For the Fiscal Year Ending December 31, 2005
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-K


x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended December 31, 2005

 

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission File No. 1-31566


PROVIDENT FINANCIAL SERVICES, INC.

(Exact Name of Registrant as Specified in its Charter)


Delaware   42-1547151
(State or Other Jurisdiction of Incorporation or Organization)   (I.R.S. Employer Identification Number)
830 Bergen Avenue, Jersey City, New Jersey   07306-4599
(Address of Principal Executive Offices)   (Zip Code)

(201) 333-1000

(Registrant’s Telephone Number)

Securities Registered Pursuant to Section 12(b) of the Act:

Common Stock, par value $0.01 per share   New York Stock Exchange
(Title of Class)   (Name Of Exchange On Which Registered)

Securities Registered Pursuant to Section 12(g) of the Act:

None


Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    YES  x    NO  ¨

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    YES  ¨    NO  x

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 twelve months (or for such shorter period that the Registrant was required to file such reports); and (2) has been subject to such requirements for the past 90 days.    YES  x    NO  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer  x   Accelerated Filer  ¨   Non-Accelerated Filer  ¨

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    YES  ¨    NO  x

As of March 3, 2006, there were issued and outstanding 68,932,974 shares of the Registrant’s Common Stock outstanding, including 748,174 shares held by the First Savings Bank Directors’ Deferred Fee Plan not otherwise considered outstanding under accounting principles generally accepted in the United States of America. The aggregate value of the voting and non-voting common equity held by non-affiliates of the Registrant, based on the closing price of the Common Stock as of June 30, 2005, as quoted by the NYSE, was approximately $1.15 billion.

DOCUMENTS INCORPORATED BY REFERENCE

(1) Proxy Statement for the 2006 Annual Meeting of Stockholders of the Registrant (Part III).



Table of Contents

PROVIDENT FINANCIAL SERVICES, INC.

 

INDEX TO FORM 10-K

 

Item
Number


        Page Number

    

PART I

    

1.

  

Business

   3

1A.

  

Risk Factors

   37

1B.

  

Unresolved SEC Staff Comments

   39

2.

  

Properties

   39

3.

  

Legal Proceedings

   39

4.

  

Submission of Matters to a Vote of Security Holders

   39
    

PART II

    

5.

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   40

6.

  

Selected Financial Data

   41

7.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   43

7A.

  

Quantitative and Qualitative Disclosures About Market Risk

   54

8.

  

Financial Statements and Supplementary Data

   57

9.

  

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

   94

9A.

  

Controls and Procedures

   94

9B.

  

Other Information

   94
    

PART III

    

10.

  

Directors and Executive Officers of the Registrant

   95

11.

  

Executive Compensation

   95

12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   95

13.

  

Certain Relationships and Related Transactions

   95

14.

  

Principal Accountant Fees and Services

   95
    

PART IV

    

15.

  

Exhibits and Financial Statement Schedules

   96

Signatures

   98

 

2


Table of Contents

Forward Looking Statements

 

Certain statements contained herein are not based on historical facts and are “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Such forward-looking statements may be identified by reference to a future period or periods, or by the use of forward-looking terminology, such as “may,” “will,” “believe,” “expect,” “estimate,” “anticipate,” “continue,” or similar terms or variations on those terms, or the negative of those terms. Forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, those related to the economic environment, particularly in the market areas in which Provident Financial Services, Inc. (the “Company”) operates, competitive products and pricing, fiscal and monetary policies of the U.S. Government, changes in government regulations affecting financial institutions, including regulatory fees and capital requirements, changes in prevailing interest rates, acquisitions and the integration of acquired businesses, credit risk management, asset-liability management, the financial and securities markets and the availability of and costs associated with sources of liquidity.

 

The Company wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made. The Company also wishes to advise readers that the factors listed above could affect the Company’s financial performance and could cause the Company’s actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any current statements. The Company does not undertake and specifically declines any obligation to publicly release the result of any revisions which may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

 

PART I

 

Item 1. Business

 

Provident Financial Services, Inc.

 

The Company is a Delaware corporation which, on January 15, 2003, became the holding company for The Provident Bank (the “Bank”), following the completion of the conversion of the Bank to a stock chartered savings bank. On January 15, 2003, the Company issued an aggregate of 59,618,300 shares of its common stock, par value $0.01 per share in a subscription offering and contributed $4.8 million in cash and 1,920,000 shares of its common stock to The Provident Bank Foundation, a charitable foundation established by the Bank. As a result of the conversion and related stock offering, the Company raised $567.2 million in net proceeds, of which $293.2 million was utilized to acquire all of the outstanding common stock of the Bank. The Company owns all of the outstanding common stock of the Bank, and as such, is a bank holding company subject to regulation by the Federal Reserve Board.

 

On December 22, 2003, the Company entered into an agreement and plan of merger under which First Sentinel Bancorp, Inc. (“First Sentinel”) merged with and into the Company and First Savings Bank, the wholly-owned subsidiary of First Sentinel, merged with and into the Bank. The Company completed the acquisition of First Sentinel and the merger of First Savings Bank, with and into the Bank as of the close of business July 14, 2004.

 

At December 31, 2005, the Company had total assets of $6.05 billion, net loans of $3.71 billion, total deposits of $3.92 billion, and total stockholders’ equity of $1.08 billion. The Company’s mailing address is 830 Bergen Avenue, Jersey City, New Jersey 07306-4599, and the Company’s telephone number is (201) 333-1000.

 

The Provident Bank

 

Originally established in 1839, the Bank is a New Jersey-chartered capital stock savings bank headquartered in Jersey City, New Jersey. The Bank is a community- and customer-oriented bank operating 76 full-service branch offices in the New Jersey counties of Hudson, Bergen, Essex, Mercer, Middlesex, Monmouth, Morris, Ocean, Somerset and Union, which we consider our primary market area. As part of its “Customer-Centric

 

3


Table of Contents

Strategy,” the Bank emphasizes personal service and customer convenience in serving the financial needs of the individuals, families and businesses residing in its markets. The Bank attracts deposits from the general public in the areas surrounding its banking offices and uses those funds, together with funds generated from operations and borrowings, to originate commercial real estate loans, residential mortgage loans, commercial business loans and consumer loans. The Bank also invests in mortgage-backed securities and other permissible investments.

 

The following are highlights of The Provident Bank’s operations:

 

Diversified Loan Portfolio. To improve asset yields and reduce its exposure to interest rate risk, the Bank diversifies its loan portfolio by emphasizing the origination of commercial mortgage and commercial business loans. These loans generally have adjustable interest rates that initially are higher than the rates applicable to one- to four-family residential mortgage loans. However, these loans also generally have a higher risk of loss than single-family residential mortgage loans.

 

Asset Quality. As of December 31, 2005, non-performing assets were $6.7 million or 0.11% of total assets compared to $6.3 million or 0.10% of total assets at December 31, 2004. The Bank’s asset quality reflects its focus on underwriting criteria and on aggressive collection efforts and conservative charge-off practices. The levels of commercial mortgage and commercial business loans and the relatively larger credit concentrations increase the Bank’s credit risk.

 

Emphasis on Relationship Banking and Core Deposits. The Bank emphasizes the acquisition and retention of core deposit accounts, such as checking and savings accounts, and expanding customer relationships. Core deposit accounts totaled $2.47 billion at December 31, 2005, representing 63.1% of total deposits. The Bank has also focused on increasing the number of households and businesses served and the number of bank products per customer through a commitment to its brand promise — “Hassle-Free Banking for Busy People.”

 

Increasing Non-Interest Income. The Bank’s emphasis on transaction accounts and expanded products and services has enabled the Bank to generate non-interest income. A primary source of non-interest income is derived from fees on core deposit accounts. The Bank has also focused on expanding products and services to generate additional non-interest income by offering investment products, estate management and trust services. Total non-interest income was $29.2 million for each of the years ended December 31, 2005 and 2004, and fee income increased to $23.0 million for the year ended December 31, 2005 from $20.9 million for the year ended December 31, 2004.

 

Managing Interest Rate Risk. Although the Bank’s liabilities are more sensitive to changes in interest rates than its assets, the Bank manages its exposure to interest rate risk by emphasizing the origination and retention of adjustable rate and shorter-term loans. In addition, the Bank uses its investments in securities to manage interest rate risk. At December 31, 2005, 52.1% of the Bank’s loan portfolio had a term to maturity of one year or less, or had adjustable interest rates. Moreover, at December 31, 2005, the Bank’s securities portfolio, excluding equity securities, totaled $1.46 billion and had an average expected life of 3.67 years.

 

Capital Management. The Company repurchased $96.3 million of its common stock and paid cash dividends totaling $21.6 million in 2005.

 

Available Information. Provident Financial Services, Inc. is a public company, and files interim, quarterly and annual reports with the Securities and Exchange Commission (“SEC”). These respective reports are on file and a matter of public record with the SEC and may be read and copied at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC (http://www.sec.gov). All filed SEC reports and interim filings can also be obtained from the Bank’s website, www.providentnj.com, on the “Investor Relations” page, without charge from the Company.

 

4


Table of Contents

MARKET AREA

 

The Company and the Bank are headquartered in Jersey City, which is located in Hudson County, New Jersey. At December 31, 2005, the Bank operated a network of 76 branch offices throughout ten counties in northern and central New Jersey, comprised of 16 offices in Hudson County, 4 in Bergen, 6 in Essex, 1 in Mercer, 23 in Middlesex, 10 in Monmouth, 2 in Morris, 6 in Ocean, 5 in Somerset and 3 in Union Counties. The Company also maintains The Provident Loan Center in Woodbridge, New Jersey. The Bank’s lending activities, though concentrated in the communities surrounding its offices, extend predominantly throughout the State of New Jersey.

 

The Bank’s ten-county primary market area includes a mix of urban and suburban communities and has a diversified mix of industries including pharmaceutical and other manufacturing companies, network communications, insurance and financial services, and retail. According to the U.S. Census Bureau’s most recent population estimates as of 2004, the Bank’s ten-county market area has a population of 6.0 million, which was 68.8% of the state’s total population. Because of the diversity of industries in the Bank’s market area and, to a lesser extent, because of its proximity to the New York City financial markets, the area’s economy can be significantly affected by changes in national and international economies. According to the U.S. Bureau of Labor Statistics and the Federal Deposit Insurance Corporation, New Jersey’s job growth rate has eased after reaching a four-year high in the first quarter of 2005. After declining steadily for the prior two years, the state’s unemployment rate slightly increased in the third quarter of 2005 primarily because of an increase in the labor force.

 

Within its ten-county market area the Bank has an approximate 2.28% share of bank deposits as of June 30, 2005, the latest date for which statistics are available, and an approximate 1.81% deposit share of the New Jersey market statewide.

 

COMPETITION

 

The Bank faces intense competition both in originating loans and attracting deposits. The northern and central New Jersey market area has a high concentration of financial institutions, including large money center and regional banks, community banks, credit unions, investment brokerage firms and insurance companies. The Bank faces direct competition for loans from each of these institutions as well as from the mortgage companies, mortgage brokers and other loan origination firms operating in our market area. The Bank’s most direct competition for deposits has come from the several commercial banks and savings banks in the market area, especially large regional banks which have obtained a major share of the available deposit market due in part to acquisitions and consolidations. Many of these banks have substantially greater financial resources than the Bank and offer services, such as private banking, that the Bank does not provide. In addition, the Bank faces significant competition for deposits from the mutual fund industry and from investors’ direct purchase of short-term money market securities and other corporate and government securities.

 

The Bank competes in this environment by maintaining a diversified product line, including mutual funds, annuities and other investment services made available through its investment subsidiary. Relationships with customers are built and maintained through the Bank’s branch network, its deployment of branch and off-site ATMs, and its telephone and web-based banking services.

 

LENDING ACTIVITIES

 

Historically, the Bank’s principal lending activity has been the origination of fixed-rate and adjustable-rate mortgage loans collateralized by one- to four-family residential real estate located within its primary market area. Since 1997, the Bank has taken a more balanced approach to the composition of the loan portfolio by increasing its emphasis on originating commercial real estate loans and commercial business loans.

 

Residential mortgage loans are primarily underwritten to standards that allow the sale of the loans to the secondary markets, primarily to the Federal National Mortgage Association (“FNMA” or “Fannie Mae”) and the

 

5


Table of Contents

Federal Home Loan Mortgage Corporation (“FHLMC” or “Freddie Mac”). To manage interest rate risk, the Bank generally sells the 20-year and 30-year fixed-rate residential mortgages that it originates. The Bank retains a majority of the originated adjustable rate mortgages for its portfolio.

 

The Bank originates commercial real estate loans that are secured by income-producing properties such as multi-family residences, office buildings, and retail and industrial properties. To limit exposure to interest rate risk, the Bank generally adjusts the interest rate following an initial five-year period in the majority of the commercial real estate loans it originates.

 

The Bank provides construction loans for both single family and condominium projects intended for sale and projects that will be retained as investments by the borrower. The Bank underwrites most construction loans for a term of three years or less. The majority of these loans are underwritten on a floating rate basis. The Bank recognizes that there is higher risk in construction lending than permanent lending. As such, the Bank takes certain precautions to mitigate this risk, including the retention of an outside engineering firm to perform plan and cost reviews and to review all construction advances made against work in place and a limitation on how and when loan proceeds are advanced. In most cases, for the single family/condominium projects, the Bank manages its exposure against houses or units that are not under contract. Similarly, commercial construction loans usually have commitments for significant pre-leasing, or funds are held back until the leases are finalized.

 

The Bank originates consumer loans that are secured, in most cases, by a borrower’s assets. Home equity loans and home equity lines of credit that are primarily secured by a second mortgage lien on the borrower’s residence comprise the largest category of the Bank’s consumer loan portfolio. The Bank’s consumer loan portfolio also includes marine loans that are secured by a first lien on recreational boats. The marine loans are generated by boat dealers located on the Atlantic Coast of the United States. In addition the Bank finances auto loans, which are generated by dealers in the New York metropolitan area. To a lesser extent, the Bank originates personal unsecured loans, primarily as an accommodation to customers. All loans, whether originated directly or purchased, are underwritten to the Bank’s lending standards.

 

Commercial loans are loans to businesses of varying size and type within the Bank’s market. The Bank’s underwriting standards for commercial loans less than $100,000 utilize an industry-recognized automated credit scoring system. The Bank lends to established businesses, and the loans are generally secured by business assets such as equipment, receivables, inventory, real estate or marketable securities. On occasion, the Bank makes unsecured commercial loans. Most commercial lines of credit are made on a floating interest rate basis and most term loans are made on a fixed interest rate basis, usually with terms of five years or less.

 

6


Table of Contents

Loan Portfolio Composition. Set forth below is selected information concerning the composition of our loan portfolio in dollar amounts and in percentages (before deductions for deferred fees and costs, unearned discounts and premiums and allowances for losses) as of the dates indicated.

 

    At December 31,

 
    2005

    2004

    2003

    2002

    2001

 
    Amount

    Percent

    Amount

    Percent

    Amount

    Percent

    Amount

    Percent

    Amount

    Percent

 
    (Dollars in thousands)  

Residential mortgage loans

  $ 1,773,288     47.83 %   $ 1,866,614     50.81 %   $ 1,044,788     47.13 %   $ 699,469     34.43 %   $ 795,442     39.88 %

Commercial mortgage loans

    636,739     17.18       685,330     18.66       449,092     20.26       444,249     21.86       412,280     20.67  

Multi-family mortgage loans

    77,619     2.09       86,292     2.35       90,552     4.08       77,006     3.79       95,456     4.78  

Construction loans

    289,453     7.81       188,902     5.14       99,072     4.47       96,028     4.73       80,717     4.05  
   


 

 


 

 


 

 


 

 


 

Total mortgage loans

    2,777,099     74.91       2,827,138     76.96       1,683,504     75.94       1,316,752     64.81       1,383,895     69.38  
   


 

 


 

 


 

 


 

 


 

Mortgage warehouse loans

    —       —         —       —         4,148     0.19       276,383     13.60       167,905     8.42  

Commercial loans

    393,827     10.62       353,626     9.63       246,606     11.12       183,410     9.03       141,491     7.09  

Consumer loans

    556,645     15.02       514,296     14.00       300,825     13.57       275,812     13.57       322,219     16.15  
   


 

 


 

 


 

 


 

 


 

Total other loans

    950,472     25.64       867,922     23.63       551,579     24.88       735,605     36.20       631,615     31.66  
   


 

 


 

 


 

 


 

 


 

Premiums on purchased loans

    13,190     0.35       14,421     0.39       5,411     0.24       2,123     0.10       2,566     0.13  

Unearned discounts

    (1,110 )   (0.03 )     (1,309 )   (0.04 )     (1,547 )   (0.07 )     —       —         —       —    

Net deferred fees

    (529 )   (0.01 )     (961 )   (0.02 )     (1,580 )   (0.07 )     (1,625 )   (0.08 )     (1,531 )   (0.07 )

Allowance for loan losses

    (31,980 )   (0.86 )     (33,766 )   (0.92 )     (20,631 )   (0.92 )     (20,986 )   (1.03 )     (21,909 )   (1.10 )
   


 

 


 

 


 

 


 

 


 

Total loans, net

  $ 3,707,142     100.00 %   $ 3,673,445     100.00 %   $ 2,216,736     100.00 %   $ 2,031,869     100.00 %   $ 1,994,636     100.00 %
   


 

 


 

 


 

 


 

 


 

 

Loan Maturity Schedule. The following table sets forth certain information as of December 31, 2005, regarding the maturities of loans in our loan portfolio. Demand loans having no stated schedule of repayment and no stated maturity, and overdrafts are reported as due in one year or less.

 

     Within
One
Year


   One
Through
Three
Years


   Three
Through
Five
Years


   Five
Through
Ten
Years


   Ten
Through
Twenty
Years


   Beyond
Twenty
Years


   Total

     (In thousands)

Residential mortgage loans

   $ 7,818    $ 10,327    $ 12,247    $ 118,943    $ 693,876    $ 930,077    $ 1,773,288

Commercial mortgage loans

     32,074      37,364      48,132      405,256      101,924      11,989      636,739

Multi-family mortgage loans

     647      6,271      6,336      53,207      9,461      1,697      77,619

Construction loans

     118,818      159,055      —        1,701      9,879      —        289,453
    

  

  

  

  

  

  

Total mortgage loans

     159,357      213,017      66,715      579,107      815,140      943,763      2,777,099

Commercial loans

     157,908      65,942      32,599      112,586      22,269      2,523      393,827

Consumer loans

     102,669      18,417      82,326      76,287      275,763      1,183      556,645
    

  

  

  

  

  

  

Total loans

   $ 419,934    $ 297,376    $ 181,640    $ 767,980    $ 1,113,172    $ 947,469    $ 3,727,571
    

  

  

  

  

  

  

 

7


Table of Contents

Fixed- and Adjustable-Rate Loan Schedule. The following table sets forth at December 31, 2005, the dollar amount of all fixed-rate and adjustable-rate loans due after December 31, 2006. Adjustable-rate loans are included based on contractual maturities.

 

     Due After December 31, 2006

     Fixed

   Adjustable

   Total

     (In thousands)

Residential mortgage loans

   $ 909,861    $ 855,609    $ 1,765,470

Commercial mortgage loans

     326,827      277,838      604,665

Multi-family mortgage loans

     40,653      36,319      76,972

Construction loans

     9,998      160,637      170,635
    

  

  

Total mortgage loans

     1,287,339      1,330,403      2,617,742

Commercial loans

     77,290      158,629      235,919

Consumer loans

     419,049      34,927      453,976
    

  

  

Total loans

   $ 1,783,678    $ 1,523,959    $ 3,307,637
    

  

  

 

Residential Mortgage Lending. A principal lending activity of the Bank is to originate loans secured by first mortgages on one- to four-family residences in the State of New Jersey. The Bank originates residential mortgages primarily through commissioned mortgage representatives and its branch offices. The Bank originates both fixed-rate and adjustable-rate mortgages. Residential mortgage lending represents the largest single component of the total loan portfolio. As of December 31, 2005, $1.77 billion or 47.6% of the total portfolio consisted of residential real estate loans. Of the one- to four-family loans at that date, 51.8% were fixed-rate and 48.2% were adjustable-rate loans.

 

The Bank originates fixed-rate fully amortizing residential mortgage loans, with the principal and interest due each month, that have maturities ranging from 10 to 30 years. The Bank also originates fixed-rate residential mortgage loans with maturities of 15, 20 and 30 years that require the payment of principal and interest on a biweekly basis. Fixed-rate jumbo residential mortgage loans (loans over the maximum that one of the government-sponsored agencies will purchase) are originated with maturities of up to 30 years. Adjustable-rate mortgage loans are offered with a fixed-rate period of 1, 3, 5, 7 or 10 years prior to the first annual interest rate adjustment. The standard adjustment formula is the one-year constant maturity Treasury rate plus 2 3/4%, adjusting annually with a 2% maximum annual adjustment and a 6% maximum adjustment over the life of the loan.

 

The residential mortgage portfolio is primarily underwritten to Freddie Mac and Fannie Mae standards. The Bank’s standard maximum loan to value ratio is 80%. However, working through mortgage insurance companies, the Bank underwrites loans for sale to Freddie Mac or Fannie Mae programs that will finance up to 100% of the value of the residence. Generally all fixed-rate loans with terms of 20 years or more, as well as loans with a loan-to-value ratio of 97% or more, are sold into the secondary market with servicing rights retained. Fixed-rate residential mortgage loans retained in our portfolio generally include loans with a term of 15 years or less and biweekly payment loans with a term of 20 years or less. The Bank retains the majority of the originated adjustable-rate mortgages for its portfolio.

 

Loans are sold without recourse with servicing rights retained by the Bank. The percentage of loans sold into the secondary market will vary depending upon interest rates and the Bank’s strategies for reducing exposure to interest rate risk. In 2005, $36.2 million, or 23.7% of residential real estate loans originated were sold into the secondary market. All of the loans sold in 2005 were long-term fixed-rate mortgages.

 

The retention of adjustable-rate mortgages, as opposed to longer term, fixed-rate residential mortgage loans, helps reduce the Bank’s exposure to interest rate risk. However, adjustable-rate mortgages generally pose credit risks different from the credit risks inherent in fixed-rate loans primarily because as interest rates rise, the

 

8


Table of Contents

underlying debt service payments of the borrowers rise, thereby increasing the potential for default. To minimize this risk, borrowers of one- to four-family one year adjustable-rate loans are qualified at the maximum rate which would be in effect after the first interest rate adjustment. The Bank believes that these risks, which have not had a material adverse effect on the Bank to date, generally are less onerous than the interest rate risks associated with holding 20- and 30-year fixed-rate loans in the loan portfolio.

 

The Bank has for many years offered discounted rates on loans to low- to moderate-income individuals. Loans originated in this category over the last five years have totaled $116.4 million. The Bank also offers a special rate program for first time homebuyers under which originations have totaled over $31.4 million for the past five years.

 

Commercial Real Estate Loans. The Bank originates loans secured by mortgages on various commercial income producing properties, including office buildings, retail and industrial properties. Commercial real estate and construction loans have increased to 26.9% of the portfolio at December 31, 2005, from 26.0% of the portfolio at December 31, 2004. A substantial majority of the Bank’s commercial real estate loans are secured by properties located in the State of New Jersey.

 

The Bank originates commercial real estate loans with adjustable rates and with fixed interest rates for a period that is generally five or fewer years, which then adjust after the initial period. Typically these loans are written for maturities of ten years or less and have an amortization schedule of 20 or 25 years. As a result, the typical amortization schedule will result in a substantial principal payment upon maturity. The Bank generally underwrites commercial real estate loans to a maximum 75% advance against either the appraised value of the property, or its purchase price (for loans to fund the acquisition of real estate), whichever is less. The Bank generally requires minimum debt service coverage of 1.25 times. There is a potential risk that the borrower may be unable to pay off or refinance the outstanding balance at the loan maturity date. The Bank typically lends to experienced owners or developers who have knowledge and contacts in the commercial real estate market.

 

Among the reasons for the Bank’s continued emphasis on commercial real estate lending is the desire to invest in assets bearing interest rates that are generally higher than interest rates on residential mortgage loans and more sensitive to changes in market interest rates. Commercial real estate loans, however, entail significant additional credit risk as compared to one- to four-family residential mortgage loans, as they typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. In addition, the payment experience on commercial real estate loans secured by income-producing properties is typically dependent on the successful operation of the related real estate project and thus may be more significantly impacted by adverse conditions in the real estate market or in the economy generally.

 

The Bank performs more extensive diligence in underwriting commercial real estate loans than loans secured by owner occupied one- to four-family residential properties due to the larger loan amounts and the riskier nature of such loans. The Bank attempts to understand and control the risk in several ways, including inspection of all such properties and the review of the overall financial condition of the borrower and guarantors, which may include, for example, the review of the rent rolls and the verification of income. If applicable, a tenant analysis and market analysis are part of the underwriting. For commercial real estate secured loans in excess of $750,000 and for all other commercial real estate loans where it is appropriate, the Bank employs environmental experts to inspect the property and ascertain any potential environmental risks.

 

The Bank requires a full independent appraisal for commercial real estate. The appraiser must be selected from the Bank’s approved list. The Bank also employs an independent review appraiser to verify that the appraisal meets the Bank’s standards. The underwriting guidelines generally provide that the loan-to-value ratio shall not exceed 75% of the appraised value and the debt service coverage should be at least 1.25 times. In addition, financial statements are required annually for review. The Bank’s policy also requires that a property inspection of commercial mortgages over $1,000,000 be completed at least every 18 months.

 

9


Table of Contents

The Bank’s largest commercial real estate loan as of December 31, 2005 was a $25.0 million loan secured by an established, 378 room, full-service hotel in Elizabeth, New Jersey. The Bank’s share of the total loan is $20.0 million, all of which was outstanding at December 31, 2005. A participation in the remaining $5.0 million was sold to another lending institution. The loan was performing in accordance with its terms and conditions as of December 31, 2005.

 

Multi-family Lending. The Bank underwrites loans secured by apartment buildings that have five or more units. The Bank classifies multi-family lending as a component of the commercial real estate lending portfolio. The underwriting standards and procedures that are used to underwrite commercial real estate loans are used to underwrite multi-family loans.

 

Construction Loans. The Bank continues to expand its activities in commercial construction lending. Commercial construction lending includes both new construction of residential and commercial real estate projects and the reconstruction of existing structures.

 

The Bank’s commercial construction financing takes two forms: projects for sale (single family/condominiums) and projects that are constructed for investment purposes (rental property). To mitigate the speculative nature of construction loans, the Bank generally requires significant pre-leasing on rental properties and requires that a percentage of the single-family residences or condominiums be under contract to support construction loan advances.

 

The Bank underwrites most construction loans for a term of three years or less. The majority of the Bank’s construction loans are floating-rate loans with a maximum 75% loan-to-value ratio for the completed project. The Bank employs professional engineering firms to assist in the review of construction cost estimates and make site inspections to determine if the work has been completed prior to the advance of funds for the project.

 

Construction lending generally involves a greater degree of risk than one- to four-family mortgage lending. Repayment of a construction loan is, to a great degree, dependent upon the successful and timely completion of the construction of the subject project and the successful marketing of the sale or lease of the project. Construction delays or the financial impairment of the builder may further impair the borrower’s ability to repay the loan.

 

For all construction loans, the Bank requires an independent appraisal, which includes information on market rents and/or comparable sales and competing projects. The Bank also attempts to procure personal guarantees and conducts environmental due diligence as appropriate.

 

The Bank also attempts to control the risk of the construction lending process by other means. For single family/condominium financing, the Bank generally requires payment for the release of a unit that exceeds the amount of the loan advance attributable to such unit. On commercial construction projects that the developer holds for rental, the Bank typically holds back funds for tenant improvements until a signed lease is executed.

 

The Bank’s largest construction loan as of December 31, 2005 was a $28.0 million construction/permanent mortgage loan secured by an 80% pre-leased, 115,000 square foot retail shopping center located in Clifton, New Jersey. The Borrower is an experienced developer of retail properties in the State of New Jersey. The loan was performing in accordance with its terms and conditions as of December 31, 2005.

 

Commercial Loans. The Bank underwrites commercial loans to corporations, partnerships and other businesses. The majority of the Bank’s commercial loan customers are local businesses with revenues of less than $50.0 million. The Bank offers commercial loans for equipment purchases, lines of credit or letters of credit, as well as loans where the borrower is the sole occupant of the property. Most commercial loans are originated on a floating-rate basis and the majority of fixed-rate commercial loans are fully amortized over a five-year period.

 

10


Table of Contents

The Bank also underwrites Small Business Administration guaranteed loans and guaranteed or assisted loans through various state, county and municipal programs. These governmental guarantees are typically used in cases where the borrower requires additional credit support.

 

The underwriting of a commercial loan is based upon a review of the financial statements of the prospective borrower and guarantors. In most cases the Bank obtains a general lien on accounts receivable and inventory, along with the specific collateral such as real estate or equipment, as appropriate.

 

For commercial loans less than $100,000, the Bank uses an automated underwriting system, which includes a nationally-recognized credit scorecard to assist in our decision-making process. For larger commercial loans, a traditional approach of reviewing all the financial information and collateral in greater detail by seasoned lenders is utilized.

 

Commercial business loans generally bear higher interest rates than residential mortgage loans, but they also involve a higher risk of default since their repayment is generally dependent on the cash flow of the borrower’s business. As a result, the availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself and the general economic environment. The Bank’s largest commercial loan was a $35.0 million participation in a $465.0 million syndicated line of credit secured by an assignment of residential mortgage loans. As of December 31, 2005, the Bank’s outstanding balance was $17.7 million and the credit was performing in accordance with its terms and conditions.

 

Consumer Loans. The Bank offers a variety of consumer loans to individuals. Home equity loans and home equity lines of credit constituted 64.7% of the consumer loan portfolio as of December 31, 2005. Indirect marine loans comprised 19.8% of the consumer loan portfolio, and indirect auto loans comprised 12.6% of the consumer loan portfolio at December 31, 2005, respectively. The remainder of the consumer loan portfolio includes personal loans and unsecured lines of credit, automobile loans and recreational vehicle loans.

 

Interest rates on home equity loans are fixed for a term not to exceed 20 years and the maximum loan amount is $500,000. A portion of the home equity loan portfolio includes “first lien product loans,” under which the Bank has offered special rates to borrowers who refinance first mortgage loans on the home equity (first lien) basis. The Bank’s home equity lines are made at floating interest rates and the Bank provides lines of credit of up to $350,000. The approved home equity lines and utilization amounts as of December 31, 2005 were $173.1 million and $98.1 million, respectively.

 

The Bank originates a majority of its home equity loans and lines directly. The Bank also purchases marine and auto loans from established dealers and brokers located on the East Coast of the United States, which are underwritten to the Bank’s pre-established underwriting standards. The maximum marine loan is $1,000,000. All marine loans are collateralized by a first lien on the vessel. The maximum automobile loan for a new automobile is $60,000 and for a used automobile is $40,000. All automobile loans are collateralized by a first lien on the automobile.

 

The Bank’s consumer loan portfolio contains other types of loans such as loans on motorcycles, recreational vehicles and personal loans, which represent 1.9% of the portfolio. Personal unsecured loans are originated primarily as an accommodation to existing customers.

 

Consumer loans generally entail greater credit risk than residential mortgage loans, particularly in the case of consumer loans that are unsecured or that are secured by assets that tend to depreciate, such as automobiles, boats and recreational vehicles. Collateral repossessed by the Bank for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan and the remaining deficiency may warrant further substantial collection efforts against the borrower. In addition, consumer loan collections are dependent on the borrower’s continued financial stability, and this is more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

 

11


Table of Contents

Loan Originations, Purchases, and Repayments. The following table sets forth our loan origination, purchase and repayment activities for the periods indicated.

 

     Year Ended December 31,

 
     2005

    2004

   2003

 
     (In thousands)  

Originations:

                       

Residential mortgage

   $ 152,826     $ 141,338    $ 397,706  

Commercial mortgage

     71,408       120,286      76,361  

Multi-family mortgage

     5,402       901      37,315  

Construction

     273,750       125,406      77,952  

Commercial

     397,751       334,844      166,654  

Consumer

     271,899       244,938      198,433  
    


 

  


Subtotal of loans originated

     1,173,036       967,713      954,421  

Mortgage warehouse

     —         3,020      2,898,507  

Loans purchased

     137,412       322,011      352,233  
    


 

  


Total loans originated

     1,310,448       1,292,744      4,205,161  
    


 

  


Loans acquired from First Sentinel:

                       

Residential mortgage

     —         720,875      —    

Commercial mortgage

     —         223,543      —    

Multi-family mortgage

     —         7,650      —    

Construction

     —         124,210      —    

Commercial

     —         7,204      —    

Consumer

             119,704         
    


 

  


Total loans acquired from First Sentinel

     —         1,203,186      —    
    


 

  


Loans sold or securitized

     36,167       86,695      16,145  

Repayments:

                       

Residential mortgage

     346,453       276,411      394,693  

Commercial mortgage

     119,977       107,591      64,945  

Multi-family mortgage

     14,075       12,812      23,769  

Construction

     173,199       159,785      74,908  

Commercial

     356,649       233,576      110,032  

Consumer

     225,018       147,736      167,217  
    


 

  


Subtotal of loan repayments

     1,235,371       937,911      835,564  

Mortgage warehouse loans

     —         7,167      3,170,741  
    


 

  


Total repayments

     1,235,371       945,078      4,006,305  
    


 

  


Total reductions

     1,271,538       1,031,773      4,022,450  
    


 

  


Other items, net(1)

     (6,999 )     5,687      (2,584 )
    


 

  


Net increase

   $ 31,911     $ 1,469,844    $ 180,127  
    


 

  



(1) Other items include charge-offs, deferred fees and expenses, discounts and premiums.

 

Loan Approval Procedures and Authority. The Bank’s Board of Directors approves the Lending Policy on an annual basis as well as on an interim basis as modifications are warranted. The Lending Policy sets the Bank’s lending authority for each type of loan. The Bank’s individual lending officers are assigned dollar authority limits based upon their experience and expertise.

 

The largest individual lending authority is $5.0 million, which only the Chief Executive Officer and the Chief Lending Officer have. Loans in excess of $5.0 million, or which when combined with existing credits of

 

12


Table of Contents

the borrower or related borrowers exceed $5.0 million, are presented to the management Credit Committee. The Credit Committee consists of six senior officers and requires a majority vote for credit approval. The Credit Committee has a $15.0 million approval authority and the Loan Committee of the Board of Directors of the Bank has approval authority exceeding $15.0 million. All credit approvals by the Loan Committee are reported to the Board of Directors of the Bank.

 

The Bank has adopted a risk rating system as part of the risk assessment of the loan portfolio. The Bank’s commercial real estate and commercial lending officers are required to assign a risk rating to each loan in their portfolio at origination. When the lender learns of important financial developments, the risk rating is reviewed accordingly. Similarly, the Credit Committee can adjust a risk rating. Quarterly, management’s Credit Risk Management Committee meets to review and change, where appropriate, all loans rated a “watch” or worse. In addition, the Loan Review Department, which is independent of the lending areas, validates the risk ratings. The risk ratings play an important role in the establishment of the loan loss provision and to confirm the adequacy of the allowance for loan losses.

 

Loans to One Borrower. The Bank’s regulatory limit on total loans to any borrower or attributed to any one borrower is 15% of unimpaired capital and surplus. As of December 31, 2005, the regulatory lending limit was $82.2 million. The Bank’s internal policy limit on total loans to a borrower or related borrowers that constitute a group exposure is up to $65.0 million for loans with a risk rating of 2 or better, $60.0 million for loans with a risk rating of 3 and $50.0 million for loans with a risk rating of 4. The Bank reviews these group exposures on a quarterly basis. The Bank also sets additional limits on size of loans by loan type. At December 31, 2005, the Bank’s largest relationship with an individual borrower and it’s related entities was $55.1 million, consisting of several construction loans, permanent commercial loans and a line of credit for residential projects in the State of New Jersey. The borrower is a well-established and experienced residential developer. This relationship was performing in accordance with its terms and conditions as of December 31, 2005.

 

As of December 31, 2005, the Bank had $721.9 million in loans outstanding to its 50 largest borrowers and their related entities.

 

ASSET QUALITY

 

General. One of the Bank’s key objectives has been and continues to be to maintain a high level of asset quality. In addition to maintaining sound credit standards for new loan originations, the Bank employs proactive collection and workout processes in dealing with delinquent or problem loans. The Bank actively markets properties that it acquires through foreclosure or otherwise in the loan collection process.

 

Collection Procedures. In the case of residential mortgage and consumer loans, the collections personnel in the Bank’s Asset Recovery Department are responsible for collection activities from the sixteenth day of delinquency. Collection efforts include automated notices of delinquency generated by our system, telephone calls, letters and other notices to the delinquent borrower. Foreclosure proceedings and other appropriate collection activities such as repossession of collateral are commenced within at least 90 to 120 days after the loan is delinquent. Periodic inspections of real estate and other collateral are conducted throughout the collection process. The collection procedures for Federal Housing Association (“FHA”) and Veteran’s Administration (“VA”) one- to four- family mortgage loans follow the collection guidelines outlined by those agencies.

 

Real estate and other assets taken by foreclosure or in connection with a loan workout are held as foreclosed assets. The Bank carries other real estate owned and other foreclosed assets at their fair market value less estimated selling costs. The Bank attempts to sell the property at foreclosure sale or as soon as practical after the foreclosure sale through a proactive marketing effort.

 

The collection procedures for commercial real estate and commercial loans include sending periodic late notices and letters to a borrower once a loan is past due. The Bank attempts to make direct contact with a borrower once a loan is 16 days past due, usually by telephone. The Chief Lending Officer reviews all

 

13


Table of Contents

commercial real estate and commercial loan delinquencies on a weekly basis. Delinquent commercial real estate and commercial loans will be transferred to the Asset Recovery Department for further action if the delinquency is not cured within a reasonable period of time, typically 60 to 90 days. The Chief Lending Officer has the authority to transfer performing commercial real estate or commercial loans to the Asset Recovery Department if, in his opinion, a credit problem exists or is likely to occur.

 

Loans deemed uncollectible are proposed for charge-off on a monthly basis. The charge-off recommendation is then submitted to the Chief Lending Officer, Chief Executive Officer, Chief Operating Officer and Chief Financial Officer for approval.

 

Delinquent Loans and Non-performing Loans and Assets. The Bank’s policies require that the Chief Lending Officer continuously monitor the status of the loan portfolios and report to the Board of Directors on a monthly basis. These reports include information on impaired loans, delinquent loans, criticized and classified assets, and foreclosed assets. An impaired loan is defined as a loan for which it is probable, based on current information, that the Bank will not collect amounts due under the contractual terms of the loan agreement. Smaller balance homogeneous loans including residential mortgages and other consumer loans are evaluated collectively for impairment and are excluded from the definition of impaired loans. Impaired loans are individually identified and reviewed to determine that each loan’s carrying value is not in excess of the fair value of the related collateral or the present value of the expected future cash flows. As of December 31, 2005, there were seven impaired loans totaling $843,000.

 

Accruing interest income is stopped on loans when interest or principal payments are 90 days in arrears or earlier when the timely collectibility of such interest or principal is doubtful. When the accrual of interest on a loan is stopped, the loan is designated as a non-accrual loan and the outstanding interest previously credited is reversed. A non-accrual loan is returned to accrual status when factors indicating doubtful collection no longer exist and the loan has been brought current.

 

Federal and state regulations as well as the Bank’s policy require that the Bank utilize an internal asset classification system as a means of reporting problem and potential problem assets. Under this internal risk rating system, the Bank currently classifies problem and potential problem assets as “substandard,” “doubtful” or “loss” assets. An asset is considered “substandard” if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. “Substandard” assets include those characterized by the “distinct possibility” that the Bank will sustain “some loss” if the deficiencies are not corrected. Assets classified as “doubtful” have all of the weaknesses inherent in those classified “substandard” with the added characteristic that the weaknesses present make “collection or liquidation in full,” on the basis of currently existing facts, conditions, and values, “highly questionable and improbable.” Assets classified as “loss” are those considered “uncollectible” and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. Assets which do not currently expose the Bank to sufficient risk to warrant classification in one of the aforementioned categories, but possess weaknesses are required to be designated “special mention.”

 

General valuation allowances represent loss allowances which have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets. When the Bank classifies one or more assets, or portions thereof, as “substandard” or “doubtful,” the Bank establishes a specific allowance for loan losses in an amount deemed prudent by management. When the Bank classifies one or more assets, or portions thereof, as “loss,” the Bank is required either to establish a specific allowance for losses equal to 100% of the amount of the asset so classified or to charge-off such amount.

 

The determination as to the classification of assets and the amount of the valuation allowances is subject to review by the FDIC and the New Jersey Department of Banking and Insurance, each of which can order the establishment of additional general or specific loss allowances. The FDIC, in conjunction with the other federal

 

14


Table of Contents

banking agencies, has adopted an interagency policy statement on the allowance for loan and lease losses. The policy statement provides guidance for financial institutions on both the responsibilities of management for the assessment and establishment of adequate allowances and guidance for banking agency examiners to use in determining the adequacy of general valuation guidelines. Generally, the policy statement recommends that institutions have effective systems and controls to identify, monitor and address asset quality problems; that management has analyzed all significant factors that affect the collectibility of the portfolio in a reasonable manner; and that management has established acceptable allowance evaluation processes that meet the objectives set forth in the policy statement. In July 2001, the SEC issued Staff Accounting Bulletin, referred to as SAB No. 102, “Selected Loan Loss Allowance Methodology and Documentation Issues.” The guidance contained in the SAB focuses on the documentation the SEC staff normally expects registrants to prepare and maintain in support of the allowance for loan and lease losses. Concurrent with the SEC’s issuance of SAB No. 102, the federal banking agencies, represented by the Federal Financial Institutions Examination Council, referred to as FFIEC, issued an interagency policy statement entitled “Allowance for Loan and Lease Losses Methodologies and Documentation for Bank and Savings Institutions” (Policy Statement). Management believes that the Company’s documentation relating to the allowance for loan loss is consistent with these pronouncements. Although management believes that, based on information currently available to it at this time, the allowance for loans losses is adequate, actual losses are dependent upon future events and, as such, further additions to the level of allowances for loan losses may become necessary.

 

Assets are classified in accordance with the management guidelines described above. At December 31, 2005, $14.9 million of assets were classified as “substandard” which consisted of $4.0 million in residential loans, $2.4 million in commercial mortgage loans, $6.6 million in commercial loans, $1.2 million in consumer loans and $742,000 in multi-family loans. At that same date, $50,000 of loans were classified as “doubtful” and no loans were classified as “loss”. As of December 31, 2005, $13.0 million of loans were designated “special mention.”

 

The following table sets forth delinquencies in the loan portfolio as of the dates indicated.

 

    At December 31, 2005

  At December 31, 2004

  At December 31, 2003

    60-89 Days

  90 Days or More

  60-89 Days

  90 Days or More

  60-89 Days

  90 Days or More

    Number
of Loans


  Principal
Balance
of Loans


  Number
of Loans


  Principal
Balance
of Loans


  Number
of Loans


  Principal
Balance
of Loans


  Number
of Loans


  Principal
Balance
of Loans


  Number
of Loans


  Principal
Balance
of Loans


  Number
of Loans


  Principal
Balance
of Loans


    (Dollars in thousands)

Residential mortgage loans

  27   $ 1,692   40   $ 3,956   29   $ 2,577   41   $ 4,184   48   $ 4,408   43   $ 3,395

Commercial mortgage loans

  —       —     —       —     —       —     —       —     —       —     1     151

Multi-family mortgage loans

  —       —     —       —     —       —     —       —     —       —     —       —  

Construction loans

  —       —     —       —     —       —     —       —     —       —     1     217
   
 

 
 

 
 

 
 

 
 

 
 

Total mortgage loans

  27     1,692   40     3,956   29     2,577   41     4,184   48     4,408   45     3,763

Mortgage warehouse loans

  —       —     —       —     —       —     —       —     —       —     1     223

Commercial loans

  4     110   7     843   6     289   5     862   17     1,781   4     1,016

Consumer loans

  35     1,769   59     1,206   59     1,082   53     1,149   317     2,919   75     1,126
   
 

 
 

 
 

 
 

 
 

 
 

Total loans

  66   $ 3,571   106   $ 6,005   94   $ 3,948   99   $ 6,195   382   $ 9,108   125   $ 6,128
   
 

 
 

 
 

 
 

 
 

 
 

 

15


Table of Contents

Non-Accrual Loans and Non-Performing Assets. The following table sets forth information regarding non-accrual loans and other non-performing assets. There were no troubled debt restructurings as defined in Statement of Financial Accounting Standards (“SFAS”) No. 114 at any of the dates indicated.

 

     At December 31,

 
     2005

    2004

    2003

    2002

    2001

 
     (Dollars in thousands)  

Non-accruing loans:

                                        

Residential mortgage loans

   $ 3,956     $ 4,184     $ 3,395     $ 4,073     $ 4,171  

Commercial mortgage loans

     —         —         151       2,682       345  

Multi-family mortgage loans

     —         —         —         —         —    

Construction loans

     —         —         217       —         1,071  

Mortgage warehouse loans

     —         —         223       —         —    

Commercial loans

     843       862       1,016       34       1,084  

Consumer loans

     1,206       1,149       1,126       1,723       1,413  
    


 


 


 


 


Total non-accruing loans

     6,005       6,195       6,128       8,512       8,084  

Accruing loans delinquent 90 days or more

     —         —         —         —         —    
    


 


 


 


 


Total non-performing loans

     6,005       6,195       6,128       8,512       8,084  

Foreclosed assets

     670       140       41       —         —    
    


 


 


 


 


Total non-performing assets

   $ 6,675     $ 6,335     $ 6,169     $ 8,512     $ 8,084  
    


 


 


 


 


Total non-performing assets as a percentage of total assets

     0.11 %     0.10 %     0.14 %     0.22 %     0.28 %
    


 


 


 


 


Total non-performing loans to total loans

     0.16 %     0.17 %     0.27 %     0.41 %     0.40 %
    


 


 


 


 



Loans generally are placed on non-accrual status when they become 90 days or more past due or if they have been identified as presenting uncertainty with respect to the collectibility of interest or principal.

 

If the non-accrual loans had performed in accordance with their original terms, interest income would have increased by $281,000 during the year ended December 31, 2005. At December 31, 2005, there were no commitments to lend additional funds to borrowers whose loans were on non-accrual status.

 

Allowance for Loan Losses. The allowance for loan losses is a valuation account that reflects an evaluation of the probable losses in the loan portfolio. The allowance for loan losses is maintained through provisions for loan losses that are charged to income. Charge-offs against the allowance for loan losses are taken on loans where it is determined the collection of loan principal is unlikely. Recoveries made on loans that have been charged-off are credited to the allowance for loan losses.

 

Management’s evaluation of the adequacy of the allowance for loan losses includes the review of all loans on which the collectibility of principal may not be reasonably assured. For residential mortgage and consumer loans this is determined primarily by delinquency and collateral values. For commercial real estate and commercial loans, an extensive review of financial performance, payment history and collateral values is conducted on a quarterly basis.

 

As part of the evaluation of the adequacy of the allowance for loan losses, each quarter management prepares a worksheet. This worksheet categorizes the entire loan portfolio by certain risk characteristics such as loan type (residential mortgage, commercial mortgage, construction, commercial, etc.) and loan risk rating. The factors considered in assessing loan risk ratings include the following:

 

    results of the routine loan quality reviews by the Loan Review Department and by outside third parties retained by the Loan Review Department;

 

    general economic and business conditions affecting our key lending areas;

 

16


Table of Contents
    credit quality trends (including trends in non-performing loans, including anticipated trends based on market conditions);

 

    collateral values;

 

    loan volumes and concentrations;

 

    seasoning of the loan portfolio;

 

    specific industry conditions within portfolio segments;

 

    recent loss experience in particular segments of the loan portfolio; and

 

    duration of the current business cycle.

 

When assigning a risk rating to a loan, management utilizes the Bank’s internal risk rating system which is a nine point rating system. Loans deemed to be “acceptable quality” are rated one through four, with a rating of one established for loans with minimal risk. Loans that are deemed to be of “questionable quality” are rated five (watch) or six (special mention). Loans with adverse classifications (substandard, doubtful or loss) are rated seven, eight or nine, respectively. Commercial mortgage, commercial, multi-family and construction loans are rated individually and each lending officer is responsible for risk rating loans in his or her portfolio. These risk ratings are then reviewed by the department manager and/or the Chief Lending Officer and by the Credit Administration Department. The risk ratings are then confirmed by the Loan Review Department and they are periodically reviewed by the Credit Committee in the credit renewal or approval process.

 

Each quarter the lending groups prepare individual Credit Risk Management Reports for the Credit Administration Department. These reports review all commercial loans and commercial mortgage loans that have been determined to involve above-average risk (risk rating of five or worse). The Credit Risk Management Reports contain the reason for the risk rating assigned to each loan, status of the loan and any current developments. These reports are submitted to a committee chaired by the Credit Administration Officer. Each loan officer reviews the loan and the corresponding credit risk management report with the committee and the risk rating is evaluated for appropriateness.

 

Based upon market conditions and the Bank’s historical experience dealing with problem credits, the reserve factor for each risk rating by type of loan is established based on estimates of probable losses in the loan portfolio. The Bank uses a five-year moving average of charge-off and recovery experience as a tool to assist in the development of the reserve factors in determining the provision for loan losses.

 

The reserve factors applied to each loan risk rating are inherently subjective in nature. Reserve factors are assigned to each of the risk rating categories. This methodology permits adjustments to the allowance for loan losses in the event that, in management’s judgment, significant conditions impacting the credit quality and collectibility of the loan portfolio as of the evaluation date are not otherwise adequately reflected in the analysis.

 

The provision for loan losses is established after considering the allowance for loan loss worksheet, the amount of the allowance for loan losses in relation to the total loan balance, loan portfolio growth, loan portfolio composition, loan delinquency trends and peer group analysis. As a result of this process, management has established an unallocated portion of the allowance for loan losses. The unallocated portion of the allowance for loan losses is warranted based on factors such as the geographic concentration of our loan portfolio and the losses inherent in commercial lending, as these types of loans are typically riskier than residential mortgages.

 

Based on the composition of the loan portfolio, management believes the primary risks inherent in the portfolio are possible increases in interest rates, a possible decline in the economy and a possible decline in real estate market values. Management will continue to review the entire loan portfolio to determine the extent, if any, to which further additional loan loss provisions may be deemed necessary. The allowance for loan losses is maintained at a level that represents management’s best estimate of probable losses related to specifically

 

17


Table of Contents

identified loans as well as probable incurred losses in the remaining loan portfolio. There can be no assurance that the allowance for loan losses will be adequate to cover all losses that may in fact be realized in the future or that additional provisions for loan losses will be required.

 

Analysis of the Allowance for Loan Losses. The following table sets forth the analysis of the allowance for loan losses for the periods indicated.

 

     Year Ended December 31,

 
     2005

    2004

    2003

    2002

    2001

 
     (Dollars in thousands)  

Balance at beginning of period

   $ 33,766     $ 20,631     $ 20,986     $ 21,909     $ 20,198  

Charge offs:

                                        

Residential mortgage loans

     18       71       1,070       333       411  

Commercial mortgage loans

     22       —         —         —         208  

Multi-family mortgage loans

     —         —         —         —         —    

Construction loans

     —         —         —         —         —    

Mortgage warehouse loans

     —         —         —         12,500       —    

Commercial loans

     1,008       1,671       1,904       1,859       46  

Consumer loans

     2,986       4,619       1,412       228       297  
    


 


 


 


 


Total

     4,034       6,361       4,386       14,920       962  
    


 


 


 


 


Recoveries:

                                        

Residential mortgage loans

     155       186       1,523       271       256  

Commercial mortgage loans

     93       —         —         —         168  

Multi-family mortgage loans

     —         —         —         —         —    

Construction loans

     —         —         —         —         —    

Mortgage warehouse loans

     —         —         —         —         —    

Commercial loans

     340       432       772       451       201  

Consumer loans

     1,060       2,353       576       475       148  
    


 


 


 


 


Total

     1,648       2,971       2,871       1,197       773  
    


 


 


 


 


Net charge-offs

     2,386       3,390       1,515       13,723       189  

Provision for loan losses

     600       3,600       1,160       12,800       1,900  

Allowance of acquired institution

     —         12,925       —         —         —    
    


 


 


 


 


Balance at end of period

   $ 31,980     $ 33,766     $ 20,631     $ 20,986     $ 21,909  
    


 


 


 


 


Ratio of net charge-offs during the period to average loans outstanding during the period

     0.07 %     0.12 %     0.08 %     0.70 %     0.01 %
    


 


 


 


 


Allowance for loan losses to total loans

     0.86 %     0.91 %     0.92 %     1.02 %     1.09 %
    


 


 


 


 


Allowance for loan losses to non-performing loans

     532.56 %     545.05 %     336.67 %     246.55 %     271.02 %
    


 


 


 


 


 

18


Table of Contents

Allocation of Allowance for Loan Losses. The following table sets forth the allocation of the allowance for loan losses by loan category for the periods indicated. This allocation is based on management’s assessment, as of a given point in time, of the risk characteristics of each of the component parts of the total loan portfolio and is subject to changes as and when the risk factors of each such component part change. The allocation is neither indicative of the specific amounts or the loan categories in which future charge-offs may be taken nor is it an indicator of future loss trends. The allocation of the allowance to each category does not restrict the use of the allowance to absorb losses in any category.

 

    At December 31,

 
    2005

    2004

    2003

    2002

    2001

 
    Amount of
Allowance
for Loan
Losses


  Percent of
Loans in
Each
Category to
Total Loans


    Amount of
Allowance
for Loan
Losses


  Percent of
Loans in
Each
Category to
Total Loans


    Amount of
Allowance
for Loan
Losses


  Percent of
Loans in
Each
Category to
Total Loans


    Amount of
Allowance
for Loan
Losses


  Percent of
Loans in
Each
Category to
Total Loans


    Amount of
Allowance
for Loan
Losses


  Percent of
Loans in
Each
Category to
Total Loans


 
    (Dollars in thousands)  

Residential mortgage loans

  $ 2,854   47.57 %   $ 3,000   50.53 %   $ 1,804   46.78 %   $ 1,447   34.08 %   $ 1,598   39.43 %

Commercial mortgage loans

    7,246   17.08       7,893   18.49       4,898   20.11       4,898   21.65       5,436   20.44  

Multi-family mortgage loans

    773   2.08       930   2.33       932   4.05       745   3.75       992   4.73  

Construction loans

    4,397   7.77       2,918   5.10       1,595   4.44       1,247   4.68       1,528   4.00  

Mortgage warehouse loans

    —     —         —     —         43   0.18       3,408   13.47       2,612   8.33  

Commercial loans

    5,676   10.57       7,400   9.54       5,278   11.04       2,708   8.94       2,281   7.02  

Consumer loans

    5,760   14.93       5,889   14.01       3,385   13.40       3,507   13.43       3,615   16.05  

Unallocated

    5,274   —         5,736   —         2,696   —         3,026   —         3,847   —    
   

 

 

 

 

 

 

 

 

 

Total

  $ 31,980   100.00 %   $ 33,766   100.00 %   $ 20,631   100.00 %   $ 20,986   100.00 %   $ 21,909   100.00 %
   

 

 

 

 

 

 

 

 

 

 

INVESTMENT ACTIVITIES

 

General. The investment policy for the Bank and the Company is approved annually by the Board of Directors. The Chief Financial Officer and the Treasurer are authorized by the Board to implement the investment policy and establish investment strategies. The President, Chief Financial Officer, Treasurer and Assistant Treasurer are authorized to make investment decisions consistent with the investment policy. Investment transactions for the Bank are reported to the Board of Directors of the Bank on a monthly basis.

 

The investment policy is designed to generate a favorable rate of return, consistent with established guidelines for liquidity, safety and diversification, and to complement the lending activities of the Bank. Investment decisions are made in accordance with the policy and are based on credit quality, interest rate risk, balance sheet composition, market expectations, liquidity, income and collateral needs.

 

The investment policy does not currently permit participation in hedging programs, interest rate swaps, options or futures transactions or the purchase of any securities that are below investment grade.

 

The investment strategy is to maximize the return on the investment portfolio consistent with guidelines that have been established for liquidity, safety, duration and diversification. The investment strategy also considers the Bank’s and the Company’s interest rate risk position as well as liquidity, loan demand and other factors. Acceptable investment securities include U. S. Treasury and Agency obligations, collateralized mortgage obligations (“CMOs”), corporate debt obligations, New Jersey municipal bonds, mortgage-backed securities, commercial paper, mutual funds, bankers acceptances and federal funds. Securities purchased for the investment portfolio require a minimum credit rating of “A” by Moody’s or Standard & Poor’s.

 

Securities for the investment portfolio are classified as held to maturity, available for sale or held for trading. Securities that are classified as held to maturity are securities that the Bank or the Company has the intent and ability to hold until their contractual maturity date and are reported at cost. Securities that are classified as available for sale are reported at fair value. Available for sale securities include U.S. Treasury and Agency Obligations, U.S. Agency and privately-issued CMOs, corporate debt obligations and equities. Sales of

 

19


Table of Contents

securities may occur from time to time in response to changes in market rates and liquidity needs and to facilitate balance sheet reallocation to effectively manage interest rate risk. At the present time, there are no securities that are classified as held for trading.

 

CMOs are a type of debt security issued by a special-purpose entity that aggregates pools of mortgages and mortgage-related securities and creates different classes of CMO securities with varying maturities and amortization schedules as well as a residual interest with each class possessing different risk characteristics. In contrast to mortgage-backed securities from which cash flow is received (and prepayment risk is shared) pro rata by all securities holders, the cash flow from the mortgages or mortgage-related securities underlying CMOs is paid in accordance with predetermined priority to investors holding various tranches of such securities or obligations. A particular tranche of CMOs may therefore carry prepayment risk that differs from that of both the underlying collateral and other tranches. Accordingly, CMOs attempt to moderate risks associated with conventional mortgage-related securities resulting from unexpected prepayment activity. In declining interest rate environments, the Bank attempts to purchase CMOs with principal lock-out periods, reducing prepayment risk in the investment portfolio. During rising interest rate periods, the Bank’s strategy is to purchase CMOs that are receiving principal payments that can be reinvested at higher current yields. Investments in CMOs involve a risk that actual prepayments will differ from those estimated in pricing the security, which may result in adjustments to the net yield on such securities. Additionally, the market value of such securities may be adversely affected by changes in the market interest rates. Management believes these securities may represent attractive alternatives relative to other investments due to the wide variety of maturity, repayment and interest rate options available. All privately-issued CMOs in the investment portfolio are rated “AAA.”

 

Amortized Cost and Fair Value of Securities. The following tables sets forth certain information regarding the amortized cost and fair values of our securities as of the dates indicated.

 

    At December 31,

    2005

  2004

  2003

    Amortized
Cost


  Fair
Value


  Amortized
Cost


  Fair
Value


  Amortized
Cost


  Fair
Value


    (Dollars in thousands)

Held to Maturity:

                                   

Mortgage-backed securities

  $ 188,506   $ 186,290   $ 229,001   $ 230,115   $ 305,496   $ 308,366

State and municipal obligations

    221,634     220,908     215,858     219,182     212,293     216,063

Equity securities

    774     774     774     774     —       —  
   

 

 

 

 

 

Total held-to-maturity

  $ 410,914   $ 407,972   $ 445,633   $ 450,071   $ 517,789   $ 524,429
   

 

 

 

 

 

Available for Sale:

                                   

U.S. Treasury obligations

  $ 80,958   $ 80,378   $ 95,887   $ 95,312   $ 120,913   $ 121,580

State and municipal obligations

    10,630     10,610     10,876     10,942     —       —  

Mortgage-backed securities

    902,629     887,188     1,167,838     1,169,087     874,401     873,933

FHLMC obligations

    —       —       1,971     2,008     —       —  

FNMA obligations

    —       —       —       —       5,000     5,036

FHLB obligations

    9,923     9,844     —       —       —       —  

Corporate obligations

    61,292     61,368     90,735     92,495     104,818     109,877

Equity securities

    32,627     33,569     32,864     36,496     35,802     41,403
   

 

 

 

 

 

Total available for sale

  $ 1,098,059   $ 1,082,957   $ 1,400,171   $ 1,406,340   $ 1,140,934   $ 1,151,829
   

 

 

 

 

 

Average expected life of securities(1)

    3.67 years           3.37 years           3.96 years      

(1) Average expected life is based on prepayment assumptions utilizing prevailing interest rates as of the reporting dates and does not include equity securities.

 

The aggregate carrying values and fair values of securities by issuer, where the aggregate book value of such securities exceeds ten percent of stockholders’ equity are as follows (in thousands):

 

     Carrying Value

   Fair Value

At December 31, 2005:

             

FNMA

   $ 492,602    $ 484,569

FHLMC

     485,335      484,519

 

20


Table of Contents

The following table sets forth certain information regarding the carrying value, weighted average yields and contractual maturities of the Company’s debt securities portfolio as of December 31, 2005. No tax equivalent adjustments were made to the weighted average yields. Amounts are shown at amortized cost for held to maturity securities and at fair value for available for sale securities.

 

    At December 31, 2005

 
    One Year or Less

   

More Than One Year to

Five Years


    More Than Five Years to
Ten Years


    After Ten Years

    Total

 
    Carrying
Value


  Weighted
Average
Yield


    Carrying
Value


  Weighted
Average
Yield


      Carrying  
Value


    Weighted  
Average
Yield


    Carrying
Value


  Weighted
Average
Yield


    Carrying
Value


  Weighted
Average
Yield(1)


 
    (Dollars in thousands)  

Held to Maturity:

                                                           

Mortgage-backed securities

  $ —     —   %   $ 2,324   6.68 %   $ 22,514   4.38 %   $ 163,668   4.72 %   $ 188,506   4.70 %

State and municipal obligations

    5,868   4.06       34,512   3.94       112,190   3.76       69,064   3.89       221,634   3.83  
   

 

 

 

 

 

 

 

 

 

Total held-to-maturity

  $ 5,868   4.06 %   $ 36,836   4.11 %   $ 134,704   3.86 %   $ 232,732   4.47 %   $ 410,140   4.23 %
   

 

 

 

 

 

 

 

 

 

Available for sale:

                                                           

U.S. Treasury obligations

  $ 70,502   2.18 %   $ 9,876   3.60 %   $ —     —   %   $ —     —   %   $ 80,378   2.36 %

State and municipal obligations

    1,197   3.10       3,592   4.31       5,821   4.44       —     —         10,610   4.24  

Mortgage-backed securities

    —     —         26,908   4.55       150,077   3.99       710,203   4.38       887,188   4.32  

FHLB obligations

    —     —         9,844   4.17       —     —         —     —         9,844   4.17  

Corporate obligations

    49,319   4.77       12,049   5.33       —     —         —     —         61,368   4.88  
   

 

 

 

 

 

 

 

 

 

Total available for sale

  $ 121,018   3.25 %   $ 62,269   4.47 %   $ 155,898   4.01 %   $ 710,203   4.38 %   $ 1,049,388   4.20 %
   

 

 

 

 

 

 

 

 

 


(1) Yields are not tax equivalent.

 

21


Table of Contents

SOURCES OF FUNDS

 

General. Primary sources of funds consist of principal and interest cash flows received from loans and mortgage-backed securities, contractual maturities on investments, deposits, Federal Home Loan Bank (“FHLB”) advances and proceeds from sales of loans and investments. These sources of funds are used for lending, investing and general corporate purposes, including acquisitions and common stock repurchases.

 

Deposits. The Bank offers a variety of deposits for retail and business accounts. Deposit products include savings accounts, checking accounts, interest-bearing checking accounts, money market deposit accounts and certificate of deposit accounts at varying interest rates and terms. The Bank also offers IRA and KEOGH accounts. Business customers are offered several checking account and savings plans, cash management services, payroll origination services, escrow account management and MasterCard business cards. The Bank’s customer relationship management strategy focuses on relationship banking for retail and business customers to enhance the customer experience. Deposit activity is influenced by state and local economic activity, changes in interest rates, internal pricing decisions and competition. Deposits are primarily obtained from the areas surrounding the Bank’s branch locations. In order to attract and retain deposits, the Bank offers competitive rates, quality customer service and offers a wide variety of products and services that meet customers’ needs, including online banking. The Bank has no brokered deposits.

 

Deposit pricing strategy is monitored monthly by a management Asset/Liability Committee. Deposit pricing is set weekly by the Bank’s Treasury Department. When considering deposit pricing, the Bank considers competitive market rates, FHLB advance rates and rates on other sources of funds. Core deposits, defined as savings accounts, interest and non-interest bearing checking accounts and money market deposit accounts represented 63.1% of total deposits at December 31, 2005 and 65.6% of total deposits at December 31, 2004. As of December 31, 2005 and December 31, 2004, time deposits maturing in less than one year amounted to $1.08 billion and $960.0 million, respectively.

 

The following table indicates the amount of certificates of deposit by time remaining until maturity as of December 31, 2005.

 

     Maturity

    
     3 Months or
Less


  

Over 3 to

6 Months


  

Over 6 to

12 Months


   Over 12
Months


   Total

     (In thousands)

Certificates of deposit of $100,000 or more

   $ 64,629    $ 67,265    $ 81,368    $ 90,967    $ 304,229

Certificates of deposit less than $100,000

     276,510      281,849      304,446      280,920      1,143,725
    

  

  

  

  

Total certificates of deposit

   $ 341,139    $ 349,114    $ 385,814    $ 371,887    $ 1,447,954
    

  

  

  

  

 

Certificates of Deposit Maturities. The following table sets forth certain information regarding certificates of deposit.

 

    Period to Maturity from December 31, 2005

  At December 31,

   

Less

Than

One Year


 

One to
Two

Years


 

Two to
Three

Years


 

Three to
Four

Years


  Four to
Five Years


  Five Years
or More


  2005

  2004

  2003

    (In thousands)

Rate:

                                                     

0.00 to 0.99%

  $ 3,555   $ 244   $ —     $ —     $ —     $ —     $ 3,799   $ 7,348   $ 745

1.00 to 2.00%

    9,111     18     61     —       —       —       9,190     812,561     632,086

2.01 to 3.00%

    589,127     29,714     2,566     —       —       —       621,407     251,131     114,800

3.01 to 4.00%

    421,369     79,144     48,238     34,467     597     5,430     589,245     129,109     104,939

4.01 to 5.00%

    41,095     36,001     9,366     39,425     43,742     9,794     179,423     135,152     56,325

5.01 to 6.00%

    11,207     4,456     2,223     2,850     26     14,450     35,212     40,843     20,954

6.01 to 7.00%

    603     5,537     173     581     1,809     844     9,547     18,886     3,232

Over 7.01%

    —       1     36     15     3     76     131     165     30
   

 

 

 

 

 

 

 

 

Total

  $ 1,076,067   $ 155,115   $ 62,663   $ 77,338   $ 46,177   $ 30,594   $ 1,447,954   $ 1,395,195   $ 933,111
   

 

 

 

 

 

 

 

 

 

22


Table of Contents

Borrowed Funds. At December 31, 2005, the Bank had $970.1 million of borrowed funds. Borrowed funds consist primarily of FHLB advances and repurchase agreements. Repurchase agreements are contracts for the sale of securities owned or borrowed by the Bank, with an agreement to repurchase those securities at an agreed-upon price and date. The Bank uses wholesale repurchase agreements, as well as retail repurchase agreements as an investment vehicle for its commercial sweep checking product. Bank policies limit the use of repurchase agreements to collateral consisting of U.S. Treasury obligations, U.S. agency obligations or mortgage-related securities.

 

As a member of the Federal Home Loan Bank of New York, the Bank is eligible to obtain advances upon the security of the FHLB common stock owned and certain residential mortgage loans, provided certain standards related to credit-worthiness have been met. FHLB advances are available pursuant to several credit programs, each of which has its own interest rate and range of maturities.

 

The following table sets forth the maximum month-end balance and average monthly balance of FHLB advances and securities sold under agreements to repurchase for the periods indicated.

 

     Year Ended December 31,

 
     2005

    2004

    2003

 
     (Dollars in thousands)  

Maximum Balance:

                        

FHLB advances

   $ 679,726     $ 768,858     $ 626,665  

FHLB line of credit

     48,000       70,000       65,000  

Securities sold under agreements to repurchase

     466,244       493,409       54,580  

Average Balance:

                        

FHLB advances

     633,000       680,297       514,914  

FHLB line of credit

     1,693       9,899       3,603  

Securities sold under agreements to repurchase

     444,454       254,185       49,215  

Weighted Average Interest Rate:

                        

FHLB advances

     3.25 %     3.04 %     2.91 %

FHLB line of credit

     3.63       1.05       1.11  

Securities sold under agreements to repurchase

     2.95       2.48       0.84  

 

The following table sets forth certain information as to borrowings at the dates indicated.

 

     At December 31,

 
     2005

    2004

    2003

 
     (Dollars in thousands)  

FHLB advances

   $ 530,982     $ 700,678     $ 626,665  

FHLB line of credit

     48,000       —         65,000  

Securities sold under repurchase agreements

     391,126       465,386       44,663  
    


 


 


Total borrowed funds

   $ 970,108     $ 1,166,064     $ 736,328  
    


 


 


Weighted average interest rate of FHLB advances

     3.27 %     3.14 %     2.87 %

Weighted average interest rate of FHLB line of credit

     4.21 %     —         1.05 %

Weighted average interest rate of securities sold under agreements to repurchase

     3.40 %     2.78 %     0.76 %

 

FINANCIAL MANAGEMENT AND TRUST SERVICES

 

The Bank offers a full range of trust and financial management services primarily to individuals. These services include wealth management services, such as investment management and investment advisory accounts, as well as custody accounts. The Bank also serves as trustee for living and testamentary trusts. Trust

 

23


Table of Contents

officers also provide estate settlement services when the Bank has been named executor or guardian of an estate. At December 31, 2005, the book value of assets under administration was $230.5 million and the number of accounts under administration was 540.

 

SUBSIDIARY ACTIVITIES

 

Provident Investment Services, Inc. is a wholly-owned subsidiary of the Bank. It was established as a New Jersey corporation to provide life and health insurance in the State of New Jersey and conducts non-deposit investment product and insurance sales.

 

Provident Title, LLC was a joint venture in which the Bank had a 49% interest and Investor’s Title Agency, Inc. had a 51% interest. Provident Title, LLC was licensed to sell title insurance in the State of New Jersey. Provident Title, LLC ceased doing business on August 31, 2005.

 

Dudley Investment Corporation is a wholly-owned subsidiary of the Bank, which operates as a New Jersey Investment Company. Dudley Investment Corporation owns all of the outstanding common stock of PSB Funding Corporation.

 

PSB Funding Corporation is a majority-owned subsidiary of Dudley Investment Corporation. It was established as a New Jersey corporation to engage in real estate activities (including the acquisition of mortgage loans from the Bank) that enable it to be taxed as a real estate investment trust for federal and New Jersey tax purposes.

 

FSB Financial LLC is an inactive wholly-owned subsidiary of the Bank that engaged in retail non-deposit investment product sales.

 

First Sentinel Capital Trust I and First Sentinel Capital Trust II are special purpose business trusts established for the purpose of issuing $25.0 million of preferred capital securities. The Company owns 100% of the common securities of each entity. First Sentinel Capital Trust I and First Sentinel Capital Trust II became subsidiaries of the Company as a result of the First Sentinel acquisition.

 

PERSONNEL

 

As of December 31, 2005, the Company had 808 full-time and 168 part-time employees. None of the Company’s employees were represented by a collective bargaining group. The Company believes its relationship with its employees is good.

 

REGULATION

 

General

 

The Company, as a bank holding company controlling the Bank, is subject to the Bank Holding Company Act of 1956, as amended (“BHCA”), and the rules and regulations of the Federal Reserve Board under the BHCA and to the provisions of the New Jersey Banking Act of 1948 (the “New Jersey Banking Act”) and the regulations of the Commissioner of the New Jersey Department of Banking and Insurance (“Commissioner”) under the New Jersey Banking Act applicable to bank holding companies. The Company and the Bank are required to file reports with, and otherwise comply with the rules and regulations of the Federal Reserve Board and the Commissioner. The Company files certain reports with, and otherwise complies with, the rules and regulations of the SEC under the federal securities laws and the listing requirements of the New York Stock Exchange.

 

The Bank is a New Jersey chartered savings bank, and its deposit accounts are insured up to applicable limits by the Federal Deposit Insurance Corporation (“FDIC”) under the Bank Insurance Fund (“BIF”) and the Savings Association Insurance Fund (“SAIF”). The Bank is subject to extensive regulation, examination and

 

24


Table of Contents

supervision by the Commissioner as the issuer of its charter, and by the FDIC as the deposit insurer. The Bank must file reports with the Commissioner and the FDIC concerning its activities and financial condition, and it must obtain regulatory approval prior to entering into certain transactions, such as mergers with, or acquisitions of, other depository institutions and opening or acquiring branch offices. The Commissioner and the FDIC conduct periodic examinations to assess the Bank’s compliance with various regulatory requirements. This regulation and supervision establishes a comprehensive framework of activities in which a savings bank can engage and is intended primarily for the protection of the deposit insurance fund and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes.

 

Any change in applicable laws and regulations, whether by the Commissioner, the FDIC, the Federal Reserve Board or through legislation, could have a material adverse impact on the Company and the Bank and their operations and stockholders.

 

New Jersey Banking Regulation

 

Activity Powers. The Bank derives its lending, investment and other activity powers primarily from the applicable provisions of the New Jersey Banking Act and its related regulations. Under these laws and regulations, savings banks, including the Bank, generally may invest in:

 

  (1) real estate mortgages;

 

  (2) consumer and commercial loans;

 

  (3) specific types of debt securities, including certain corporate debt securities and obligations of federal, state and local governments and agencies;

 

  (4) certain types of corporate equity securities; and

 

  (5) certain other assets.

 

A savings bank may also invest pursuant to a “leeway” power that permits investments not otherwise permitted by the New Jersey Banking Act. “Leeway” investments must comply with a number of limitations on the individual and aggregate amounts of “leeway” investments. A savings bank may also exercise trust powers upon approval of the Commissioner. New Jersey savings banks may exercise those powers, rights, benefits or privileges authorized for national banks or out-of-state banks or for federal or out-of-state savings banks or savings associations, provided that before exercising any such power, right, benefit or privilege, prior approval by the Commissioner by regulation or by specific authorization is required. The exercise of these lending, investment and activity powers is limited by federal law and the related regulations.

 

Loans-to-One-Borrower Limitations. With certain specified exceptions, a New Jersey chartered savings bank may not make loans or extend credit to a single borrower and to entities related to the borrower in an aggregate amount that would exceed 15% of the bank’s capital funds. A savings bank may lend an additional 10% of the bank’s capital funds if secured by collateral meeting the requirements of the New Jersey Banking Act. The Bank currently complies with applicable loans-to-one-borrower limitations.

 

Dividends. Under the New Jersey Banking Act, a stock savings bank may declare and pay a dividend on its capital stock only to the extent that the payment of the dividend would not impair the capital stock of the savings bank. In addition, a stock savings bank may not pay a dividend unless the savings bank would, after the payment of the dividend, have a surplus of not less than 50% of its capital stock, or the payment of the dividend would not reduce the surplus. Federal law may also limit the amount of dividends that may be paid by the Bank.

 

Minimum Capital Requirements. Regulations of the Commissioner impose on New Jersey chartered depository institutions, including the Bank, minimum capital requirements similar to those imposed by the FDIC on insured state banks.

 

25


Table of Contents

Examination and Enforcement. The New Jersey Department of Banking and Insurance may examine the Bank whenever it deems an examination advisable. The Department examines the Bank at least every two years. The Commissioner may order any savings bank to discontinue any violation of law or unsafe or unsound business practice and may direct any director, officer, attorney or employee of a savings bank engaged in an objectionable activity, after the Commissioner has ordered the activity to be terminated, to show cause at a hearing before the Commissioner why such person should not be removed.

 

Federal Banking Regulation

 

Capital Requirements. FDIC regulations require banks to maintain minimum levels of capital. The FDIC regulations define two tiers, or classes, of capital.

 

Tier 1 capital is comprised of:

 

    common stockholders’ equity, less net unrealized holding losses on available-for-sale equity securities with readily determinable fair values;

 

    non-cumulative perpetual preferred stock, including any related surplus; and

 

    minority interests in consolidated subsidiaries minus all intangible assets, other than qualifying servicing rights and any net unrealized loss on marketable equity securities.

 

The components of Tier 2 capital are comprised of:

 

    cumulative perpetual preferred stock;

 

    certain perpetual preferred stock for which the dividend rate may be reset periodically;

 

    hybrid capital instruments, including mandatory convertible securities;

 

    term subordinated debt;

 

    intermediate term preferred stock;

 

    allowance for possible loan losses; and

 

    up to 45% of pretax net unrealized holding gains on available for sale equity securities with readily determinable fair market values.

 

The allowance for loan losses may be includible in Tier 2 capital up to a maximum of 1.25% of risk-weighted assets. Overall, the amount of Tier 2 capital that may be included in total capital cannot exceed 100% of Tier 1 capital. The FDIC regulations establish a minimum leverage capital requirement for banks in the strongest financial and managerial condition, with a rating of 1 (the highest examination rating of the FDIC for banks) under the Uniform Financial Institutions Rating System that are not anticipating or experiencing significant growth, of not less than a ratio of 3.0% of Tier 1 capital to total assets. For all other banks, the minimum leverage capital requirement is 4.0%, unless a higher leverage capital ratio is warranted by the particular circumstances or risk profile of the bank.

 

The FDIC regulations also establish a risk-based capital standard. The risk-based capital standard requires the maintenance of a ratio of total capital, which is defined as the sum of Tier 1 capital and Tier 2 capital, to risk-weighted assets of at least 8% and a ratio of Tier 1 capital to risk-weighted assets of at least 4%. In determining the amount of a bank’s risk-weighted assets, all assets, plus certain off balance sheet items, are multiplied by a risk-weight of 0% to 100%, based on the risks the FDIC believes are inherent in the type of asset or item.

 

The federal banking agencies, including the FDIC, have also adopted regulations to require an assessment of a bank’s exposure to declines in the economic value of the bank’s capital due to changes in interest rates when assessing the bank’s capital adequacy. Under such a risk assessment, examiners will evaluate a bank’s capital for

 

26


Table of Contents

interest rate risk on a case-by-case basis, with consideration of both quantitative and qualitative factors. According to the agencies, applicable considerations include:

 

    the quality of the bank’s interest rate risk management process;

 

    the overall financial condition of the bank; and

 

    the level of other risks at the bank for which capital is needed.

 

Institutions with significant interest rate risk may be required to maintain additional capital.

 

The following table shows the Bank’s leverage ratio, Tier 1 risk-based capital ratio, and total risk-based capital ratio, at December 31, 2005:

 

     As of December 31, 2005

 
     Capital

   Percent of
Assets(1)


    Capital
Requirements(1)


 
     (Dollars in thousands)  

Regulatory Tier 1 leverage capital

   $ 514,869    9.18 %   4.0 %

Tier 1 risk-based capital

     514,869    13.53     4.0  

Total risk-based capital

     546,927    14.37     8.0  

(1) For purposes of calculating Regulatory Tier 1 leverage capital, assets are based on adjusted total leverage assets. In calculating Tier 1 risk based capital and total risk-based capital, assets are based on total risk-weighted assets.

 

As the table shows, as of December 31, 2005, the Bank was considered “well capitalized” under FDIC guidelines.

 

Activity Restrictions on State-Chartered Banks. Federal law and FDIC regulations generally limit the activities and investments of state-chartered FDIC insured banks and their subsidiaries to those permissible for national banks and their subsidiaries, unless such activities and investments are specifically exempted by law or consented to by the FDIC.

 

Before making a new investment or engaging in a new activity that is not permissible for a national bank or otherwise permissible under federal law or FDIC regulations, an insured bank must seek approval from the FDIC to make such investment or engage in such activity. The FDIC will not approve the activity unless the bank meets its minimum capital requirements and the FDIC determines that the activity does not present a significant risk to the FDIC insurance funds. Certain activities of subsidiaries that are engaged in activities permitted for national banks only through a “financial subsidiary” are subject to additional restrictions.

 

Federal law permits a state-chartered savings bank to engage, through financial subsidiaries, in any activity in which a national bank may engage through a financial subsidiary and on substantially the same terms and conditions. In general, the law permits a national bank that is well-capitalized and well-managed to conduct, through a financial subsidiary, any activity permitted for a financial holding company other than insurance underwriting, insurance investments, real estate investment or development or merchant banking. The total assets of all such financial subsidiaries may not exceed the lesser of 45% of the bank’s total assets or $50 billion. The bank must have policies and procedures to assess the financial subsidiary’s risk and protect the bank from such risk and potential liability, must not consolidate the financial subsidiary’s assets with the bank’s and must exclude from its own assets and equity all equity investments, including retained earnings, in the financial subsidiary. State chartered savings banks may retain subsidiaries in existence as of March 11, 2000 and may engage in activities that are not authorized under federal law. Although the Bank meets all conditions necessary to establish and engage in permitted activities through financial subsidiaries, it has not yet determined whether or the extent to which it may seek to engage in such activities.

 

27


Table of Contents

Federal Home Loan Bank System. The Bank is a member of the FHLB system, which consists of twelve regional FHLBs, each subject to supervision and regulation by the Federal Housing Finance Board (“FHFB”). The FHLB provides a central credit facility primarily for member thrift institutions as well as other entities involved in home mortgage lending. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLBs. It makes loans to members (i.e., advances) in accordance with policies and procedures, including collateral requirements, established by the respective boards of directors of the FHLBs. These policies and procedures are subject to the regulation and oversight of the FHFB. All long term advances are required to provide funds for residential home financing. The FHFB has also established standards of community or investment service that members must meet to maintain access to such long term advances. The Bank, as a member of the FHLB of New York, is required to purchase and hold shares of capital stock in that FHLB in an amount as required by that FHLB’s capital plan and minimum capital requirements. The Bank is in compliance with these requirements.

 

Deposit Insurance. The FDIC established a system for setting deposit insurance premiums based upon the risks a particular bank posed to its deposit insurance funds. Under the risk-based deposit insurance assessment system, the FDIC assigns an institution to one of three capital categories based on the institution’s financial information, as of the reporting period ending six months before the assessment period. The three capital categories are: (1) well capitalized, (2) adequately capitalized and (3) undercapitalized. With respect to the capital ratios, institutions are classified as well capitalized, adequately capitalized or undercapitalized using ratios that are substantially similar to the prompt corrective action capital ratios discussed under the heading Prompt Corrective Action below. The FDIC also assigns an institution to supervisory subgroups based on a supervisory evaluation provided to the FDIC by the institution’s primary federal regulator and information that the FDIC determines to be relevant to the institution’s financial condition and the risk posed to the deposit insurance funds, which may include information provided by the institution’s state supervisor.

 

An institution’s assessment rate depends on the capital category and supervisory category to which it is assigned. Under the final risk-based assessment system, there are nine assessment risk classifications, or combinations of capital groups and supervisory subgroups, to which different assessment rates are applied. Assessment rates for deposit insurance currently range from 0 basis points to 27 basis points. The capital and supervisory subgroup to which an institution is assigned by the FDIC is confidential and may not be disclosed. A bank’s rate of deposit insurance assessments will depend upon the category and subcategory to which the bank is assigned by the FDIC. Any increase in insurance assessments could have an adverse effect on the earnings of insured institutions, including the Bank.

 

The Federal Deposit Insurance Reform Act of 2005 was signed into law on February 8, 2006. Among other things this legislation merges the Savings Association Insurance Fund and the Bank Insurance Fund into a unified fund and increases the amount of deposit insurance from $100,000 to $130,000 with a cost of living adjustment to become effective in five years. The reserve ratio is also modified to provide for a range between 1.15% and 1.5% of estimated insured deposits.

 

The FDIC may terminate the insurance of an institution’s deposits upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. Management does not know of any practice, condition or violation that might lead to termination of deposit insurance.

 

Enforcement. The FDIC has extensive enforcement authority over insured savings banks, including the Bank. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease and desist orders and to remove directors and officers. In general, these enforcement actions may be initiated in response to violations of law and to unsafe or unsound practices.

 

Transactions with Affiliates. Transactions between an insured bank, such as the Bank, and any of its affiliates are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a bank is any

 

28


Table of Contents

company or entity that controls, is controlled by or is under common control with the bank. A subsidiary of a bank that is not also a depository institution, financial subsidiary or other entity defined by the regulation generally is not treated as an affiliate of the bank for purposes of Sections 23A and 23B.

 

Section 23A:

 

    limits the extent to which a bank or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10% of such bank’s capital stock and retained earnings, and limits all such transactions with all affiliates to an amount equal to 20% of ` such capital stock and retained earnings; and

 

    requires that all such transactions be on terms that are consistent with safe and sound banking practices.

 

The term “covered transaction” includes the making of loans, purchase of assets, issuance of guarantees and other similar types of transactions. Further, most loans by a bank to any of its affiliates must be secured by collateral in amounts ranging from 100 to 130 percent of the loan amounts. In addition, any covered transaction by a bank with an affiliate and any purchase of assets or services by a bank from an affiliate must be on terms that are substantially the same, or at least as favorable to the bank, as those that would be provided to a non-affiliate.

 

Prohibitions Against Tying Arrangements. Banks are subject to statutory prohibitions on certain tying arrangements. A depository institution is prohibited, subject to certain exceptions, from extending credit to or offering any other service, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or its affiliates or that the customer not obtain services of a competitor of the institution.

 

Privacy Standards. FDIC regulations require the Company and the Bank to disclose their privacy policies, including identifying with whom they share “non-public personal information” to customers at the time of establishing the customer relationship and annually thereafter.

 

The FDIC regulations also require the Company and the Bank to provide their customers with initial and annual notices that accurately reflect their privacy policies and practices. In addition, the Company and the Bank are required to provide their customers with the ability to “opt-out” of having the Company and the Bank share their non-public personal information with unaffiliated third parties before they can disclose such information, subject to certain exceptions.

 

Community Reinvestment Act and Fair Lending Laws. All FDIC insured institutions have a responsibility under the Community Reinvestment Act and related regulations to help meet the credit needs of their communities, including low- and moderate-income neighborhoods. In connection with its examination of a state chartered savings bank, the FDIC is required to assess the institution’s record of compliance with the Community Reinvestment Act. Among other things, the current Community Reinvestment Act regulations replace the prior process-based assessment factors with a new evaluation system that rates an institution based on its actual performance in meeting community needs. In particular, the current evaluation system focuses on three tests:

 

    a lending test, to evaluate the institution’s record of making loans in its service areas;

 

    an investment test, to evaluate the institution’s record of investing in community development projects, affordable housing, and programs benefiting low or moderate income individuals and businesses; and

 

    a service test, to evaluate the institution’s delivery of services through its branches, ATMs and other offices.

 

An institution’s failure to comply with the provisions of the Community Reinvestment Act could, at a minimum, result in regulatory restrictions on its activities, including, but not limited to, engaging in acquisitions and mergers. The Bank received a satisfactory Community Reinvestment Act rating in its most recently completed federal examination, which was conducted by the FDIC as of March 2005.

 

29


Table of Contents

In addition, the Equal Credit Opportunity Act and the Fair Housing Act prohibit lenders from discriminating in their lending practices on the basis of characteristics specified in those statutes. An institution’s failure to comply with the Equal Credit Opportunity Act and the Fair Housing Act could result in enforcement actions by the FDIC, as well as other federal regulatory agencies and the Department of Justice.

 

As previously reported in the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2003, the FDIC completed an examination relating to the Bank’s compliance with various federal banking regulations in June 2002, which examination was unrelated to safety and soundness. In response to the report of examination relating to the Bank’s compliance with various federal banking regulations, the Bank’s Board of Directors adopted resolutions delivered to the FDIC that direct management to take corrective action to address the findings of the FDIC and that confirm the oversight obligations of the Board of Directors. The resolutions adopted by the Board of Directors provided for the Bank to make quarterly reports to the FDIC regarding corrective actions taken, including the development and implementation of procedures to verify the accuracy of the Bank’s reporting of Home Mortgage Disclosure Act data. Such quarterly reports were made by the Bank on a timely basis. In a compliance examination of the Bank conducted as of March 2005, the FDIC confirmed the Bank’s improved compliance posture. As a result, the FDIC advised that the quarterly reporting was no longer necessary since the requirements of the Board’s resolutions had been satisfied.

 

Safety and Soundness Standards. Each federal banking agency, including the FDIC, has adopted guidelines establishing general standards relating to internal controls, information and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, asset quality, earnings, compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director, or principal stockholder.

 

In addition, FDIC regulations require a bank that is given notice by the FDIC that it is not satisfying any of such safety and soundness standards to submit a compliance plan to the FDIC. If, after being so notified, a bank fails to submit an acceptable compliance plan or fails in any material respect to implement an accepted compliance plan, the FDIC may issue an order directing corrective and other actions of the types to which a significantly undercapitalized institution is subject under the “prompt corrective action” provisions discussed below. If a bank fails to comply with such an order, the FDIC may seek to enforce such an order in judicial proceedings and to impose civil monetary penalties.

 

Prompt Corrective Action. The FDIC Improvement Act of 1991 established a system of prompt corrective action to resolve the problems of undercapitalized institutions. The FDIC, as well as the other federal banking regulators, adopted regulations governing the supervisory actions that may be taken against undercapitalized institutions. The regulations establish five categories, consisting of “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” The FDIC’s regulations define the five capital categories as follows:

 

An institution will be treated as “well capitalized” if:

 

    its ratio of total capital to risk-weighted assets is at least 10%;

 

    its ratio of Tier 1 capital to risk-weighted assets is at least 6%; and

 

    its ratio of Tier 1 capital to total assets is at least 5%, and it is not subject to any order or directive by the FDIC to meet a specific capital level.

 

An institution will be treated as “adequately capitalized” if:

 

    its ratio of total capital to risk-weighted assets is at least 8%; or

 

    its ratio of Tier 1 capital to risk-weighted assets is at least 4%; and

 

30


Table of Contents
    its ratio of Tier 1 capital to total assets is at least 4% (3% if the bank receives the highest rating under the Uniform Financial Institutions Rating System) and it is not a well-capitalized institution.

 

An institution will be treated as “undercapitalized” if:

 

    its total risk-based capital is less than 8%; or

 

    its Tier 1 risk-based-capital is less than 4%; and

 

    its leverage ratio is less than 4% (or less than 3% if the institution receives the highest rating under the Uniform Financial Institutions Rating System).

 

An institution will be treated as “significantly undercapitalized” if:

 

    its total risk-based capital is less than 6%;

 

    its Tier 1 capital is less than 3%; or

 

    its leverage ratio is less than 3%.

 

An institution that has a tangible capital to total assets ratio equal to or less than 2% would be deemed “critically undercapitalized.” The FDIC is required, with some exceptions, to appoint a receiver or conservator for an insured state bank if that bank is critically undercapitalized. The FDIC may also appoint a conservator or receiver for an insured state bank on the basis of the institution’s financial condition or upon the occurrence of certain events, including:

 

    insolvency, or when the assets of the bank are less than its liabilities to depositors and others;

 

    substantial dissipation of assets or earnings through violations of law or unsafe or unsound practices;

 

    existence of an unsafe or unsound condition to transact business;

 

    likelihood that the bank will be unable to meet the demands of its depositors or to pay its obligations in the normal course of business; and

 

    insufficient capital, or the incurring or likely incurring of losses that will substantially deplete all of the institution’s capital with no reasonable prospect of replenishment of capital without federal assistance.

 

Loans to a Bank’s Insiders

 

Federal Regulation. A bank’s loans to its executive officers, directors, any owner of 10% or more of its stock (each, an insider) and any of certain entities affiliated with any such person (an insider’s related interest) are subject to the conditions and limitations imposed by Section 22(h) of the Federal Reserve Act and the Federal Reserve Board’s Regulation O. Under these restrictions, the aggregate amount of the loans to any insider and the insider’s related interests may not exceed the loans-to-one-borrower limit applicable to national banks, which is comparable to the loans-to-one-borrower limit applicable to loans by the Bank. All loans by a bank to all insiders and insiders’ related interests in the aggregate may not exceed the bank’s unimpaired capital and unimpaired surplus. With certain exceptions, loans to an executive officer, other than loans for the education of the officer’s children and certain loans secured by the officer’s residence, may not exceed at any one time the higher of 2.5% of the bank’s unimpaired capital and unimpaired surplus or $25,000, but in no event more than $100,000. Regulation O also requires that any proposed loan to an insider or a related interest of that insider be approved in advance by a majority of the board of directors of the bank, with any interested directors not participating in the voting, if such loan, when aggregated with any existing loans to that insider and the insider’s related interests, would exceed either (1) $500,000; or (2) the greater of $25,000 or 5% of the bank’s unimpaired capital and surplus. Generally, loans to insiders must be made on substantially the same terms as, and follow credit underwriting procedures that are not less stringent than, those that are prevailing at the time for comparable transactions with other persons, and not involve more than the normal risk of payment or present other unfavorable features.

 

31


Table of Contents

An exception is made for extensions of credit made pursuant to a benefit or compensation plan of a bank that is widely available to employees of the bank and that does not give any preference to insiders of the bank over other employees of the bank.

 

In addition, federal law prohibits extensions of credit to a bank’s insiders and their related interests by any other institution that has a correspondent banking relationship with the bank, unless such extension of credit is on substantially the same terms as those prevailing at the time for comparable transactions with other persons and does not involve more than the normal risk of repayment or present other unfavorable features.

 

New Jersey Regulation. Provisions of the New Jersey Banking Act impose conditions and limitations on the liabilities to a savings bank of its directors and executive officers and of corporations and partnerships controlled by such persons that are comparable in many respects to the conditions and limitations imposed on the loans and extensions of credit to insiders and their related interests under Regulation O, as discussed above. The New Jersey Banking Act also provides that a savings bank that is in compliance with Regulation O is deemed to be in compliance with such provisions of the New Jersey Banking Act.

 

Federal Reserve System

 

Under Federal Reserve Board regulations, the Bank is required to maintain noninterest-earning reserves against its transaction accounts. The Federal Reserve Board regulations generally require that reserves of 3% must be maintained against aggregate transaction accounts over $7.8 million and up to $48.3 million, subject to adjustment by the Federal Reserve Board, and an initial reserve of $1.2 million plus 10% against that portion of total transaction accounts in excess of up to $48.3 million. The first $7.8 million of otherwise reservable balances, subject to adjustments by the Federal Reserve Board, are exempted from the reserve requirements. The Bank is in compliance with these requirements. Because required reserves must be maintained in the form of either vault cash, a noninterest-bearing account at a Federal Reserve Bank or a pass-through account as defined by the Federal Reserve Board, the effect of this reserve requirement is to reduce the Bank’s interest-earning assets.

 

Internet Banking

 

Technological developments are significantly altering the ways in which most companies, including financial institutions, conduct their business. The growth of the Internet is prompting banks to reconsider business strategies and adopt alternative distribution and marketing systems. The federal bank regulatory agencies have conducted seminars and published materials targeted to various aspects of internet banking, and have indicated their intention to reevaluate their regulations to ensure that they encourage banks’ efficiency and competitiveness consistent with safe and sound banking practices. There can be no assurance that the bank regulatory agencies will adopt new regulations that will not materially affect our internet operations or restrict any such further operations.

 

The USA PATRIOT Act

 

The USA PATRIOT Act was signed into law on October 26, 2001 and gave the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. By way of amendments to the Bank Secrecy Act, Title III of the USA PATRIOT Act included measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III imposed affirmative obligations on a broad range of financial institutions, including banks, thrifts, brokers, dealers, credit unions, money transfer agents and parties registered under the Commodity Exchange Act.

 

The bank regulatory agencies have increased the regulatory scrutiny of the Bank Secrecy Act and anti-money laundering programs maintained by financial institutions. Significant penalties and fines, as well as other supervisory orders may be imposed on a financial institution for non-compliance with these requirements. In

 

32


Table of Contents

addition, the federal bank regulatory agencies must consider the effectiveness of financial institutions engaging in a merger transaction in combating money laundering activities. The Bank has adopted policies and procedures which are in compliance with these requirements.

 

Holding Company Regulation

 

Federal Regulation. The Company is regulated as a bank holding company. Bank holding companies are subject to examination, regulation and periodic reporting under the Bank Holding Company Act, as administered by the Federal Reserve Board. The Federal Reserve Board has adopted capital adequacy guidelines for bank holding companies on a consolidated basis substantially similar to those of the FDIC for the Bank. As of December 31, 2005, the Company’s total capital and Tier 1 capital ratios exceed these minimum capital requirements.

 

The following table shows the Company’s leverage ratio, Tier 1 risk-based capital ratio and the total risk-based capital ratio as of December 31, 2005:

 

     As of December 31, 2005

 
     Capital

   Percent of
Assets(1)


    Capital
Requirements(1)


 
     (Dollars in thousands)  

Regulatory Tier 1 leverage capital

   $ 676,643    11.98 %   4.0 %

Tier 1 risk-based capital

     676,643    17.59     4.0  

Total risk-based capital

     709,943    18.45     8.0  

(1) For purposes of calculating Regulatory Tier 1 leverage capital, assets are based on adjusted total leverage assets. In calculating Tier 1 risk-based capital and total risk-based capital, assets are based on total risk-weighted assets.

 

As the table shows, as of December 31, 2005, the Company was also “well capitalized” under Federal Reserve Bank guidelines.

 

Regulations of the Federal Reserve Board provide that a bank holding company must serve as a source of strength to any of its subsidiary banks and must not conduct its activities in an unsafe or unsound manner. Under the prompt corrective action provisions discussed above, a bank holding company parent of an undercapitalized subsidiary bank would be directed to guarantee, within limitations, the capital restoration plan that is required of such an undercapitalized bank. If the undercapitalized bank fails to file an acceptable capital restoration plan or fails to implement an accepted plan, the Federal Reserve Board may prohibit the bank holding company parent of the undercapitalized bank from paying any dividend or making any other form of capital distribution without the prior approval of the Federal Reserve Board.

 

As a bank holding company, the Company is required to obtain the prior approval of the Federal Reserve Board to acquire all, or substantially all, of the assets of any bank or bank holding company. Prior Federal Reserve Board approval will be required for the Company to acquire direct or indirect ownership or control of any voting securities of any bank or bank holding company if, after giving effect to such acquisition, it would, directly or indirectly, own or control more than 5% of any class of voting shares of such bank or bank holding company.

 

A bank holding company is required to give the Federal Reserve Board prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months will be equal to 10% or more of the company’s consolidated net worth. The Federal Reserve Board may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe and unsound practice, or would violate any law, regulation, Federal Reserve Board order or directive, or any condition imposed by, or written agreement with, the Federal Reserve Board. Such notice and approval is not

 

33


Table of Contents

required for a bank holding company that would be treated as “well capitalized” under applicable regulations of the Federal Reserve Board, is well-managed, and that is not the subject of any unresolved supervisory issues.

 

In addition, a bank holding company which does not qualify as a financial holding company under applicable federal law is generally prohibited from engaging in, or acquiring direct or indirect control of any company engaged in non-banking activities. One of the principal exceptions to this prohibition is for activities found by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be permissible. Some of the principal activities that the Federal Reserve Board has determined by regulation to be so closely related to banking as to be permissible are:

 

    making or servicing loans;

 

    performing certain data processing services;

 

    providing discount brokerage services; or acting as fiduciary, investment or financial advisor;

 

    leasing personal or real property;

 

    making investments in corporations or projects designed primarily to promote community welfare; and

 

    acquiring a savings and loan association.

 

Bank holding companies that do qualify as a financial holding company may engage in activities that are financial in nature or incident to activities which are financial in nature. The Company has not elected to qualify as a financial holding company under federal regulations, although it may seek to do so in the future. Bank holding companies may qualify to become a financial holding company if:

 

    each of its depository institution subsidiaries is “well capitalized”;

 

    each of its depository institution subsidiaries is “well managed”;

 

    each of its depository institution subsidiaries has at least a “satisfactory” Community Reinvestment Act rating at its most recent examination; and

 

    the bank holding company has filed a certification with the Federal Reserve Board that it elects to become a financial holding company.

 

Under federal law, depository institutions are liable to the FDIC for losses suffered or anticipated by the FDIC in connection with the default of a commonly controlled depository institution or any assistance provided by the FDIC to such an institution in danger of default. This law would potentially be applicable to the Company if it ever acquired as a separate subsidiary, a depository institution in addition to the Bank.

 

New Jersey Regulation. Under the New Jersey Banking Act, a company owning or controlling a savings bank is regulated as a bank holding company. The New Jersey Banking Act defines the terms “company” and “bank holding company” as such terms are defined under the BHCA. Each bank holding company controlling a New Jersey chartered bank or savings bank must file certain reports with the Commissioner and is subject to examination by the Commissioner.

 

Acquisition of Control. Under federal law and under the New Jersey Banking Act, no person may acquire control of the Company or the Bank without first obtaining approval of such acquisition of control by the Federal Reserve Board and the Commissioner.

 

Federal Securities Laws. The Company’s common stock is registered with the SEC under the Securities Exchange Act of 1934, as amended. The Company is subject to the information, proxy solicitation, insider trading restrictions and other requirements under the Securities Exchange Act of 1934.

 

Sarbanes-Oxley Act of 2002

 

The Sarbanes-Oxley Act of 2002 (the “Act”) implemented legislative reforms intended to address corporate and accounting irregularities. In addition to the establishment of a new accounting oversight board which will

 

34


Table of Contents

enforce auditing, quality control and independence standards and will be funded by fees from all publicly traded companies, the Act restricts accounting companies from providing both auditing and consulting services. To ensure auditor independence, any non-audit services being provided to an audit client will require pre-approval by the company’s audit committee members. In addition, the audit partners must be rotated. The Act requires chief executive officers and chief financial officers, or their equivalent, to certify to the accuracy of periodic reports filed with the SEC, subject to civil and criminal penalties if they knowingly or willfully violate this certification requirement. In addition, under the Act, counsel will be required to report evidence of a material violation of the securities laws or a breach of fiduciary duty by a company to its chief executive officer or its chief legal officer, and, if such officer does not appropriately respond, to report such evidence to the audit committee or other similar committee of the board of directors or the board itself.

 

The Act accelerates the time frame for disclosures by public companies, as they must immediately disclose any material changes in their financial condition or operations. Directors and executive officers must also provide information for most changes in ownership in a company’s securities within two business days of the change. The period during which certain types of law suits can be instituted against a company or its officers has been extended, and bonuses issued to top executives prior to restatement of a company’s financial statements are now subject to disgorgement if such restatement was due to corporate misconduct. Executives are also prohibited from insider trading during retirement plan “blackout” periods, and loans to company executives are restricted. In addition, civil and criminal penalties have been enhanced.

 

The Act also increases the oversight of, and codifies certain requirements relating to, audit committees of public companies and how they interact with the company’s “registered public accounting firm” (RPAF). Audit Committee members must be independent and are barred from accepting consulting, advisory or other compensatory fees from the issuer. In addition, companies must disclose whether at least one member of the Audit Committee is a “financial expert” (as such term will be defined by the SEC) and if not, why not. Under the Act, a RPAF is prohibited from performing statutorily mandated audit services for a company if such company’s chief executive officer, chief financial officer, comptroller, chief accounting officer or any person serving in equivalent positions has been employed by such firm and participated in the audit of such company during the one-year period preceding the audit initiation date. The Act also prohibits any officer or director of a company or any other person acting under their direction from taking any action to fraudulently influence, coerce, manipulate or mislead any independent public or certified accountant engaged in the audit of the company’s financial statements for the purpose of rendering the financial statement’s materially misleading. In accordance with the Act, the SEC has adopted rules requiring inclusion of an internal control report and assessment by management in the annual report to shareholders. The Act requires the RPAF that issues the audit report to attest to and report on management’s assessment of the company’s internal controls. In addition, the Act requires that each financial report required to be prepared in accordance with (or reconciled to) generally accepted accounting principles and filed with the SEC reflect all material correcting adjustments that are identified by a RPAF in accordance with generally accepted accounting principles and the rules and regulations of the SEC.

 

Delaware Corporation Law

 

The Company is incorporated under the laws of the State of Delaware. As a result, the rights of its stockholders are governed by the Delaware General Corporate Law.

 

TAXATION

 

Federal Taxation

 

General. The Company is subject to federal income taxation in the same general manner as other corporations, with some exceptions discussed below. The following discussion of federal taxation is intended only to summarize certain pertinent federal income tax matters and is not a comprehensive description of the tax rules applicable to the Company.

 

35


Table of Contents

Method of Accounting. For federal income tax purposes, the Company currently reports its income and expenses on the accrual method of accounting and uses a tax year ending December 31 for filing its consolidated federal income tax returns.

 

Bad Debt Reserves. Prior to the Small Business Protection Act of 1996 (the “1996 Act”), the Bank was permitted to establish a reserve for bad debts and to make annual additions to the reserve. These additions could, within specified formula limits, be deducted in arriving at taxable income. The Bank was required to use the direct charge off method to compute its bad debt deduction beginning with its 1996 federal income tax return. Savings institutions were required to recapture any excess reserves over those established as of December 31, 1987 (base year reserve).

 

Taxable Distributions and Recapture. Prior to the 1996 Act, bad debt reserves created prior to January 1, 1988 were subject to recapture into taxable income should the Bank fail to meet certain asset and definitional tests. Federal legislation has eliminated these recapture rules.

 

Retained earnings at December 31, 2005 included approximately $51.8 million for which no provisions for income tax had been made. This amount represents an allocation of income to bad debt deductions for tax purposes only. Events that would result in taxation of these reserves include failure to qualify as a bank for tax purposes, distributions in complete or partial liquidation, stock redemptions and excess distributions to shareholders. At December 31, 2005, the Bank had an unrecognized tax liability of $21.2 million with respect to this reserve.

 

Charitable Donations. Under the Internal Revenue Code, charitable donations are tax deductible subject to a limitation based on 10% of the Company’s annual taxable income. The Company, however, is able to carry forward any unused portion of the deduction for five years following the year in which the contribution is made. Based on the Company’s estimate of taxable income and the carry forward period, all of its charitable donation expense was considered tax deductible as the Company will realize sufficient earnings over the six year period to take the full deduction. As a result, the Company recorded a tax benefit amounting to $8.4 million relating to the charitable donation in the first quarter of 2003.

 

Corporate Alternative Minimum Tax. The Internal Revenue Code of 1986, as amended (the “Code”), imposes an alternative minimum tax (AMT) at a rate of 20% on a base of regular taxable income plus certain tax preferences (alternative minimum taxable income or AMTI). The AMT is payable to the extent such AMTI is in excess of an exemption amount and the AMT exceeds the regular income tax. Net operating losses can offset no more than 90% of AMTI. Certain payments of alternative minimum tax may be used as credits against regular tax liabilities in future years. The Company has not been subject to the alternative minimum tax and has no such amounts available as credits for carryover.

 

Net Operating Loss Carryovers. A financial institution may carry back net operating losses to the preceding two taxable years and forward to the succeeding 20 taxable years. At December 31, 2005, the Company had no net operating loss carry-forwards for federal income tax purposes.

 

Corporate Dividends-Received Deduction. The Company may exclude from its income 100% of dividends received from the Bank as a member of the same affiliated group of corporations.

 

State Taxation

 

New Jersey State Taxation. The Company and the Bank file New Jersey Corporation Business Tax returns. Generally, the income of financial institutions in New Jersey, which is calculated based on federal taxable income, subject to certain adjustments, is subject to New Jersey tax.

 

On July 2, 2002, the State of New Jersey enacted income tax law changes which were retroactive to tax years beginning January 1, 2002. The more relevant changes include an increase in the tax rate for savings banks from three percent to nine percent and the establishment of an Alternative Minimum Assessment (“AMA”) tax.

 

36


Table of Contents

Under this legislation, a taxpayer, including the Company and the Bank, pays the greater of the corporate business tax (“CBT”) (at 9% of taxable income) or the AMA tax. There are two methods for calculating the AMA tax, the gross receipts method or the gross profits method. Under the gross receipts method, the tax is calculated by multiplying the gross receipts by the applicable factor, which ranges from 0.125% to 0.4%. Under the gross profits method, the tax is calculated by multiplying the gross profits by the applicable factor, which ranges from 0.25% to 0.8%. The taxpayer has the option of choosing either the gross receipts or gross profits method, but once an election is made, the taxpayer must use the same method for the next four tax years. The AMA tax is creditable against the CBT in a year in which the CBT is higher, limited to the AMA for that year, and limited to an amount such that the tax is not reduced by more than 50% of the tax otherwise due and other statutory minimums. The AMA tax for each taxpayer may not exceed $5.0 million per year and the sum of the AMA for each member of an affiliated group may not exceed $20.0 million per year for members of an affiliated group with five or more taxpayers. The AMA for tax years beginning after June 30, 2006 shall be zero.

 

New Jersey tax law does not and has not allowed for a taxpayer to file a tax return on a combined or consolidated basis with another member of the affiliated group where there is common ownership. However, under the new tax legislation, if the taxpayer cannot demonstrate by clear and convincing evidence that the tax filing discloses the true earnings of the taxpayer on its business carried on in the State of New Jersey, the New Jersey Director of the Division of Taxation may, at the director’s discretion, require the taxpayer to file a consolidated return of the entire operations of the affiliated group or controlled group, including its own operations and income.

 

Delaware State Taxation. As a Delaware holding company not earning income in Delaware, the Company is exempted from Delaware corporate income tax but is required to file annual returns and pay annual fees and a franchise tax to the State of Delaware.

 

Item 1A. Risk Factors.

 

In addition to factors discussed in the description of our business and elsewhere in this Annual Report on Form 10-K, the following are risk factors that could aversely affect our future results of operations and our financial condition.

 

Our Commercial Real Estate, Multi-Family, and Commercial Loans Expose Us to Increased Lending Risks

 

Our strategy continues to be to increase our construction loans, commercial mortgage loans and commercial loans. These loans are generally regarded as having a higher risk of default and loss than single-family residential mortgage loans, because repayment of these loans often depends on the successful operation of a business or of the underlying property. In addition, our construction loans, commercial mortgage loans and commercial loans have significantly larger average loan balances compared to our single-family residential mortgage loans. At December 31, 2005, the average loan size for a construction loan was $3.5 million, for a commercial real estate loan was $1.4 million and for a commercial loan was $252,000, compared to an average loan size of $179,000 for a single-family residential mortgage loan. Also, many of our borrowers of these types of loans have more than one loan outstanding with us. Consequently, any adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss compared to an adverse development with respect to one single-family residential mortgage loan.

 

Our Continuing Concentration of Loans in Our Primary Market Area May Increase Our Risk

 

Our success depends primarily on the general economic conditions in northern and central New Jersey. Unlike some larger banks that are more geographically diversified, we provide banking and financial services to customers primarily in northern and central New Jersey. The local economic conditions in northern and central New Jersey have a significant impact on our construction loans, commercial mortgage loans and commercial loans, the ability of the borrowers to repay these loans and the value of the collateral securing these loans. A

 

37


Table of Contents

significant decline in general economic conditions caused by inflation, recession, unemployment or other factors beyond our control would impact these local economic conditions and could negatively affect the financial results of our banking operations. Additionally, because we have a significant amount of real estate loans, decreases in real estate values may also have a negative effect on the ability of many of our borrowers to make timely repayments of their loans, which would have an adverse impact on our earnings.

 

We target our business development and marketing strategy for loans to serve primarily the banking and financial services needs of small- to medium-sized businesses in northern and central New Jersey. These small- to medium-sized businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities. If general economic conditions negatively impact these businesses, our results of operations and financial condition may be adversely affected.

 

If Our Allowance for Loan Losses is Not Sufficient to Cover Actual Loan Losses, Our Earnings Could Decrease

 

Our loan customers may not repay their loans according to the terms of the loans, and the collateral securing the payment of these loans may be insufficient to pay any remaining loan balance. We may experience significant loan losses, which could have a material adverse effect on our operating results. We make various assumptions and judgments about the collectibility of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. In determining the amount of the allowance for loan losses, we rely on our loan quality reviews, our experience and our evaluation of economic conditions, among other factors. If our assumptions prove to be incorrect, our allowance for loan losses may not be sufficient to cover losses inherent in our loan portfolio, resulting in additions to our allowance. Material additions to our allowance would materially decrease our net income.

 

Our emphasis on continued diversification of our loan portfolio through the origination of construction loans, commercial mortgage loans, and commercial loans has been one of the more significant factors we have taken into account in evaluating our allowance for loan losses and provision for loan losses. In the event we were to further increase the amount of such types of loans in our portfolio, we may determine to make additional or increased provisions for loans losses, which could adversely affect our earnings.

 

In addition, bank regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs. Any increase in our allowance for loan losses or loan charge-offs as required by these regulatory authorities could have a material adverse effect on our results of operations and financial condition.

 

Changes in Interest Rates Could Adversely Affect Our Results of Operations and Financial Condition

 

Our results of operations and financial condition are significantly affected by changes in interest rates. Our results of operations are affected substantially by our net interest income, which is the difference between the interest income earned on our interest-earning assets and the interest expense paid on our interest-bearing liabilities. Changes in interest rates could have an adverse affect on net interest income because, as a general matter, our interest-bearing liabilities reprice or mature more quickly than our interest-earning assets, an increase in interest rates generally would result in a decrease in our average interest rate spread and net interest income, which would have a negative effect on our profitability. In the event of a 200 basis point increase in interest rates, whereby rates ramp up evenly over a twelve-month period, and assuming management took no actions to mitigate the effect of such change, we are projecting that our net interest income would decrease 11.2% or $19.5 million.

 

Changes in interest rates also affect the value of our interest-earning assets, and in particular our securities portfolio. Generally, the value of securities fluctuates inversely with changes in interest rates. At December 31, 2005, our available for sale securities portfolio totaled $1.08 billion. Unrealized gains and losses on securities

 

38


Table of Contents

available for sale are reported as a separate component of equity. Decreases in the fair value of securities available for sale resulting from increases in interest rates therefore could have an adverse effect on stockholders’ equity.

 

We are also subject to prepayment and reinvestment risk related to interest rate movements. Changes in interest rates can affect the average life of loans and mortgage related securities. Decreases in interest rates can result in increased prepayments of loans and mortgage related securities, as borrowers refinance to reduce borrowing costs. Under these circumstances, we are subject to reinvestment risk to the extent that we are unable to reinvest such prepayments at rates that are comparable to the rates on existing loans or securities.

 

We Operate in a Highly Regulated Environment and May be Adversely Affected by Changes in Laws and Regulations

 

We are subject to extensive regulation, supervision and examination by the New Jersey Department of Banking and Insurance, our chartering authority, and by the Federal Deposit Insurance Corporation, as insurer of our deposits. As a bank holding company, Provident Financial Services, Inc. is subject to regulation and oversight by the Board of Governors of the Federal Reserve System. Such regulation and supervision govern the activities in which a bank and its holding company may engage and are intended primarily for the protection of the insurance fund and depositors. These regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the imposition of restrictions on our operations, the classification of our assets and the adequacy of our allowance for loan losses. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, or legislation, could have a material impact on The Provident Bank, Provident Financial Services, Inc., and our operations.

 

Strong Competition Within Our Market Area May Limit Our Growth and Profitability

 

Competition in the banking and financial services industry is intense. In our market area, we compete with commercial banks, savings institutions, mortgage brokerage firms, credit unions, finance companies, mutual funds, insurance companies, and brokerage and investment banking firms operating locally and elsewhere. In particular, over the past decade, New Jersey has experienced the effects of substantial banking consolidation, and large out-of-state competitors have grown significantly. There are also a number of strong locally-based competitors in our market. Many of these competitors (whether regional or national institutions) have substantially greater resources and lending limits than we do, and may offer certain services that we do not or cannot provide. Our profitability depends upon our continued ability to successfully compete in our market area.

 

Item 1B. Unresolved Staff Comments

 

There are no unresolved comments from the staff of the SEC to report.

 

Item 2. Properties

 

Property

 

At December 31, 2005, the Company and the Bank conducted business through 76 full-service branch offices located in Hudson, Bergen, Essex, Mercer, Middlesex, Monmouth, Morris, Ocean, Somerset and Union Counties, New Jersey. The aggregate net book value of premises and equipment was $60.9 million at December 31, 2005.

 

Item 3. Legal Proceedings

 

The Company is involved in various legal actions and claims arising in the normal course of its business. In the opinion of management, these legal actions and claims are not expected to have a material adverse impact on the Company’s financial condition and results of operations.

 

Item 4. Submission of Matters to a Vote of Security Holders

 

No matters were submitted during the fourth quarter of the year ended December 31, 2005 to a vote of the Company’s stockholders.

 

39


Table of Contents

PART II

 

Item 5. Market For Registrant’s Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities.

 

The Company’s common stock trades on the New York Stock Exchange (“NYSE”) under the symbol “PFS”. Trading in the Company’s common stock commenced on January 16, 2003.

 

As of December 31, 2005, there were 79,879,017 shares of the Company’s common stock issued and 68,661,800 shares outstanding and 6,601 stockholders of record.

 

The table below shows the high and low closing prices reported on the NYSE for the Company’s common stock, as well as, the cash dividends paid per common share during the periods indicated.

 

     2005

   2004

     High

   Low

   Dividend

   High

   Low

   Dividend

First Quarter

   $ 19.14    $ 17.06    $ 0.07    $ 19.70    $ 18.25    $ 0.06

Second Quarter

     17.88      16.03      0.08      18.75      16.55      0.06

Third Quarter

     18.23      17.22      0.08      17.90      16.91      0.06

Fourth Quarter

     19.00      16.42      0.09      19.64      17.01      0.06

 

On January 25, 2006, the Board of Directors declared a quarterly cash dividend of $0.09 per common share, which was paid on February 28, 2006, to common stockholders of record as of the close of business on February 15, 2006. The Company’s Board of Directors intends to review the payment of dividends quarterly and plans to continue to maintain a regular quarterly cash dividend in the future, subject to financial condition, results of operations, tax considerations, industry standards, economic conditions, regulatory restrictions that affect the payment of dividends by the Bank to the Company and other relevant factors.

 

The Company is subject to the requirements of Delaware law that generally limits dividends to an amount equal to the difference between the amount by which total assets exceed total liabilities and the amount equal to the aggregate par value of the outstanding shares of capital stock. If there is no difference between these amounts, dividends are limited to net income for the current and/or immediately preceding year.

 

The following table reports information regarding purchases of the Company’s common stock during the fourth quarter of 2005 and the stock repurchase plan approved by the Company’s Board of Directors:

 

ISSUER PURCHASES OF EQUITY SECURITIES

 

Period


   (a) Total Number
of Shares
Purchased


   (b) Average
Price Paid per
Share


   (c) Total Number of
Shares
Purchased as Part of
Publicly Announced
Plans or Programs(1)


   (d) Maximum Number of
Shares that May Yet
Be Purchased Under the
Plans or Programs(1)


October 1, 2005 through October 31, 2005

   —      $ —      —      2,667,862

November 1, 2005 through November 30, 2005

   153,000      17.96    153,000    2,514,862

December 1, 2005 through December 31, 2005

   557,701      18.31    557,701    1,957,161

Total

   710,701      18.24    710,701     

(1) On January 26, 2005, the Company’s Board of Directors approved the purchase of up to 3,742,205 shares of its common stock under a general repurchase program. On July 27, 2005, the Company’s Board of Directors approved an additional stock repurchase program, which commenced upon completion of the prior repurchase program. The new authorization provides that the Company may repurchase an additional 3,589,234 shares. The repurchase program has no expiration date.

 

40


Table of Contents
Item 6. Selected Financial Data

 

The summary information presented below at or for each of the periods presented is derived in part from and should be read in conjunction with the consolidated financial statements of Provident Financial Services, Inc. presented in Item 8. On January 15, 2003, the Bank completed its conversion from a mutual savings bank to a stock savings bank, and in connection therewith the Company sold 59,618,300 shares of common stock which resulted in $567.2 million of net proceeds of which $293.2 million was utilized to acquire all of the outstanding common stock of the Bank. In addition, the Company contributed $4.8 million in cash and 1,920,000 shares of its common stock to The Provident Bank Foundation.

 

     At December 31,

     2005

   2004

   2003

   2002

    2001

     (In thousands)

Selected Financial Condition Data:

                                   

Total assets

   $ 6,052,374    $ 6,433,322    $ 4,284,878    $ 3,919,208     $ 2,869,717

Loans, net(1)

     3,707,142      3,673,445      2,216,736      2,031,869       1,994,636

Investment securities(2)

     410,914      445,633      517,789      216,119       112,951

Securities available for sale

     1,082,957      1,406,340      1,151,829      1,242,118       494,716

Deposits

     3,921,458      4,050,473      2,695,976      3,243,334       2,341,723

Borrowed funds

     970,108      1,166,064      736,328      323,081       195,767

Stockholders’ equity

     1,076,295      1,136,776      817,119      326,009       292,130
     For the Year Ended December 31,

     2005

   2004

   2003

   2002

    2001

     (In thousands)

Selected Operations Data:

                                   

Interest income

   $ 276,462    $ 229,543    $ 184,506    $ 177,307     $ 180,979

Interest expense

     95,007      67,185      54,633      63,241       84,523
    

  

  

  


 

Net interest income

     181,455      162,358      129,873      114,066       96,456

Provision for loan losses

     600      3,600      1,160      12,800       1,900
    

  

  

  


 

Net interest income after provision for loan losses

     180,855      158,758      128,713      101,266       94,556
    

  

  

  


 

Non-interest income

     29,221      29,151      23,834      24,147       21,236
    

  

  

  


 

Non-interest expense

     124,178      119,334      126,779      89,087       80,629
    

  

  

  


 

Income before income tax expense and the cumulative effect of a change in accounting principle

     85,898      68,575      25,768      36,326       35,163

Income tax expense

     27,399      19,274      7,024      9,231       11,083
    

  

  

  


 

Income before the cumulative effect of a change in accounting principle

     58,499      49,301      18,744      27,095       24,080
    

  

  

  


 

Cumulative effect of change in accounting principle(3)

     —        —        —        (519 )     —  
    

  

  

  


 

Net income

   $ 58,499    $ 49,301    $ 18,744    $ 26,576     $ 24,080
    

  

  

  


 

Earnings Per Share:

                                   

Basic earnings per share(4)

   $ 0.89    $ 0.80    $ 0.31      —         —  

Diluted earnings per share(4)

   $ 0.88    $ 0.80    $ 0.31      —         —  

(1) Loans are shown net of allowance for loan losses, deferred fees and unearned discount.
(2) Investment securities are held to maturity.
(3)

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, the Company performed a goodwill impairment test on the goodwill associated with the purchase of Provident Mortgage

 

41


Table of Contents
 

Corporation. It was determined that the goodwill was impaired and a charge of $519,000 was recorded as a cumulative effect of a change in accounting principle.

(4) Basic and diluted earnings per share for the year ended December 31, 2003 include the results of operations from January 15, 2003, the date the Company became the holding company for the Bank and the date the Bank completed its conversion, in the amount of $17,755,000.

 

     At or For the Year Ended December 31,

 
     2005

    2004

    2003

    2002

    2001

 

Selected Financial and Other Data(1)

                              

Performance Ratios:

                              

Return on average assets

   0.94 %   0.93 %   0.46 %   0.86 %   0.88 %

Return on average equity

   5.32     5.06     2.31     8.71     8.70  

Average net interest rate spread

   3.01     3.09     2.91     3.59     3.26  

Net interest margin(2)

   3.34     3.40     3.37     3.96     3.97  

Average interest-earning assets to average interest-bearing liabilities

   1.18     1.22     1.32     1.17     1.15  

Non-interest income to average total assets

   0.47     0.55     0.58     0.78     0.77  

Non-interest expenses to average total assets

   2.00     2.24     3.08     2.90     2.94  

Efficiency ratio(3)

   58.94     62.31     66.87     64.46     68.51  

Asset Quality Ratios:

                              

Non-performing loans to total loans

   0.16 %   0.17 %   0.27 %   0.41 %   0.40 %

Non-performing assets to total assets

   0.11     0.10     0.14     0.22     0.28  

Allowance for loan losses to non-performing loans

   532.56     545.05     336.67     246.55     271.02  

Allowance for loan losses to total loans

   0.86     0.91     0.92     1.02     1.09  

Capital Ratios:

                              

Leverage capital(4)

   11.98 %   11.88 %   18.81 %   8.98 %   9.41 %

Total risk based capital(4)

   18.45     19.80     31.44     13.32     14.15  

Average equity to average assets

   17.68     18.34     19.73     9.92     10.10  

Other Data:

                              

Number of full-service offices

   76     78     54     49     48  

Full time equivalent employees

   892     926     717     656     688  

(1) Averages presented are daily averages.
(2) Net interest income divided by average interest earning assets.
(3) Represents the ratio of non-interest expense divided by the sum of net interest income and non-interest income.

 

     12/31/2005

    12/31/2004

    12/31/2003

    12/31/2002

    12/31/2001

 

Efficiency Ratio Calculation:

                                        

Net interest income

   $ 181,455     $ 162,358     $ 129,873     $ 114,066     $ 96,456  

Non-interest income

     29,221       29,151       23,834       24,147       21,236  
    


 


 


 


 


Total income

   $ 210,676     $ 191,509     $ 153,707     $ 138,213     $ 117,692  
    


 


 


 


 


Non-interest expense

     124,178       119,334       126,779       89,087       80,629  

Less: Provident Bank Foundation donation

     —         —         (24,000 )     —         —    
    


 


 


 


 


Adjusted non-interest expense

   $ 124,178     $ 119,334     $ 102,779     $ 89,087     $ 80,629  
    


 


 


 


 


Expense/income

     58.94 %     62.31 %     66.87 %     64.46 %     68.51 %
    


 


 


 


 


 

(4) Leverage capital ratios are presented as a percentage of tangible assets. Risk-based capital ratios are presented as a percentage of risk-weighted assets.

 

42


Table of Contents
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

General

 

On January 15, 2003, the Company became the holding company for the Bank, following the completion of the conversion of the Bank to a stock-chartered bank. The Company issued an aggregate of 59,618,300 shares of its common stock in a subscription offering to eligible depositors. Concurrent with the conversion, the Company contributed an additional 1,920,000 shares of its common stock and $4.8 million in cash to The Provident Bank Foundation, a charitable foundation established by the Bank.

 

The Company conducts business through its subsidiary, the Bank, a community- and customer-oriented bank operating 76 full-service branches in ten counties throughout northern and central New Jersey.

 

On December 22, 2003, the Company entered into an agreement and plan of merger, under which First Sentinel Bancorp, Inc. (“First Sentinel”) merged with and into the Company and First Savings Bank, the wholly-owned subsidiary of First Sentinel, merged with and into the Bank. The Company completed the acquisition of First Sentinel and the merger of First Savings Bank, with and into the Bank, as of July 14, 2004.

 

Strategy

 

The Bank, established in 1839, is the oldest bank in the state of New Jersey. The Bank offers a full range of retail and commercial loan and deposit products. The Bank emphasizes personal service and convenience as part of its Customer Relationship Management strategy.

 

The Bank’s strategy is to grow profitably through a commitment to credit quality and expanding market share by acquiring, retaining and expanding customer relationships, while carefully managing interest rate risk.

 

In recent years, the Bank has focused on commercial real estate, construction, multi-family and commercial loans as part of its strategy to diversify the loan portfolio and reduce interest rate risk. These types of loans generally have adjustable rates that initially are higher than residential mortgage loans and generally have a higher rate of risk. The Bank’s credit policy focuses on quality underwriting standards and close monitoring of the loan portfolio. The First Sentinel acquisition increased the residential mortgage component of the loan portfolio. At year-end 2005, retail loans accounted for 62.5% of the loan portfolio and commercial loans accounted for 37.5%. The Company’s strategy is to continue to diversify the loan portfolio and to focus on commercial real estate and commercial and industrial lending relationships.

 

The Company’s Customer Relationship Management strategy focuses on increasing core accounts and expanding relationships through its branch network, online banking and telephone banking touch points. The First Sentinel acquisition added 22 full-service branches with $1.36 billion in deposits, including core deposits totaling $862.7 million as of the July 14, 2004 acquisition date. Also in 2004, the Company opened two de novo branch locations. In 2005, the Company closed a branch that was under-performing and relocated a supermarket branch to an existing full service facility. The Company continues to evaluate opportunities to increase market share by expanding within existing and contiguous markets. Core deposits, consisting of all savings and demand deposit accounts, are generally a stable, relatively inexpensive source of funds. At December 31, 2005, core deposits were 63.1% of total deposits.

 

A significant amount of capital was raised in the conversion of the Bank to a stock-chartered bank in 2003. Management has developed a capital management strategy to effectively utilize excess capital and improve return on equity and earnings per share growth. The Company’s capital management strategy includes the following components: payment of cash dividends; stock repurchases; acquisitions; and use of wholesale leverage. The Company declared and paid its first cash dividend in the second quarter of 2003, and has since increased the quarterly cash dividend per share five times for a total of 125.0%. The Company’s Board of Directors approved the most recent quarterly cash dividend of $0.09 per common share on January 25, 2006. The Company’s range of cash dividend payout is approximately 30% to 45% of net income.

 

43


Table of Contents

In 2005, the Company repurchased 5.4 million shares of its common stock at an average cost of $17.92 per share. At December 31, 2005, approximately 2.0 million shares remained eligible for repurchase under the current common stock repurchase authorization.

 

The Company’s results of operations are primarily dependent upon net interest income, the difference between interest earned on interest-earning assets and the interest paid on interest-bearing liabilities. Changes in interest rates could have an adverse effect on net interest income, because as a general matter, the Company’s interest-bearing liabilities reprice or mature more quickly than its interest-earning assets. An increase in interest rates generally would result in a decrease in the Company’s average interest rate spread and net interest income, which could have a negative effect on profitability. The Company generates non-interest income such as income from retail and business account fees, loan servicing fees, loan origination fees, income from loan or securities sales, fees from trust services and investment product sales and other fees. The Company’s operating expenses primarily consist of compensation and benefits expenses, marketing and advertising expense, occupancy and equipment expense and other general and administrative expenses. The Company’s results of operations are also affected by general economic conditions, changes in market interest rates, actions of regulatory agencies and government policies.

 

Critical Accounting Policies

 

The calculation of the allowance for loan losses is a critical accounting policy of the Company. The allowance for loan losses is a valuation account that reflects management’s evaluation of the probable losses in the loan portfolio. The Company maintains the allowance for loan losses through provisions for loan losses that are charged to income. Charge-offs against the allowance for loan losses are taken on loans where management determines that the collection of loan principal is unlikely. Recoveries made on loans that have been charged-off are credited to the allowance for loan losses.

 

The Company’s evaluation of the adequacy of the allowance for loan losses includes a review of all loans on which the collectibility of principal may not be reasonably assured. For residential mortgage and consumer loans this is determined primarily by delinquency and collateral values. For commercial real estate and commercial loans, an extensive review of financial performance, payment history and collateral values is conducted on a quarterly basis.

 

As part of the evaluation of the adequacy of the allowance for loan losses, each quarter management prepares a worksheet. This worksheet categorizes the entire loan portfolio by certain risk characteristics such as loan type (residential mortgage, commercial mortgage, construction, commercial, etc.) and loan risk rating.

 

When assigning a risk rating to a loan, management utilizes a nine point internal risk rating system. Loans deemed to be “acceptable quality” are rated one through four, with a rating of one established for loans with minimal risk. Loans that are deemed to be of “questionable quality” are rated five (watch) or six (special mention). Loans with adverse classifications (substandard, doubtful or loss) are rated seven, eight or nine, respectively. Commercial mortgage, commercial and construction loans are rated individually and each lending officer is responsible for risk rating loans in his or her portfolio. These risk ratings are then reviewed by the department manager, the Chief Lending Officer and the Credit Administration Department. The risk ratings are then confirmed by the Loan Review Department and they are periodically reviewed by the Credit Committee in the credit renewal or approval process.

 

Management believes the primary risks inherent in the portfolio are possible increases in interest rates, a decline in the economy, generally, and a decline in real estate market values. Any one or a combination of these events may adversely affect borrowers’ ability to repay the loans, resulting in increased delinquencies, loan losses and future levels of provisions. Accordingly, the Company has provided for loan losses at the current level to address the current risk in the loan portfolio. Management considers it important to maintain the ratio of the allowance for loan losses to total loans at an acceptable level given current economic conditions, interest rates and the composition of the portfolio.

 

44


Table of Contents

Although management believes that the Company has established and maintained the allowance for loan losses at adequate levels, additions may be necessary if future economic and other conditions differ substantially from the current operating environment. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance or additional write-downs based on their judgments about information available to them at the time of their examination. Although management uses the best information available, the level of the allowance for loan losses remains an estimate that is subject to significant judgment and short-term change.

 

Additional critical accounting policies relate to judgments about other asset impairments, including goodwill, investment securities and deferred tax assets. The Company engages an independent third party to perform an annual analysis to test the aggregate balance of goodwill for impairment in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”. For purposes of goodwill impairment evaluation, the Bank is identified as the reporting unit. Fair value of goodwill is determined in the same manner as goodwill recognized in a business combination and uses standard valuation methodologies including a review of comparable transactions and discounted cash flow analysis. If the carrying amount of goodwill pursuant to this analysis were to exceed the implied fair value of goodwill, an impairment loss would be recognized. No impairment loss was required to be recognized for the years ended December 31, 2005, 2004 or 2003.

 

The Company’s available for sale securities portfolio is carried at estimated fair value, with any unrealized gains or losses, net of taxes, reported as accumulated other comprehensive income (loss) in stockholders’ equity. Estimated fair values are based on published or securities dealers’ market prices. Securities which the Company has the positive intent and ability to hold to maturity are classified as held to maturity and carried at amortized cost. The Company conducts a periodic review and evaluation of the securities portfolio to determine if any declines in the fair values of securities are other than temporary. If such a decline were deemed other than temporary, the Company would write down the security to fair value through a charge to current period operations. The market value of the securities portfolio is significantly affected by changes in interest rates. In general, as interest rates rise, the market value of fixed-rate securities decreases and as interest rates fall, the market value of fixed-rate securities increases. With significant changes in interest rates, the Company evaluates its intent and ability to hold securities to maturity or for a sufficient amount of time to recover the recorded principal balance.

 

The determination of whether deferred tax assets will be realizable is predicated on estimates of future taxable income. Such estimates are subject to management’s judgment. A valuation reserve is established when management is unable to conclude that it is more likely than not that it will realize deferred tax assets based on the nature and timing of these items. In 2005, the valuation reserve pertaining to the charitable contributions carry-forward declined $838,000 as a result of the utilization of the related deferred tax asset. In 2004, the Company reduced the valuation reserve pertaining to the charitable contribution carry-forward as a result of projected improvement in the Company’s ability to generate sufficient future taxable income to realize the deferred tax asset.

 

Analysis of Net Interest Income

 

Net interest income represents the difference between income on interest-earning assets and expense on interest-bearing liabilities. Net interest income depends on the relative amounts of interest-earning assets and interest-bearing liabilities and the interest rates earned on such assets and paid on such liabilities.

 

45


Table of Contents

Average Balance Sheet. The following table sets forth certain information for the years ended December 31, 2005, 2004 and 2003. For the periods indicated, the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, is expressed both in dollars and rates. No tax equivalent adjustments were made. Average balances are daily averages.

 

    For the Year Ended December 31,

 
    2005

    2004

    2003

 
    Average
Outstanding
Balance


   

Interest

Earned/
Paid


 

Average
Yield/

Rate


    Average
Outstanding
Balance


    Interest
Earned/
Paid


 

Average
Yield/

Rate


    Average
Outstanding
Balance


    Interest
Earned/
Paid


 

Average
Yield/

Rate


 
    (Dollars in thousands)  

Interest-earning assets:

                                                           

Federal funds sold and short-term investments

  $ 58,156     $ 1,801   3.10 %   $ 87,635     $ 1,001   1.14 %   $ 157,854     $ 1,709   1.08 %

Investment securities(1)

    428,461       17,185   4.01       484,583       19,183   3.96       461,742       17,708   3.84  

Securities available for sale

    1,249,419       48,607   3.89       1,253,570       45,968   3.67       1,196,435       40,880   3.42  

Federal Home Loan Bank Stock

    44,813       2,091   4.67       41,261       707   1.71       26,030       759   2.92  

Net loans(2)

    3,658,930       206,778   5.65       2,906,982       162,684   5.60       2,014,861       123,450   6.13  
   


 

       


 

       


 

     

Total interest-earning assets

    5,439,779       276,462   5.08       4,774,031       229,543   4.81       3,856,922       184,506   4.78  
           

 

         

 

         

 

Non-interest earning assets

    781,133                   541,829                   260,205              
   


             


             


           

Total assets

  $ 6,220,912                 $ 5,315,860                 $ 4,117,127              
   


             


             


           

Interest-bearing liabilities:

                                                           

Savings deposits

  $ 1,474,053       15,657   1.06 %   $ 1,254,758       11,011   0.88 %   $ 952,776       11,839   1.24 %

Demand deposits

    618,280       6,223   1.01       541,120       4,274   0.79       413,582       3,590   0.87  

Time deposits

    1,399,258       37,894   2.71       1,156,388       24,221   2.09       988,789       23,742   2.40  

Borrowed funds

    1,105,948       35,233   3.19       956,922       27,679   2.89       567,732       15,462   2.72  
   


 

       


 

       


 

     

Total interest-bearing liabilities

    4,597,539       95,007   2.07       3,909,188       67,185   1.72       2,922,879       54,633   1.87  
           

 

         

 

         

 

Non-interest bearing liabilities

    523,531                   431,709                   381,796              
   


             


             


           

Total liabilities

    5,121,070                   4,340,897                   3,304,675              

Stockholders’ equity

    1,099,842                   974,963                   812,452              
   


             


             


           

Total liabilities and equity

  $ 6,220,912                 $ 5,315,860                 $ 4,117,127              
   


             


             


           

Net interest income

          $ 181,455                 $ 162,358                 $ 129,873      
           

               

               

     

Net interest rate spread

                3.01 %                 3.09 %                 2.91 %
                 

               

               

Net interest earning assets

  $ 842,240                 $ 864,843                 $ 934,043              
   


             


             


           

Net interest margin(3)

                3.34 %                 3.40 %                 3.37 %
                 

               

               

Ratio of interest-earning assets to total interest-bearing liabilities

    1.18 x                 1.22 x                 1.32 x            
   


             


             


           

(1) Average outstanding balance amounts shown are amortized cost.
(2) Average outstanding balances shown net of the allowance for loan losses, deferred loan fees and expenses, and loan premiums and discounts and include non-accrual loans.
(3) Net interest income divided by average interest-earning assets.

 

46


Table of Contents

Rate/Volume Analysis. The following table presents the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected interest income and interest expense during the periods indicated. Information is provided in each category with respect to: (i) changes attributable to changes in volume (changes in volume multiplied by prior rate); (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume); and (iii) the net change. The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate.

 

     Year Ended December 31,

 
     2005 vs. 2004

    2004 vs. 2003

 
     Increase/(Decrease)
Due to


    Total
Increase/
(Decrease)


    Increase/(Decrease)
Due to


   

Total
Increase/

(Decrease)


 
     Volume

    Rate

      Volume

    Rate

   
     (In thousands)  

Interest-earning assets:

                                                

Federal funds sold and short-term investments

   $ (431 )   $ 1,231     $ 800     $ (797 )   $ 89     $ (708 )

Investment securities

     (2,239 )     241       (1,998 )     893       582       1,475  

Securities available for sale

     (151 )     2,790       2,639       2,009       3,079       5,088  

Federal Home Loan Bank Stock

     66       1,318       1,384       337       (389 )     (52 )

Loans

     42,261       1,833       44,094       50,700       (11,466 )     39,234  
    


 


 


 


 


 


Total interest-earning assets

     39,506       7,413       46,919       53,142       (8,105 )     45,037  
    


 


 


 


 


 


Interest-bearing liabilities:

                                                

Savings deposits

     2,141       2,505       4,646       3,180       (4,008 )     (828 )

Money market deposits

     87       (450 )     (363 )     289       334       623  

Interest-bearing checking deposits

     460       1,852       2,312       680       (619 )     61  

Time deposits

     5,668       8,005       13,673       3,731       (3,252 )     479  

Borrowed funds

     4,533       3,021       7,554       11,203       1,014       12,217  
    


 


 


 


 


 


Total interest-bearing liabilities

     12,889       14,933       27,822       19,083       (6,531 )     12,552  
    


 


 


 


 


 


Net interest income

   $ 26,617     $ (7,520 )   $ 19,097     $ 34,059     $ (1,574 )   $ 32,485  
    


 


 


 


 


 


 

Comparison of Financial Condition at December 31, 2005 and December 31, 2004

 

Total assets were $6.05 billion at December 31, 2005, compared to $6.43 billion at December 31, 2004, with the decrease due primarily to reductions in cash and securities balances that were used to fund loan originations, repayments of borrowings, net deposit outflows and common stock repurchases.

 

Total loans at December 31, 2005 were $3.74 billion, compared to $3.71 billion at December 31, 2004. The increase in loans was attributable to loan originations of $1.17 billion and loan purchases of $137.4 million. Residential mortgage loans decreased $93.3 million to $1.77 billion at December 31, 2005, compared to $1.87 billion at December 31, 2004. Residential mortgage loan originations totaled $152.8 million and one- to four-family loans purchased totaled $137.4 million for the year ended December 31, 2005. Principal repayments on residential mortgage loans totaled $346.5 million, and loans sold totaled $36.2 million for the year ended December 31, 2005. Commercial real estate loans decreased $48.6 million to $636.7 million at December 31, 2005, compared to $685.3 million at December 31, 2004. Multi-family loans decreased $8.7 million to $77.6 million at December 31, 2005, compared to $86.3 million at December 31, 2004. Construction loans increased $100.6 million to $289.5 million at December 31, 2005, compared to $188.9 million at December 31, 2004. Commercial loans increased $40.2 million to $393.8 million at December 31, 2005, compared to $353.6 million at December 31, 2004. Consumer loans increased $42.3 million to $556.6 million at December 31, 2005, compared to $514.3 million at December 31, 2004. Retail loans, which consist of one- to four-family residential mortgages and consumer loans, such as fixed-rate home equity loans and lines of credit, totaled $2.33 billion and

 

47


Table of Contents

accounted for 62.5% of the loan portfolio at December 31, 2005, compared to $2.38 billion, or 64.4%, of the portfolio at December 31, 2004. The decrease in retail loans as a percentage of the total loan portfolio was largely the result of residential loan prepayments and sales and to organic growth in the construction and commercial loan portfolios. The Company continues to rebalance the loan portfolio over time, consistent with its strategy towards a more commercial mix. Commercial loans, consisting of commercial real estate, multi-family, construction and commercial loans, totaled $1.40 billion, accounting for 37.5% of the loan portfolio at December 31, 2005, compared to $1.31 billion, or 35.6%, at December 31, 2004.

 

The allowance for loan losses decreased $1.8 million at December 31, 2005, as a result of net charge-offs of $2.4 million, partially offset by provisions for loan losses of $600,000 during 2005. Non-performing loans totaled $6.0 million at December 31, 2005, compared to $6.2 million at December 31, 2004. Non-performing loans as a percentage of total loans were 0.16% at December 31, 2005 and 0.17% at December 31, 2004. The allowance for loan losses as a percentage of total loans was 0.86% at December 31, 2005, and 0.91% at December 31, 2004.

 

Intangible assets decreased $7.3 million to $435.8 million at December 31, 2005, from $443.1 million at December 31, 2004, due primarily to the amortization of the core deposit intangible relating to the First Sentinel acquisition. At December 31, 2005, the goodwill and the core deposit intangible related to the First Sentinel acquisition totaled $389.9 million and $23.3 million, respectively. The core deposit intangible is being amortized on an accelerated basis over 8.8 years. The Company performs periodic impairment testing of intangible assets. There was no impairment recognized in 2005.

 

Total investments decreased $358.1 million, or 19.3%, during the year ended December 31, 2005. Proceeds from investment sales, maturities and scheduled cash flows were used to fund loan growth, repay borrowings, fund net deposit outflow and repurchase common stock.

 

Total deposits decreased $129.0 million to $3.92 billion at December 31, 2005, from $4.05 billion at December 31, 2004. At December 31, 2005, core deposits represented 63.1% of total deposits, compared with 65.6% at December 31, 2004. Within the core deposit account category, savings and money market deposits decreased $212.9 million to $1.48 billion at December 31, 2005, from $1.69 billion at December 31, 2004, as depositors shifted funds to higher-yielding investments. Checking balances, however, increased $31.1 million to $992.4 million at December 31, 2005, from $961.3 million at December 31, 2004, as the Company continued to focus on attracting and retaining core business and personal account relationships while remaining disciplined in its liability pricing. Certificates of deposit increased $52.8 million to $1.45 billion at December 31, 2005, from $1.40 billion at December 31, 2004, with much of that growth occurring in the under two-year maturity categories, as depositors opted for shorter-maturity instruments in a rising interest rate environment.

 

Total borrowed funds decreased $196.0 million to $970.1 million at December 31, 2005, from $1.17 billion at December 31, 2004. The decrease was a result of repayments made during the year as part of the Company’s strategy to reduce wholesale funding in a flat yield curve environment.

 

Total stockholders’ equity decreased $60.5 million to $1.08 billion at December 31, 2005, from $1.14 billion at December 31, 2004. This decrease was a result of common stock repurchases of $96.3 million and cash dividends of $21.6 million, partially offset by comprehensive income of $45.8 million and the allocation of shares to stock-based compensation plans of $11.6 million.

 

Comparison of Operating Results for the Years Ended December 31, 2005 and December 31, 2004

 

General. Net income for the year ended December 31, 2005 was $58.5 million, compared to net income of $49.3 million for the year ended December 31, 2004. Return on average assets for the year ended December 31, 2005 was 0.94%, compared to 0.93% for 2004. Return on average equity was 5.32% for the year ended December 31, 2005, compared to 5.06% for 2004. Basic and diluted earnings per share were $0.89 and $0.88 respectively for the year ended December 31, 2005, compared to basic and diluted earnings per share of $0.80 for

 

48


Table of Contents

2004. Earnings and per share data reflect the inclusion of the operations of First Sentinel which merged with the Company on July 14, 2004, and the related issuance of 18.5 million shares of the Company’s common stock in connection with the merger from the July 14, 2004 merger date. Earnings for the year ended December 31, 2005 also reflect the acceptance of a Voluntary Resignation Initiative (“VRI”) by certain officers of the Company in the second quarter of 2005, which resulted in an after-tax charge of $815,000. One-time expenses totaling $1.2 million, net of tax, related to the merger and integration of First Sentinel’s operations were recognized in 2004.

 

Net Interest Income. Net interest income increased $19.1 million, or 11.8%, to $181.5 million for 2005, from $162.4 million for 2004. The average interest rate spread decreased 8 basis points to 3.01% for 2005, from 3.09% for 2004. The net interest margin decreased six basis points to 3.34% for 2005, compared to 3.40% for 2004.

 

Interest income increased $46.9 million, or 20.4%, to $276.5 million for 2005, compared to $229.5 million for 2004. The increase in interest income was primarily attributable to increased earning asset volume as a result of the First Sentinel acquisition and increases in the yield on average earning assets. Average interest-earning assets increased $665.7 million, or 13.9%, to $5.44 billion for 2005, compared to $4.77 billion for 2004. Average outstanding loan balances increased $751.9 million, or 25.9%, to $3.66 billion for 2005 from $2.91 billion for 2004. The average balance of investment securities decreased $56.1 million, or 11.6%, to $428.5 million for 2005, compared to $484.6 million for 2004. The average balance of securities available for sale decreased $4.2 million, or 0.3%, to $1.25 billion for 2005, compared to $1.25 billion for 2004. Average federal funds sold and short-term investment balances decreased $29.5 million, or 33.6%, to $58.2 million for 2005, from $87.6 million for 2004. The yield on interest-earning assets increased 27 basis points to 5.08% for 2005, from 4.81% for 2004.

 

Interest expense increased $27.8 million, or 41.4%, to $95.0 million for 2005, from $67.2 million for 2004. The increase in interest expense was attributable to increased interest-bearing liability volume as a result of the First Sentinel acquisition and to the increase in the average cost of interest-bearing liabilites for 2005 compared with 2004. The average balance of interest-bearing liabilities increased $688.4 million, or 17.6%, to $4.60 billion for 2005, compared to $3.91 billion for 2004. Rates paid on interest-bearing liabilities increased 35 basis points to 2.07% for 2005, from 1.72% for 2004. Average interest-bearing deposits increased $539.3 million, or 18.3%, to $3.49 billion for 2005, from $2.95 billion for 2004. The average rate paid on interest-bearing deposits increased 37 basis points to 1.71% for 2005, from 1.34% for 2004. Average interest-bearing core deposits increased $296.5 million, or 16.5%, for 2005, compared with 2004, while average time deposits increased $242.9 million, or 21.0%, for 2005, compared with 2004. Average outstanding borrowings, including subordinated debentures, increased $149.0 million, or 15.6%, to $1.11 billion for 2005, compared with $956.9 million for 2004. The average rate paid on borrowings increased to 3.19% for 2005, from 2.89% for 2004.

 

Provision for Loan Losses. Provisions for loan losses are charged to operations in order to maintain the allowance for loan losses at a level management considers necessary to absorb credit losses inherent in the loan portfolio. In determining the level of the allowance for loan losses, management considers past and current loss experience, evaluations of real estate collateral, current economic conditions, volume and type of lending, adverse situations that may affect the borrower’s ability to repay the loan and the levels of non-performing and other classified loans. The amount of the allowance is based on estimates and the ultimate losses may vary from such estimates as more information becomes available or later events change. Management assesses the allowance for loan losses on a quarterly basis and makes provisions for loan losses in order to maintain the adequacy of the allowance. The Company’s emphasis on continued diversification of the loan portfolio through the origination of construction loans, commercial mortgage loans and commercial loans has been one of the more significant factors management takes into account in evaluating the allowance for loan losses and provision for loan losses. In the event the Company further increases the amount of such types of loans in the portfolio, it may be determined that additional or increased provisions for loan losses are necessary, which could adversely affect earnings.

 

The provision for loan losses was $600,000 in 2005, compared to $3.6 million in 2004. The decrease in the provision for loan losses was attributable to lower loan growth and an improvement in asset quality compared

 

49


Table of Contents

with 2004. Net charge-offs for 2005 were $2.4 million, compared to $3.4 million for 2004. Total charge-offs for the year ended December 31, 2005 were $4.0 million, compared to $6.4 million for the year ended December 31, 2004. Recoveries for the year ended December 31, 2005 were $1.6 million, compared to $3.0 million for the year ended December 31, 2004.

 

The allowance for loan losses at December 31, 2005 was $32.0 million, or 0.86% of total loans, compared to $33.8 million, or 0.91% of total loans at December 31, 2004.

 

At December 31, 2005, non-performing loans as a percentage of total loans were 0.16%, compared to 0.17% at December 31, 2004. Non-performing assets as a percentage of total assets were 0.11% at December 31, 2005, compared to 0.10% at December 31, 2004. At December 31, 2005, non-performing loans were $6.0 million, compared to $6.2 at December 31, 2004, and non-performing assets were $6.7 million at December 31, 2005, compared to $6.3 million at December 31, 2004.

 

Non-Interest Income. For the year ended December 31, 2005, total non-interest income totaled $29.2 million, an increase of $70,000 or 0.2% compared to 2004. Fee income from deposit accounts increased $2.1 million, or 10.1%, to $23.0 million for 2005, from $20.9 million for 2004. This increase was primarily attributable to deposit fees, loan prepayment fees, ATM and debit card fees and fees related to the outsourcing of the official check function. Income on BOLI increased $666,000 or 14.9% in 2005 compared to 2004, primarily as a result of the additional BOLI acquired from the First Sentinel merger. The increases in fee income and BOLI were largely offset by a reduction in securities gains of $1.0 million and a decline in other income of $1.7 million. Other income for the year ended December 31, 2005, included losses on loan sales of $152,000 compared with gains of $1.5 million recorded in 2004.

 

Non-Interest Expense. For the year ended December 31, 2005, non-interest expense increased $4.8 million, or 4.1%, to $124.2 million, compared to $119.3 million for 2004. Compensation and employee benefits expense increased $3.7 million, or 6.1%, to $64.8 million for 2005, from $61.1 million for 2004. The increase in compensation and benefits expense for 2005 was primarily attributable to the increase in staff following the First Sentinel acquisition and the expense recognized in the second quarter of 2005 in connection with the VRI. The increase in salaries, incentives and related payroll taxes of $2.0 million, include the $1.4 million in expense recognized in the second quarter of 2005 in connection with the acceptance of the VRI by certain officers of the Bank. Pension and other post retirement benefit expense increased $1.6 million and employee insurance increased $846,000 in 2005, compared with 2004. For the year ended December 31, 2005, stock-based compensation expense decreased $336,000 to $11.4 million compared to $11.7 million for the same period in 2004.

 

Net occupancy expense increased $2.4 million, or 14.4% for 2005, compared with 2004, primarily as a result of the additional 22 branch locations added through the First Sentinel acquisition, including the former headquarters building which serves as the Provident Loan Center as well as two de novo branches opened in 2004.

 

Advertising and promotions expense decreased $1.7 million, or 28.3% for the year ended 2005, compared with the same period in 2004, as a result of customer communications associated with the integration of First Sentinel in 2004.

 

Data processing expense increased $530,000, or 6.4% for 2005, compared with 2004, primarily due to the acquisition and integration of First Sentinel’s operations.

 

Amortization of intangibles increased $1.9 million for the year ended December 31, 2005, compared with the same period in 2004, primarily as a result of the amortization of the core deposit intangible recorded in connection with the First Sentinel acquisition.

 

Other operating expenses decreased $2.0 million, or 9.4% for 2005, compared with 2004. This decrease was primarily due to significant reductions in consultant and audit related expense, insurance costs and ATM processing expense.

 

50


Table of Contents

Income Tax Expense. Income tax expense increased $8.1 million, to $27.4 million, on income before taxes of $85.9 million resulting in an effective tax rate of 31.9% in 2005, compared to income tax expense of $19.3 million on income before taxes of $68.6 million in 2004 resulting in an effective tax rate of 28.1%. In 2004, the Company reduced a valuation reserve pertaining to charitable contribution carry-forwards created in connection with the formation of The Provident Bank Foundation in early 2003. The reduction in valuation reserve resulted in a decrease in 2004 income tax expense of $1.9 million.

 

Comparison of Operating Results for the Years Ended December 31, 2004 and December 31, 2003

 

General. Net income for the year ended December 31, 2004 was $49.3 million, compared to net income of $18.7 million for the year ended December 31, 2003. Return on average assets for the year ended December 31, 2004 was 0.93%, compared to 0.46% for 2003. Return on average equity was 5.06% for the year ended December 31, 2004, compared to 2.31% for 2003. Basic and diluted earnings per share were $0.80 for the year ended December 31, 2004, compared to $0.31 for 2003, which included the results of operations from January 15, 2003, the date of the Bank’s stock conversion. Earnings and per share data for 2004 reflected the impact of the Company’s acquisition of First Sentinel from July 14, 2004, the date the acquisition was completed. One-time expenses totaling $1.2 million, net of tax, related to the merger and integration of First Sentinel’s operations were recognized in 2004. Net income for 2003 was impacted by the one-time expense associated with the $15.6 million contribution, net of tax, to The Provident Bank Foundation.

 

Net Interest Income. Net interest income increased $32.5 million, or 25.0%, to $162.4 million for 2004, from $129.9 million for 2003. The average interest rate spread increased 18 basis points to 3.09% for 2004, from 2.91% for 2003. The net interest margin increased three basis points to 3.40% for 2004, compared to 3.37% for 2003.

 

Interest income increased $45.0 million, or 24.4%, to $229.5 million for 2004, compared to $184.5 million for 2003. The increase in interest income was primarily attributable to increased earning asset volume as a result of the First Sentinel acquisition. Average interest-earning assets increased $917.1 million, or 23.8%, to $4.77 billion for 2004, compared to $3.86 billion for 2003. Average outstanding loan balances increased $892.1 million, or 44.3%, to $2.91 billion for 2004 from $2.01 billion for 2003. The average balance of investment securities increased $22.8 million, or 4.9%, to $484.6 million for 2004, compared to $461.7 million for 2003. The average balance of securities available for sale increased $57.1 million, or 4.8%, to $1.25 billion for 2004, compared to $1.20 billion for 2003. Partially offsetting these increases, average federal funds sold and short-term investment balances decreased $70.2 million, or 44.5%, to $87.6 million for 2004, from $157.9 million for 2003. The yield on interest-earning assets increased three basis points to 4.81% for 2004, from 4.78% for 2003.

 

Interest expense increased $12.6 million, or 23.0%, to $67.2 million for 2004, from $54.6 million for 2003. The increase in interest expense was attributable to increased interest-bearing liability volume as a result of the First Sentinel acquisition, partially offset by reductions in the average cost of interest-bearing liabilities for 2004 compared with 2003. The average balance of interest-bearing liabilities increased $986.3 million, or 33.7%, to $3.91 billion for 2004, compared to $2.92 billion for 2003. Rates paid on interest bearing liabilities decreased 15 basis points to 1.72% for 2004, from 1.87% for 2003. Average interest-bearing deposits increased $597.1 million, or 25.4%, to $2.95 billion for 2004, from $2.36 billion for 2003. The average rate paid on interest-bearing deposits declined 32 basis points to 1.34% for 2004, from 1.66% for 2003. Average interest-bearing core deposits increased $429.5 million, or 31.4%, for 2004, compared with 2003, while average time deposits increased $167.6 million, or 16.9%, for 2004, compared with 2003. Average outstanding borrowings, including subordinated debentures, increased $389.2 million, or 68.6%, to $956.2 million for 2004, compared with $567.7 million for 2003. The average rate paid on borrowings increased to 2.89% for 2004, from 2.72% for 2003.

 

The provision for loan losses was $3.6 million in 2004, compared to $1.2 million in 2003. The increase in the provision for loan losses was attributable to loan growth and an increase in net charge-offs compared with 2003. Net charge-offs for 2004 were $3.4 million, compared to $1.5 million for 2003. Total charge-offs for the

 

51


Table of Contents

year ended December 31, 2004 were $6.4 million, compared to $4.4 million for the year ended December 31, 2003. Recoveries for the year ended December 31, 2004 were $3.0 million, compared to $2.9 million for the year ended December 31, 2003.

 

The allowance for loan losses at December 31, 2004 was $33.8 million, or 0.91% of total loans, compared to $20.6 million, or 0.92% of total loans at December 31, 2003.

 

At December 31, 2004, non-performing loans as a percentage of total loans were 0.17%, compared to 0.27% at December 31, 2003. Non-performing assets as a percentage of total assets were 0.10% at December 31, 2004, compared to 0.14% at December 31, 2003. At December 31, 2004, non-performing loans were $6.2 million, compared to $6.1 at December 31, 2003, and non-performing assets were $6.3 million at December 31, 2004, compared to $6.2 million at December 31, 2003.

 

Non-Interest Income. Total non-interest income increased $5.3 million, or 22.3%, to $29.2 million for 2004, compared to $23.8 million for 2003. Fee income from deposit accounts increased $4.1 million, or 25.0%, to $20.4 million for 2004, from $16.3 million for 2003. This increase was primarily attributable to fees earned on an overdraft privilege service introduced in late 2003 and growth in core deposit accounts. Income from the appreciation in the cash surrender value of BOLI increased $630,000, or 16.4%, as a result of $29.9 million of BOLI added through the First Sentinel acquisition and an additional $20.0 million of BOLI purchased by the Company in the first quarter of 2003. Gains on the sales of securities totaled $1.3 million for 2004, compared with $1.1 million in 2003. Securities sales are dependent upon interest rate risk and cash flow requirements, market conditions, and projections of future price performance and interest rate movements. Commissions on sales of mutual funds and annuities increased $170,000, or 60.7%, to $450,000 for 2004, from $280,000 for 2003. In late 2003, the Company outsourced the sales and operations of its non-deposit investment subsidiary to its third party provider. Other income increased $239,000, or 10.5% to $2.5 million in 2004, compared to $2.3 million in 2003. Other income consisted of net gains on the sale of loans, net gains on sales of other assets and other non-recurring income.

 

Non-Interest Expense. For the year ended December 31, 2004, non-interest expense decreased $7.4 million, or 5.9%, to $119.3 million, compared to $126.8 million for 2003. The decrease in non-interest expense for the year ended December 31, 2004 was due to the one-time expense associated with the $24.0 million contribution to The Provident Bank Foundation that was recorded in the first quarter of 2003, partially offset by increases in other non-interest expense categories. Compensation and benefits expense increased $6.4 million, or 11.7%, to $61.1 million for 2004, from $54.7 million for 2003. The increase in compensation and benefits expense for 2004 was primarily attributable an increase in salaries, incentives and related payroll taxes of $7.3 million, which included merger-related charges of $182,000 and other executive severance of $1.6 million. The remaining increase in salaries and incentives was primarily attributable to increased staffing levels during the acquisition integration period and in support of the additional 22 branch locations acquired from First Sentinel. Expenses related to stock-based compensation and benefit plans increased $5.4 million for 2004, compared with 2003, as those plans were implemented in mid-2003. Expenses related to other employee benefits, consisting of the Company’s defined benefit pension plan and post-retirement health care plan, decreased $3.6 million for 2004, compared with 2003. The pension plan was frozen as of April 1, 2003. Commissions decreased $1.5 million for 2004, compared with 2003, largely as a result of historically high mortgage origination volume in 2003. In addition, salaries and commissions related to the Company’s mortgage banking subsidiary decreased $827,000 in 2004 compared with 2003. The Company discontinued the operations of its mortgage banking subsidiary in February, 2004.

 

Net occupancy expense increased $2.9 million, or 20.1% for 2004, compared with 2003, primarily as a result of the additional 22 branch locations added through the First Sentinel acquisition, as well as two de novo branches opened in each of the years 2004 and 2003, and the acquisition of three branches with deposits from another depository institution in 2003.

 

52


Table of Contents

Advertising and promotions expense increased $2.2 million, or 58.3% for 2004, compared with 2003, as a result of customer communications associated with the integration of First Sentinel, as well as increased marketing efforts in support of the Company’s focus on loan and core deposit generation.

 

Data processing expense increased $1.6 million, or 24.4% for 2004, compared with 2003, reflecting the First Sentinel acquisition and related growth in customer relationships.

 

Amortization of intangibles increased $1.6 million, or 42.4% for 2004, compared with 2003, mainly as a result of the amortization of the core deposit intangible recorded in connection with the First Sentinel acquisition.

 

Other operating expenses increased $1.8 million, or 9.5% for 2004, compared with 2003. This increase was primarily due to increases in printing and supplies expense, regulatory examination and audit fees, ATM card maintenance costs, consulting fees and corporate insurance expense. The increases in other operating expenses were largely attributable to the First Sentinel acquisition and integration and resulting growth in customer relationships. In addition, compliance with the Sarbanes-Oxley Act of 2002 added approximately $623,000 to the Company’s audit and consulting expenses.

 

Income Tax Expense. Income tax expense increased $12.3 million, to $19.3 million, on income before taxes of $68.6 million resulting in an effective tax rate of 28.1% in 2004, compared to income tax expense of $7.0 million on income before taxes of $25.8 million in 2003 resulting in an effective tax rate of 27.3%. In 2004, the Company reduced a valuation reserve pertaining to charitable contribution carry-forwards created in connection with the formation of The Provident Bank Foundation in early 2003. The reduction in valuation reserve resulted in a decrease in 2004 income tax expense of $1.9 million. The reduction in the valuation reserve was attributable to projected improvement in the Company’s ability to generate sufficient future taxable income to realize the deferred tax asset. The improvement in the Company’s future earnings outlook was largely due to the successful acquisition and integration of First Sentinel.

 

Liquidity and Capital Resources

 

Liquidity refers to the Company’s ability to generate adequate amounts of cash to meet financial obligations to its depositors, to fund loans and securities purchases, deposit outflows and operating expenses. Sources of funds include scheduled amortization of loans, loan prepayments, scheduled maturities of investments, cash flows from mortgage-backed securities and the ability to borrow funds from the Federal Home Loan Bank of New York and approved broker dealers. The Bank has a $100.0 million overnight line of credit and a $100.0 million one-month overnight repricing line of credit with the Federal Home Loan Bank of New York. As of December 31, 2005, there were $48.0 million outstanding borrowings against these lines of credit.

 

Cash flows from loan payments and maturing investment securities are a fairly predictable source of funds. Changes in interest rates, local economic conditions and the competitive marketplace can influence loan prepayments, prepayments on mortgage-backed securities and deposit flows. For the year ended December 31, 2005, loan repayments, excluding mortgage warehouse activity, totaled $1.24 billion compared to $937.9 million for the year ended December 31, 2004.

 

One- to four-family residential loans, consumer loans, commercial real estate loans, multi-family loans and commercial and small business loans are the primary investments of the Company. Purchasing securities for the investment portfolio is a secondary use of funds and the investment portfolio is structured to complement and facilitate the Company’s lending activities and ensure adequate liquidity. Loan originations and purchases, excluding mortgage warehouse loans, totaled $1.31 billion for the year ended December 31, 2005, compared to $1.29 billion for the year ended December 31, 2004. Purchases for the investment portfolio totaled $124.6 million for the year-ended December 31, 2005, compared to $301.3 million for the year ended December 31, 2004.

 

53


Table of Contents

At December 31, 2005, the Bank had outstanding loan commitments to borrowers of $696.2 million. Undisbursed home equity lines and personal credit lines were $194.1 million at December 31, 2005. Total deposits decreased $129.0 million for the year ended December 31, 2005. Deposit activity is affected by changes in interest rates, competitive pricing and product offerings in our marketplace, local economic conditions and other factors such as stock market volatility. Certificate of deposit accounts that are scheduled to mature within one year totaled $1.08 billion at December 31, 2005. Based on current pricing strategy and customer retention experience, the Bank expects to retain a significant share of these accounts. The Bank manages liquidity on a daily basis and expects to have sufficient funds to meet all of its funding requirements.

 

As of December 31, 2005, the Bank exceeded all regulatory capital requirements. At December 31, 2005, the Bank’s leverage (Tier 1) capital ratio was 9.18%. FDIC regulations require banks to maintain a minimum leverage ratio of Tier 1 capital to adjusted total assets of 4.00%. At December 31, 2005, the Bank’s total risk-based capital ratio was 14.37%. Under current regulations, the minimum required ratio of total capital to risk-weighted assets is 8.00%. A bank is considered to be well-capitalized if it has a leverage (Tier 1) capital ratio of at least 5.00% and a risk-based capital ratio of at least 10.00%. As of December 31, 2005, the Bank exceeded the well-capitalized capital requirements.

 

Off-Balance Sheet and Contractual Obligations

 

Off-balance sheet and contractual obligations as of December 31, 2005, are summarized below:

 

     Payments Due by Period

     Total

  

Less than

1 year


   1-3 years

   3-5 years

   More than
5 years


     (in thousands)

Off-Balance Sheet:

                                  

Long term commitments

   $ 696,169    $ 696,169    $ —      $ —      $ —  

Letters of credit

     7,187      7,187      —        —        —  
    

  

  

  

  

Total Off-Balance Sheet

     703,356      703,356      —        —        —  

Contractual Obligations:

                                  

Operating leases

     13,324      2,935      4,438      2,712      3,239

Certificate of deposits

     1,447,954      1,076,067      217,778      123,515      30,594
    

  

  

  

  

Total Contractual Obligations

     1,461,278      1,079,002      222,216      126,227      33,833
    

  

  

  

  

Total

   $ 2,164,634    $ 1,785,358    $ 222,216    $ 126,227    $ 33,833
    

  

  

  

  

 

Off-balance sheet commitments consist of unused commitments to borrowers for term loans, unused lines of credit and outstanding letters of credit. Total off-balance sheet obligations were $703.4 million at December 31, 2005, an increase of $104.0 million, or 17.4%, from $599.3 million at December 31, 2004.

 

Contractual obligations consist of operating leases and certificate of deposit liabilities. There were no securities purchases that were entered into in December 2005 or 2004 that would have settled in January 2006 or 2005, respectively. Total contractual obligations at December 31, 2005 were $1.46 billion, an increase of $18.4 million, or 1.3%, compared to $1.44 billion at December 31, 2004. Contractual obligations under operating leases decreased $34.4 million, or 72.1%, to $13.3 million at December 31, 2005, compared to $47.7 million at December 31, 2004, and certificate of deposit accounts increased $52.8 million, or 3.8%, to $1.45 billion at December 31, 2005, from $1.40 billion at December 31, 2004.

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

 

Qualitative Analysis. Interest rate risk is the exposure of a bank’s current and future earnings and capital arising from adverse movements in interest rates. The Company’s most significant risk exposure is interest rate

 

54


Table of Contents

risk. The guidelines of the Company’s interest rate risk policy seek to limit the exposure to changes in interest rates that affect the underlying economic value of assets and liabilities, earnings and capital. To minimize interest rate risk, the Company generally sells all twenty- and thirty-year fixed-rate mortgage loans at origination. Commercial real estate loans generally have interest rates that reset in five years and other commercial loans, such as construction loans and commercial lines of credit reset with changes in the prime rate, LIBOR or the federal funds rate. Investment securities purchases generally have maturities of five years or less and mortgage-backed securities have weighted average lives between three and five years.

 

The management Asset/Liability Committee meets on a monthly basis to review the impact of interest rate changes on net interest income, net interest margin, net income and economic value of equity. Members of the Asset/Liability Committee include the Chief Executive Officer, President, Chief Operating Officer and Chief Financial Officer, as well as senior officers from our finance, lending and customer management departments. The Asset/Liability Committee reviews a variety of strategies that project changes in asset or liability mix and the impact of those changes on projected net interest income and net income.

 

The Company’s strategy for liabilities has been to maintain a stable core-funding base by focusing on core deposit account acquisition and increasing products and services per household. Certificate of deposit accounts as a percentage of total deposits were 36.9% at December 31, 2005 compared to 34.4% at December 31, 2004. Certificate of deposit accounts are generally short-term. As of December 31, 2005, 74.3% of all time deposits had maturities of one year or less compared to 68.8% at December 31, 2004. The Company’s ability to retain maturing certificate of deposit accounts is the result of a strategy to remain competitively priced within the marketplace, typically within the upper quartile of rates offered by competitors. The Company’s pricing strategy may vary depending upon funding needs and the Company’s ability to fund operations through alternative sources, primarily by accessing short-term lines of credit with the FHLB during periods of pricing dislocation.

 

Quantitative Analysis. The Company measures sensitivity to changes in interest rates through the use of balance sheet and income simulation models. The analyses capture changes in net interest income using flat rates as a base, a most likely rate forecast and rising and declining interest rate forecasts. The Company measures changes in net interest income and net income for the forecast period, generally twelve to twenty-four months, within set limits for acceptable change.

 

The following table sets forth the results of the twelve month projected net interest income model as of December 31, 2005.

 

Change in

Interest Rates in Basis Points

(Rate Ramp)


   Net Interest Income

 
   Amount ($)

   Change ($)

    Change (%)

 
   (Dollars in thousands)  

-200

   $ 185,036    $ 10,573     6.1 %

-100

     182,233      7,770     4.5  

Static

     174,463      —       —    

+100

     164,833      (9,630 )   (5.5 )

+200

     154,970      (19,493 )   (11.2 )

 

The above table indicates that as of December 31, 2005, in the event of a 200 basis point increase in interest rates, whereby rates ramp up evenly over a twelve-month period, the Company would experience an 11.2%, or $19.5 million decrease in net interest income. In the event of a 200 basis point decrease in interest rates, whereby rates ramp down 200 basis points evenly over a twelve-month p