bancorp


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 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, 2004
 
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 NUMBER: 0-14703
 
NBT BANCORP INC. (Exact name of registrant as specified in its charter)
 
 DELAWARE
 16-1268674
  (State or other jurisdiction of incorporation or organization)
 (IRS Employer Identification No.)
 
 
52 SOUTH BROAD STREET
NORWICH, NEW YORK 13815 (Zip Code)
(Address of principal executive office)

(607) 337-2265 (Registrant’s telephone number, including area code)
 
 
Securities registered pursuant to section 12(b) of the Act: None
 
Securities registered pursuant to section 12(g) of the Act: Common Stock ($0. 01 par value per share)
 
Stock Purchase Rights Pursuant to Stockholders Rights Plan
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]
 
Indicate by check mark if disclosure of delinquent filers pursuant to item 405 of Regulation S-K (Section 299.405 of this chapter) is not contained herein, and will not be contained, to the best of the 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 [ ].
 
Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [X] No [ ]
 
Based upon the closing price of the registrant’s common stock as of June 30, 2004, the aggregate market value of the voting stock, common stock, par value, $0.01 per share, held by non-affiliates of the registrant is $728,615,302.
 
The number of shares of Common Stock outstanding as of February 28, 2005, was 32,689,332.
 
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of registrant’s definitive Proxy Statement for the Registrant’s Annual Meeting of Stockholders to be held on May 3, 2005 are incorporated by reference into Part III, Items 10, 11, 12, 13 and 14 of this Form 10-K.
 
 
 
PART ITEM
 
 
I  
 1
BUSINESS
        Description of Business
        Average Balance Sheets
        Net Interest Income Analysis -Taxable Equivalent Basis
        Net Interest Income and Volume/Rate Variance-Taxable Equivalent Basis
        Securities Portfolio
        Debt Securities -Maturity Schedule
        Loans
        Maturities and Sensitivities of Loans to Changes in Interest Rates
       Nonperforming Assets
        Allowance for Loan Losses
        Maturity Distribution of Time Deposits
        Return on Equity and Assets
        Short-Term Borrowings
     
 
 2
PROPERTIES
     
 
 3
LEGAL PROCEEDINGS
     
 
4
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
     
 II
 5
MARKET FOR THE REGISTRANT’S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
     
 
6
     
 
 7
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
     
 
 7A
QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
     
 
 8
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
        Consolidated Balance Sheets at December 31, 2004 and 2003
        Consolidated Statements of Income for each of the years in the three-year period ended December 31, 2004
        Consolidated Statements of Changes in Stockholders’ Equity for each of the years in the three-year period ended December 31, 2004
        Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 31, 2004
        Consolidated Statements of Comprehensive Income for each of the years in the three-year period ended December 31, 2004
        Notes to Consolidated Financial Statements
        Independent Auditors’ Report
     
 
 9
     
 
 9A
CONTROLS AND PROCEDURES
     
 
 9B
     
III
 10
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT*
     
 
 11
 EXECUTIVE COMPENSATION*
     
 
 12
SECURITY OWNERSHIP OF CERTAIN BENECIAL OWNERS AND MANAGEMENT*      
     
 
 13
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS*
     
 
 14
PRINCIPAL ACCOUNTANT FEES AND SERVICES*
     
 IV
15
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
     
 
 
    (a)   (1) Financial Statements (See Item 8 for Reference).
            (2) Financial Statement Schedules normally required on Form 10-K are omitted since they are not applicable.
          
(3) Exhibits.
     
        (b)   Reports on Form 8-K.
     
        (c)   Refer to item 15(a)(3)above.
     
        (d)   Refer to item 15(a)(2) above.
     
    SIGNATURES
     
    *   Information called for by Part III (Items 10 through 14) is incorporated by reference to the Registrant’s Proxy Statement for the 2005 Annual Meeting of Stockholders.
     
 
 
 
 
 
 
PART I

 

 
 
ITEM 1. BUSINESS

 
NBT Bancorp Inc. (the “Registrant” or the “Company”) is a registered financial holding company incorporated in the state of Delaware in 1986, with its principal headquarters located in Norwich, New York. The Registrant is the parent holding company of NBT Bank, N.A. (“the Bank”), NBT Financial Services, Inc. (“NBT Financial”), and CNBF Capital Trust I (see Note 12 to the Notes to Consolidated Financial Statements). Through the Bank and NBT Financial, the Company operates as one segment focused on community banking operations. CNBF Capital Trust I was organized to raise additional Tier 1 Capital. The Registrant’s primary business consists of providing commercial banking and financial services to its customers in its market area. The principal assets of the Registrant are all of the outstanding shares of common stock of its direct subsidiaries, and its principal sources of revenue are the management fees and dividends it receives from the Bank and NBT Financial.
 
The Bank is a full service commercial bank formed in 1856, which provides a broad range of financial products to individuals, corporations and municipalities throughout the central and upstate New York and northeastern Pennsylvania market area. The Bank conducts business through two geographic operating divisions, NBT Bank and Pennstar Bank.
 
The NBT Bank division has 73 divisional offices and 97 automated teller machines (ATMs), located primarily in central and upstate New York. At December 31, 2004, NBT Bank had total loans and leases of $2.2 billion and total deposits of $2.3 billion.
 
The Pennstar Bank division has 41 divisional offices and 54 ATMs, located primarily in northeastern Pennsylvania. At December 31, 2004, Pennstar Bank had total loans and leases of $640.9 million and total deposits of $810.3 million.
 
The Bank has eight operating subsidiaries, NBT Capital Corp., LA Lease, Inc., Pennstar Services Company, Colonial Financial Services, Inc. (“CFS”), Broad Street Property Associates, Inc., NBT Services, Inc., Pennstar Realty Trust, and CNB Realty Trust. NBT Capital Corp., formed in 1998, is a venture capital corporation formed to assist young businesses develop and grow in the markets we serve. LA Lease, Inc., formed in 1987, provides automobile and equipment leases to individuals and small business entities. Broad Street Property Associates, Inc. formed in 2004, is a property management company. NBT Services, Inc. formed in 2004, is the holding company of and has an 80% ownership interest in NBT Settlement Services, LLC. NBT Settlement Services, formed in 2004, provides title insurance products to individuals and corporations. Pennstar Realty Trust, formed in 2000, and CNB Realty Trust formed in 1998, are real estate investment trusts. Pennstar Services Company, formed in 2002, provides services to the Pennstar Bank division of the Bank. CFS, formed in 2001, offered a variety of financial services products and currently conducts no operations as of December 31, 2004.
 
NBT Financial, formed in 1999, is the parent company of two subsidiaries, Pennstar Financial Services, Inc. and M. Griffith, Inc. Pennstar Financial Services, Inc., formed in 1997, offered a variety of financial services products. Pennstar Financial Services conducted no operations during 2004. M. Griffith, Inc., formed in 1951 and acquired by the Company in 2000, is a registered securities broker-dealer and also offers financial and retirement planning as well as life, accident and health insurance. The Company has entered into a definitive agreement to sell M.Griffith, Inc., which is expected to close in the first quarter of 2005.
 
CNBF Capital Trust I (“Trust I”) is a Delaware statutory business trust formed in 1999, for the purpose of issuing $18 million in trust preferred securities and lending the proceeds to the Company. The Company guarantees, on a limited basis, payments of distributions on the trust preferred securities and payments on redemption of the trust preferred securities.

Trust I is a variable interest entity (VIEs) for which the Company is not the primary beneficiary, as defined in Financial Accounting Standards Board Interpretation (“FIN”) No. 46 “Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (Revised December 2003).” In accordance with FIN 46R, which was implemented in the first quarter of 2004, the accounts of Trust I are not included in the Company’s consolidated financial statements. Prior to the first quarter of 2004, the financial statements of Trust I were included in the consolidated financial statements of the Company because the Company owns all of the outstanding common equity securities of the Trust. See the Company’s accounting policy related to consolidation in Note 1 — Summary of Significant Accounting Policies in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which is located elsewhere in this report.
 
Despite the fact that the accounts of Trust I are not included in the Company’s consolidated financial statements, $17 million of the $18 million (the Bank owns $1.0 million of these securities) in trust preferred securities issued by this subsidiary trust is included in the Tier 1 capital of the Company for regulatory capital purposes as allowed by the Federal Reserve Board. In May 2004, the Federal Reserve Board proposed a rule that would continue to allow the inclusion of trust preferred securities issued by unconsolidated subsidiary trusts in Tier 1 capital, but with stricter quantitative limits and clearer qualitative standards. Under the proposal, after a three-year transition period, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25% of Tier 1 capital elements, net of goodwill. The amount of trust preferred securities and certain other elements in excess of the limit could be included in Tier 2 capital, subject to restrictions. Based on the proposed rule, the Company expects to include all of its $17 million in trust preferred securities in Tier 1 capital. However, the provisions of the final rule could significantly differ from those proposed and there can be no assurance that the Federal Reserve Board will not further limit the amount of trust preferred securities permitted to be included in Tier 1 capital for regulatory capital purposes. The trust preferred securities could be redeemed without penalty if they were no longer permitted to be included in Tier 1 capital. See Note 12 — CNBF Capital Trust I in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which is located elsewhere in this report.
 
COMPETITION
 
The banking and financial services industry in New York and Pennsylvania generally, and in the Company’s market areas specifically, is highly competitive. The increasingly competitive environment is a result primarily of changes in regulation, changes in technology and product delivery systems, additional financial service providers, and the accelerating pace of consolidation among financial services providers. The Company competes for loans and leases, deposits, and customers with other commercial banks, savings and loan associations, securities and brokerage companies, mortgage companies, insurance companies, finance companies, money market funds, credit unions, and other nonbank financial service providers. Many of these competitors are much larger in total assets and capitalization, have greater access to capital markets and offer a broader range of financial services than the Company. In order to compete with other financial services providers, the Company stresses the community nature of its banking operations and principally relies upon local promotional activities, personal relationships established by officers, directors, and employees with their customers, and specialized services tailored to meet the needs of the communities served.
 
SUPERVISION AND REGULATION
 
As a bank holding company, the Company is subject to extensive regulation, supervision, and examination by the Board of Governors of the Federal Reserve System (“FRS”) as its primary federal regulator. The Company also has elected to be registered with the FRS as a financial holding company. The Bank, as a nationally chartered bank, is subject to extensive regulation, supervision and examination by the Office of the Comptroller of the Currency (“OCC”) as its primary federal regulator and, as to certain matters, by the FRS and the Federal Deposit Insurance Corporation (“FDIC”).
 
The Company is subject to capital adequacy guidelines of the FRS. The guidelines apply on a consolidated basis and require bank holding companies to maintain a minimum ratio of Tier 1 capital to total average assets (or “leverage ratio”) of 4%. For the most highly rated bank holding companies, the minimum ratio is 3%. The FRS capital adequacy guidelines also require bank holding companies to maintain a minimum ratio of Tier 1 capital to risk-weighted assets of 4% and a minimum ratio of qualifying total capital to risk-weighted assets of 8%. As of December 31, 2004, the Company’s leverage ratio was 7.13%, its ratio of Tier 1 capital to risk-weighted assets was 9.78%, and its ratio of qualifying total capital to risk-weighted assets was 11.04%. The FRS may set higher minimum capital requirements for bank holding companies whose circumstances warrant it, such as companies anticipating significant growth or facing unusual risks. The FRS has not advised the Company of any special capital requirement applicable to it.
 
Any holding company whose capital does not meet the minimum capital adequacy guidelines is considered to be undercapitalized and is required to submit an acceptable plan to the FRS for achieving capital adequacy. Such a company’s ability to pay dividends to its shareholders and expand its lines of business through the acquisition of new banking or nonbanking subsidiaries also could be restricted.
 
The Bank is subject to leverage and risk-based capital requirements and minimum capital guidelines of the OCC that are similar to those applicable to the Company. As of December 31, 2004, the Bank was in compliance with all minimum capital requirements. The Bank’s leverage ratio was 6.83%, its ratio of Tier 1 capital to risk-weighted assets was 9.40%, and its ratio of qualifying total capital to risk-weighted assets was 10.65%.
 
Under FDIC regulations, no FDIC-insured bank can accept brokered deposits unless it is well capitalized, or is adequately capitalized and receives a waiver from the FDIC. In addition, these regulations prohibit any bank that is not well capitalized from paying an interest rate on brokered deposits in excess of three-quarters of one percentage point over certain prevailing market rates. As of December 31, 2004, the total amount of brokered deposits were $189.8 million.
 
The Bank also is subject to substantial regulatory restrictions on its ability to pay dividends to the Company. Under OCC regulations, the Bank may not pay a dividend, without prior OCC approval, if the total amount of all dividends declared during the calendar year, including the proposed dividend, exceed the sum of its retained net income to date during the calendar year and its retained net income over the preceding two years. As of December 31, 2004, approximately $56.3 million was available for the payment of dividends without prior OCC approval. The Bank’s ability to pay dividends also is subject to the Bank being in compliance with regulatory capital requirements. The Bank is currently in compliance with these requirements.
 
The OCC generally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be undercapitalized. Undercapitalized institutions are subject to growth limitations and are required to submit a capital restoration plan. The agencies may not accept such a plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. In addition, for a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with such capital restoration plan. The aggregate liability of the parent holding company is limited to the lesser of (i) an amount equal to 5.0% of the depository institution’s total assets at the time it became undercapitalized and (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it is “significantly undercapitalized.”

“Significantly undercapitalized” depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become “adequately capitalized,” requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. “Critically undercapitalized” institutions are subject to the appointment of a receiver or conservator.
 
The deposits of the Bank are insured up to regulatory limits by the FDIC and, accordingly, are subject to deposit insurance assessments to maintain the insurance funds administered by the FDIC. The deposits of the Bank historically have been subject to deposit insurance assessments to maintain the Bank Insurance Fund (“BIF”). Due to certain branch deposit acquisitions by the Bank and its predecessors, some of the deposits of the Bank are subject to deposit insurance assessments to maintain the Savings Association Insurance Fund (“SAIF”).
 
The FDIC has adopted regulations establishing a permanent risk-related deposit insurance assessment system. Under this system, the FDIC places each insured bank in one of nine risk categories based on the bank’s capitalization and supervisory evaluations provided to the FDIC by the institution’s primary federal regulator. Each insured bank’s insurance assessment rate is then determined by the risk category in which it is classified by the FDIC.
 
In light of the then prevailing favorable financial situation of the federal deposit insurance funds and the low number of depository institution failures, since January 1, 1997, the annual insurance premiums on bank deposits insured by the BIF or the SAIF have varied between $0.00 per $100 of deposits for banks classified in the highest capital and supervisory evaluation categories to $0.27 per $100 of deposits for banks classified in the lowest capital and supervisory evaluation categories. BIF and SAIF assessment rates are subject to semi-annual adjustment by the FDIC within a range of up to five basis points without public comment. The FDIC also possesses authority to impose special assessments from time to time.
 
The Federal Deposit Insurance Act provides for additional assessments to be imposed on insured depository institutions to pay for the cost of Financing Corporation (“FICO”) funding. The FICO assessments are adjusted quarterly to reflect changes in the assessment bases of the FDIC insurance funds and do not vary depending upon a depository institution’s capitalization or supervisory evaluation. During 2004, FDIC-insured banks paid an average rate of approximately $0.017 per $100 for purposes of funding FICO bond obligations.
 
Transactions between the Bank and any of its affiliates, including the Company, are governed by sections 23A and 23B of the Federal Reserve Act. An “affiliate” of a bank is any 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 is not treated as an affiliate of the bank for purposes of sections 23A and 23B, unless the subsidiary is also controlled through a non-bank chain of ownership by affiliates or controlling shareholders of the bank or the subsidiary engages in activities that are not permissible for a bank to engage in directly (except insurance agency subsidiaries). Generally, sections 23A and 23B are intended to protect insured depository institutions from suffering losses arising from transactions with non-insured affiliates, by limiting the extent to which a bank or its subsidiaries may engage in covered transactions with any one affiliate and with all affiliates of the bank in the aggregate, and requiring that such transactions be on terms that are consistent with safe and sound banking practices.
 
Under the Gramm-Leach-Bliley Act (“GLB Act”), a qualifying bank holding company, known as a financial holding company, may engage in certain financial activities that a bank holding company may not otherwise engage in under the Bank Holding Company Act (“BHC Act”). In addition to engaging in banking and activities closely related to banking as determined by the FRS by regulation or order prior to November 11, 1999, a financial holding company may engage in activities that are financial in nature or incidental to financial activities, or activities that are complementary to a financial activity and do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.
 
Under the GLB Act, all financial institutions, including the Company and the Bank, are required to adopt privacy policies, restrict the sharing of nonpublic customer data with nonaffiliated parties at the customer’s request, and establish procedures and practices to protect customer data from unauthorized access.
 
Under Title III of the USA PATRIOT Act, also known as the International Money Laundering Abatement and Anti-Terrorism Financing Act of 2001, all financial institutions, including the Company and the Bank, are required in general to identify their customers, adopt formal and comprehensive anti-money laundering programs, scrutinize or prohibit altogether certain transactions of special concern, and be prepared to respond to inquiries from U.S. law enforcement agencies concerning their customers and their transactions.
 
Additional information-sharing among financial institutions, regulators, and law enforcement authorities is encouraged by the presence of an exemption from the privacy provisions of the GLB Act for financial institutions that comply with this provision and the authorization of the Secretary of the Treasury to adopt rules to further encourage cooperation and information-sharing. The effectiveness of a financial institution in combating money laundering activities is a factor to be considered in any application submitted by the financial institution under the Bank Merger Act, which applies to the Bank, or the BHC Act, which applies to the Company. As of December 31, 2004, the Company and the Bank are in compliance with USA PATRIOT Act. Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal, financial and reputational consequences for the institution.

The Sarbanes-Oxley Act of 2002 implemented a broad range of corporate governance and reporting measures for companies that have securities registered under the Exchange Act, including publicly-held bank holding companies such as the Company. Specifically, the Sarbanes-Oxley Act of 2002 and the various regulations promulgated thereunder, established, among other things: (i) new requirements for audit committees, including independence, expertise, and responsibilities; (ii) additional responsibilities regarding financial statements for the Chief Executive Officer and Chief Financial Officer of the reporting company; (iii) the forfeiture of bonuses or other incentive-based compensation and profits from the sale of the reporting company’s securities by the Chief Executive Officer and Chief Financial Officer in the twelve-month period following the initial publication of any financial statements that later require restatement; (iv) the creation of an independent accounting oversight board; (v) new standards for auditors and regulation of audits, including independence provisions that restrict non-audit services that accountants may provide to their audit clients; (vi) increased disclosure and reporting obligations for the reporting company and their directors and executive officers, including accelerated reporting of stock transactions and a prohibition on trading during pension blackout periods; (vii) a prohibition on personal loans to directors and officers, except certain loans made by insured financial institutions on nonpreferential terms and in compliance with other bank regulatory requirements; and (viii) a range of new and increased civil and criminal penalties for fraud and other violations of the securities laws.
 
EMPLOYEES
 
At December 31, 2004, the Company had 1,218 full-time equivalent employees. The Company’s employees are not presently represented by any collective bargaining group. The Company considers its employee relations to be good.
 
 
AVAILABLE INFORMATION
 
The Company’s website is http://www.nbtbancorp.com. The Company makes available free of charge through its internet site, its annual reports on Form 10-K; quarterly reports on Form 10-Q; current reports on Form 8K; and any amendments to those reports filed or furnished pursuant to the Securities Exchange Act of 1934 as soon as reasonably practicable after such material is electronically filed with, or furnished to the SEC. The reference to our website does not constitute incorporation by reference of the information contained in the website and should not be considered part of this document.
 
 
ITEM 2. PROPERTIES

 
The Company’s headquarters are located at 52 South Broad Street, Norwich, New York 13815. The Company operated the following number of community banking branches and automated teller machines (ATMs) as of December 31, 2004:

County
 
Branches
 
ATMs
 
County
 
Branches
 
ATMs
 
NBT Bank Division
               
Pennstar Bank Division
             
New York
               
New York
             
Albany County
   
2
   
2
   
Orange County
   
1
   
1
 
Broome County
   
7
   
11
                   
Chenango County
   
11
   
13
   
Pennsylvania
             
Clinton County
   
3
   
2
   
Lackawanna County
   
19
   
25
 
Delaware County
   
5
   
11
   
Luzerne County
   
5
   
8
 
Essex County
   
3
   
6
   
Monroe County
   
4
   
5
 
Franklin County
   
1
   
1
   
Pike County
   
3
   
3
 
Fulton County
   
4
   
5
   
Susquehanna County
   
6
   
8
 
Greene County
   
   
2
   
Wayne County
   
3
   
4
 
Herkimer County
   
2
   
1
                   
Montgomery County
   
6
   
4
                   
Oneida County
   
6
   
10
                   
Otsego County
   
9
   
16
                   
Saratoga County
   
3
   
3
                   
Schenectady County
   
1
   
1
                   
Schoharie County
   
4
   
2
                   
St. Lawrence County
   
5
   
4
                   
Sullivan County
   
   
1
                   
Tioga County
   
1
   
1
                   
Ulster County
   
   
1
                   

 
The Company leases forty-five of the above listed branches from third parties under terms and conditions considered by management to be equitable to the Company. The Company owns all other banking premises. All automated teller machines are owned.
 
 
ITEM 3. LEGAL PROCEEDINGS

 
There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the Company or any of its subsidiaries is a party or of which their property is the subject.
 
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 
(a) Not applicable.
(b) Not applicable.
(c) Not applicable.
(d) Not applicable.
 
 
PART II

 
 
ITEM 5. MARKET FOR REGISTRANT’S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

 
The common stock of NBT Bancorp Inc. (“Common Stock”) is quoted on the Nasdaq Stock Market National Market Tier under the symbol “NBTB.” The following table sets forth the market prices and dividends declared for the Common Stock for the periods indicated:
 

   
High
 
Low
 
Dividend
 
2003
                   
1st quarter
 
$
18.60
 
$
16.75
 
$
0.17
 
2nd quarter
   
19.94
   
17.37
   
0.17
 
3rd quarter
   
21.76
   
19.24
   
0.17
 
4th quarter
   
22.78
   
19.50
   
0.17
 
2004
                   
1st quarter
 
$
23.00
 
$
21.21
 
$
0.17
 
2nd quarter
   
23.18
   
19.92
   
0.19
 
3rd quarter
   
24.34
   
21.02
   
0.19
 
4th quarter
   
26.84
   
21.94
   
0.19
 
The closing price of the Common Stock on February 28, 2004 was $23.45.
                   
 
 
ITEM 6. SELECTED FINANCIAL DATA


The following summary of financial and other information about the Company is derived from the Company’s audited consolidated financial statements for each of the five fiscal years ended December 31, 2004:
 

   
Year ended December 31,
 
(In thousands, except per share data)
   
2004
   
2003
   
2002
   
2001
   
2000
 
Interest, fee and dividend income
 
$
210,179
 
$
207,298
 
$
227,222
 
$
255,434
 
$
260,381
 
Interest expense
   
59,692
   
62,874
   
80,402
   
117,502
   
133,003
 
Net interest income
   
150,487
   
144,424
   
146,820
   
137,932
   
127,378
 
Provision for loan and lease losses
   
9,615
   
9,111
   
9,073
   
31,929
   
10,143
 
Noninterest income excluding securities
                               
gains (losses)
   
40,673
   
37,603
   
31,934
   
31,826
   
24,854
 
Securities gains (losses), net
   
216
   
175
   
(413
)
 
(7,692
)
 
(2,273
)
Merger, acquisition and reorganization
                               
  costs
   
-
   
-
   
-
   
15,322
   
23,625
 
Other noninterest expense
   
109,777
   
104,517
   
102,455
   
110,536
   
95,509
 
Income before income taxes
   
71,984
   
68,574
   
66,813
   
4,279
   
20,682
 
Net income
   
50,047
   
47,104
   
44,999
   
3,737
   
14,154
 
                                 
Per common share
                               
Basic earnings
 
$
1.53
 
$
1.45
 
$
1.36
 
$
0.11
 
$
0.44
 
Diluted earnings
   
1.51
   
1.43
   
1.35
   
0.11
   
0.44
 
Cash dividends paid
   
0.74
   
0.68
   
0.68
   
0.68
   
0.68
 
Book value at year-end
   
10.11
   
9.46
   
8.96
   
8.05
   
8.29
 
Tangible book value at year-end
   
8.66
   
7.94
   
7.47
   
6.51
   
6.88
 
Average diluted common shares outstanding
   
33,087
   
32,844
   
33,235
   
33,085
   
32,405
 
                                 
At December 31,
                               
Trading securities, at fair value
 
$
-
 
$
-
 
$
-
 
$
-
 
$
20,540
 
Securities available for sale, at fair value
   
952,542
   
980,961
   
1,007,583
   
909,341
   
936,757
 
Securities held to maturity, at amortized cost
   
81,782
   
97,204
   
82,514
   
101,604
   
110,415
 
Loans and leases
   
2,869,921
   
2,639,976
   
2,355,932
   
2,339,636
   
2,247,655
 
Allowance for loan and lease losses
   
44,932
   
42,651
   
40,167
   
44,746
   
32,494
 
Assets
   
4,212,304
   
4,046,885
   
3,723,726
   
3,638,202
   
3,605,506
 
Deposits
   
3,073,838
   
3,001,351
   
2,922,040
   
2,915,612
   
2,843,868
 
Borrowings
   
752,066
   
672,631
   
451,076
   
394,344
   
425,233
 
Stockholders’ equity
   
332,233
   
310,034
   
292,382
   
266,355
   
269,641
 
                                 
Key ratios
                               
Return on average assets
   
1.21
%
 
1.22
%
 
1.23
%
 
0.10
%
 
0.41
%
Return on average equity
   
15.69
   
15.90
   
16.13
   
1.32
   
5.57
 
Average equity to average assets
   
7.74
   
7.69
   
7.64
   
7.82
   
7.35
 
Net interest margin
   
4.03
   
4.16
   
4.43
   
4.19
   
4.02
 
Dividend payout ratio
   
49.01
   
47.55
   
50.37
   
618.18
   
154.55
 
Tier 1 leverage
   
7.13
   
6.76
   
6.73
   
6.34
   
6.88
 
Tier 1 risk-based capital
   
9.78
   
9.96
   
9.93
   
9.43
   
9.85
 
Total risk-based capital
   
11.04
   
11.21
   
11.18
   
10.69
   
11.08
 
 

Selected Quarterly Financial Data
 
     
2004
   
2003
 
(Dollars in thousands, except per share data)
   
First
   
Second
   
Third
   
Fourth
   
First
   
Second
   
Third
   
Fourth
 
Interest, fee and dividend income
 
$
51,727
 
$
50,938
 
$
53,093
 
$
54,421
 
$
52,635
 
$
51,593
 
$
50,788
 
$
52,282
 
Interest expense
   
14,633
   
14,258
   
15,041
   
15,760
   
16,606
   
16,101
   
15,210
   
14,957
 
Net interest income
   
37,094
   
36,680
   
38,052
   
38,661
   
36,029
   
35,492
   
35,578
   
37,325
 
Provision for loan and lease losses
   
2,124
   
2,428
   
2,313
   
2,750
   
1,940
   
1,413
   
2,436
   
3,322
 
Noninterest income excluding net securities gains
   
10,434
   
9,960
   
10,099
   
10,180
   
8,715
   
8,901
   
9,955
   
10,032
 
Net securities gains
   
9
   
29
   
18
   
160
   
27
   
38
   
18
   
92
 
Noninterest expense
   
27,202
   
25,863
   
27,305
   
29,407
   
25,892
   
25,848
   
25,983
   
26,794
 
Net income
 
$
12,371
 
$
12,568
 
$
12,617
 
$
12,491
 
$
11,566
 
$
11,808
 
$
11,848
 
$
11,882
 
Basic earnings per share
 
$
0.38
 
$
0.38
 
$
0.38
 
$
0.38
 
$
0.36
 
$
0.36
 
$
0.36
 
$
0.36
 
Diluted earnings per share
 
$
0.37
 
$
0.38
 
$
0.38
 
$
0.38
 
$
0.35
 
$
0.36
 
$
0.36
 
$
0.36
 
Net interest margin
   
4.10
%
 
3.99
%
 
3.99
%
 
4.03
%
 
4.38
%
 
4.18
%
 
4.02
%
 
4.07
%
Return on average assets
   
1.23
%
 
1.24
%
 
1.20
%
 
1.18
%
 
1.27
%
 
1.25
%
 
1.21
%
 
1.17
%
Return on average equity
   
15.73
%
 
16.05
%
 
15.94
%
 
15.08
%
 
16.05
%
 
16.07
%
 
16.06
%
 
15.47
%
Average diluted common shares outstanding
   
33,174
   
33,084
   
32,936
   
33,155
   
32,783
   
32,653
   
32,865
   
33,070
 
 
                                                 
 
 
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 
 
GENERAL
 
The financial review which follows focuses on the factors affecting the consolidated financial condition and results of operations of NBT Bancorp Inc. (the “Registrant”) and its wholly owned subsidiaries, NBT Bank, N.A. (“the Bank”) and NBT Financial Services, Inc. (“NBT Financial), during 2004 and, in summary form, the preceding two years. Collectively, the Registrant and its subsidiaries are referred to herein as “the Company.” Net interest margin is presented in this discussion on a fully taxable equivalent (FTE) basis. Average balances discussed are daily averages unless otherwise described. The audited consolidated financial statements and related notes as of December 31, 2004 and 2003 and for each of the years in the three-year period ended December 31, 2004 should be read in conjunction with this review. Amounts in prior period consolidated financial statements are reclassified whenever necessary to conform to the 2004 presentation.
 
The preparation of the consolidated financial statements requires management to make estimates and assumptions, in the application of certain accounting policies, about the effect of matters that are inherently uncertain. Those estimates and assumptions affect the reported amounts of certain assets, liabilities, revenues and expenses. Different amounts could be reported under different conditions, or if different assumptions were used in the application of these accounting policies.
 
The business of the Company is providing commercial banking and financial services through its subsidiaries. The Company’s primary market area is central and upstate New York and northeastern Pennsylvania. The Company has been, and intends to continue to be, a community-oriented financial institution offering a variety of financial services. The Company’s principle business is attracting deposits from customers within its market area and investing those funds primarily in loans and leases, and, to a lesser extent, in marketable securities. The financial condition and operating results of the Company are dependent on its net interest income which is the difference between the interest and dividend income earned on its earning assets and the interest expense paid on its interest bearing liabilities, primarily consisting of deposits and borrowings. Net income is also affected by provisions for loan and lease losses and noninterest income, such as service charges on deposit accounts, broker/dealer fees, trust fees, and gains/losses on securities sales; it is also impacted by noninterest expense, such as salaries and employee benefits, data processing, communications, occupancy, and equipment.
 
The Company’s results of operations are significantly affected by general economic and competitive conditions (particularly changes in market interest rates), government policies, changes in accounting standards, and actions of regulatory agencies. Future changes in applicable laws, regulations, or government policies may have a material impact on the Company. Lending activities are substantially influenced by the demand for and supply of housing, competition among lenders, the level of interest rates, the state of the local and regional economy, and the availability of funds. The ability to gather deposits and the cost of funds are influenced by prevailing market interest rates, fees and terms on deposit products, as well as the availability of alternative investments including mutual funds and stocks.
 
 
CRITICAL ACCOUNTING POLICIES
 
The Company has identified two policies as being critical because they require management to make particularly difficult, subjective and/or complex judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. These policies relate to the allowance for loan and lease losses and pension accounting.

Management of the Company considers the accounting policy relating to the allowance for loan and lease losses to be a critical accounting policy given the uncertainty in evaluating the level of the allowance required to cover credit losses inherent in the loan and lease portfolio and the material effect that such judgments can have on the results of operations. While management’s current evaluation of the allowance for loan and lease losses indicates that the allowance is adequate, under adversely different conditions or assumptions, the allowance would need to be increased. For example, if historical loan and lease loss experience significantly worsened or if current economic conditions significantly deteriorated, additional provisions for loan and lease losses would be required to increase the allowance. In addition, the assumptions and estimates used in the internal reviews of the Company’s nonperforming loans and potential problem loans has a significant impact on the overall analysis of the adequacy of the allowance for loan and lease losses. While management has concluded that the current evaluation of collateral values is reasonable under the circumstances, if collateral values were significantly lowered, the Company’s allowance for loan and lease policy would also require additional provisions for loan and lease losses.
 
Management is required to make various assumptions in valuing its pension assets and liabilities. These assumptions include the expected rate of return on plan assets, the discount rate, and the rate of increase in future compensation levels. Changes to these assumptions could impact earnings in future periods. The Company takes into account the plan asset mix, funding obligations, and expert opinions in determining the various rates used to estimate pension expense. The Company also considers the Moody’s AA corporate bond yields and other market interest rates in setting the appropriate discount rate. In addition, the Company reviews expected inflationary and merit increases to compensation in determining the rate of increase in future compensation levels. While differences in these rate assumptions could alter pension expense, given not only past history and controls in place including use of expert opinions, it is not expected that such estimates could adversely impact pension expense.

The Company’s policy on the allowance for loan and lease losses and pension accounting is disclosed in note 1 to the consolidated financial statements. A more detailed description of the allowance for loan and lease losses is included in the “Risk Management” section of this Form 10-K. All significant pension accounting assumptions and detail is disclosed in note 16 to the consolidated financial statements. All accounting policies are important, and as such, the Company encourages the reader to review each of the policies included in note 1 to obtain a better understanding on how the Company’s financial performance is reported.
 
 
FORWARD LOOKING STATEMENTS
 
Certain statements in this filing and future filings by the Company with the Securities and Exchange Commission, in the Company’s press releases or other public or shareholder communications, or in oral statements made with the approval of an authorized executive officer, contain forward-looking statements, as defined in the Private Securities Litigation Reform Act. These statements may be identified by the use of phrases such as “anticipate,” “believe,” “expect,” “forecasts,” “projects,” “will,” “can,” “would,” “should,” “could,” “may,” or other similar terms. There are a number of factors, many of which are beyond the Company’s control that could cause actual results to differ materially from those contemplated by the forward looking statements. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, among others, the following possibilities:
 
• Local, regional, national and international economic conditions and the impact they may have on the Company and its customers and the Company’s assessment of that impact.
• Changes in the level of non-performing assets and charge-offs.
• Changes in estimates of future reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements.
• The effects of and changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve Board.
• Inflation, interest rate, securities market and monetary fluctuations.
• Political instability.
• Acts of war or terrorism.
• The timely development and acceptance of new products and services and perceived overall value of these products and services by users.
• Changes in consumer spending, borrowings and savings habits.
• Changes in the financial performance and/or condition of the Company’s borrowers.
• Technological changes.
• Acquisitions and integration of acquired businesses.
• The ability to increase market share and control expenses.
• Changes in the competitive environment among financial holding companies.
• The effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) with which the Company and its subsidiaries must comply.
• The effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standard setters.
• Changes in the Company’s organization, compensation and benefit plans.
• The costs and effects of legal and regulatory developments including the resolution of legal proceedings or regulatory or other governmental inquiries and the results of regulatory examinations or reviews.
• Greater than expected costs or difficulties related to the integration of new products and lines of business.
• The Company’s success at managing the risks involved in the foregoing items.

The Company cautions readers not to place undue reliance on any forward-looking statements, which speak only as of the date made, and to advise readers that various factors, including but not limited to those described above, could affect the Company’s financial performance and could cause the Company’s actual results or circumstances for future periods to differ materially from those anticipated or projected.
 
Except as required by law, the Company does not undertake, and specifically disclaims any obligations to, publicly release any revisions that may be made to any forward-looking statements to reflect statements to the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

 
OVERVIEW
 
The Company had net income of $50.0 million or $1.51 per diluted share for 2004, compared to net income of $47.1 million or $1.43 per diluted share for 2003. Results were driven by several factors. Net interest income increased $6.1 million or 4% in 2004 compared to 2003. The increase in net interest income resulted mainly from an increase in average earning assets of 7%, driven by an 11% increase in average loans and leases for the period. Noninterest income increased $3.1 million or 8% compared to 2003. This increase resulted from increases in other income, Bank Owned Life Insurance (BOLI) income, service charges on deposit accounts and trust revenue. Offsetting the increases in net interest income and noninterest income was an increase in noninterest expense of $5.3 million in 2004 compared to 2003. The increase in noninterest expense resulted mainly from increases in salaries and employee benefits, occupancy expense, professional fees and outside services and a goodwill impairment charge offset by decreases in other operating expense and loan collection and other real estate owned expense. The provision for loan and lease losses increased slightly in 2004 compared to 2003, as credit quality was stable, net charge-offs as a percentage of total loans and leases remained unchanged, and loan growth was solid, increasing 9% at December 31, 2004 when compared to total loans and leases at December 31, 2003.
 
The Company had net income of $47.1 million or $1.43 per diluted share for 2003, compared to net income of $45.0 million or $1.35 per diluted share for 2002. There were several factors driving the improvement in results in 2003 compared to 2002. Noninterest income increased $6.3 million or 20% in 2003 compared to 2002. This increase resulted from strong growth in service charges on deposit accounts and increases from trust revenue, broker/ dealer fees, Bank Owned Life Insurance (BOLI) income, and other income. Offsetting this increase in noninterest income was a decrease in net interest income of $2.4 million and an increase in noninterest expenses of $2.1 million. The decrease in net interest income was driven primarily by the decrease in the Company’s net interest margin, which declined from 4.43% for 2002 to 4.16% for 2003, primarily as a result of continued low market interest rates. The decline in margin was offset some what by growth in average earning assets of 5% driven primarily by loan growth. Average loans and leases increased 6% in 2003 or $137.1 million compared to 2002 average loans. The increase in noninterest expense resulted primarily from increases in salaries and employee benefits, occupancy expense, and other noninterest expense offset by decreases in professional fees and outside services and loan collection and other real estate owned (OREO) expenses. The provision for loan and lease losses remained relatively unchanged in 2003 from 2002, as improvements in credit quality were offset by loan growth in 2003.

ASSET/LIABILITY MANAGEMENT
 
The Company attempts to maximize net interest income, and net income, while actively managing its liquidity and interest rate sensitivity through the mix of various core deposit products and other sources of funds, which in turn fund an appropriate mix of earning assets. The changes in the Company’s asset mix and sources of funds, and the resultant impact on net interest income, on a fully tax equivalent basis, are discussed below.
 
The following table includes the condensed consolidated average balance sheet, an analysis of interest income/ expense and average yield/rate for each major category of earning assets and interest bearing liabilities on a taxable equivalent basis. Interest income for tax-exempt securities and loans and leases has been adjusted to a taxable-equivalent basis using the statutory Federal income tax rate of 35%.
 

Table 1. Average Balances and Net Interest Income
 
     
2004
   
2003
   
2002
 
Average
               
Yield/
   
Average
         
Yield/
   
Average
         
Yield/
 
(Dollars in thousands)
   
Balance
   
Interest
   
Rate
   
Balance
   
Interest
   
Rate
   
Balance
   
Interest
   
Rate
 
Assets
                                                       
Short-term interest bearing accounts
 
$
7,583
 
$
222
   
2.93
%
$
3,358
 
$
84
   
2.50
%
$
12,597
 
$
411
   
3.26
%
Securities available for sale1
   
970,024
   
44,633
   
4.60
   
984,620
   
46,313
   
4.70
   
947,042
   
56,586
   
5.98
 
Securities held to maturity1
   
85,771
   
4,385
   
5.11
   
90,601
   
4,657
   
5.14
   
92,981
   
5,620
   
6.04
 
Investment in FRB and FHLB Banks
   
34,813
   
854
   
2.45
   
28,117
   
854
   
3.04
   
21,766
   
962
   
4.42
 
Loans and leases2
   
2,743,753
   
164,285
   
5.99
   
2,474,899
   
159,827
   
6.46
   
2,337,767
   
167,917
   
7.18
 
Total earning assets
   
3,841,944
   
214,379
   
5.58
   
3,581,595
   
211,735
   
5.91
   
3,412,153
   
231,496
   
6.78
 
Other non-interest earning assets
   
278,603
               
270,928
               
236,919
             
Total assets
 
$
4,120,547
             
$
3,852,523
             
$
3,649,072
             
                                                         
Liabilities and stockholders’ equity
                                                       
Money market deposit accounts
 
$
438,819
   
5,327
   
1.21
%
$
359,722
   
4,332
   
1.20
%
$
279,407
   
4,461
   
1.60
%
NOW deposit accounts
   
462,509
   
2,230
   
0.48
   
411,236
   
2,340
   
0.57
   
382,562
   
3,488
   
0.91
 
Savings deposits
   
574,386
   
3,846
   
0.67
   
523,571
   
4,542
   
0.87
   
479,312
   
6,887
   
1.44
 
Time deposits
   
1,079,670
   
28,358
   
2.63
   
1,188,497
   
34,727
   
2.92
   
1,331,281
   
48,496
   
3.64
 
Total interest-bearing deposits
   
2,555,384
   
39,761
   
1.56
   
2,483,026
   
45,941
   
1.85
   
2,472,562
   
63,332
   
2.56
 
Short-term borrowings
   
302,276
   
4,086
   
1.35
   
190,332
   
2,171
   
1.14
   
87,039
   
1,334
   
1.53
 
Trust preferred debentures
   
18,297
   
823
   
4.50
   
-
   
-
   
-
   
-
   
-
   
-
 
Long-term debt
   
381,756
   
15,022
   
3.93
   
360,928
   
14,762
   
4.09
   
334,479
   
15,736
   
4.70
 
Total interest-bearing liabilities
   
3,257,713
   
59,692
   
1.83
   
3,034,286
   
62,874
   
2.07
   
2,894,080
   
80,402
   
2.78
 
Demand deposits
   
492,746
               
457,238
               
419,744
             
Other non-interest-bearing liabilities
   
51,187
               
64,723
               
56,293
             
Stockholders’ equity
   
318,901
               
296,276
               
278,955
             
Total liabilities and stockholders’ equity
 
$
4,120,547
             
$
3,852,523
             
$
3,649,072
             
Interest rate spread
               
3.75
%
             
3.84
%
             
4.00
%
Net interest income-FTE
         
154,687
               
148,861
               
151,094
       
Net interest margin
               
4.03
%
             
4.16
%
             
4.43
%
Taxable equivalent adjustment
         
4,200
               
4,437
               
4,274
       
Net interest income
       
$
150,487
             
$
144,424
             
$
146,820
       
1. Securities are shown at average amortized cost. For purposes of these computations, nonaccrual securities are included in the average securities balances, but the interest collected thereon is not included in interest income.
2. For purposes of these computations, nonaccrual loans are included in the average loan balances outstanding. The interest collected thereon is included in interest income based upon the characteristics of the related loans.
 
NET INTEREST INCOME
 
On a tax equivalent basis, the Company’s net interest income for 2004 was $154.7 million, up from $148.9 million for 2003. The Company’s net interest margin declined to 4.03% for 2004 from 4.16% for 2003. The decline in the net interest margin resulted primarily from earning assets repricing downward faster than interest bearing liabilities. The yield on earning assets decreased 33 basis points (bp), from 5.91% for 2003 to 5.58% for 2004. Meanwhile, the rate paid on interest bearing liabilities decreased 24 bp, from 2.07% for 2003 to 1.83% for 2004. Offsetting the decline in net interest margin was an increase in average earning assets of $260.3 million or 7%, driven primarily by a $268.9 million increase in average loans and leases. The following table presents changes in interest income, on a FTE basis, and interest expense attributable to changes in volume (change in average balance multiplied by prior year rate), changes in rate (change in rate multiplied by prior year volume), and the net change in net interest income. The net change attributable to the combined impact of volume and rate has been allocated to each in proportion to the absolute dollar amounts of change.
 

Table 2. Analysis of Changes in Taxable Equivalent Net Interest Income
 
 
   
Increase (Decrease)
   
Increase (Decrease)
 
 
   
2004 over 2003
   
2003 over 2002
 
(In thousands)
   
Volume
   
Rate
   
Total
   
Volume
   
Rate
   
Total
 
Short-term interest-bearing accounts
 
$
122
 
$
16
 
$
138
 
$
(248
)
$
(79
)
$
(327
)
Securities available for sale
   
(680
)
 
(1,000
)
 
(1,680
)
 
2,170
   
(12,443
)
 
(10,273
)
Securities held to maturity
   
(247
)
 
(25
)
 
(272
)
 
(141
)
 
(822
)
 
(963
)
Investment in FRB and FHLB Banks
   
182
   
(182
)
 
-
   
238
   
(346
)
 
(108
)
Loans and leases
   
16,605
   
(12,147
)
 
4,458
   
9,485
   
(17,575
)
 
(8,090
)
Total interest income
   
14,904
   
(12,260
)
 
2,644
   
11,084
   
(30,845
)
 
(19,761
)
Money market deposit accounts
   
960
   
35
   
995
   
1,112
   
(1,241
)
 
(129
)
NOW deposit accounts
   
272
   
(382
)
 
(110
)
 
245
   
(1,393
)
 
(1,148
)
Savings deposits
   
411
   
(1,107
)
 
(696
)
 
588
   
(2,933
)
 
(2,345
)
Time deposits
   
(3,027
)
 
(3,342
)
 
(6,369
)
 
(4,840
)
 
(8,929
)
 
(13,769
)
Short-term borrowings
   
1,457
   
458
   
1,915
   
1,250
   
(413
)
 
837
 
Long-term debt*
   
1,561
   
(478
)
 
1,083
   
1,183
   
(2,157
)
 
(974
)
Total interest expense
   
4,421
   
(7,603
)
 
(3,182
)
 
3,737
   
(21,265
)
 
(17,528
)
Change in FTE net interest income
 
$
10,483
 
$
(4,657
)
$
5,826
 
$
7,347
 
$
(9,580
)
$
(2,233
)
* Includes Trust Preferred Debentures for 2004.
                                     
 
 
LOANS AND LEASES AND CORRESPONDING INTEREST AND FEES ON LOANS
 
The average balance of loans and leases increased 11%, totaling $2.7 billion in 2004 compared to $2.5 billion in 2003. The yield on average loans and leases decreased from 6.46% in 2003 to 5.99% in 2004, as long-term interest rates remained at relatively historic low levels for much of 2004. Interest income from loans and leases on a FTE basis increased 3%, from $159.8 million in 2003 to $164.3 million in 2004. The increase in interest income from loans and leases was due primarily to the increase the average balance of loans and leases noted above offset somewhat by a the decline in yield on loans and leases in 2004 compared to 2003.
 
Total loans and leases increased 9% at December 31, 2004, totaling $2.9 billion from $2.6 billion at December 31, 2003. The increase in loans and leases was driven by strong growth in home equity loans, real estate construction and development (primarily comprised of commercial real estate), lease financing and modest growth in commercial loans and commercial real estate. Home equity loans increased $55.3 million or 16% from $336.5 million at December 31, 2003 to $391.8 million at December 31, 2004. The increase in home equity loans was due to strong product demand as the Bank’s prime lending rate (which the home equity line product is tied to) remained at historic lows for the first-half of 2004. Additionally, the Bank was successful in marketing its home equity product in its newer markets. Real estate construction and development loans increased $50.9 million or 59% from $86.0 million at December 31, 2003 to $136.9 million at December 31, 2004, as the Bank originated several large commercial construction development loans in 2004 in its newer markets. Lease financing increased $18.0 million or 29% from $62.7 million at December 31, 2003 to $80.7 million at December 31, 2004. The increase in lease financing resulted from the Bank’s expanded presence in the northeastern Pennsylvania market in 2004. Commercial loans and commercial real estate increased $64.5 million or 7% from $954.0 million at December 31, 2003 to $1.0 billion at December 31, 2004, as the Bank continued to expand its commercial banking presence in Albany, Binghamton, and northeastern Pennsylvania.
 
 
The following table reflects the loan and lease portfolio by major categories as of December 31 for the years indicated:
 

Table 3. Composition of Loan and Lease Portfolio
 
   
December 31,
 
(In thousands)
   
2004
   
2003
   
2002
   
2001
   
2000
 
Residential real estate mortgages
 
$
721,615
 
$
703,906
 
$
579,638
 
$
525,411
 
$
504,590
 
Commercial and commercial real estate
   
1,018,548
   
954,024
   
920,330
   
958,075
   
948,472
 
Real estate construction and development
   
136,934
   
86,046
   
64,025
   
60,513
   
44,829
 
Agricultural and agricultural real estate
   
108,181
   
106,310
   
104,078
   
103,884
   
92,713
 
Consumer
   
412,139
   
390,413
   
357,214
   
387,081
   
357,822
 
Home equity
   
391,807
   
336,547
   
269,553
   
232,624
   
219,355
 
Lease financing
   
80,697
   
62,730
   
61,094
   
72,048
   
79,874
 
Total loans and leases
 
$
2,869,921
 
$
2,639,976
 
$
2,355,932
 
$
2,339,636
 
$
2,247,655
 

Real estate mortgages consist primarily of loans secured by first or second deeds of trust on primary residences. Loans in the commercial and agricultural category, as well as commercial and agricultural real estate mortgages, consist primarily of short-term and/or floating rate loans made to small to medium-sized entities. Consumer loans consist primarily of installment credit to individuals secured by automobiles and other personal property including manufactured housing. Real estate construction and development loans include $109.4 million in commercial construction and development and $27.5 million in residential construction loans. Commercial construction loans are for small and medium sized office buildings and other commercial properties and residential construction loans are primarily for projects located in upstate New York and northeastern Pennsylvania.
 
The Company’s automobile lease financing portfolio totaled $80.7 million at December 31, 2004 and $62.7 million at December 31, 2003. Lease receivables primarily represent automobile financing to customers through direct financing leases and are carried at the aggregate of the lease payments receivable and the estimated residual values, net of unearned income and net deferred lease origination fees and costs. Net deferred lease origination fees and costs are amortized under the effective interest method over the estimated lives of the leases. The estimated residual value related to the total lease portfolio is reviewed quarterly, and if there had been a decline in the estimated fair value of the residual that is judged by management to be other-than-temporary, including consideration of residual value insurance, a loss would be recognized.
 
Adjustments related to such other-than-temporary declines in estimated fair value are recorded with other noninterest expenses in the consolidated statements of income. One of the most significant risks associated with leasing operations is the recovery of the residual value of the leased vehicles at the termination of the lease. A lease receivable asset includes the estimated residual value of the leased vehicle at the termination of the lease. At termination, the lessor has the option to purchase the vehicle or may turn the vehicle over to the Company. The residual values included in lease financing receivables totaled $50.2 million and $38.9 million at December 31, 2004 and 2003, respectively.

The Company has acquired residual value insurance protection in order to reduce the risk related to residual values. Based on analysis performed by management, the Company has concluded that no other-than-temporary impairment exists which would warrant a charge to earnings during December 31, 2004 and 2003.
 
The following table, Maturities and Sensitivities of Certain Loans to Changes in Interest Rates, are the maturities of the commercial and agricultural and real estate and construction development loan portfolios and the sensitivity of loans to interest rate fluctuations at December 31, 2004. Scheduled repayments are reported in the maturity category in which the contractual payment is due.
 
 

Table 4. Maturities and Sensitivities of Certain Loans to Changes in Interest Rates
 
 
   
Remaining maturity at December 31, 2004
 
 
          After One Year But     
       
(In thousands)
   
Within One Year
   
Within Five Years
   
After Five Years
   
Total
 
Floating/adjustable rate
                         
Commercial, commercial real estate, agricultural,
                         
  and agricultural real estate
 
$
525,357
 
$
105,782
 
$
-
 
$
631,139
 
Real estate construction and development
   
52,189
   
7,501
   
7,877
   
67,567
 
  Total floating rate loans
   
577,546
   
113,283
   
7,877
   
698,706
 
                           
Fixed rate
                         
Commercial, commercial real estate, agricultural,
                         
  and agricultural real estate
   
223,387
   
198,146
   
74,058
   
495,591
 
Real estate construction and development
   
694
   
5,377
   
63,295
   
69,366
 
  Total fixed rate loans
   
224,081
   
203,523
   
137,353
   
564,957
 
  Total
 
$
801,627
 
$
316,806
 
$
145,230
 
$
1,263,663
 


 
 
SECURITIES AND CORRESPONDING INTEREST AND DIVIDEND INCOME
 
The average balance of securities available for sale in 2004 was $970.0 million, a decrease of $14.6 million, or 1%, from $984.6 million in 2003. The yield on average securities available for sale was 4.60% for 2004 compared to 4.70% in 2003. The slight decrease in yield on securities available for sale resulted from continued efforts to shorten the duration and weighted average life of the securities available for sale portfolio in 2004. At December 31, 2004, approximately 67% of securities available for sale were comprised of fifteen/ten year mortgage-backed securities and collateralized mortgage obligations and 9% were comprised of thirty/twenty year mortgaged-backed securities. At December 31, 2003, the mix was 63% fifteen/ten year mortgage-backed securities and 10% thirty/twenty year mortgaged-backed securities. Furthermore, the Company shortened the estimated weighted average life of the total securities portfolio from 5.0 years at December 31, 2003 to 4.6 years at December 31, 2004. In the event of a rising rate environment, the Company should be positioned to reinvest cash flows at a faster rate from shortening the expected life of the portfolio.
 
The average balance of securities held to maturity decreased from $90.6 million in 2003 to $85.8 million in 2004. At December 31, 2004, securities held to maturity were comprised primarily of tax-exempt municipal securities. The yield on securities held to maturity decreased slightly from 5.14% in 2003 to 5.11% in 2004. Investments in FRB and Federal Home Loan Bank (FHLB) stock increased to $34.8 million in 2004 from $28.1 million in 2003. This increase was driven primarily by an increase in the investment in FHLB resulting from an increase in the Company’s borrowing capacity at FHLB. The yield from investments in FRB and FHLB Banks declined from 3.04% in 2003 to 2.45% in 2004. In 2003, the FHLB disclosed it had capital concerns and credit issues in their investment security portfolio. As a result of these issues, the FHLB suspended a quarterly dividend payment in 2003 and reduced their dividend rate in 2004.
 
The Company classifies its securities at date of purchase as either available for sale, held to maturity or trading. Held to maturity debt securities are those that the Company has the ability and intent to hold until maturity. Available for sale securities are recorded at fair value. Unrealized holding gains and losses, net of the related tax effect, on available for sale securities are excluded from earnings and are reported in stockholders’ equity as a component of accumulated other comprehensive income or loss. Held to maturity securities are recorded at amortized cost. Trading securities are recorded at fair value, with net unrealized gains and losses recognized currently in income. Transfers of securities between categories are recorded at fair value at the date of transfer. A decline in the fair value of any available for sale or held to maturity security below cost that is deemed other-than-temporary is charged to earnings resulting in the establishment of a new cost basis for the security. Securities with an other-than- temporary impairment are generally placed on non-accrual status.
 
Non-marketable equity securities are carried at cost, with the exception of small business investment company (SBIC) investments, which are carried at fair value in accordance with SBIC rules.
 
Premiums and discounts are amortized or accreted over the life of the related security as an adjustment to yield using the interest method. Dividend and interest income are recognized when earned. Realized gains and losses on securities sold are derived using the specific identification method for determining the cost of securities sold.
 

Table 5. Securities Portfolio
 
   
As of December 31,
 
     
2004
   
2003
   
2002
 
Amortized
         
Fair
   
Amortized
   
Fair
   
Amortized
   
Fair
 
(In thousands)
   
Cost
   
Value
   
Cost
   
Value
   
Cost
   
Value
 
Securities available for sale
                                     
U.S. Treasury
 
$
10,037
 
$
9,977
 
$
58
 
$
59
 
$
502
 
$
514
 
Federal Agency and mortgage-backed
   
694,928
   
696,835
   
843,777
   
849,686
   
810,784
   
833,940
 
State & Municipal, collateralized mortgage
                                     
obligations and other securities
   
238,770
   
245,730
   
123,570
   
131,216
   
168,803
   
173,129
 
  Total securities available for sale
 
$
943,735
 
$
952,542
 
$
967,405
 
$
980,961
 
$
980,089
 
$
1,007,583
 
                                       
                                       
Securities held to maturity
                                     
Federal Agency and mortgage-backed
 
$
6,412
 
$
6,706
 
$
11,363
 
$
11,867
 
$
24,613
 
$
25,720
 
State & Municipal
   
75,128
   
75,764
   
85,437
   
86,305
   
56,021
   
56,917
 
Other securities
   
242
   
242
   
404
   
404
   
1,880
   
1,880
 
  Total securities held to maturity
 
$
81,782
 
$
82,712
 
$
97,204
 
$
98,576
 
$
82,514
 
$
84,517
 



 
FUNDING SOURCES AND CORRESPONDING INTEREST EXPENSE
 
The Company utilizes traditional deposit products such as time, savings, NOW, money market, and demand deposits as its primary source for funding. Other sources, such as short-term FHLB advances, federal funds purchased, securities sold under agreements to repurchase, brokered time deposits, and long-term FHLB borrowings are utilized as necessary to support the Company’s growth in assets and to achieve interest rate sensitivity objectives. The average balance of interest-bearing liabilities increased $223.4 million, totaling $3.3 billion in 2004 from $3.0 billion in 2003. The rate paid on interest-bearing liabilities decreased from 2.07% in 2003 to 1.83% in 2004. The decrease in the rate paid on interest bearing liabilities caused a decrease in interest expense of $3.2 million, or 5%, from $62.9 million in 2003 to $59.7 million in 2004.
 
 
DEPOSITS
 
Average interest bearing deposits increased $72.4 million during 2004 compared to 2003. The increase resulted primarily from increases in average NOW, Money Market Deposit Accounts (“MMDA”), and savings. The average balance of these core deposit types increased collectively $181.2 million or 14% during 2004 when compared to 2003. The increase in core deposits resulted primarily from increases in average collected balances, continued market expansion and the migration of funds from time deposits. Average time deposits decreased $108.8 million or 9% during 2004 when compared to 2003. The decrease in average time deposits resulted primarily from the Company’s decision to not aggressively price time deposits during a period where the rate environment remained low throughout 2004. This contributed to the increase in core deposits as well as lead to an increase in short-term borrowings. The average balance of demand deposits increased $35.5 million, or 8%, from $457.2 million in 2003 to $492.7 million in 2004. The ratio of average demand deposits to total average deposits increased from 15.6% in 2003 to 16.2% in 2004.
 
 
The improvement in the Company’s deposit mix noted above, combined with the low interest rate environment prevalent in 2004, resulted in a decrease in the rate paid on interest bearing deposits of 29 bp, from 1.85% in 2003 to 1.56% in 2004. The rate paid on average time deposits decreased 29 bp, from 2.92% in 2003 to 2.63% in 2004. The decrease in the rate paid on average time deposits, combined with the decline in the average balance of time deposits, resulted in a $6.4 million decrease in interest expense paid on time deposits, from $34.7 million in 2003 to $28.4 million in 2004.
 
The following table presents the maturity distribution of time deposits of $100,000 or more at December 31, 2004:


Table 6. Maturity Distribution of Time Deposits of  $100, 000 or More
     
(In thousands)
   
December 31, 2004
 
Within three months
 
$
147,487
 
After three but within twelve months
   
144,420
 
After one but within three years
   
175,453
 
Over three years
   
10,430
 
Total
 
$
477,790
 


 
BORROWINGS
 
Average short-term borrowings increased $111.9 million to $302.3 million in 2004. The average rate paid on short-term borrowings increased from 1.14% in 2003 to 1.35% in 2004, as the Federal Reserve Bank increased the discount rate (which directly impacts short-term borrowing rates) 125 bp in 2004. The increases in the average balance and the average rate paid caused interest expense on short-term borrowings to increase $1.9 million from $2.2 million in 2003 to $4.1 million in 2004. Average long-term debt increased $20.8 million, from $360.9 million in 2003 to $381.8 million in 2004. The increases in long-term debt and short-term borrowings resulted primarily from loan growth exceeding deposit growth in 2004.
 
As a result of the adoption of a new accounting pronouncement in 2004 (see footnote 1 “Summary of Significant Accounting Policies” under Item 8 “Notes to Consolidated Financial Statements” for more information about this pronouncement), the Company’s junior subordinated debentures are classified as a component of interest-bearing liabilities and the associated interest expense paid to the trust preferred debenture holder is classified as a component of interest expense in 2004. The rate paid on these debentures for 2004 was 4.50%, as the debentures are tied to 3-month LIBOR plus 275 basis points (see footnote 12 “CNBF Capital Trust I” under Item 8 “Notes to Consolidated Financial Statements” for more information about these debentures). In 2003, the junior subordinated debentures were classified as guaranteed preferred beneficial interest in Company’s junior subordinated debentures as a mezzanine item between total liabilities and stockholders’ equity in the Consolidated Balance Sheet and the associated interest expense paid on these debentures was classified a capital securities expense as a component of noninterest expense in the Consolidated Statements of Income.
 

Short-term borrowings consist of Federal funds purchased and securities sold under repurchase agreements, which generally represent overnight borrowing transactions, and other short-term borrowings, primarily FHLB advances, with original maturities of one year or less. The Company has unused lines of credit and access to brokered deposits available for short-term financing of approximately $545 million and $544 million at December 31, 2004 and 2003, respectively. Securities collateralizing repurchase agreements are held in safekeeping by non-affiliated financial institutions and are under the Company’s control. Long-term debt, which is comprised primarily of FHLB advances, are collateralized by the FHLB stock owned by the Company, certain of its mortgage-backed securities and a blanket lien on its residential real estate mortgage loans.
 
 
RISK MANAGEMENT-CREDIT RISK
 
Credit risk is managed through a network of loan officers, credit committees, loan policies, and oversight from the senior credit officers and Board of Directors. Management follows a policy of continually identifying, analyzing, and grading credit risk inherent in each loan portfolio. An ongoing independent review, subsequent to management’s review, of individual credits in the commercial loan portfolio is performed by the independent loan review function. These components of the Company’s underwriting and monitoring functions are critical to the timely identification, classification, and resolution of problem credits.
 
 
NONPERFORMING ASSETS
 

Table 7. Nonperforming Assets
 
   
As of December 31,
 
(Dollars in thousands)
   
2004
   
2003
   
2002
   
2001
   
2000
 
Nonaccrual loans
                               
Commercial and agricultural loans and real estate
 
$
10,550
 
$
8,693
 
$
16,980
 
$
31,372
 
$
14,054
 
Real estate mortgages
   
2,553
   
2,483
   
5,522
   
5,119
   
647
 
Consumer
   
1,888
   
2,685
   
1,507
   
3,719
   
2,402
 
Total nonaccrual loans
   
14,991
   
13,861
   
24,009
   
40,210
   
17,103
 
Loans 90 days or more past due and still accruing
                               
Commercial and agricultural loans and real estate
   
-
   
242
   
237
   
198
   
4,523
 
Real estate mortgages
   
737
   
244
   
1,325
   
1,844
   
3,042
 
Consumer
   
449
   
482
   
414
   
933
   
865
 
Total loans 90 days or more past due and still accruing
   
1,186
   
968
   
1,976
   
2,975
   
8,430
 
Restructured loans
   
-
   
-
   
409
   
603
   
656
 
Total nonperforming loans
   
16,177
   
14,829
   
26,394
   
43,788
   
26,189
 
Other real estate owned
   
428
   
1,157
   
2,947
   
1,577
   
1,856
 
Total nonperforming loans and other real estate owned
   
16,605
   
15,986
   
29,341
   
45,365
   
28,045
 
Nonperforming securities
   
-
   
395
   
1,122
   
4,500
   
1,354
 
Total nonperforming loans, securities, and other real estate owned
 
$
16,605
 
$
16,381
 
$
30,463
 
$
49,865
 
$
29,399
 
Total nonperforming loans to loans and leases
   
0.56
%
 
0.56
%
 
1.12
%
 
1.87
%
 
1.17
%
Total nonperforming loans and other real estate owned to total assets
   
0.39
%
 
0.40
%
 
0.79
%
 
1.25
%
 
0.78
%
Total nonperforming loans, securities, and other real estate owned to total assets
   
0.39
%
 
0.40
%
 
0.82
%
 
1.37
%
 
0.82
%
Total allowance for loan and lease losses to nonperforming loans
   
277.75
%
 
287.62
%
 
152.18
%
 
102.19
%
 
124.07
%

 
The allowance for loan and lease losses is maintained at a level estimated by management to provide adequately for risk of probable losses inherent in the current loan and lease portfolio. The adequacy of the allowance for loan and lease losses is continuously monitored. It is assessed for adequacy using a methodology designed to ensure the level of the allowance reasonably reflects the loan and lease portfolio’s risk profile. It is evaluated to ensure that it is sufficient to absorb all reasonably estimable credit losses inherent in the current loan and lease portfolio.
 
Management considers the accounting policy relating to the allowance for loan and lease losses to be a critical accounting policy given the inherent uncertainty in evaluating the levels of the allowance required to cover credit losses in the portfolio and the material effect that such judgements can have on the consolidated results of operations.
 
For purposes of evaluating the adequacy of the allowance, the Company considers a number of significant factors that affect the collectibility of the portfolio. For individually analyzed loans, these include estimates of loss exposure, which reflect the facts and circumstances that affect the likelihood of repayment of such loans as of the evaluation date. For homogeneous pools of loans and leases, estimates of the Company’s exposure to credit loss reflect a current assessment of a number of factors, which could affect collectibility. These factors include: past loss experience; size, trend, composition, and nature; changes in lending policies and procedures, including underwriting standards and collection, charge-offs and recoveries; trends experienced in nonperforming and delinquent loans; current economic conditions in the Company’s market; portfolio concentrations that may affect loss experienced across one or more components of the portfolio; the effect of external factors such as competition, legal and regulatory requirements; and the experience, ability, and depth of lending management and staff. In addition, various regulatory agencies as an integral component of their examination process, periodically review the Company’s allowance for loan and lease losses. Such agencies may require the Company to recognize additions to the allowance based on their examination.
 
After a thorough consideration of the factors discussed above, any required additions to the allowance for loan and lease losses are made periodically by charges to the provision for loan and lease losses. These charges are necessary to maintain the allowance at a level which management believes is reasonably reflective of overall inherent risk of probable loss in the portfolio. While management uses available information to recognize losses on loans and leases, additions to the allowance may fluctuate from one reporting period to another. These fluctuations are reflective of changes in risk associated with portfolio content and/or changes in management’s assessment of any or all of the determining factors discussed above. Total nonperforming assets were $16.6 million at December 31, 2004, compared to $16.4 million at December 31, 2003. Credit quality remained stable in 2004, as nonperforming loans totaled $16.2 million at December 31, 2004, up slightly from the $14.8 million outstanding at December 31, 2003. Nonperforming loans as a percentage of total loans and leases remained unchanged at 0.56% for December 31, 2004 and 2003. The total allowance for loan and lease losses is 277.75% of non-performing loans at December 31, 2004 as compared to 287.62% at December 31, 2003.
 
Impaired loans, which primarily consist of nonaccruing commercial type loans increased slightly, totaling $10.5 million at December 31, 2004 as compared to $8.7 million at December 31, 2003. The related allowance for these impaired loans is $0.2 million or 1.4% of the impaired loans at December 31, 2004 as compared to $0.2 million and 2.3%, respectively, at December 31, 2003. At December 31, 2004 and 2003 there were $10.0 million and $7.5 million, respectively, of impaired loans which did not have an allowance for loan losses due to the adequacy of their collateral or previous charge offs.
 
Total net charge-offs for 2004 totaled $7.3 million as compared to $6.6 million for 2003. The ratio of net charge-offs to average loans and leases was 0.27% for 2004 and 2003. Gross charge-offs decreased slightly totaling $11.6 million for 2004 compared to $11.8 million for 2003. Recoveries decreased $0.9 million from $5.2 million in 2003 to $4.3 million in 2004, due to a decrease in commercial and agricultural recoveries in 2004 (due in part to several large commercial loan workouts in 2003). The provision for loan and lease losses increased to $9.6 million in 2004 from $9.1 million in 2003. The allowance for loan and lease losses as a percentage of total loans and leases was 1.57% at December 31, 2004 compared to 1.62% at December 31, 2003. The slight increase in the provision for loan and lease losses in 2004 compared to 2003 resulted mainly from strong loan growth, a slight increase in net charge-offs; and stable credit quality as the Company’s credit quality measures remained relatively unchanged in 2004 compared to 2003.
 

Table 8. Allowance for Loan and Lease Losses
(Dollars in thousands)
   
2004
   
2003
   
2002
   
2001
   
2000
 
Balance at January 1
 
$
42,651
 
$
40,167
 
$
44,746
 
$
32,494
 
$
28,240
 
Loans and leases charged-off
                               
Commercial and agricultural
   
4,595
   
5,619
   
9,970
   
17,097
   
3,949
 
Real estate mortgages
   
772
   
362
   
2,547
   
783
   
1,007
 
Consumer*
   
6,239
   
5,862
   
5,805
   
4,491
   
2,841
 
  Total loans and leases charged-off
   
11,606
   
11,843
   
18,322
   
22,371
   
7,797
 
Recoveries
                               
Commercial and agricultural
   
2,547
   
3,185
   
3,394
   
1,063
   
503
 
Real estate mortgages
   
215
   
430
   
104
   
122
   
141
 
Consumer*
   
1,510
   
1,601
   
1,172
   
1,004
   
739
 
  Total recoveries
   
4,272
   
5,216
   
4,670
   
2,189
   
1,383
 
Net loans and leases charged-off
   
7,334
   
6,627
   
13,652
   
20,182
   
6,414
 
Allowance related to purchase acquisitions
   
-
   
-
   
-
   
505
   
525
 
Provision for loan and lease losses
   
9,615
   
9,111
   
9,073
   
31,929
   
10,143
 
Balance at December 31
 
$
44,932
 
$
42,651
 
$
40,167
 
$
44,746
 
$
32,494
 
Allowance for loan and lease losses to loans and leases outstanding at end of year
   
1.57
%
 
1.62
%
 
1.70
%
 
1.91
%
 
1.45
%
Net charge-offs to average loans and leases outstanding
   
0.27
%
 
0.27
%
 
0.58
%
 
0.87
%
 
0.31
%
* Consumer charge-off and recoveries include consumer, home equity, and lease financing.
                               
 
Total nonperforming assets were $16.4 million at December 31, 2003, compared to $30.5 million at December 31, 2002. Nonperforming loans totaled $14.8 million at December 31, 2003, down significantly from the $26.4 million outstanding at December 31, 2002. The decrease in nonperforming loans in 2003 resulted primarily from the Company’s successful efforts in selling certain large problematic commercial loans and a group of nonperforming real estate mortgages at approximately their book value during the quarter ended March 31, 2003. Additionally, the Company continued to workout or charge-off additional nonperforming loans for the remainder of 2003 without experiencing any significant migration of new nonperforming loans during the year. As a result of the reduction in nonperforming loans during 2003, the total allowance for loan and lease losses is 287.62% of non-performing loans at December 31, 2003 as compared to 152.18% at December 31, 2002.

Impaired loans, which primarily consist of nonaccruing commercial type loans also decreased significantly, totaling $8.7 million at December 31, 2003 as compared to $17.4 million at December 31, 2002. The related allowance for these impaired loans is $0.2 million or 2.3% of the impaired loans at December 31, 2003 as compared to $0.5 million and 3.1%, respectively, at December 31, 2002. At December 31, 2003 and 2002 there were $7.5 million and $15.5 million, respectively, of impaired loans which did not have an allowance for loan losses due to the adequacy of their collateral or previous charge offs.

Total net charge-offs for 2003 totaled $6.6 million as compared to $13.7 million for 2002. The ratio of net charge-offs to average loans and leases was 0.27% for 2003 and 0.58% for 2002. The decrease in net charge-offs in 2003 resulted from the reduction in nonperforming loans and an improvement in loan quality. However, the amount provided for loan and lease losses for 2003 remained relatively unchanged from 2002, as improvements in loan quality were offset by strong loan growth. The provision for loan and lease losses exceeded net charge-offs by $2.5 million in 2003 while the ratio of the allowance for loan and lease losses to total loans and leases decreased to 1.62% at December 31, 2003 from 1.70% at December 31, 2002.
 
In addition to the nonperforming loans discussed above, the Company has also identified approximately $48.0 million in potential problem loans at December 31, 2004 as compared to $54.3 million at December 31, 2003. Potential problem loans are loans that are currently performing, but where known information about possible credit problems of the related borrowers causes management to have doubts as to the ability of such borrowers to comply with the present loan repayment terms and which may result in disclosure of such loans as non-performing at some time in the future. At the Company, potential problem loans are typically loans that are performing but are classified by the Company’s loan rating system as “substandard.” At December 31, 2004, potential problem loans primarily consisted of commercial and agricultural real estate and commercial and agricultural loans. At December 31, 2004, there were six potential problem loans that exceeded $1.0 million, totaling $15.2 million in aggregate. Management cannot predict the extent to which economic conditions may worsen or other factors which may impact borrowers and the potential problem loans. Accordingly, there can be no assurance that other loans will not become 90 days or more past due, be placed on nonaccrual, become restructured, or require increased allowance coverage and provision for loan losses.
 
The following table sets forth the allocation of the allowance for loan losses by category, as well as the percentage of loans and leases in each category to total loans and leases, as prepared by the Company. This allocation is based on management’s assessment of the risk characteristics of each of the component parts of the total loan portfolio as of a given point in time and is subject to changes as and when the risk factors of each such component part change. The allocation is not indicative of either the specific amounts of the loan categories in which future charge-offs may be taken, nor should it be taken as 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. The following table sets forth the allocation of the allowance for loan losses by loan category:
 

Table 9. Allocation of the Allowance for Loan and Lease Losses
 
 
   
December 31,
 
     
2004
         
2003
         
2002
         
2001
         
2000
       
 
          Category           
Category
         
Category
         
Category
         
Category
 
 
          Percent of           
Percent of
         
Percent of
         
Percent of
         
Percent of
 
(Dollars in thousands)
   
Allowance
   
Loans
   
Allowance
   
Loans
   
Allowance
   
Loans
   
Allowance
   
Loans
   
Allowance
   
Loans
 
Commercial and agricultural
 
$
28,158
   
67
%
$
25,502
   
67
%
$
25,589
   
71
%
$
34,682
   
85
%
$
20,510
   
72
%
Real estate mortgages
   
4,029
   
9
%
 
4,699
   
11
%
 
3,884
   
10
%
 
1,611
   
4
%
 
1,669
   
6
%
Consumer
   
10,887
   
24
%
 
9,357
   
22
%
 
7,654
   
19
%
 
4,626
   
11
%
 
6,379
   
22
%
Unallocated
   
1,858
   
0
%
 
3,093
   
0
%
 
3,040
   
0
%
 
3,827
   
0
%
 
3,936
   
0
%
Total
 
$
44,932
   
100
%
$
42,651
   
100
%
$
40,167
   
100
%
$
44,746
   
100
%
$
32,494
   
100
%
 
 
The unallocated reserve decreased from $3.1 million in 2003 to $1.9 million in 2004. The unallocated reserved ranged from $3.9 million to $3.1 million for the periods 2000 through 2003. This level of unallocated reserve for this period was primarily in response to the integration of three acquired banks during 2000 and 2001. These acquired banks appeared to have used generally less conservative underwriting and monitoring standards for their commercial related loans, which increased the inherent risk of loss in the loan and lease portfolio. This situation was exacerbated by the economic downturn in 2001 (recession and the terrorist attacks of September 11, 2001), which helped create a higher risk environment for the loan and lease portfolio. The Company responded to this higher risk environment by increasing unallocated reserves based on risk factors thought to increase with the slowing economy and inherent risk of recently acquired loans underwritten with less conservative underwriting standards. During 2002 and 2003, the Company successfully integrated the credit functions of the acquired banks noted above and for the period of 2002 through 2004, worked out a majority of the nonaccrual loans and potential problem loans associated with these acquired banks. During 2004, economic conditions continued to improve and the Company continued to experience positive trends in several credit quality measures. As a result of improved economic conditions and the reduction of risk from loans from acquired banks noted above, the level of unallocated reserve was decreased in 2004.

Offsetting the decrease in unallocated reserve was an increase in reserve for commercial and agricultural loans as well as consumer loans. The increase in reserve allocations for these segments of the loan and lease portfolio was the result of portfolio growth and increases in historical loan loss experience for similar loans with similar characteristics and trends.

At December 31, 2004, approximately 64.3% of the Company’s loans are secured by real estate located in central and northern New York and northeastern Pennsylvania. Accordingly, the ultimate collectibility of a substantial portion of the Company’s portfolio is susceptible to changes in market conditions of those areas.
 
 
LIQUIDITY RISK
 
Liquidity involves the ability to meet the cash flow requirements of customers who may be depositors wanting to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. The Asset Liability Committee (ALCO) is responsible for liquidity management and has developed guidelines which cover all assets and liabilities, as well as off balance sheet items that are potential sources or uses of liquidity. Liquidity policies must also provide the flexibility to implement appropriate strategies and tactical actions. Requirements change as loans and leases grow, deposits and securities mature, and payments on borrowings are made. Liquidity management includes a focus on interest rate sensitivity management with a goal of avoiding widely fluctuating net interest margins through periods of changing economic conditions.
 
The primary liquidity measurement the Company utilizes is called Basic Surplus which captures the adequacy of its access to reliable sources of cash relative to the stability of its funding mix of average liabilities. This approach recognizes the importance of balancing levels of cash flow liquidity from short- and long-term securities with the availability of dependable borrowing sources which can be accessed when necessary. At December 31, 2004, the Company’s Basic Surplus measurement was 6.6% of total assets or $274 million, which was above the Company’s minimum of 5% (calculated at $211 million of period end total assets at December 31, 2004) set forth in its liquidity policies.
 
This Basic Surplus approach enables the Company to adequately manage liquidity from both operational and contingency perspectives. By tempering the need for cash flow liquidity with reliable borrowing facilities, the Company is able to operate with a more fully invested and, therefore, higher interest income generating, securities portfolio. The makeup and term structure of the securities portfolio is, in part, impacted by the overall interest rate sensitivity of the balance sheet. Investment decisions and deposit pricing strategies are impacted by the liquidity position. At December 31, 2004, the Company considered its Basic Surplus position as tightening, and certain events may adversely impact the Company’s liquidity position in 2005. Continued improvement in the economy may increase demand for equity related products or increase competitive pressure on deposit pricing, which in turn, could result in a decrease in the Company’s deposit base or increase funding costs. Additionally, liquidity will come under additional pressure if loan growth continues to exceed deposit growth in 2005. These scenarios could lead to a decrease in its basic surplus measure below the minimum policy level of 5%. To manage this risk, the Company has the ability to purchase brokered time deposits, established borrowing facilities with other banks (Federal funds), and has the ability to enter into repurchase agreements with investment companies. The additional liquidity that could be provided by these measures amounted to $503 million at December 31, 2004.

At December 31, 2004, a portion of the Company’s loans and securities were pledged as collateral on borrowings. Therefore, future growth of earning assets will depend upon the Company’s ability to obtain additional funding, through growth of core deposits and collateral management, and may require further use of brokered time deposits, or other higher cost borrowing arrangements.
 
Net cash flows provided by operating activities totaled $96.6 million in 2004 and $45.7 million in 2003. The critical elements of net operating cash flows include net income, provision for loan and lease losses, and depreciation and amortization. The increase in cash provided by operating activities in 2004 compared to 2003 resulted primarily from the purchase of $30.0 million in Bank Owned Life Insurance (“BOLI”) in 2003 compared to no such purchases in 2004 and an increase in proceeds from the sale of loans of $10.6 million in 2004.
 
Net cash used in investing activities totaled $224.7 million in 2004 and $307.8 million in 2003. Critical elements of investing activities are loan and investment securities transactions. The decrease in investing activities in 2004 was due primarily to the net increase in loans which totaled $297.0 million in 2003 compared to $255.0 million in 2004.
 
Net cash flows provided by financing activities totaled $106.8 million in 2004 and $265.3 million in 2003. The critical elements of financing activities are proceeds from deposits, long-term debt, short-term borrowings, and stock issuances. In addition, financing activities are impacted by dividends and treasury stock transactions. The decrease in financing activities when compared to 2003 resulted from the increase in cash provided by operating activities and the decrease in net cash used in investing activities noted above.
 
In connection with its financing and operating activities, the Company has entered into certain contractual obligations. The Company’s future minimum cash payments, excluding interest, associated with its contractual obligations pursuant to its borrowing agreements and operating leases at December 31, 2004 are as follows:
 

Contractual Obligations
                             
(In thousands)
                                           
Payments Due by Period
                                           
     
2005
   
2006
   
2007
   
2008
   
2009
   
Thereafter
   
Total
 
Short-term debt obligations
 
$
338,823
 
$
-
 
$
-
 
$
-
 
$
-
 
$
-
 
$
338,823
 
Long-term debt obligations
   
65,000
   
25,000
   
65,000
   
90,354
   
75,000
   
74,169
   
394,523
 
Trust preferred debentures
   
-
   
-
   
-
   
-
   
-
   
18,720
   
18,720
 
Operating lease obligations
   
2,573
   
2,357
   
2,089
   
1,614
   
1,233
   
6,320
   
16,186
 
Total contractual obligations
 
$
406,396
 
$
27,357
 
$
67,089
 
$
91,968
 
$
76,233
 
$
99,209
 
$
768,252
 
 
OFF-BALANCE SHEET RISK COMMITMENTS TO EXTEND CREDIT
 
The Company makes contractual commitments to extend credit, which include unused lines of credit, which are subject to the Company’s credit approval and monitoring procedures. At December 31, 2004 and 2003, commitments to extend credit in the form of loans, including unused lines of credit, amounted to $507.4 million and $473.0 million, respectively. In the opinion of management, there are no material commitments to extend credit, including unused lines of credit, that represent unusual risks. Generally, commitments to extend credit in the form of loans, including unused lines of credit, expire within one year.
 
STAND-BY LETTERS OF CREDIT

In November 2002, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 45 (FIN No. 45), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others; an Interpretation of FASB Statements Nos. 5, 57, and 107 and rescission of FASB Interpretation No. 34.” FIN No. 45 requires certain new disclosures and potential liability-recognition for the fair value at issuance of guarantees that fall within its scope. Under FIN No. 45, the Company does not issue any guarantees that would require liability-recognition or disclosure, other than its stand-by letters of credit.
 
The Company guarantees the obligations or performance of customers by issuing stand-by letters of credit to third parties. These stand-by letters of credit are frequently issued in support of third party debt, such as corporate debt issuances, industrial revenue bonds, and municipal securities. The risk involved in issuing stand-by letters of credit is essentially the same as the credit risk involved in extending loan facilities to customers, and they are subject to the same credit origination, portfolio maintenance and management procedures in effect to monitor other credit and off-balance sheet products. Typically, these instruments have terms of five years or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements. At December 31, 2004 and 2003, outstanding stand-by letters of credit were approximately $31.6 million and $17.1 million, respectively. The fair value of the Company’s stand-by letters of credit at December 31, 2004 and 2003 was not significant. The following table sets forth the commitment expiration period for stand-by letters of credit at December 31, 2004:
 

Commitment Expiration of Stand-by Letters of Credit
     
Within one year
 
$
12,052
 
After one but within three years
   
18,166
 
After three but within five years
   
1,398
 
Total
 
$
31,616
 

 
LOANS SERVICED FOR OTHERS AND LOANS SOLD WITH RECOURSE
 
The total amount of loans serviced by the Company for unrelated third parties was approximately $70.8 million and $66.4 million at December 31, 2004 and 2003, respectively. At December 31, 2004 and 2003, the Company serviced $5.6 million and $10.8 million, respectively, of loans sold with recourse. Due to collateral on these loans, no reserve is considered necessary at December 31, 2004 and 2003.
 
 
RELATED PARTY TRANSACTIONS
 
In the ordinary course of business, the Company has made loans at prevailing rates and terms to directors, officers, and other related parties. Such loans, in management’s opinion, do not present more than the normal risk of collectibility or incorporate other unfavorable features. The aggregate amount of loans outstanding to qualifying related parties at December 31, 2004 and 2003 were $16.2 million and $16.1 million, respectively.
 
The law firm of Kowalczyk, Tolles, Deery and Johnston, of which Director Andrew S. Kowalczyk, Jr., is a partner, provided legal services in the amount of $161,737 to us and NBT Bank in 2004. The law firms of Harris Beach LLP, and Oliver, Price, & Rhodes, of which Directors William L. Owens and Paul D. Horger are partners, respectively, provide legal services to us from time to time. Payments for services provided by Directors Owens and Horger, did not exceed $60,000 during 2004. Services from these firms were provided in the ordinary course of business and at market terms.
 
 
CAPITAL RESOURCES
 
Consistent with its goal to operate a sound and profitable financial institution, the Company actively seeks to maintain a “well-capitalized” institution in accordance with regulatory standards. The principal source of capital to the Company is earnings retention. The Company’s capital measurements are in excess of both regulatory minimum guidelines and meet the requirements to be considered well capitalized.
 
The Company’s principal source of funds to pay interest on CNBF Capital Trust I’s capital securities and pay cash dividends to its shareholders is dividends from its subsidiaries. Various laws and regulations restrict the ability of banks to pay dividends to their shareholders. Generally, the payment of dividends by the Company in the future as well as the payment of interest on the capital securities will require the generation of sufficient future earnings by its subsidiaries.
 
The Bank also is subject to substantial regulatory restrictions on its ability to pay dividends to the Company. Under OCC regulations, the Bank may not pay a dividend, without prior OCC approval, if the total amount of all dividends declared during the calendar year, including the proposed dividend, exceed the sum of its retained net income to date during the calendar year and its retained net income over the preceding two years. At December 31, 2004, approximately $56.3 million of the total stockholders’ equity of the Bank was available for payment of dividends to the Company without approval by the OCC. The Bank’s ability to pay dividends also is subject to the Bank being in compliance with regulatory capital requirements. The Bank is currently in compliance with these requirements.
 
 
STOCK REPURCHASE PLAN
 
On April 28, 2003, the Company announced that it intended to repurchase up to an additional one million shares (approximately 3%) of its outstanding common stock from time to time in open market and privately negotiated transactions. At that time, there were 155,054 shares remaining under a previous authorization approved on July 22, 2002 that were to be repurchased before shares could be repurchased under the April 28, 2003 authorization. On January 26, 2004, the two above mentioned repurchase authorizations were combined into one repurchase plan. During 2004, the Company repurchased 423,989 shares of its own common stock for $9.1 million at an average price of $21.58 per share. At December 31, 2004, there were 731,065 shares available for repurchase under the January 26, 2004 authorization.
 
On January 24, 2005, the Company’s Board of Directors authorized a new repurchase program whereby the Company intends to repurchase up to 1,500,000 shares (approximately 5%) of its outstanding common stock. At that time, there were 719,800 shares remaining under the January 26, 2004 authorization that were superseded by the new repurchase program.
 
 
NONINTEREST INCOME
 
Noninterest income is a significant source of revenue for the Company and an important factor in the Company’s results of operations. The following table sets forth information by category of noninterest income for the years indicated:
 

   
Years ended December 31,
(In thousands)
   
2004
   
2003
   
2002
 
Service charges on deposit accounts
 
$
16,470
 
$
15,833
 
$
13,875
 
Broker/dealer and insurance revenue
   
6,782
   
6,869
   
5,780
 
Trust
   
4,605
   
4,041
   
3,226
 
Bank owned life insurance income
   
1,487
   
815
   
-
 
ATM fees
   
5,530
   
5,307
   
4,703
 
Other
   
5,799
   
4,738
   
4,350
 
Total before net securities gains (losses)
   
40,673
   
37,603
   
31,934
 
Net securities gains (losses)
   
216
   
175
   
(413
)
  Total
 
$
40,889
 
$
37,778
 
$
31,521
 
 
 
Noninterest income before securities losses increased $3.1 million or 8% to $40.7 million for 2004 from $37.6 million for 2003. Fees from service charges on deposit accounts increased $0.6 million or 4% for 2004 when compared to 2003, primarily from an increase in deposits pricing adjustments related to overdraft fees. Broker/dealer and insurance fees remained relatively unchanged as the Company’s insurance subsidiary CFS , which no longer provided insurance services in May 2003, had revenues of $0.4 million for 2003 compared to no revenue for 2004. Offsetting this decrease was a $0.3 million increase in revenue from the Company’s financial services division in 2004 from continued growth from this relatively new business initiative, which was launched in 2003. Trust revenue increased $0.6 million or 14% in 2004, primarily from growth in assets under management and increased trust accounts. Other income increased $1.1 million or 22%, in 2004, from growth in other consumer and commercial banking fee income. Bank owned life insurance (“BOLI”) income increased $0.7 million in 2004 compared to 2003 as the Company recognized a full year of BOLI income in 2004 compared to 6 months of BOLI income in 2003 due to the $30 million purchase of BOLI in June 2003.
 

NONINTEREST EXPENSE

Noninterest expenses are also an important factor in the Company’s results of operations. The following table sets forth the major components of noninterest expense for the years indicated:
 

   
Years ended December 31,
 
(In thousands)
   
2004
   
2003
   
2002
 
Salaries and employee benefits
 
$
54,063
 
$
49,560
 
$
48,212
 
Occupancy
   
9,905
   
9,328
   
8,333
 
Equipment
   
7,573
   
7,627
   
7,066
 
Data processing and communications
   
10,972
   
10,752
   
10,593
 
Professional fees and outside services
   
6,175
   
5,433
   
6,589
 
Office supplies and postage
   
4,459
   
4,216
   
4,446
 
Amortization of intangible assets
   
284
   
620
   
774
 
Capital securities
   
-
   
732
   
839
 
Loan collection and other real estate owned
   
1,241
   
1,840
   
2,846
 
Goodwill impairment
   
1,950
   
-
   
-
 
Other
   
13,155
   
14,409
   
12,757
 
Total noninterest expense
 
$
109,777
 
$
104,517
 
$
102,455
 
 
 
Total noninterest expense increased $5.3 million or 5% from $104.5 million in 2003 to $109.8 million in 2004. Salaries and benefits increased $4.5 million or 9% in 2004 from increases in salaries of $2.1 million, incentive compensation of $0.8 million, and medical insurance of $1.4 million. The increase in salaries was driven primarily by merit increases and an increase in full-time equivalent employees (from market expansion). Incentive compensation increased from increases in revenue generator incentive payments, financial services commissions and 401(K)/ESOP contributions as the Company’s focus has shifted to a variable compensation structure for sales-oriented employees. Rising health care costs drove the increase in medical insurance. Occupancy expense increased $0.6 million or 6% in 2004 from increases in depreciation, rent and property taxes from branch expansion in the Albany and Binghamton markets in 2004 and 2003. Professional fees and outside services increased $0.7 million or 14% in 2004 compared to 2003 from increases in audit costs related to Sarbanes-Oxley compliance and courier expense (market expansion and increased fuel costs). In the fourth quarter of 2004, the Company took a $2.0 million goodwill impairment charge related to its broker/dealer subsidiary MGI. The goodwill impairment charge stems from the purchase price agreed to in a definitive agreement signed in the fourth quarter 2004 for the sale of MGI, which is expected to close in the first quarter of 2005. The sale of MGI was due to the Company’s decision to change its strategy in delivering financial services directly through its Bank and Trust Department.
 
Offsetting these increases were decreases in 2004 in other operating expense of $1.3 million and $0.6 million in loan collection and OREO costs. The decrease in other operating expense resulted from a $1.4 million reversal of an accrued liability that was determined to no longer be required in the fourth quarter of 2004. The decrease in loan collection and OREO costs resulted from lower collection costs from a decrease in nonperforming loans.
 
 
INCOME TAXES
 
In 2004, income tax expense was $21.9 million, as compared to $21.5 million in 2003 and $21.8 million in 2002. The Company’s effective tax rate was 30.5%, 31.3%, and 32.6% in 2004, 2003, and 2002, respectively. The decrease in the effective rate for 2004 compared to 2003 resulted primarily from the reversal of an $0.8 million accrued liability that was determined to no longer be required in the fourth quarter of 2004. The decrease in the effective rate in 2003 from 2002 resulted from an increase in tax exempt income in 2003.

The Company has two Real Estate Investment Trusts (REIT), Pennstar Realty Trust and CNB Realty Trust. Currently, the Company derives a New York State tax benefit, as a portion of the dividends received from these REITs are exempt from income tax expense. There is proposed legislation for the 2005 New York State Budget no longer allowing the exclusion of REIT dividend income effective for tax years beginning on January 1, 2005. If the legislation noted above is approved, the Company expects that impact on diluted earnings per share will be approximately $0.03 for 2005.
 
We calculate our current and deferred tax provision based on estimates and assumptions that could differ from the actual results reflected in income tax returns filed during the subsequent year. Adjustments based on filed returns are recorded when identified, which is generally in the third quarter of the subsequent year for U.S. federal and state provisions.

The amount of income taxes we pay is subject at times to ongoing audits by federal and state tax authorities, which often result in proposed assessments. Our estimate for the potential outcome for any uncertain tax issue is highly judgmental. We believe we have adequately provided for any reasonably foreseeable outcome related to these matters. However, our future results may include favorable or unfavorable adjustments to our estimated tax liabilities in the period the assessments are proposed or resolved or when statutes of limitation on potential assessments expire. As a result, our effective tax rate may fluctuate significantly on a quarterly or annual basis.
 
2003  
OPERATING RESULTS AS COMPARED TO 2002 OPERATING RESULTS
 
 
NET INTEREST INCOME
 
On a tax equivalent basis, the Company’s net interest income for 2003 was $148.9 million, down from $151.1 million for 2002. The Company’s net interest margin declined to 4.16% for 2003 from 4.43% for 2002. The decline in the net interest margin resulted primarily from earning assets repricing downward faster than interest bearing liabilities. The yield on earning assets decreased 87 basis points (bp), from 6.78% for 2002 to 5.91% for 2003. Meanwhile, the rate paid on interest bearing liabilities decreased 71 (bp), from 2.78% for 2002 to 2.07% for 2003. Additionally, historically low interest rates for residential real estate increased prepayments and refinancing activity during 2003, which in turn increased amortization expense of investment security premiums related to mortgage-backed securities. Offsetting the decline in net interest margin was an increase in average earning assets of $169.4 million or 5%, driven primarily by a $137.1 million increase in average loans.
 
 
LOANS AND LEASES AND CORRESPONDING INTEREST AND FEES ON LOANS
 
The average balance of loans and leases increased 6%, totaling $2.5 billion in 2003 compared to $2.4 billion in 2002. The yield on average loans and leases decreased from 7.18% in 2002 to 6.46% in 2003, as a declining interest rate environment prevailed for much of 2003. Interest income from loans and leases on a FTE basis decreased 5%, from $167.9 million in 2002 to $159.8 million in 2003. The decrease in interest income from loans and leases was due primarily to the decrease in yield on loans and leases in 2003 of 72 (bp) when compared to 2002.
 
Total loans and leases increased 12% at December 31, 2003, totaling $2.6 billion from $2.4 billion at December 31, 2002. The increase in loans and leases was driven by strong growth in residential real estate mortgages and home equity loans. Residential real estate mortgages increased $124.3 million or 21% from $579.6 million at December 31, 2002 to $703.9 million at December 31, 2003. The increase in residential real estate mortgages was driven by a combination of historically low interest rates increasing the demand for the product and the integration and centralization of the mortgage origination function for the Company’s three divisional banks at the end of 2002. Centralizing the mortgage origination function enabled the Company to provide customers with efficient service and competitive products while strengthening the Company’s market presence. Home equity loans increased $67.0 million or 25% from $269.6 million at December 31, 2002 to $336.5 million at December 31, 2003. The increase in home equity loans was due again to the previously mentioned increased demand from the historically low interest rate environment combined with a strong product that has sold well historically in the NBT bank division. The Company expanded its training programs for the sales staff of its Pennstar and new regions within the NBT bank division and experienced strong sales of its home equity products in these newer markets and maintained strong growth within its NBT bank division during 2003. All other loan categories experienced modest increases during 2003.
 
SECURITIES AND CORRESPONDING INTEREST AND DIVIDEND INCOME
 
The average balance of securities available for sale in 2003 was $984.6 million, an increase of $37.6 million, or 4%, from $947.0 million in 2002. The increase resulted primarily from modest leverage during 2003. The yield on average securities available for sale was 4.70% for 2003 compared to 5.98% in 2002. The decrease in yield for 2003 was due to several factors. The low interest rate environment prevalent throughout 2003 resulted in lower yields as reinvestment of funds from maturities, sales and paydowns led to the purchase of lower yielding securities. Additionally, the low rate environment fostered an increase in the refinancing of residential real estate mortgages, which increased the prepayment speeds of mortgage-backed security investments resulting in an increase in bond premium amortization in 2003. Lastly, to manage its risk to rising interest rates, the Company shortened the average life of securities available for sale by increasing its investment in fifteen and ten year mortgage-backed securities and lowering its exposure to thirty-year mortgage-backed securities. At December 31, 2003, approximately 63% of securities available for sale were comprised of fifteen/ten year mortgage-backed securities and 10% were comprised of thirty/twenty year mortgaged-backed securities. At December 31, 2002, the mix was 50% fifteen/ten year mortgage-backed securities and 18% thirty/twenty year mortgaged-backed securities.

The average balance of securities held to maturity decreased slightly from $93.0 million in 2002 to $90.6 million in 2003. At December 31, 2003, securities held to maturity were comprised primarily of tax-exempt municipal securities. The yield on securities held to maturity declined from 6.04% in 2002 to 5.14% in 2003. The decline in yield was due mainly to the previously mentioned low rate environment prevalent throughout 2003. Investments in FRB and FHLB Banks increased to $28.1 million in 2003 from $21.8 million in 2002. This increase was driven primarily by an increase in the investment in FHLB resulting from an increase in the Company’s borrowing capacity at FHLB. The yield from investments in FRB and FHLB Banks declined from 4.42% in 2002 to 3.04% in 2003. The decrease in yield resulted primarily from the suspension of the October 2003 dividend by the FHLB as a result of capital concerns and credit issues in the FHLB investment security portfolio.

 
BORROWINGS
 
Average short-term borrowings increased from $87.0 million in 2002 to $190.3 million in 2003. Consistent with the low interest rate environment during 2003, the average rate paid also decreased from 1.53% in 2002 to 1.14% in 2003. The increase in the average balance offset by the decrease in the average rate paid caused interest expense on short-term borrowings to increase $0.8 million from $1.3 million in 2002 to $2.2 million in 2003. Average long-term debt increased $26.4 million, from $334.5 million in 2002 to $360.9 million in 2003. The increases in long-term debt and short-term borrowings resulted primarily from loan growth exceeding deposit growth in 2003.
 
NONINTEREST INCOME
 
Noninterest income before securities losses increased $5.7 million or 18% to $37.6 million for 2003 from $31.9 million for 2002. Fees from service charges on deposit accounts increased $2.0 million or 14% for 2003 when compared to 2002, primarily from an increase in core deposits and pricing adjustments. Broker/dealer and insurance fees increased $1.1 million, primarily driven by the initiative implemented at the end of 2002 to offer financial service products throughout the Company’s 111 branch network. Trust revenue increased $0.8 million or 25% in 2003, primarily from growth in assets under management and increased estate fees. ATM fees increased $0.6 million or 13% in 2003, from expanded market presence and increases in core deposits. Other income increased $0.4 million or 9%, in 2003, from strong growth in other consumer banking fee income.
 
 
The Company purchased $30 million in BOLI in June 2003. BOLI represents life insurance on the lives of certain employees who are deemed to be significant contributors to the Company. All employees in the policy are aware of and have consented to the coverage. Increases in the cash value of the policies, as well as insurance proceeds that may be received, are recorded in other noninterest income, and are not subject to income taxes. The Company reviewed the financial strength of the insurance carriers prior to the purchase of BOLI and will do so annually thereafter. Total BOLI income was $0.8 million for 2003. Net securities gains stemming primarily from the call of certain debt securities totaled $0.2 million in 2003 compared to a $0.4 million net loss in 2002 which resulted primarily from a charge taken for the other-than-temporary impairment of a certain security totaling $0.7 million.
 
NONINTEREST EXPENSE
 
Total noninterest expense increased $2.1 million or 2% from $102.5 million in 2002 to $104.5 million in 2003. Salaries and benefits increased $1.3 million or 3% in 2003 from increases in salaries of $2.0 million, incentive compensation of $0.9 million, and medical insurance of $0.3 million offset by an increase in loan origination deferrals of $2.0 million and a decrease in pension and post-retirement health care costs of $0.4 million. The increase in salaries was driven primarily by merit increases and an increase in full-time equivalent employees. Incentive compensation increased from increases in bonuses, financial services commissions and 401(K)/ESOP contributions as the Company’s focus has shifted to a sales-driven culture. Occupancy expense increased $1.0 million or 12% in 2003 from increases in depreciation and rent stemming from renovations and expansion at the Company’s corporate headquarters as well as an increase in seasonal maintenance. Equipment expense increased $0.6 million or 6%, from ATM upgrades and increased depreciation for office equipment from renovations at the Company’s corporate headquarters and several CNB locations. Other operating expenses increased $1.7 million or 13% in 2003 from an $0.8 million charge for the write-down of nonmarketable investment securities and an increase in insurance expense of $0.6 million from higher premiums for property and casualty insurance, and contingent auto liability insurance.
 
Offsetting these increases were decreases in 2003 in professional fees and outside services of $1.2 million and loan collection and OREO costs of $1.0 million. The decrease in professional fees and outside services resulted from a $0.4 million charge related to an adverse judgment against the Company in 2002, legal fees of $0.3 million incurred during 2002 for the recovery of deposit overdraft write-offs, and $0.4 million in professional fees for a tax project in 2002. The decrease in loan collection and OREO costs resulted from gains on the sale of OREO and a decrease in nonperforming loans.
 

 
IMPACT OF INFLATION AND CHANGING PRICES
 
 
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

 
Interest rate risk is the most significant market risk affecting the Company. Other types of market risk, such as foreign currency exchange rate risk and commodity price risk, do not arise in the normal course of the Company’s business activities or are immaterial to the results of operations.
 
Interest rate risk is defined as an exposure to a movement in interest rates that could have an adverse effect on the Company’s net interest income. Net interest income is susceptible to interest rate risk to the degree that interest-bearing liabilities mature or reprice on a different basis than earning assets. When interest-bearing liabilities mature or reprice more quickly than earning assets in a given period, a significant increase in market rates of interest could adversely affect net interest income. Similarly, when earning assets mature or reprice more quickly than interest-bearing liabilities, falling interest rates could result in a decrease in net interest income.
 
In an attempt to manage the Company’s exposure to changes in interest rates, management monitors the Company’s interest rate risk. Management’s asset/liability committee (ALCO) meets monthly to review the Company’s interest rate risk position and profitability, and to recommend strategies for consideration by the Board of Directors. Management also reviews loan and deposit pricing, and the Company’s securities portfolio, formulates investment and funding strategies, and oversees the timing and implementation of transactions to assure attainment of the Board’s objectives in the most effective manner. Notwithstanding the Company’s interest rate risk management activities, the potential for changing interest rates is an uncertainty that can have an adverse effect on net income.
 
In adjusting the Company’s asset/liability position, the Board and management attempt to manage the Company’s interest rate risk while minimizing net interest margin compression. At times, depending on the level of general interest rates, the relationship between long and short-term interest rates, market conditions and competitive factors, the Board and management may determine to increase the Company’s interest rate risk position somewhat in order to increase its net interest margin. The Company’s results of operations and net portfolio values remain vulnerable to changes in interest rates and fluctuations in the difference between long-and short-term interest rates.

The primary tool utilized by ALCO to manage interest rate risk is a balance sheet/income statement simulation model (interest rate sensitivity analysis). Information such as principal balance, interest rate, maturity date, cash flows, next repricing date (if needed), and current rates is uploaded into the model to create an ending balance sheet. In addition, ALCO makes certain assumptions regarding prepayment speeds for loans and leases and mortgage related investment securities along with any optionality within the deposits and borrowings. The model is first run under an assumption of a flat rate scenario (i.e. no change in current interest rates) with a static balance sheet over a 12-month period. Three additional models are run in which a gradual increase of 200 bp, a gradual increase of 200 bp where the long end of the yield curve remains flat (the long end of the yield curve is defined as 5 years and longer) and a gradual decrease of 100 bp takes place over a 12 month period with a static balance sheet. Under these scenarios, assets subject to prepayments are adjusted to account for faster or slower prepayment assumptions. Any investment securities or borrowings that have callable options embedded into them are handled accordingly based on the interest rate scenario. The resultant changes in net interest income are then measured against the flat rate scenario.

In the declining rate scenario, net interest income is projected to decrease when compared to the forecasted net interest income in the flat rate scenario through the simulation period. The decrease in net interest income is a result of earning assets repricing downward faster than interest-bearing liabilities. The inability to effectively lower deposit rates will likely reduce or eliminate the otherwise normal expected benefit of lower interest rates. In the rising rate scenarios, net interest income is projected to experience a decline from the flat rate scenario. Net interest income is projected to remain at lower levels than in a flat rate scenario through the simulation period primarily due to a lag in assets repricing while funding costs increase. The potential impact on earnings is dependent on the ability to lag deposit repricing. Net interest income for the next twelve months in the +200/+ 200 flat/- 100 bp scenarios, as described above, is within the internal policy risk limits of not more than a 7.5% change in net interest income. The following table summarizes the percentage change in net interest income in the rising and declining rate scenarios over a 12-month period from the forecasted net interest income in the flat rate scenario using the December 31, 2004 balance sheet position:

 

Table 10. Interest Rate Sensitivity Analysis
Change in interest rates
   
Percent change
 
(In basis points)
   
in net interest income
 
+200 Flat
   
(0.37
%)
+ 200
   
(0.21
%)
-100
   
(0.75
%)

 

 
Under the flat rate scenario with a static balance sheet, net interest income is anticipated to increase approximately 1.3% from total net interest income for 2004. The Company anticipates under current conditions, earning assets will continue to reprice down at a faster rate than interest bearing liabilities. However, the growth in loans experienced in the second half of 2004 should minimize the impact of margin compression. In order to protect net interest income from anticipated net interest margin compression, the Company will continue to focus on increasing earning assets through loan growth and leverage opportunities. However, if the Company cannot maintain the level of earning assets at December 31, 2004, the Company expects net interest income to decline in 2005.
 

 
Currently, the Company is holding fixed rate residential real estate mortgages in its loan portfolio and mortgage related securities in its investment portfolio. Two major factors the Company considers in holding residential real estate mortgages is its level of core deposits and the duration of its mortgage-related securities and loans. Current core deposit levels combined with a shortening of duration of mortgage-related securities and loans have enabled the Company to hold fixed rate residential real estate mortgages without having a significant negative impact on interest rate risk, as the Company is well matched at December 31, 2004. The Company’s net interest income is projected to decrease by 0.21% if interest rates gradually rise 200 basis points. Since December 31, 2003, we have continued to minimize our exposure to 30-year fixed rate mortgage related securities and loans. Approximately 10.8% of earning assets were comprised of 30-year fixed rate mortgage related securities and loans at December 31, 2004, down from a ratio of 11.5% at December 31, 2003. The Company closely monitors its matching of earning assets to funding sources. If core deposit levels decrease or the rate of growth in core deposit levels does not equal or exceed the rate in growth of 30-year fixed rate real estate mortgage related securities or loans, the Company will reevaluate its strategy and may sell new originations of fixed rate mortgages in the secondary market, price 30-year fixed rate mortgages above market rates, or may sell certain mortgage related securities in order to limit the Company’s exposure to long-term earning assets.
 


 


Report of Independent Registered Public Accounting Firm




The Board of Directors and Stockholders
 
NBT Bancorp Inc.:
 
We have audited the accompanying consolidated balance sheets of NBT Bancorp Inc. (the Company) and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of income, changes in stockholders’ equity, cash flows and comprehensive income for each of the years in the three-year period ended December 31, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of NBT Bancorp Inc. and subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of NBT Bancorp Inc.’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 11, 2005 expressed an unqualified opinion on management’s assessment of, and effective operation of, internal control over financial reporting.


/S/ KPMG LLP
 
 
Albany, New York
 
March 11, 2005


 

Consolidated Balance Sheets
 
 
   
December 31,
 
(In thousands, except share and per share data)
   
2004
   
2003
 
Assets
             
Cash and due from banks
 
$
98,437
 
$
125,590
 
Short-term interest bearing accounts
   
8,286
   
2,502
 
Securities available for sale, at fair value
   
952,542
   
980,961
 
Securities held to maturity (fair value $82,712 and $98,576)
   
81,782
   
97,204
 
Federal Reserve and Federal Home Loan Bank stock
   
36,842
   
34,043
 
Loans and leases
   
2,869,921
   
2,639,976
 
Less allowance for loan and lease losses
   
44,932
   
42,651
 
  Net loans and leases
   
2,824,989
   
2,597,325
 
Premises and equipment, net
   
63,743
   
62,443
 
Goodwill
   
45,570
   
47,521
 
Intangible assets, net
   
2,013
   
2,331
 
Bank owned life insurance
   
32,302
   
30,815
 
Other assets
   
65,798
   
66,150
 
  Total assets
 
$
4,212,304
 
$
4,046,885
 
Liabilities, Guaranteed Preferred Beneficial Interests in Company’s Junior Subordinate Debentures, and Stockholders’ Equity
             
Deposits
             
Demand (noninterest bearing)
 
$
520,218
 
$
500,303
 
Savings, NOW, and money market
   
1,435,561
   
1,401,825
 
Time
   
1,118,059
   
1,099,223
 
  Total deposits
   
3,073,838
   
3,001,351
 
Short-term borrowings
   
338,823
   
302,931
 
Long-term debt
   
394,523
   
369,700
 
Trust preferred debentures
   
18,720
   
-
 
Other liabilities
   
54,167
   
45,869
 
  Total liabilities
   
3,880,071
   
3,719,851
 
Guaranteed preferred beneficial interests in Company’s junior subordinate debentures (capital securities)
   
-
   
17,000
 
Stockholders’ equity
             
Preferred stock, $0.01 par at December 31, 2004 and 2003. Authorized 2,500,000 shares
   
-
   
-
 
Common stock, $0.01 par value. Authorized 50,000,000 shares at December 31, 2004 and 2003; issued 34,401,008 and 34,401,088 at December 31, 2004 and 2003, respectively
   
344
   
344
 
Additional paid-in-capital
   
209,523
   
209,267
 
Unvested restricted stock
   
(296
)
 
(197
)
Retained earnings
   
145,812
   
120,016
 
Accumulated other comprehensive income
   
4,989
   
7,933
 
Common stock in treasury, at cost, 1,544,247 and 1,592,435 shares
   
(28,139
)
 
(27,329
)
  Total stockholders’ equity
   
332,233
   
310,034
 
  Total liabilities, guaranteed preferred beneficial interests in Company’s junior subordinate debentures, and stockholders’ equity
 
$
4,212,304
 
$
4,046,885
 
               
See accompanying notes to consolidated financial statements.
             
 

Consolidated Statements of Income
                     
 
   
December 31,
 
(In thousands, except per share data)
   
2004
   
2003
   
2002
 
Interest, fee, and dividend income
                   
Interest and fees on loans and leases
 
$
163,795
 
$
159,118
 
$
167,185
 
Securities available for sale
   
42,264
   
43,851
   
54,404
 
Securities held to maturity
   
3,044
   
3,391
   
4,260
 
Other
   
1,076
   
938
   
1,373
 
  Total interest, fee, and dividend income
   
210,179
   
207,298
   
227,222
 
Interest expense
                   
Deposits
   
39,761
   
45,941
   
63,332
 
Short-term borrowings
   
4,086
   
2,171
   
1,334
 
Long-term debt
   
15,022
   
14,762
   
15,736
 
Trust preferred debentures
   
823
   
-
   
-
 
  Total interest expense
   
59,692
   
62,874
   
80,402
 
Net interest income
   
150,487
   
144,424
   
146,820
 
Provision for loan losses
   
9,615
   
9,111
   
9,073
 
  Net interest income after provision for loan losses
   
140,872
   
135,313
   
137,747
 
Noninterest income
                   
Service charges on deposit accounts
   
16,470
   
15,833
   
13,875
 
Broker/ dealer and insurance revenue
   
6,782
   
6,869
   
5,780
 
Trust
   
4,605
   
4,041
   
3,226
 
Net securities gains (losses)
   
216
   
175
   
(413
)
Bank owned life insurance
   
1,487
   
815
   
-
 
ATM Fees
   
5,530
   
5,307
   
4,703
 
Other
   
5,799
   
4,738
   
4,350
 
  Total noninterest income
   
40,889
   
37,778
   
31,521
 
Noninterest expense
                   
Salaries and employee benefits
   
54,063
   
49,560
   
48,212
 
Occupancy
   
9,905
   
9,328
   
8,333
 
Equipment
   
7,573
   
7,627
   
7,066
 
Data processing and communications
   
10,972
   
10,752
   
10,593
 
Professional fees and outside services
   
6,175
   
5,433
   
6,589
 
Office supplies and postage
   
4,459
   
4,216
   
4,446
 
Amortization of intangible assets
   
284
   
620
   
774
 
Capital securities
   
-
   
732
   
839
 
Loan collection and other real estate owned
   
1,241
   
1,840
   
2,846
 
Goodwill impairment
   
1,950
   
-
   
-
 
Other
   
13,155
   
14,409
   
12,757
 
  Total noninterest expense
   
109,777
   
104,517
   
102,455
 
Income before income tax expense
   
71,984
   
68,574
   
66,813
 
Income tax expense
   
21,937
   
21,470
   
21,814
 
  Net income
 
$
50,047
 
$
47,104
 
$
44,999
 
Earnings per share
                   
Basic
 
$
1.53
 
$