loans
Total  
Acquired
Loans
Contractually required principal and interest at acquisition
$41,730
$680,516
$722,246
Contractual cash flows not expected to be collected
      (20,061)
(31,115)
(51,176)
    Expected cash flows at acquisition
21,669
649,401
671,070
Interest component of expected cash flows
(2,509)
(206,227)
(208,736)
   Fair value of acquired loans
$19,160
$443,174
$462,334

The core deposit intangible and customer list are being amortized over their estimated useful life of approximately eight years, using an accelerated method.  The goodwill, which is not amortized for book purposes, was assigned to the Banking segment for the Wilber acquisition and to the Other segment for the CAI acquisition.  The goodwill arising from the Wilber acquisition is not deductible for tax purposes while the goodwill arising from the CAI acquisition is deductible for tax purposes.

The fair value of checking, savings and money market deposit accounts acquired from Wilber were assumed to approximate the carrying value as these accounts have no stated maturity and are payable on demand.  Certificate of deposit accounts were valued as the present value of the certificates expected contractual payments discounted at market rates for similar certificates.

Direct costs related to the acquisitions were expensed as incurred.  During the three months ended March 31, 2012 and 2011, the Company incurred $0.3 million and $0.7 million, respectively, of merger and acquisition integration-related expenses and have been separately stated in the Consolidated Statements of Income.

Supplemental Pro Forma Financial Information
The following unaudited condensed pro forma information assumes the Wilber acquisition had been completed as of January 1,  2011 for the three months ended March 31, 2011 and January 1, 2010 for the three months ended March 31, 2010. The pro forma information does not include amounts related to CAI as the amounts were immaterial and financial information is not readily available. The table below has been prepared for comparative purposes only and is not necessarily indicative of the actual results that would have been attained had the acquisition occurred as of the beginning of the periods presented, nor is it indicative of the Company’s future results. Furthermore, the unaudited pro forma information does not reflect management’s estimate of any revenue-enhancing opportunities nor anticipated cost savings or the impact of conforming certain acquiree accounting policies to the Company’s policies that may have occurred as a result of the integration and consolidation of the acquisitions.

 
The pro forma information, for the three months ended March 31, 2011 set forth below reflects adjustments related to (a) certain purchase accounting fair value adjustments; (b) amortization of core deposit and other intangibles; and (c) income tax rate adjustment.  Expenses related to conversion of systems and other costs of integration, as well as certain one-time costs, are included in the periods in which they were incurred.
     
 
Pro Forma (Unaudited) Three Months Ended
(000’s omitted)
March 31, 2011
March 31, 2010
Total revenue, net of interest expense
$75,671
$75,706
Net income
16,523
15,363
Earnings per share:
   
Basic
$0.45
$0.42
Diluted
$0.44
$.042
     




 
9

 

NOTE C:  ACCOUNTING POLICIES

The accounting policies of the Company, as applied in the consolidated interim financial statements presented herein, are substantially the same as those followed on an annual basis as presented on pages 54 through 60 of the Annual Report on Form 10-K for the year ended December 31, 2011 filed with the Securities and Exchange Commission (“SEC”) on February 29, 2012.

Critical Accounting Policies

Acquired loans
Acquired loans are initially recorded at their acquisition date fair values.  The carryover of allowance for loan losses is prohibited as any credit losses in the loans are included in the determination of the fair value of the loans at the acquisition date.  Fair values for acquired loans are based on a discounted cash flow methodology that involves assumptions and judgments as to credit risk, prepayment risk, liquidity risk, default rates, loss severity, payment speeds, collateral values and discount rate.  Subsequent to the acquisition of acquired impaired loans, GAAP requires the continued estimation of expected cash flows to be received.  This estimation requires numerous assumptions, interpretations and judgments using internal and third-party credit quality information.  Changes in expected cash flows could result in the recognition of impairment through provision for credit losses.

For acquired loans that are not deemed impaired at acquisition, credit discounts representing the principal losses expected over the life of the loan are a component of the initial fair value.  Subsequent to the purchase date, the methods utilized to estimate the required allowance for loan losses for the non-impaired acquired loans is similar to originated loans, however, the Company records a provision for loan losses only when the required allowance exceeds any remaining pooled discounts for loans evaluated collectively for impairment.  For loans individually evaluated for impairment, a provision is recoded when the required allowance exceeds any remaining discount on the loan.

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

The general loan loss allocation is composed of two calculations that are computed on five main loan segments:  business lending, consumer installment - direct, consumer installment - indirect, home equity and consumer mortgage.  The first calculation determines an allowance level based on the latest 36 months of historical net charge-off data for each loan class (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 conditions; 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 and allowances needed for acquired loans, if any, to derive the total required allowance for loan losses to be reflected on the Consolidated Statement of Condition.

Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance.  A provision for loan loss is charged to operations based on management’s periodic evaluation of 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 until 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 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 March 31, 2012.  Certain equity securities are stated at cost and include restricted stock of the Federal Reserve Bank of New York and Federal Home Loan Bank of New York.

Fair values for investment securities are based 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 D and K for more information.


 
10

 
 
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.
 
An OTTI loss must be recognized for a debt security in an unrealized loss position if there is 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 management does not have the intent and it is not more likely than not that the Company will be required to sell the securities, 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 OTTI  charges.  Premiums and discounts on securities are amortized and accreted, respectively, on the interest method 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, expected equity market premiums, peer volatility indicators 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 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.  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.

Retirement Benefits
The Company provides defined benefit pension benefits to eligible employees and post-retirement health and life insurance benefits to certain eligible retirees.  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.


 
11

 
 
New Accounting Pronouncements
In December 2011, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2011-11—Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities. The standard requires new disclosures about certain financial instruments and derivative instruments that are either offset in the balance sheet (presented on a net basis) or subject to an enforceable master netting arrangement or similar arrangement. The standard requires disclosures that provide both gross and net information in the notes to the financial statements for relevant assets and liabilities. The new requirements do not change the accounting guidance on netting, but rather enhance the disclosures to more clearly show the impact of netting arrangements on a company’s financial position. This new accounting guidance will be effective, on a retrospective basis for all comparative periods presented, beginning on January 1, 2013.  The adoption of this standard is not expected to have an impact on the Company’s consolidated financial statements.

NOTE D:  INVESTMENT SECURITIES

The amortized cost and estimated fair value of investment securities as of March 31, 2012 and December 31, 2011 are as follows:

 
March 31, 2012
 
December 31, 2011
   
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
$546,636
$50,127
$1,968
$594,795
 
$448,260
$56,800
$0
$505,060
Obligations of state and political subdivisions
70,987
5,515
0
76,502
 
69,623
5,088
0
74,711
Government agency mortgage-backed securities
32,083
1,696
0
33,779
 
35,576
2,452
0
38,028
Corporate debt securities
2,940
0
30
2,910
 
0
0
0
0
Other securities
27
0
0
27
 
36
0
0
36
     Total held-to-maturity portfolio
$652,673
$57,338
$1,998
$708,013
 
$553,495
$64,340
$0
$617,835
                   
Available-for-Sale Portfolio:
                 
U.S. Treasury and agency securities
$927,036
$49,971
$104
$976,903
 
$463,922
$56,626
$0
$520,548
Obligations of state and political subdivisions
614,466
28,162
2,130
640,498
 
543,527
29,721
236
573,012
Government agency mortgage-backed securities
294,686
19,416
25
314,077
 
310,541
20,840
2
331,379
Pooled trust preferred securities
67,087
0
19,702
47,385
 
68,115
0
24,269
43,846
Government agency collateralized mortgage obligations
41,726
1,655
71
43,310
 
45,481
1,572
110
46,943
Corporate debt securities
21,495
1,294
0
22,789
 
21,495
1,360
0
22,855
Marketable equity securities
381
84
47
418
 
380
92
82
390
     Total available-for-sale portfolio
$1,966,877
$100,582
$22,079
$2,045,380
 
$1,453,461
$110,211
$24,699
$1,538,973
                   
Other Securities:
                 
Federal Home Loan Bank common stock
$46,533
   
$46,533
 
$38,343
   
$38,343
Federal Reserve Bank common stock
15,451
   
15,451
 
15,451
   
15,451
Other equity securities
5,108
   
5,108
 
5,108
   
5,108
     Total other securities
$67,092
   
$67,092
 
$58,902
   
$58,902


 
12

 

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 March 31, 2012
 
   
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    5
$96,318
$1,968
   0  $0  $0    5
$96,318
$1,968
  Corporate debt securities   2
2,910
 30    0  0  0    2  2,910  30
     Total held-to-maturity portfolio    7  99,228  1,998    0  0  0    7  99,228  1,998
                         
 Available-for-Sale Portfolio:                        
  U.S. Treasury and agency securities    2
34,365
104
   0
0
 0    2
34,365
 104
  Obligations of state and political subdivisions    116
80,605
 2,096    6
6,238
 34    122
86,843
 2,130
  Government agency mortgage-backed securities    3
3,421
 24    1
30
 1    4
3,451
25
  Pooled trust preferred securities    0
0
 0    3
47,385
 19,702    3
47,385
 19,702
  Government agency collateralized mortgage obligations    2
49
 0    9
5,157
 71    11
5,206
 71
  Marketable equity securities    1
157
 44    3
13
 3    4
170
 47
     Total available-for-sale portfolio    124
118,597
 2,268    22
58,823
 19,811    146
177,420
 22,079
       Total investment portfolio    131
$217,825
 $4,266    22
$58,823
 $19,811    153
$276,648
$24,077
 
As of December 31, 2011
 
   
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
 
2
$211
$0
 
6
$6,038
$236
 
8
$6,249
$236
 Government agency mortgage-backed securities
 
3
2,415
2
 
0
0
0
 
3
2,415
2
 Pooled trust preferred securities
 
0
0
0
 
3
43,846
24,269
 
3
43,846
24,269
 Government agency collateralized mortgage obligations    17
6,648
110
 
0
0
0
 
17
6,648
110
 Marketable equity securities
 
1
123
78
 
3
12
4
 
4
135
82
    Total available-for-sale/investment portfolio
 
23
$9,397
$190
 
12
$49,896
$24,509
 
35
$59,293
$24,699

Included in the available-for-sale portfolio are pooled trust preferred, class A-1 securities with a current total par value of $68.6 million and unrealized losses of $19.7 million at March 31, 2012.  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 March 31, 2012, an additional 37% - 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 March 31, 2012.  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 OTTI did not exist at March 31, 2012.  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.

Management does not believe any individual unrealized loss as of March 31, 2012 represents OTTI.  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, AA+ by 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.
 
 
13

 
 
The amortized cost and estimated fair value of debt securities at March 31, 2012, 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
 
$12,525
$12,615
 
$31,089
$31,342
Due after one through five years
 
279,894
307,866
 
228,714
243,293
Due after five years through ten years
 
163,599
183,466
 
885,741
917,083
Due after ten years
 
164,572
170,287
 
484,540
495,857
     Subtotal
 
620,590
674,234
 
1,630,084
1,687,575
Government agency collateralized mortgage obligations
 
0
0
 
41,726
43,310
Government agency mortgage-backed securities
 
32,083
33,779
 
294,686
314,077
     Total
 
$652,673
$708,013
 
$1,966,496
$2,044,962

NOTE E:  LOANS

The segments of the Company’s loan portfolio are disaggregated into classes that allow management to monitor risk and performance.  Consumer mortgages consist primarily of fixed rate residential instruments, typically 15 – 30 years in contractual term, secured by first liens on real property.  Business lending is comprised of general purpose commercial and industrial loans including agricultural-related and dealer floor plans, as well as mortgages on commercial property.  Consumer installment – indirect consists primarily of loans originated through selected dealerships and are secured by automobiles, marine and other recreational vehicles.  Consumer installment – direct are all other loans to consumers such as personal installment loans and lines of credit.  Home equity products are consumer purpose installment loans or lines of credit most often secured by a first or second lien position on residential real estate with terms of 15 years or less.  Loans are summarized as follows:
 
 
March 31,
December 31,
(000's omitted)
2012
2011
Consumer mortgage
$1,245,217
$1,214,621
Business lending
1,210,773
1,226,439
Consumer installment - indirect
542,605
556,955
Consumer installment - direct
144,428
149,170
Home equity
317,716
323,840
  Gross loans, including deferred origination costs
3,460,739
3,471,025
Allowance for loan losses
(41,809)
(42,213)
Loans, net of allowance for loan losses
$3,418,930
$3,428,812

The outstanding balance related to credit impaired acquired loans was $25.5 million and $25.9 million at March 31, 2012 and December 31, 2011, respectively.  The changes in the accretable discount related to the credit impaired acquired loans are as follows:

Balance at December 31, 2011
$2,610
Accretion recognized, to-date
(456)
Net reclassification from accretable to nonaccretable
184
Balance at March 31, 2012
$2,338
 
Credit Quality
Management monitors the credit quality of its loan portfolio on an ongoing basis.  Measurement of delinquency and past due status are based on the contractual terms of each loan.  Past due loans are reviewed on a monthly basis to identify loans for non-accrual status.  The following is an aged analysis of the Company’s past due loans, by class as of March 31, 2012:

Legacy Loans (excludes loans acquired after January 1, 2009)
(000’s omitted)
30 - 89 Days
90+ Days Past Due and
 Still Accruing
Nonaccrual
Total
Past Due
Current
Total Loans
Consumer mortgage
$11,611
$2,256
$6,027
$19,894
$1,151,433
$1,171,327
Business lending
5,975
111
13,312
19,398
945,140
964,538
Consumer installment - indirect
5,775
30
0
5,805
519,300
525,105
Consumer installment – direct
1,272
63
0
1,335
135,358
136,693
Home equity
2,015
240
839
3,094
283,830
286,924
Total
$26,648
$2,700
$20,178
$49,526
$3,035,061
$3,084,587
 
 
14

 
 
Acquired Loans (includes loans acquired after January 1, 2009)

 
(000’s omitted)
30 - 89 Days
90+ Days Past Due and
 Still Accruing
Nonaccrual
Total
Past Due
 
Acquired Impaired(1)
Current
Total Loans
Consumer mortgage
$697
$137
$1,105
$1,939
$0
$71,951
$73,890
Business lending
1,778
1,051
8,467
11,296
17,037
217,902
246,235
Consumer installment - indirect
434
1
1
436
0
17,064
17,500
Consumer installment – direct
61
0
0
61
0
7,674
7,735
Home equity
343
0
396
739
0
30,053
30,792
Total
$3,313
$1,189
$9,969
$14,471
$17,037
$344,644
$376,152
(1)  
– Acquired impaired loans were not classified as nonperforming assets as the loans are considered to be performing under ASC 310-30.  As a result interest income, through the accretion of the difference between the carrying amount of the loans and the expected cashflows, is being recognized on all acquired impaired loans.

The following is an aged analysis of the Company’s past due loans by class as of December 31, 2011:

Legacy Loans (excludes loans acquired after January 1, 2009)

(000’s omitted)
30 - 89 Days
90+ Days Past Due and
 Still Accruing
Nonaccrual
Total
Past Due
Current
Total Loans
Consumer mortgage
$16,026
$2,144
$5,755
$23,925
$1,111,795
$1,135,720
Business lending
4,799
389
10,966
16,154
953,745
969,899
Consumer installment - indirect
8,847
32
0
8,879
527,030
535,909
Consumer installment – direct
1,912
95
0
2,007
138,500
140,507
Home equity
2,269
218
864
3,351
290,093
293,444
Total
$33,853
$2,878
$17,585
$54,316
$3,021,163
$3,075,479

Acquired Loans (includes loans acquired after January 1, 2009)

 
(000’s omitted)
30 - 89 Days
90+ Days Past Due and
 Still Accruing
Nonaccrual
Total
Past Due
 
Acquired Impaired(1)
Current
Total Loans
Consumer mortgage
$985
$27
$765
$1,777
$0
$77,124
$78,901
Business lending
3,473
10
9,592
13,075
17,428
226,037
256,540
Consumer installment - indirect
737
0
2
739
0
20,307
21,046
Consumer installment – direct
167
0
0
167
0
8,496
8,663
Home equity
465
175
341
981
0
29,415
30,396
Total
$5,827
$212
$10,700
$16,739
$17,428
$361,379
$395,546
(1)  
– Acquired impaired loans were not classified as nonperforming assets as the loans are considered to be performing under ASC 310-30.  As a result interest income, through the accretion of the difference between the carrying amount of the loans and the expected cashflows, is being recognized on all acquired impaired loans.


The Company uses several credit quality indicators to assess credit risk in an ongoing manner.  The Company’s primary credit quality indicator for its business lending portfolio is an internal credit risk rating system that categorizes loans as “pass”, “special mention”, or “classified”.  Credit risk ratings are applied individually to those classes of loans that have significant or unique credit characteristics that benefit from a case-by-case evaluation.  The following are the definitions of the Company’s credit quality indicators:
 
Pass  In general, the condition of the borrower and the performance of the loans are satisfactory or better.
   
Special Mention   In general, the condition of the borrower has deteriorated although the loan performs as agreed.
   
Classified
 In general, the condition of the borrower has significantly deteriorated and the performance of the loan could further deteriorate, if deficiencies are not corrected.
   
Doubtful    In general, the condition of the borrower has deteriorated to the point that collection of the balance is improbable based on currently facts and conditions.
 
                                                      
 
15

 
 
The following table shows the amount of business lending loans by credit quality category:

 
March 31, 2012
 
December 31, 2011
(000’s omitted)
Legacy
Acquired
Total
 
Legacy
Acquired
Total
Pass
$737,844
$146,507
$884,351
 
$732,873
$157,494
$890,367
Special mention
105,680
43,785
149,465
 
118,800
47,890
166,690
Classified
120,563
38,906
159,469
 
118,226
33,728
151,954
Doubtful
451
0
451
 
0
0
0
Acquired impaired
0
17,037
17,037
 
0
17,428
17,428
Total
$964,538
$246,235
$1,210,773
 
$969,899
$256,540
$1,226,439

All other loans are underwritten and structured using standardized criteria and characteristics, primarily payment performance, and are normally risk rated and monitored collectively on a monthly basis.  These are typically loans to individuals in the consumer categories and are delineated as either performing or nonperforming.   Performing loans include current, 30 – 89 days past due and acquired impaired loans.  Nonperforming loans include 90+ days past due and still accruing and non-accrual loans.

The following table details the balances in all other loan categories at March 31, 2012:

Legacy loans (excludes loans acquired after January 1, 2009)
(000’s omitted)
Consumer
Mortgage
Consumer Indirect
Consumer Direct
Home Equity
Total
Performing
$1,163,044
$525,075
$136,630
$285,845
$2,110,594
Nonperforming
8,283
30
63
1,079
9,455
Total
$1,171,327
$525,105
$136,693
$286,924
$2,120,049

Acquired loans (includes loans acquired after January 1, 2009)
(000’s omitted)
Consumer
Mortgage
Consumer Indirect
Consumer Direct
Home Equity
Total
Performing
$72,648
$17,498
$7,735
$30,396
$128,277
Nonperforming
1,242
2
0
396
1,640
Total
$73,890
$17,500
$7,735
$30,792
$129,917

The following table details the balances in all other loan categories at December 31, 2011:

Legacy loans (excludes loans acquired after January 1, 2009)
(000’s omitted)
Consumer
Mortgage
Consumer Indirect
Consumer Direct
Home Equity
Total
Performing
$1,127,821
$535,877
$140,412
$292,362
$2,096,472
Nonperforming
7,899
32
95
1,082
9,108
Total
$1,135,720
$535,909
$140,507
$293,444
$2,105,580

Acquired loans (includes loans acquired after January 1, 2009)
(000’s omitted)
Consumer
Mortgage
Consumer Indirect
Consumer Direct
Home Equity
Total
Performing
$78,109
$21,044
$8,663
$29,880
$137,696
Nonperforming
792
2
0
516
1,310
Total
$78,901
$21,046
$8,663
$30,396
$139,006

All loan classes are collectively evaluated for impairment except business lending, as described in Note B.  A summary of individually evaluated impaired loans as of March 31, 2012 and December 31, 2011 follows:

 
March 31,
December 31,
(000’s omitted)
2012
2011
Loans with reserve
$8,017 
$4,118 
Loans without reserve
7,043 
2,308 
Carrying balance
15,060 
6,426 
Contractual balance
18,270 
8,527 
Specifically allocated allowance
1,880 
895 
 
 
 
16

 
 
Allowance for Loan Losses

The following presents by class the activity in the allowance for loan losses:

 
Three Months Ended March 31, 2012
 
Consumer
Business
Consumer
Consumer
Home
 
Acquired 
 
(000’s omitted)
Mortgage
Lending
Indirect
Direct
Equity
Unallocated
Impaired 
Total
Beginning balance
$4,651
$20,574
$8,960
$3,290
$1,130
$3,222
$386   
$42,213
Charge-offs
(269)
(1,565)
(1,039)
(457)
(116)
0
0 0
(3,446)
Recoveries
13
155
1,042
172
16
0
0 0
1,398
Provision
490
2,249
(1,025)
61
251
(452)
70   
1,644
Ending balance
$4,885
$21,413
$7,938
$3,066
$1,281
$2,770
$456   
$41,809
 
 
Three Months Ended March 31, 2011
 
Consumer
Business
Consumer
Consumer
Home
 
Acquired 
 
(000’s omitted)
Mortgage
Lending
Indirect
Direct
Equity
Unallocated
Impaired 
Total
Beginning balance
$2,451
$22,326
$9,922
$3,977
$689
$3,145
$0   
$42,510
Charge-offs
(236)
(843)
(1,026)
(417)
(36)
0
0 0
(2,558)
Recoveries
19
86
817
216
7
0
0 0
1,145
Provision
865
(10)
(74)
18
200
51
0 0
1,050
Ending balance
$3,099
$21,559
$9,639
$3,794
$860
$3,196
$0   
$42,147

Despite the above allocation, the allowance for loan losses is general in nature and is available to absorb losses from any loan type.

NOTE F:  GOODWILL AND IDENTIFIABLE INTANGIBLE ASSETS

The gross carrying amount and accumulated amortization for each type of identifiable intangible asset are as follows:
 
   
March 31, 2012
 
December 31, 2011
   
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
 
$32,437
($21,722)
$10,715
 
$32,437
($20,918)
$11,519
  Other intangibles
 
9,431
(5,716)
3,715
 
9,429
(5,434)
3,995
 Total amortizing intangibles
 
$41,868
($27,438)
$14,430
 
$41,866
($26,352)
$15,514

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

Apr - Dec 2012
$3,027
2013
3,305
2014
2,579
2015
1,905
2016
1,314
Thereafter
2,300
Total
$14,430

Shown below are the components of the Company’s goodwill at March 31, 2012:

(000’s omitted)
December 31, 2011
Activity
March 31, 2012
Goodwill
$349,874
$0
$349,874
Accumulated impairment
(4,824)
-
(4,824)
Goodwill, net
$345,050
$0
$345,050


 
17

 

NOTE G:  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 Price
III
7/31/2001
$24.5 million
3 month LIBOR plus 3.58% (4.13%)
7/31/2031
Par
IV
12/8/2006
$75 million
3 month LIBOR plus 1.65% (2.12%)
12/15/2036
Par

On December 8, 2006, the Company established Trust IV, which completed the sale of $75 million of trust preferred securities.  At the time of the offering, the Company also entered into an interest rate swap agreement to convert the variable rate trust preferred securities into fixed rate securities for a term of five years at a fixed rate of 6.43%.  The interest rate swap agreement expired December 15, 2011.  Additional interest expense of approximately $0.8 million was recognized during the three months ended March 31, 2011 due to the interest rate swap agreement.

NOTE H:  BENEFIT PLANS

The Company provides a qualified defined benefit pension to eligible employees and retirees, other post-retirement health and life insurance benefits to certain retirees, an unfunded supplemental pension plan for certain key executives, and an unfunded stock balance plan for certain of its nonemployee directors.  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 months ended March 31 is as follows:
 
 
Pension Benefits
 
Post-retirement Benefits
 
Three Months Ended
 
Three Months Ended
 
March 31,
 
March 31,
(000's omitted)
2012
2011
 
2012
2011
Service cost
$848
$686
 
$0
$0
Interest cost
1,098
961
 
29
38
Expected return on plan assets
(2,299)
(1,767)
 
0
0
Amortization of unrecognized net loss
922
474
 
3
2
Amortization of prior service cost
(37)
(37)
 
(206)
(264)
Net periodic benefit cost
$532
$317
 
($174)
($224)

Effective September 30, 2011, the Wilber National Bank Retirement Plan, with $20.5 million in assets, was merged into the Community Bank System, Inc. Pension Plan and, as required, the combined plan was revalued.


 
18

 

NOTE I:  EARNINGS PER SHARE

Basic earnings per share are computed based on the weighted-average of the common shares outstanding for the period.  Diluted earnings per share are based on the weighted-average of the 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 0.3 million weighted-average anti-dilutive stock options outstanding at March 31, 2012, compared to approximately 0.6 million weighted-average anti-dilutive stock options outstanding at March 31, 2011, that were not included in the computation below.

The following is a reconciliation of basic to diluted earnings per share for the three months ended March 31, 2012 and 2011.

 
Three Months Ended
March 31,
(000's omitted, except per share data)
2012
2011
Net income
$18,826
$16,160
Income attributable to unvested stock-based compensation awards
(104)
(131)
Income available to common shareholders
18,722
16,029
     
Weighted-average common shares outstanding – basic
38,573
33,245
Basic earnings per share
$0.49
$0.48
     
Net income
$18,826
$16,160
Income attributable to unvested stock-based compensation awards
(104)
(131)
Income available to common shareholders
18,722
16,029
     
Weighted-average common shares outstanding
38,573
33,245
Assumed exercise of stock options
535
472
Weighted-average shares – diluted
39,108
33,717
Diluted earnings per share
$0.48
$0.48

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 in 2011 or thus far in 2012.  At its December 2011 meeting, the Board approved extending the stock repurchase program authorizing the repurchase, at the discretion of senior management, of up to 1,500,000 shares through December 31, 2012.  

NOTE J:  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)
March 31,
 2012
December 31,
2011
Commitments to extend credit
$583,856
$572,393
Standby letters of credit
24,539
25,279
Total
$608,395
$597,672
 
 
 
19

 
 
The Company is subject in the normal course of business to various pending and threatened legal proceedings in which claims for monetary damages are asserted. Management, after consultation with legal counsel, does not anticipate that the aggregate ultimate liability arising out of litigation pending or threatened against the Company will be material to its consolidated financial position. On an on-going basis the Company assesses its liabilities and contingencies in connection with such legal proceedings. For those matters where it is probable that the Company will incur losses and the amounts of the losses can be reasonably estimated, the Company records an expense and corresponding liability in its consolidated financial statements. To the extent the pending or threatened litigation could result in exposure in excess of that liability, the amount of such excess is not currently estimable. Although not considered probable, the range of reasonably possible losses for such matters in the aggregate, beyond the existing recorded liability, was between $0 and $1 million. Although the Company does not believe that the outcome of pending litigations will be material to the Company’s consolidated financial position, it cannot rule out the possibility that such outcomes will be material to the consolidated results of operations for a particular reporting period in the future.

NOTE K:  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 any of the levels for the periods presented.

 
March 31, 2012
(000's omitted)
Level 1
Level 2
Level 3
Total Fair Value
Available-for-sale investment securities:
       
U.S. Treasury and agency securities
$770,022
$206,881
$0
$976,903
Obligations of state and political subdivisions
0
640,498
0
640,498
Government agency mortgage-backed securities
0
314,077
0
314,077
Pooled trust preferred securities
0
0
47,385
47,385
Government agency collateralized mortgage obligations
0
43,310
0
43,310
Corporate debt securities
0
22,789
0
22,789
Marketable equity securities
418
0
0
418
   Total available-for-sale investment securities
$770,440
$1,227,555
$47,385
$2,045,380

 
December 31, 2011
(000's omitted)
Level 1
Level 2
Level 3
Total Fair Value
Available-for-sale investment securities:
       
U.S. Treasury and agency securities
$311,958
$208,590
$0
$520,548
Obligations of state and political subdivisions
0
573,012
0
573,012
Government agency mortgage-backed securities
0
331,379
0
331,379
Pooled trust preferred securities
0
0
43,846
43,846
Government agency collateralized mortgage obligations
0
46,943
0
46,943
Corporate debt securities
0
22,855
0
22,855
Marketable equity securities
390
0
0
390
   Total available-for-sale investment securities
312,348
1,182,779
43,846
1,538,973
Mortgage loans held for sale
0
532
0
532
   Total
$312,348
$1,183,311
$43,846
$1,539,505
 
 
 
20

 
 
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 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 from third party sources 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 Company did not hold any mortgage loans held for sale at March 31, 2012.   Unrealized gains and losses on mortgage loans held for sale, when they occur, are recognized in other banking services income in the consolidated statement of income.

The changes in Level 3 assets measured at fair value on a recurring basis are summarized in the following tables:
 
 
Three Months Ended March 31,
 
2012
 
2011
(000's omitted)
Pooled Trust Preferred Securities
 
Pooled Trust Preferred Securities
Commitments to Originate Real Estate Loans for Sale
Total
Beginning balance
$43,846
 
$41,993
$58
$42,051
Total gains (losses) included in earnings (1)(2)
47
 
23
(58)
(35)
Total gains included in other comprehensive income(3)
4,567
 
6,523
0
6,523
Principal reductions
(1,075)
 
(367)
0
(367)
Commitments to originate real estate loans held for sale, net
0
 
0
58
58
Ending balance
$47,385
 
$48,172
$58
$48,230
(1) Amounts included in earnings associated with the pooled trust preferred securities relate to accretion of related discount and are reported in interest and dividends on taxable investments.
(2) Amounts included in earnings associated with the commitments to originate real estate loans for sale are reported as a component of other banking service fees.
(3) Amounts included in other comprehensive income associated with the pooled trust preferred securities are relate to changes in unrealized loss and are reported as a component of unrealized gains on securities in the Statement of Comprehensive Income.
 
Assets and liabilities measured on a non-recurring basis:

 
March 31, 2012
 
December 31, 2011
(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
$4,582
$4,582
 
$0
$0
$4,118
$4,118
Other real estate owned
0
0
2,690
2,690
 
0
0
2,682
2,682
Mortgage servicing rights
0
0
890
890
 
0
0
1,747
1,747
   Total
$0
$0
$8,162
$8,162
 
$0
$0
$8,547
$8,547

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


 
21

 

Other real estate owned is valued at the time the loan is foreclosed upon and the asset is transferred to other real estate owned. The value is based primarily on third party appraisals, less costs to sell. The appraisals are sometimes further discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and client’s business. Such discounts are significant, ranging from 9% to 46% at March 31, 2012 and result in a Level 3 classification of the inputs for determining fair value. Other real estate owned is reviewed and evaluated on at least an annual basis for additional impairment and adjusted accordingly, based on the same factors identified above. The Company recovers the carrying value of other real estate owned through the sale of the property. The ability to affect future sales prices is subject to market conditions and factors beyond our control and may impact the estimated fair value of a property.

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 GAAP, the Company must record impairment charges, on a nonrecurring basis, when the carrying value of certain strata exceed their estimated fair value.  The fair value of mortgage servicing rights is based on a valuation model incorporating inputs that market participants would use in estimating future net servicing income.  Such inputs include estimates of the cost of servicing loans, appropriate discount rate and prepayment speeds 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 exceeds estimated fair value.  Impairment is recognized through a valuation allowance.  There is a valuation allowance of approximately $332,000 at March 31, 2012.

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 expectation of the market in relation to present risk-free interest rates, expected equity market premiums, peer volatility indicators and company-specific risk indicators.  The Company did not recognize an impairment charge during 2011 or the three months ended March 31, 2012.

The significant unobservable inputs used in the determination of fair value of assets classified as Level 3 on a recurring or non-recurring basis as of March 31, 2012 are as follows:
 
(000's omitted)
Fair Value at
March 31, 2012
Valuation Technique
Significant Unobservable Inputs
Significant Unobservable Input Range
(Weighted Average)
         
Pooled trust preferred securities
$47,385
Consensus pricing
Weighting of prices   
56.5 – 75.3 (69.1%)
         
Impaired loans
4,582
Appraisals
Estimated cost of disposal/market adjustment   
11% - 25%
         
Other real estate owned
2,690
Appraisals
Estimated cost of disposal/market adjustment   
9% – 46%
         
Mortgage servicing rights
890
Discounted cash flow
Weighted average constant prepayment rate   
16.2% - 29.3% (24.7%)
     
Spread over market curve   
2.98% - 4.10% (3.68%)
     
Adequate compensation   
$7/loan

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 D.

The carrying amounts and estimated fair values of the Company’s other financial instruments that are not accounted for at fair value at March 31, 2012 and December 31, 2011 are as follows:

   
March 31, 2012
 
December 31, 2011
   
Carrying
Fair
 
Carrying
Fair
(000's omitted)
 
Value
Value
 
Value
Value
Financial assets:
           
   Net loans
 
$3,460,739
$3,468,883
 
$3,471,025
$3,491,729
Financial liabilities:
           
   Deposits
 
4,952,007
4,964,875
 
4,795,245
4,810,856
   Borrowings
 
910,427
1,004,813
 
728,281
828,018
   Subordinated debt held by unconsolidated subsidiary trusts
 
102,054
75,196
 
102,048
73,211
 
 
 
22

 
 
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 have been classified as a Level 3 valuation.  Fair values for variable rate loans that re-price 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 for the same remaining maturity.

Deposits have been classified as a Level 2 valuation.  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 as rates re-price frequently and, therefore, are deemed to approximate market interest rates.  The fair value of time deposit obligations is determined using a discounted cash flow analysis based on current market rates for similar products.

Borrowings have been classified as a Level 2 valuation.  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 have been classified as a Level 2 valuation.  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 have been classified as a Level 1 valuation, while accrued interest receivable and accrued interest payable have been classified as a Level 2 valuation.  The fair values of each approximate the respective carrying values because the instruments are payable on demand or have short-term maturities and present low credit and interest rate risk.

NOTE L:  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.  Community Bank, N.A. operates the banking segment that provides full-service banking to consumers, businesses and governmental units in northern, central and western New York as well as Northern Pennsylvania.

Other 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, 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, 2011 filed with the SEC on February 29, 2012).

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 March 31, 2012
       
Net interest income
$53,869
$40
$0
$53,909
Provision for loan losses
1,644
0
0
1,644
Noninterest income
11,363
12,679
(574)
23,468
Amortization of intangible assets
804
282
0
1,086
Other operating expenses
38,517
10,374
(574)
48,317
Income before income taxes
$24,267
$2,063
$0
$26,330
Assets
$6,887,276
$39,412
($14,230)
$6,912,458
Goodwill
$334,554
$10,496
$0
$345,050
Three Months Ended March 31, 2011
       
Net interest income
$45,501
$22
$0
$45,523
Provision for loan losses
1,050
0
0
1,050
Noninterest income
10,480
10,843
(481)
20,842
Amortization of intangible assets
700
201
0
901
Other operating expenses
34,549
8,347
(481)
42,415
Income before income taxes
$19,682
$2,317
$0
$21,999
Assets
$5,525,773
$33,141
($9,542)
$5,549,372
Goodwill
$287,411
$10,281
$0
$297,692
         
 
 
 
23

 
 
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 months ended March 30, 2012 and 2011, although in some circumstances the fourth quarter of 2011 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 23.  All references in the discussion to the financial condition and results of operations are to those of the Company and its subsidiaries taken as a whole.  Unless otherwise noted, the term “this year” refers to results in calendar year 2012, “first quarter” refers to the quarter ended March 31, 2012, 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 38.

Critical Accounting Policies

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

·  
Acquired loans - Acquired loans are initially recorded at their acquisition date fair values.  The carryover of allowance for loan losses is prohibited as any credit losses in the loans are included in the determination of the fair value of the loans at the acquisition date.  Fair values for acquired loans are based on a discounted cash flow methodology that involves assumptions and judgments as to credit risk, prepayment risk, liquidity risk, default rates, loss severity, payment speeds, collateral values and discount rate.  Subsequent to the acquisition of acquired impaired loans, GAAP requires the continued estimation of expected cash flows to be received.  This estimation requires numerous assumptions, interpretations and judgments using internal and third-party credit quality information.  Changes in expected cash flows could result in the recognition of impairment through provision for credit losses.

For acquired loans that are not deemed impaired at acquisition, credit discounts representing the principal losses expected over the life of the loan are a component of the initial fair value.  Subsequent to the purchase date, the methods utilized to estimate the required allowance for loan losses for the non-impaired acquired loans is similar to originated loans, however, the Company records a provision for loan losses only when the required allowance exceeds any remaining pooled discounts for loans evaluated collectively for impairment.  For loans individually evaluated for impairment, a provision is recoded when the required allowance exceeds any remaining discount on the loan.

·  
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 (“OTTI”).  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 OTTI 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 of the full value of its amortized cost basis.
 
 
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·  
Retirement benefits – The Company provides defined benefit pension benefits to eligible employees and post-retirement health and life insurance benefits to certain eligible retirees.  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.

·  
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, expected equity market premiums, peer volatility indicators 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 54-60 of the most recent Form 10-K (fiscal year ended December 31, 2011) filed with the Securities and Exchange Commission on February 29, 2012.

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 banking subsidiary is Community Bank, N.A. (the “Bank” or “CBNA”), which operates in Pennsylvania under the name First Liberty Bank and Trust.

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 continually improve operating efficiency.

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

On April 8, 2011 the Company acquired The Wilber Corporation (“Wilber”), the parent company of Wilber National Bank, for $103 million in stock and cash, comprised of $20.4 million in cash and the issuance of 3.35 million additional shares of the Company’s common stock.  Based in Oneonta, New York, Wilber operated 22 branches in the Central, Greater Capital District and Catskills regions of Upstate New York.  The acquisition added approximately $462 million of loans, $297 million of investment securities and $772 million of deposits.

On November 30, 2011, the Company, through its BPAS subsidiary, acquired certain assets and liabilities of CAI Benefits, Inc. (“CAI”) a provider of actuarial, consulting and retirement plan administration services, with offices in New York City and Northern New Jersey.  The transaction adds valuable service capacity and enhances distribution prospects in support of the Company’s broader-based employee benefits business, including daily valuation plan and collective investment fund administration.


 
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First quarter net income of $18.8 million was $2.7 million or 16% higher than the respective prior year period.  Earnings per share were $0.48 for the three months ended March 31, 2012, consistent with the first quarter of 2011.  The higher net income was due in large part to higher net interest income that resulted from earning asset growth, principally from the Wilber acquisition, partially offset by a lower net interest margin.  Also contributing to higher net income was a higher level of noninterest income due to incremental deposit service fees from the Wilber acquisition, higher debit card-related revenue, higher employee benefits administration and consulting revenues, primarily driven by the CAI acquisition and solid revenue growth from the wealth management businesses, which benefitted from more favorable market conditions.  These were partially offset by a higher provision for loan losses, higher operating expenses  reflective of the additional operating costs from the Wilber acquisition, and a higher effective income tax rate.  First quarter 2012 earnings per share were reduced by approximately two cents per share due to the successful common stock offering in January 2012 in which the Company issued 2.13 million shares of its common stock in support of the pending bank branch acquisition.

Asset quality in the first quarter of 2012 remained stable and favorable in comparison to averages for peer financial organizations.  First quarter loan net charge-off  ratios were higher than those experienced in the first quarter of 2011.  Nonperforming loan ratios were higher than experienced in the last year.  The current quarter provision for loan losses was higher than the first quarter of 2011.  Delinquency ratios increased from the first quarter of 2011, but were below those experienced in the fourth quarter of 2011.  The Company experienced year-over-year growth in first quarter average interest-earning assets, reflective of the Wilber acquisition which added approximately $421 million of loans and $297 million of investments.  Average deposits in the first quarter of 2012 were higher than the first quarter of 2011 driven by the Wilber acquisition, and were higher than the fourth quarter of 2011 due to organic deposit growth.  Average borrowings increased during the first quarter of 2012, as the Company pre-invested a portion of the expected liquidity to be derived from the branch acquisition expected to close in the third quarter of 2012.

On January 19, 2012, the Bank, the wholly-owned banking subsidiary of the Company, entered into an Assignment, Purchase and Assumption Agreement (“the HSBC Branch Agreement”) and a Purchase and Assumption Agreement (the” First Niagara Branch Agreement”) (collectively, the “Agreements”) with First Niagara Bank, N.A. (“First Niagara”).  Under the Agreements, the Bank will acquire 19 branches in Central, Northern, and Western New York, consisting of three branches purchased directly from First Niagara and 16 branches which are currently owned by HSBC Bank USA, National Association (“HSBC”).  First Niagara is assigning its rights to the HSBC branches in connection with its pending acquisition of HSBC’s Upstate New York banking franchise.  The branch acquisitions will strengthen and extend the Company’s Upstate New York presence.  Under the terms of the Agreements, the Bank will acquire approximately $218 million in loans and $955 million in deposits at a blended deposit premium of 3.22%.  The branch acquisitions are expected to close during the third quarter of 2012, subject to regulatory review and approval and customary closing conditions.  The Company expects to incur certain one-time, transaction-related costs related to the acquisition in 2012.

The Company completed a public stock offering in late January 2012.  The offering raised $57.5 million through the issuance of 2.13 million shares.  The net proceeds of the offering were approximately $54.9 million.  The Company intends to use the capital raised in this offering to support the HSBC and First Niagara branch acquisitions.

Net Income and Profitability

As shown in Table 1, net income for the first quarter of $18.8 million increased 16% versus the comparable period of 2011.  Earnings per share for the first quarter of $0.48 were consistent with the first quarter of 2011.  First quarter 2012’s earnings per share were approximately two cents per share lower than the first quarter of 2011 due to the successful common stock offering in January in support of the pending branch acquisition.

 As reflected in Table 1, first quarter net interest income of $53.9 million was up $8.4 million or 18% from the comparable prior year period resulting from an increase in interest-earning assets, primarily due to the Wilber acquisition, partially offset by a lower net interest margin in the first quarter of 2012.  The current quarter’s provision for loan losses increased $0.6 million as compared to the first quarter of 2011, consistent with the $0.6 million increase in first quarter net charge-offs and the continuation of generally stable and favorable asset quality metrics.  First quarter noninterest income was $23.5 million, up $2.6 million or 12.6%, from the first quarter of 2011, primarily due to the Wilber and CAI acquisitions.  Contributing to the increase was a $1.0 million increase in revenue generated from the Company’s wealth management group, principally from activities related to the trust operations acquired from Wilber, as well as solid organic growth generated by more favorable market conditions.

Operating expenses of $49.4 million for the first quarter  increased $6.1 million or 14.1% from the comparable prior year period, reflective of additional operating costs associated with the Wilber and CAI  acquisitions completed in April and November, respectively, partially offset by lower FDIC insurance costs and acquisition expenses.
 
 

 
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A condensed income statement is as follows:

Table 1: Condensed Income Statements

   
Three Months Ended
   
March 31,
(000's omitted, except per share data)
 
2012
2011
Net interest income
 
$53,909
$45,523
Provision for loan losses
 
1,644
1,050
Noninterest income
 
23,468
20,842
Operating expenses
 
49,403
43,316
Income before taxes
 
26,330
21,999
Income taxes
 
7,504
5,839
Net income
 
$18,826
$16,160
       
Diluted weighted average common shares outstanding
 
39,323
33,989
Diluted earnings per share
 
$0.48
$0.48

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 2, net interest income (with nontaxable income converted to a fully tax-equivalent basis) for the first quarter of 2012 was $57.9 million, an $8.4 million or 17% increase from the same period last year.  The increase was a result of a $966.5 million increase in first quarter interest-earning assets versus the prior year having a greater impact than the $758.4 million increase in average interest-bearing liabilities and a 12-basis point decrease in the net interest margin.  As reflected in Table 3, the first quarter volume increase from interest-bearing assets combined with the rate decrease on interest-bearing liabilities had a $15.6 million favorable impact on net interest income, while the rate decrease on interest bearing assets and the volume increase on interest bearing liabilities had a $7.2 million unfavorable impact on net interest income.

Average investments, including cash equivalents, for the first quarter were $518.2 million higher than the comparable period of 2011, reflective of the acquired Wilber portfolio and the purchase of approximately $600 million of U.S. Treasury securities late in the first quarter of 2012.  The Company actively redeployed maturing loan and investment cash flows and excess funding supplied by deposit growth, and began its planned investment of a portion of the excess liquidity expected from the pending branch acquisition.  First quarter average loan balances increased $448.3 million as compared to the comparable period of 2011, due to the approximately $424 million of acquired Wilber loans, and $24.0 million of organic growth, principally in the consumer mortgage and indirect portfolios.  In comparison to the prior year, total average interest-bearing deposits were up $729.1 million or 23% for the quarter as compared to the first quarter of 2011, primarily as a result of the Wilber acquisition and organic growth.  Quarterly average borrowings increased $29.3 million or 3.5% reflective of the initiative to pre-invest a portion of the liquidity expected from the branch acquisition in the third quarter.

The net interest margin of 3.96% for the first quarter decreased 12 basis points as compared to the first quarter of 2011.  Earning asset yields declined by 41 basis points reflective of lower yields on loans and investment securities, and a $93 million increase in low-rate cash equivalent balances versus last year’s first quarter.   This was partially offset by continued disciplined deposit pricing, the expiration of the interest rate swap agreement on the trust preferred securities and the addition of low-rate overnight borrowings resulting in a 29-basis point reduction in the total cost of funds in comparison to the first quarter of 2011.  A significant portion of the net interest margin decline was a result of the $600 million of U.S. Treasury purchases in mid-March of 2012, which carried lower net spread characteristics.
 
The decrease in the earning-asset yield was attributable to a 70-basis point decrease in investment yield, including cash equivalents, for the quarter as compared to the prior year period and the maturity of higher rate investments being replaced with lower rate investments and cash equivalents.  Additionally, contributing to the decrease in earning-asset yield for the quarter was a 15-basis point decline in the loan yield as compared to the like period of 2011, as 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 existing adjustable and fixed-rate loans repricing downward.  The decline in the yield on the investment portfolio throughout the last year was largely a result of a higher level of average invested cash balances, the maturity of longer term investments and the purchase of $600 million of U.S. Treasury securities with an average yield of 2.32%.
 
 
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The first quarter cost of funds decreased versus the prior year quarter due to a 19-basis point decrease in interest-bearing deposit rates, a higher proportion of funding being supplied from low and noninterest bearing deposits and a 49-basis point decrease in the average interest rate paid on external borrowings.  The decreases in the cost of funds were reflective of disciplined deposit pricing, whereby interest rates on selected categories of deposit accounts were lowered throughout 2011 and the first three months of 2012 in response to market conditions.  Additionally, the proportion of customer deposits held in higher cost time deposits has continued to decline over the last twelve months.  The decrease in the average rate paid on external borrowings was primarily due to the maturing of the interest rate swap in December of 2011 which had converted the variable rate trust preferred securities into a fixed rate obligation at 6.43% for a term of five years and the utilization of low-rate overnight borrowings to fund acquisition related investment activity.

Table 2 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 (“FTE”) using a marginal income tax rate of 38.79% and 38.53% in 2012 and 2011, respectively.  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, deferred loan costs and accretion of acquired loan marks.  Average loan balances include nonaccrual loans and loans held for sale.

Table 2: Quarterly Average Balance Sheet

 
Three Months Ended
 
Three Months Ended
 
March 31, 2012
 
March 31, 2011
     
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
$251,828
$161
0.26%
 
$159,044
$98
0.25%
   Taxable investment securities (1)
1,565,215
14,608
3.75%
 
1,188,182
12,585
4.30%
   Nontaxable investment securities (1)
613,947
8,870
5.81%
 
565,564
9,076
6.51%
   Loans (net of unearned discount)(2)
3,454,240
47,903
5.58%
 
3,005,926
42,497
5.73%
       Total interest-earning assets
5,885,230
71,542
4.89%
 
4,918,716
64,256
5.30%
Noninterest-earning assets
733,582
     
568,902
   
     Total assets
$6,618,812
     
$5,487,618
   
               
Interest-bearing liabilities:
             
   Interest checking, savings and money market deposits
$2,862,820
2,018
0.28%
 
$2,323,181
2,361
0.41%
   Time deposits
1,101,242
3,491
1.28%
 
911,805
3,645
1.62%
   Borrowings
859,774
8,093
3.79%
 
830,454
8,758
4.28%
     Total interest-bearing liabilities
4,823,836
13,602
1.13%
 
4,065,440
14,764
1.47%
Noninterest-bearing liabilities:
             
   Noninterest checking deposits
884,451
     
739,515
   
   Other liabilities
89,482
     
70,104
   
Shareholders' equity
821,043
     
612,559
   
     Total liabilities and shareholders' equity
$6,618,812
     
$5,487,618
   
               
Net interest earnings
 
$57,940
     
$49,492
 
Net interest spread
   
3.76%
     
3.83%
Net interest margin on interest-earning assets
   
3.96%
     
4.08%
               
Fully tax-equivalent adjustment
 
$4,031
     
$3,969
 
 
 (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.
 

 
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 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

 
 Three months ended March 31, 2012
versus March 31, 2011
 
Increase (Decrease) Due to Change in (1)
(000's omitted)
Volume
Rate
Net Change
Interest earned on:
     
  Cash equivalents
$59
$4
$63
  Taxable investment securities
3,648
(1,625)
2,023
  Nontaxable investment securities
741
(947)
(206)
  Loans (net of unearned discount)
6,230
(824)
5,406
Total interest-earning assets (2)
12,013
(4,727)
7,286
       
Interest paid on:
     
  Interest checking, savings and money market deposits
476
(819)
(343)
  Time deposits
679
(833)
(154)
  Borrowings
301
(966)
(665)
Total interest-bearing liabilities (2)
2,474
(3,636)
(1,162)
       
Net interest earnings (2)
9,539
(1,091)
8,448
 
 (1)  The change in interest due to both rate and volume has been allocated to volume and rate changes 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 of the
   totals; they 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 CBNA and First Liberty Bank and Trust); 2) employee benefit trust, administration, actuarial and consulting services (performed by BPAS); and 3) wealth management services, comprised of trust services (performed by the trust units within CBNA), investment and insurance products and services (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
   
March 31,
(000's omitted)
 
2012
2011
Deposit service fees
 
$10,369
$9,685
Benefit trust, administration, consulting and actuarial fees
 
8,973
8,183
Wealth management services
 
3,132
2,180
Other banking services
 
674
398
Mortgage banking
 
320
396
     Total noninterest income
 
23,468
$20,842
       
Noninterest income/operating income (FTE basis) (1)
 
28.8%
29.6%
       
(1) For purposes of this ratio noninterest income excludes gains on investment securities and debt extinguishments. Operating income is defined as net interest income plus noninterest income, excluding gains on investment securities and debt extinguishments, plus a fully-tax equivalent basis adjustment.
 


 
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As displayed in Table 4, noninterest income was $23.5 million in the first quarter of 2012, an increase of $2.6 million or 12.6% for the quarter in comparison to 2011.  General recurring banking fees of $11.0 million for the first quarter were $1.0 million or 9.5% higher than the first quarter of 2011 primarily due to the Wilber acquisition.  Excluding the Wilber acquisition, certain general recurring banking fees were lower than the prior year period, reflective of lower service utilization due to economic conditions and regulatory and process changes.  Effective in the third quarter of 2010, Regulation E (a Federal Reserve Board Regulation) prohibited financial institutions from charging consumers fees for paying overdrafts on ATM and debit card transactions unless the customer formally consents.  Although the majority of the Company’s customers who responded did consent to protecting their accounts from electronic transaction rejection, net lower utilization of this customer service has been experienced.  Offsetting this decline are increased fees from the expansion of ATM and debit-card usage.

Residential mortgage banking income totaled $0.3 million for the first quarter of 2012 as compared to $0.4 million in the first quarter of 2011, comprised almost entirely from servicing fees, reflective of the decision to hold a majority of secondary market eligible mortgages in portfolio in the first quarter of 2012.  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.  First quarter 2012 mortgage banking income includes a $0.1 million recovery of impairment charges taken in prior periods for the fair value of the mortgage servicing rights due primarily to a decrease in the expected prepayment speed of the Company’s sold loan portfolio with servicing retained.  Residential mortgage loans sold to investors, primarily Fannie Mae, totaled $1.5 million in the first quarter of 2012 as compared to $21.0 million for the comparable 2011 period.  There were no residential mortgage loans held for sale at March 31, 2012.  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 $0.8 million or 9.7% for the three months ended March 31, 2012 as compared to the prior year period, a result of the CAI acquisition completed in December 2011.  While not immediately additive to earnings, the acquisition added approximately $0.8 million in revenue in the strategically important metropolitan New York market place.  Wealth management services revenue increased $1.0 million, or 44% for the first quarter as compared to the first quarter of 2011, driven by incremental revenue produced from the acquired Wilber trust operations as well as solid organic growth at the other wealth management businesses which benefited from more favorable market conditions and generation of new client relationships.

The ratio of noninterest income to total income (FTE basis) was 28.8% for the quarter versus 29.6% for the comparable period of 2011.  The decrease is a function of a 17% increase in net interest income, primarily the result of the Wilber acquisition, while noninterest income increased at a lesser 12.6% rate.

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
   
March 31,
(000's omitted)
 
2012
2011
Salaries and employee benefits
 
$27,425
$23,111
Occupancy and equipment
 
6,463
6,057
Data processing and communications
 
5,583
4,771
Amortization of intangible assets
 
1,086
901
Legal and professional fees
 
2,208
1,339
Office supplies and postage
 
1,468
1,196
Business development and marketing
 
1,172
1,254
FDIC insurance premiums
 
906
1,361
Acquisition expenses
 
260
691
Other
 
2,832
2,635
  Total operating expenses
 
$49,403
$43,316
       
Operating expenses(1)/average assets
 
2.92%
3.08%
Efficiency ratio
 
59.0%
59.3%
       
(1) Operating expenses are total noninterest expenses excluding acquisition expenses, contract termination charges, goodwill impairment and amortization of intangibles.




 
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As shown in Table 5, first quarter 2012 operating expenses were $49.4 million, an increase of $6.1 million or 14.1% from the prior year level, and reflective of the additional operating costs associated with the Wilber and CAI acquisitions completed in 2011.  Salaries and employee benefits increased $4.3 million or 19% from the comparable prior year period, primarily due to the addition of approximately 200 employees from the Wilber acquisition and 30 employees from the CAI acquisition, as well as the impact of annual merit increases.  Additional changes to operating expenses can be attributable to higher data processing and communications (up $0.8 million in total and up $0.4 million excluding acquisitions), legal and professional fees (up $0.9 million in total and up $0.8 million excluding acquisitions), occupancy and equipment costs (up $0.4 million in total and down $0.3 million excluding acquisitions), office supplies (up $0.3 million in total and up $0.2 million excluding acquisitions), property related write-downs (up $0.2 million in total and excluding the acquisitions), and amortization of intangible assets (up $0.2 million in total and down  $0.1 million excluding the acquisition), partially offset by lower FDIC insurance premiums (down $0.5 million in total).

The Company’s efficiency ratio (recurring operating expenses excluding intangible amortization, acquisition expenses and special charges divided by the sum of net interest income (FTE) and noninterest income excluding gain/(loss) on investment securities) was 59.0% for the first quarter, 0.3 percentage points favorable to the comparable quarter of 2011.  This resulted from operating expenses (as described above) increasing 15.2%, while recurring operating income increased at a higher 15.8% rate, driven by a 17% increase in net interest income and a 13% increase in noninterest income primarily due to the acquisitions of Wilber and CAI.  Operating expenses, excluding intangible amortization and acquisition expenses, as a percentage of average assets decreased 16 basis points for the quarter.  Operating expenses (as defined above) for the quarter versus the same prior year period increased 15%, while average assets increased 21% for the same time periods.

Income Taxes

The first quarter effective income tax rate was 28.5%, up from the 26.5% effective tax rate for the comparable period of 2011.  The higher effective tax rate for 2012 was principally a result of a higher proportion of income being generated from fully taxable sources.
 
 
Investments

As reflected in Table 6 below, the carrying value of investments (including unrealized gains on available-for-sale securities) was $2.77 billion at the end of the first quarter, an increase of $613.8 million from December 31, 2011 and an increase of $972.9 million from March 31, 2011.  The book value (excluding unrealized gains) of investments increased $620.8 million from December 31, 2011 and $913.3 million from March 31, 2011.  In April 2011, the Company added $297 million of investments from the Wilber acquisition, primarily government agency mortgage-backed securities, government agency collateralized mortgage obligations and U.S. Treasury and agency securities.  In March 2012, the Company purchased approximately $600 million of U.S. Treasury securities utilizing cash flows from deposit growth, maturing loans and investments and short-term borrowings that will be replaced with liquidity provided by the pending branch acquisition.  With these purchases, the overall mix of securities within the portfolio over the last year has changed, with an increase in the proportion of U.S. Treasury and agency securities and government agency collateralized mortgage obligations and a decrease in the proportion of obligations of state and political subdivisions and corporate 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 March 31, 2012, the portfolio had a $78.5 million net unrealized gain, an increase of $59.6 million from the unrealized gain at March 31, 2011 and $7.0 million lower than the unrealized gain at December 31, 2011.  These changes in the unrealized gain are indicative of interest rate movements during the respective time periods and 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 $55.3 million of net unrealized gains as of March 31, 2012.

 
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Table 6: Investment Securities
     
March 31, 2012
 
December 31, 2011
 
March 31, 2011
   
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
 
$546,636
$594,795
 
$448,260
$505,060
 
$478,190
$496,042
Obligations of state and political subdivisions
 
70,987
76,502
 
69,623
74,711
 
66,599
66,315
Government agency mortgage-backed securities
 
32,083
33,779
 
35,576
38,028
 
48,489
50,854
Corporate debt securities
 
2,940
2,910
 
0
0
 
0
0
Other securities
 
27
27
 
36
36
 
47
47
     Total held-to-maturity portfolio
 
652,673
708,013
 
553,495
617,835
 
593,325
613,258
                   
Available-for-Sale Portfolio:
                 
U.S. Treasury and agency securities
 
927,036
976,903
 
463,922
520,548
 
323,545
345,288
Obligations of state and political subdivisions
 
614,466
640,498
 
543,527
573,012
 
534,421
542,278
Government agency mortgage-backed securities
 
294,686
314,077
 
310,541
331,379
 
165,374
173,626
Pooled trust preferred securities
 
67,087
47,385
 
68,115
43,846
 
69,164
48,172
Government agency collateralized mortgage  obligations
 
41,726
43,310
 
45,481
46,943
 
9,665
10,075
Corporate debt securities
 
21,495
22,789
 
21,495
22,855
 
24,016
25,589
Marketable equity securities