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

 

 

Form 10-K

 

 

COMMISSION FILE NUMBER 0-11204

 

AMERISERV FINANCIAL, INC.
(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code
(814) 533-5300

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

 

Securities registered pursuant to Section 12(g) of the Act:

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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 þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

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

 

 

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

 

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked prices of such common equity, as of the business day of the registrant’s most recently completed second fiscal quarter. The aggregate market value was $97,535,834 as of June 30, 2007.

 

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date. There were 22,178,335 shares outstanding as of January 31, 2008.

 

DOCUMENTS INCORPORATED BY REFERENCE.

 

List hereunder the following documents if incorporated by reference and the Part of the Form 10-K (e.g., Part I, Part II, etc.) into which the document is incorporated: (1) Any annual report to security holders; (2) Any proxy or information statement; and (3) Any prospectus filed pursuant to Rule 424(b) or (e) under the Securities Act of 1933. The listed documents should be clearly described for identification purposes (e.g., annual report to security holders for fiscal year ended December 24, 1980).

 

Portions of the annual shareholders’ report for the year ended December 31, 2007, are incorporated by reference into Parts I and II.

 

Portions of the proxy statement for the annual shareholders’ meeting are incorporated by reference in Part III.

 

Exhibit Index is located on page 88.

 

 

FORM 10-K INDEX

 

 

 

GENERAL

 

AmeriServ Financial, Inc. (the Company) is a bank holding company, organized under the Pennsylvania Business Corporation Law. The Company became a holding company upon acquiring all of the outstanding shares of AmeriServ Financial Bank (the Bank) on January 5, 1983. The Company’s other wholly owned subsidiaries include AmeriServ Trust and Financial Services Company (the Trust Company) formed in October 1992, and AmeriServ Life Insurance Company (AmeriServ Life) formed in October 1987.

 

The Company’s principal activities consist of owning and operating its three wholly owned subsidiary entities. At December 31, 2007, the Company had, on a consolidated basis, total assets, deposits, and shareholders’ equity of $905 million, $710 million and $90 million, respectively. The Company and its subsidiaries derive substantially all of their income from banking and bank-related services. The Company functions primarily as a coordinating and servicing unit for its subsidiary entities in general management, accounting and taxes, loan review, auditing, investment accounting, marketing and insurance risk management.

 

As previously stated, the Company is a bank holding company and is subject to supervision and regular examination by the Federal Reserve Bank of Philadelphia and Pennsylvania Department of Banking. The Company is also under the jurisdiction of the Securities and Exchange Commission (SEC) for matters relating to offering and sale of its securities. The Company is subject to the disclosure and regulatory requirements of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, as administered by the SEC. The Company is listed on the NASDAQ Stock Market under the trading symbol “ASRV,” and is subject to the rules of NASDAQ for listed companies.

 

AMERISERV FINANCIAL BANKING SUBSIDIARY

 

AmeriServ Financial Bank

 

The Bank is a state bank chartered under the Pennsylvania Banking Code of 1965, as amended. Through 19 locations in Allegheny, Cambria, Centre, Somerset, and Westmoreland Counties, Pennsylvania, AmeriServ Financial Bank conducts a general banking business. It is a full-service bank offering (i) retail banking services, such as demand, savings and time deposits, money market accounts, secured and unsecured loans, mortgage loans, safe deposit boxes, holiday club accounts, collection services, money orders, and traveler’s checks; (ii) lending, depository and related financial services to commercial, industrial, financial, and governmental customers, such as real estate-mortgage loans, short- and medium-term loans, revolving credit arrangements, lines of credit, inventory and accounts receivable financing, real estate-construction loans, business savings accounts, certificates of deposit, wire transfers, night depository, and lock box services. The Bank also operates 22 automated bank teller machines (ATMs) through its 24-Hour Banking Network that is linked with NYCE, a regional ATM network and CIRRUS, a national ATM network.

 

On March 7, 2007, the Bank completed the acquisition of West Chester Capital Advisors (WCCA). WCCA is a registered investment advisor with expertise in large cap stocks and as of December 31, 2007 had $137 million in assets under management. The Bank had a wholly owned mortgage banking subsidiary — Standard Mortgage Corporation of Georgia (SMC). SMC was a residential mortgage loan servicer based in Atlanta, GA. The Company concluded that mortgage servicing was not a core community banking business and it did not have the scale nor the earnings power to absorb the volatility and risk associated with this business line. On December 28, 2004, the Company sold all of its remaining mortgage servicing rights and discontinued operations of this non-core business in 2005. Additionally, AmeriServ Financial Services Corporation was formed on May 23, 1997 and engages in the sale of annuities, mutual funds, and insurance. On December 31, 2004, the Company merged AmeriServ Financial Services Corporation into the Bank.

 

The Bank’s deposit base is such that loss of one depositor or a related group of depositors would not have a materially adverse effect on its business. In addition, the loan portfolio is also diversified so that one industry or

group of related industries does not comprise a material portion of the loan portfolio. The Bank’s business is not seasonal nor does it have any risks attendant to foreign sources.

 

The Bank is subject to supervision and regular examination by the Federal Reserve Bank of Philadelphia and the Pennsylvania Department of Banking. See Note 22, Regulatory Matters, for a discussion of the Memorandum Of Understanding (MOU) which the Company and its Board of Directors entered into with its primary regulators in February 2003 and which was terminated in February 2006. Various federal and state laws and regulations govern many aspects of its banking operations. The following is a summary of key data (dollars in thousands) and ratios at December 31, 2007:

 

 

RISK MANAGEMENT OVERVIEW:

 

Risk identification and management are essential elements for the successful management of the Company. In the normal course of business, the Company is subject to various types of risk, which includes interest rate, credit, and liquidity risk. The Company controls and monitors these risks with policies, procedures, and various levels of managerial and Board oversight.

 

Interest rate risk is the sensitivity of net interest income and the market value of financial instruments to the magnitude, direction, and frequency of changes in interest rates. Interest rate risk results from various repricing frequencies and the maturity structure of assets and liabilities. The Company uses its asset liability management policy to control and manage interest rate risk.

 

Liquidity risk represents the inability to generate cash or otherwise obtain funds at reasonable rates to satisfy commitments to borrowers, as well as, the obligations to depositors and debtholders. The Company uses its asset liability management policy and contingency funding plan to control and manage liquidity risk.

 

Credit risk represents the possibility that a customer may not perform in accordance with contractual terms. Credit risk results from extending credit to customers, purchasing securities, and entering into certain off-balance sheet loan funding commitments. The Company’s primary credit risk occurs in the loan portfolio. The Company uses its credit policy and disciplined approach to evaluating the adequacy of the allowance for loan losses to control and manage credit risk. The Company’s investment policy and hedging policy strictly limit the amount of credit risk that may be assumed in the investment portfolio and through hedging activities. The following summarizes and describes the Company’s various loan categories and the underwriting standards applied to each:

 

Commercial

 

This category includes credit extensions to commercial and industrial borrowers. Business assets, including accounts receivable, inventory and/or equipment, typically secure these credits. In appropriate instances, extensions of credit in this category are subject to collateral advance formulas. Balance sheet strength and profitability are considered when analyzing these credits, with special attention given to historical, current and prospective sources of cash flow, and the ability of the customer to sustain cash flow at acceptable levels. Our policy permits flexibility in determining acceptable debt service coverage ratios, with a minimum level of 1.1 to 1 desired. Personal guarantees are frequently required; however, as the financial strength of the borrower increases, the Company’s

ability to obtain personal guarantees decreases. In addition to economic risk, this category is impacted by the management ability of the borrower and industry risk, which are also considered during the underwriting process.

 

Commercial Loans Secured by Real Estate

 

This category includes various types of loans, including acquisition and construction of investment property, owner-occupied property and operating property. Maximum term, minimum cash flow coverage, leasing requirements, maximum amortization and maximum loan to value ratios are controlled by the Company’s credit policy and follow industry guidelines and norms, and regulatory limitations. Personal guarantees are normally required during the construction phase on construction credits, and are frequently obtained on mid to smaller commercial real estate loans. In addition to economic risk, this category is subject to geographic and portfolio concentration risk, which are monitored and considered in underwriting.

 

Real Estate — Mortgage

 

This category includes mortgages that are secured by residential property. Underwriting of loans within this category is pursuant to Freddie Mac/Fannie Mae underwriting guidelines, with the exception of Community Reinvestment Act (CRA) loans, which exhibit more liberal standards. The major risk in this category is that a significant downward economic trend would increase unemployment and cause payment default. The Company does not and has never engaged in sub-prime residential mortgage lending.

 

Consumer

 

This category includes consumer installment loans and revolving credit plans. Underwriting is pursuant to industry norms and guidelines and is achieved through a process, which is inclusive of the Appro Credit Scoring program. The major risk in this category is a significant economic downturn.

 

MAJOR TYPES OF INVESTMENTS AND THE ASSOCIATED INVESTMENT POLICIES

 

The investment securities portfolio of the Company and its subsidiaries is managed to provide ample liquidity in a manner that is consistent with proper bank asset/liability management and current banking practices. The objectives of portfolio management include consideration of proper liquidity levels, interest rate and market valuation sensitivity, and profitability. The investment portfolios of the Company and subsidiaries are proactively managed in accordance with federal and state laws and regulations in accordance with generally accepted accounting principles.

 

The investment portfolio is primarily made up of AAA Agency Mortgage-backed securities and short maturity agency securities. The purpose of this type of portfolio is to generate adequate cash flow to fund potential loan growth, as the market allows. Management strives to maintain a relatively short duration in the portfolio. All holdings must meet standards documented in the AmeriServ Financial Investment Policy.

 

DEPOSIT ACTIVITIES AND OTHER SOURCES OF FUNDS, INCLUDING REPAYMENTS AND MATURITIES OF LOANS, SALES AND MATURITIES OF INVESTMENTS AND FHLB ADVANCES

 

Deposits

 

The Bank has a loyal core deposit base made up of traditional commercial bank products that exhibits little fluctuation, other than Jumbo CDs, which demonstrate some seasonality. The bank also utilizes certain Trust Company specialty deposits related to the Build and Erect Funds as a funding source which serve as an alternative to wholesale borrowings and could exhibit some degree of volatility.

 

Borrowings

 

The Bank, when needed, uses both overnight borrowings and term advances from the Federal Home Loan Bank of Pittsburgh for liquidity management purposes. During the past several years the Company has significantly deleveraged its balance sheet and reduced its level of borrowings through investment portfolio cash flow and security sales.

Loans

 

During the periods presented herein, the Company has moderately grown its loan portfolio with no adverse effect on liquidity. The Company believes it will be able to fund anticipated loan growth generally from investment securities portfolio cash flow and deposit growth.

 

Secondary Market Activities

 

The Residential Lending department of the Bank continues to originate one-to-four family mortgage loans for both outside investors in the secondary market and for the AmeriServ portfolio. Mortgages sold on the secondary market are sold to investors on a “flow” basis: Mortgages are priced and delivered on a “best efforts” pricing, with servicing released to the investor. Freddie Mac guidelines are used in underwriting all mortgages with the exception of CRA loans. The mortgages with longer terms such as 20-year, 30-year, FHA, and VA loans are usually sold. The remaining production of the department includes Adjustable Rate Mortgages, 10-year, 15-year, and bi-weekly mortgages. These loans are usually kept in the AmeriServ portfolio.

 

AMERISERV FINANCIAL NON-BANKING SUBSIDIARIES

 

AmeriServ Trust and Financial Services Company

 

AmeriServ Trust and Financial Services Company is a trust company organized under Pennsylvania law in October 1992. As one of the larger providers of trust and investment management products and services between Pittsburgh and Harrisburg, AmeriServ Trust and Financial Services Company is committed to delivering personalized, professional service to its clients. Its staff of approximately 39 professionals administer assets valued at approximately $1.9 billion at December 31, 2007. The Trust Company has two primary business divisions, traditional trust and union collective investment funds. Traditional trust includes personal trust products and services such as personal portfolio investment management, estate planning and administration, custodial services and pre-need trusts. Also, institutional trust products and services such as 401(k) plans, defined benefit and defined contribution employee benefit plans, and individual retirement accounts are included in this division. The union collective investment funds, namely the ERECT and BUILD Funds, are designed to invest union pension dollars in construction projects that utilize union labor. At December 31, 2007, AmeriServ Trust and Financial Services had total assets of $2.9 million and total shareholder’s equity of $2.7 million. The Trust Company is subject to regulation and supervision by the Federal Reserve Bank of Philadelphia and the Pennsylvania Department of Banking.

 

The diversification of the revenue-generating divisions within the trust company is one of the primary reasons for its successful profitable growth. The specialized union collective funds have attracted several international labor unions as investors as well as many local unions from a number of states. At the end of 2007, assets in these union funds totaled approximately $415 million.

 

The Trust Investment Division focuses on producing better-than-average investment returns by offering an array of individually managed accounts and several asset allocation disciplines utilizing non-proprietary mutual funds. In addition, the Tactical High Yield Bond Fund, the Pathroad Funds and the Premier Equity Discipline are examples of the Investment Division’s ability to respond to the needs and expectations of our clients. The diversified array of investment options, experienced staff and good investment returns facilitate client retention and the development of new clients.

 

In 2007, the Trust Company continued to be a major contributor of earnings to the corporation. Gross revenue in 2007 amounted to $6.9 million which represents an increase of $248,000 or 3.7% over 2006. The Trust Company’s net income contribution was $1.7 million, an increase of $135,000 or 8.7% over 2006.

 

AmeriServ Life

 

AmeriServ Life is a captive insurance company organized under the laws of the State of Arizona. AmeriServ Life engages in underwriting as reinsurer of credit life and disability insurance within the Company’s market area. Operations of AmeriServ Life are conducted in each office of the Company’s banking subsidiary. AmeriServ Life is subject to supervision and regulation by the Arizona Department of Insurance, the Insurance Department of the

Commonwealth of Pennsylvania, and the Federal Reserve. At December 31, 2007, AmeriServ Life had total assets of $1.1 million and total shareholder’s equity of $939,000.

 

MONETARY POLICIES

 

Commercial banks are affected by policies of various regulatory authorities including the Federal Reserve System. An important function of the Federal Reserve System is to regulate the national supply of bank credit. Among the instruments of monetary policy used by the Board of Governors are: open market operations in U.S. Government securities, changes in the discount rate on member bank borrowings, and changes in reserve requirements on bank deposits. These means are used in varying combinations to influence overall growth of bank loans, investments, and deposits, and may also affect interest rate charges on loans or interest paid for deposits. The monetary policies of the Board of Governors have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.

 

COMPETITION

 

The subsidiaries face strong competition from other commercial banks, savings banks, savings and loan associations, and several other financial or investment service institutions for business in the communities they serve. Several of these institutions are affiliated with major banking and financial institutions which are substantially larger and have greater financial resources than the subsidiary entities. As the financial services industry continues to consolidate, the scope of potential competition affecting the subsidiary entities will also increase. For most of the services that the subsidiary entities perform, there is also competition from credit unions and issuers of commercial paper and money market funds. Such institutions, as well as brokerage houses, consumer finance companies, insurance companies, and pension trusts, are important competitors for various types of financial services. In addition, personal and corporate trust investment counseling services are offered by insurance companies, other firms, and individuals.

 

MARKET AREA

 

Nationally, economic growth slowed during 2007 but remained positive at 2.2%, the least growth in five years. Consumer spending, which accounts for more than two thirds of the economy, increased 2.9% in 2007, which was the least growth in four years. By the fourth quarter of 2007, the Federal Reserve’s monetary policy had shifted from a neutral stance to an accommodative position in light of a weakening economic outlook and increasing downside risks to growth. The sub-prime mortgage crisis caused housing activity and home values to decline. The troubled housing market along with rising energy and food prices began to negatively impact other sectors of the economy and increase the possibility of the economy slipping into a recession. Credit markets have tightened making it more difficult for households and businesses to borrow money. As a result, the labor markets began to soften. National economic growth is expected to be flat in the first quarter of 2008 and rebound slightly averaging 2% for the remainder of the year.

 

The economy in Cambria and Somerset Counties, while growing slowly, had unemployment rates of 5.3% and 5.5%, respectively at December 31, 2007, as compared to national and state rates of 4.9% and 4.3%. Local markets have shown improvement as jobs in the area have increased causing the unemployment rate to decline from last year’s number of 5.7%. Johnstown, PA, where AmeriServ Financial, Inc is headquartered, is a national leader in technology, ranked 45th in the nation for technology growth by the Milken Institute, the 4th best city in the eastern US by Money Magazine and the most affordable city in the nation by Forbes Magazine. The local economy did suffer a set back during the summer of 2007 with the announced layoff of 200 workers at a local freight car manufacturer. However, the beginning of construction on a planned technology park, greater work on defense projects and the recent announcement of several retail and restaurant openings are expected to contribute to economic expansion. Overall, local economic conditions in 2008 are expected to remain positive.

 

Economic conditions are stronger in the State College market. The unemployment rate is 3.4% and one of the lowest of all regions in the Commonwealth. The State College market presents the Company with a more vibrant economic market and a much different demographic. A large percentage of the population in State College falls into the 18 to 34 year old age group, while potential customers in the Cambria/Somerset markets tend to be over 50 years

of age. Overall, opportunities in the State College market are quite different and challenging, providing a promising source of business to profitably grow the Company.

 

EMPLOYEES

 

The Company employed 385 people as of December 31, 2007, in full- and part-time positions. Approximately 221 non-supervisory employees of the Bank are represented by the United Steelworkers of America, AFL-CIO-CLC, Local Union 2635-06. The Bank’s current labor contract with the Steelworkers Local will expire on October 15, 2009. The Bank has not experienced a work stoppage since 1979. The Bank is one of 13 union-represented banks nationwide.

 

FEDERAL DEPOSIT INSURANCE CORPORATION IMPROVEMENT ACT

 

The Federal Deposit Insurance Corporation Improvement Act of 1991 (the “FDICIA”), among other things, identifies five capital categories for insured depository institutions: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. It requires U.S. federal bank regulatory agencies to implement systems for “prompt corrective action” for insured depository institutions that do not meet minimum capital requirements based on these categories. The FDICIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the category in which an institution is classified. Unless a bank is well capitalized, it is subject to restrictions on its ability to offer brokered deposits and on other aspects of its operations. The FDICIA generally prohibits a bank from paying any dividend or making any capital distribution or paying any management fee to its holding company if the bank would thereafter be undercapitalized. An undercapitalized bank must develop a capital restoration plan, and its parent holding company must guarantee the bank’s compliance with the plan up to the lesser of 5% of the bank’s assets at the time it became undercapitalized and the amount needed to comply with the plan.

 

As of December 31, 2007, the Company believes that its bank subsidiary was well capitalized, based on the prompt corrective action guidelines described above. A bank’s capital category is determined solely for the purpose of applying the prompt corrective action regulations, and the capital category may not constitute an accurate representation of the bank’s overall financial condition or prospects for other purposes.

 

SARBANES-OXLEY ACT OF 2002

 

The Sarbanes-Oxley Act of 2002 contains important requirements for public companies in the area of financial disclosure and corporate governance. In accordance with section 302(a) of the Sarbanes-Oxley act, written certifications by the Company’s Chief Executive Officer and Chief Financial Officer are required. These certifications attest that the Company’s quarterly and annual reports filed with the SEC do not contain any untrue statement of a material fact. In response to the Sarbanes-Oxley Act of 2002, the Company adopted a series of procedures to further strengthen its corporate governance practices. The Company also requires signed certifications from managers who are responsible for internal controls throughout the Company as to the integrity of the information they prepare. These procedures supplement the Company’s Code of Conduct Policy and other procedures that were previously in place. In 2005, the Company implemented a program designed to comply with Section 404 of the Sarbanes-Oxley Act. This program included the identification of key processes and accounts, documentation of the design of control effectiveness over process and entity level controls, and testing of the effectiveness of key controls.

 

PRIVACY PROVISIONS OF GRAMM-LEACH-BLILEY ACT

 

Under the Gramm-Leach-Bliley Act (GLB Act), federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about customers to non-affiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to non-affiliated third parties. The privacy provision of the GLB Act affects how consumer information is transmitted through diversified financial companies and conveyed to outside vendors. The Company believes it is in compliance with the various provisions of the GLB Act.

CHECK CLEARING FOR THE 21^ST CENTURY ACT

 

The Check Clearing for the 21st Century Act, also known as Check 21, which became effective on October 28, 2004, altered the way banks process checks. Check 21 facilitates check truncation, eliminating the original paper check from the clearing process. Instead, many checks are processed electronically. Under Check 21, as a bank processes a check, funds from the check writer’s account are transferred to the check depositor’s account, and an electronic image of the check, a processable printout known as a substitute check or Image Replacement Document (IRD), is considered the legal equivalent of the original check. Banks can choose to send substitute checks as electronic files to be printed on-site or in close proximity to the paying bank. For financial institutions and their clients, these changes have the potential to reduce costs, improve efficiency in check collections and accelerate funds availability, while alleviating dependence on the national transportation system.

 

STATISTICAL DISCLOSURES FOR BANK HOLDING COMPANIES

 

The following Guide 3 information is included in this Form 10-K as listed below:

 

I. Distribution of Assets, Liabilities, and Stockholders’ Equity; Interest Rates and Interest Differential Information. Information required by this section is presented on pages 22-24, and 33-35.

 

II. Investment Portfolio Information required by this section is presented on pages 8-9 and 52-56.

 

III. Loan Portfolio Information required by this section appears on pages 9-10 and 26-27.

 

IV. Summary of Loan Loss Experience Information required by this section is presented on pages 27-29.

 

V. Deposits Information required by this section follows on page 11.

 

VI. Return on Equity and Assets Information required by this section is presented on page 20.

 

VII. Short-Term Borrowings Information required by this section is presented on page 12.

 

INVESTMENT PORTFOLIO

 

Investment securities classified as held to maturity are carried at amortized cost while investment securities classified as available for sale are reported at fair market value. The following table sets forth the cost basis and fair market value of the Company’s investment portfolio as of the periods indicated:

 

Investment securities available for sale at:

 

 

 

 

Investment securities held to maturity at:

 

 

LOAN PORTFOLIO

 

The loan portfolio of the Company consisted of the following:

 

 

 

 

NON-PERFORMING ASSETS

 

The following table presents information concerning non-performing assets:

 

 

 

The Company is unaware of any additional loans which are required to either be charged-off or added to the non-performing asset totals disclosed above. Other real estate owned is recorded at the lower of 1) fair value minus estimated costs to sell, or 2) carrying cost.

 

The following table sets forth, for the periods indicated, (i) the gross interest income that would have been recorded if non-accrual loans had been current in accordance with their original terms and had been outstanding throughout the period or since origination if held for part of the period, (ii) the amount of interest income actually recorded on such loans, and (iii) the net reduction in interest income attributable to such loans.

 

DEPOSITS

 

The following table sets forth the average balance of the Company’s deposits and average rates paid thereon for the past three calendar years:

 

 

Interest expense on deposits consisted of the following:

 

 

Additionally, the following table provides more detailed maturity information regarding certificates of deposit issued in denominations of $100,000 or more as of December 31, 2007:

 

MATURING IN:

 

FEDERAL FUNDS PURCHASED AND OTHER SHORT-TERM BORROWINGS

 

The outstanding balances and related information for federal funds purchased and other short-term borrowings are summarized as follows:

 

 

 

 

Average amounts outstanding during the year represent daily averages. Average interest rates represent interest expense divided by the related average balances.

 

These borrowing transactions can range from overnight to one year in maturity. The average maturity was two days at the end of 2007 and three days at the end of 2006 and 2005.

 

 

Investors should carefully consider the risks described below before investing in our common stock. The risks described below are not the only ones facing the Company. Additional risks not currently known to us or that we currently believe are immaterial also may impair our business. Our business could be harmed by any of these risks. The trading price of our common stock could decline due to any of these risks, and you may lose all or part of your investment. In assessing these risks, you should also refer to the other information contained or incorporated by reference in this Form 10-K, including our consolidated financial statements and related notes. Other corporate information is available at www.AmeriServFinancial.com

Failure to successfully execute our turnaround strategy would adversely affect future earnings.

 

At the end of 2003, we adopted a turnaround strategy that consisted of three distinct elements. These were:

 

 

We believe we accomplished the first two elements of the turnaround strategy. With our earnings growth in 2007, we achieved some success towards the third element of the turnaround. However, this final element of the turnaround requires sustained execution of our business plan to drive our financial performance closer to peer bank levels. If we are unable to achieve the last element of the turnaround strategy, our financial condition and results of operations will not dramatically improve and may deteriorate.

 

Weak loan growth may hinder our ability to improve earnings performance.

 

In order to improve our financial performance, we must increase our average balance of quality loans. However, our market area is characterized by an aging and declining population base and comparatively slow economic growth. Despite these unattractive fundamentals, our market also is highly competitive. Unless loan originations increase, our earnings performance may not improve to the degree we have planned.

 

We have unionized employees, which increases our costs and may deter any acquisition proposal.

 

The Bank is party to a collective bargaining agreement with the United Steelworkers of America, which represents approximately 61% of our employees. In 2007, our current contract was extended until October 15, 2009. Terms of the contract extension remain the same as the prior contract with the exception of a 2.0% wage increase in the first year, and a 2.5% increase in the second year. As a result of provisions in the contract, generally known as work rules, we sometimes cannot take steps that would reduce our operating costs. Furthermore, to our knowledge, we are one of only 13 unionized banking institutions in the United States. The banking industry is a consolidating industry in which acquisitions are frequent. However, some banking institutions may be reluctant to buy a unionized bank because of a perception that operating costs may be higher or that it could result in unionization of its work force. Additionally, there is the risk of a work stoppage if a new collective bargaining agreement cannot be negotiated before the end of the current agreement. Therefore, our stock price may be adversely affected because investors may conclude that there is a reduced likelihood that we will be acquired or could be an acquiror.

 

A meaningful portion of our trust business is dependent on a union client base.

 

In an effort to capitalize on the Bank’s union affiliation, our Trust Company operates the ERECT Funds and the BUILD Funds that seek to attract investment from union pension funds. These funds then use the investments to make loans and/or equity investments on construction projects that use union labor. At December 31, 2007, approximately $415 million was invested by unions in the ERECT and BUILD Funds. This represents approximately 22.0% of the total assets under management held by the Trust Company. Therefore, the Trust Company is dependent on a discrete union client base for a meaningful portion of its assets under management and its resulting revenue and net income.

 

Changes in interest rates could reduce our income, cash flows and asset values.

 

Our income, cash flows and the value of our assets depend to a great extent on the difference between the interest rates we earn on interest-earning assets, such as loans and investment securities, as well as the interest rates we pay on interest-bearing liabilities such as deposits and borrowings. These rates are highly sensitive to many factors which are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Board of Governors of the Federal Reserve System. Changes in

monetary policy, including changes in interest rates, will influence not only the interest we receive on our loans and investment securities and the amount of interest we pay on deposits and borrowings, but it also will affect our ability to originate loans and obtain deposits and the value of our investment portfolio. If the rate of interest we pay on our deposits and other borrowings increases more than the rate of interest we earn on our loans and other investments, our net interest income, and therefore our earnings, could be adversely affected. This challenge was particularly evident during periods such as 2006 and the first half of 2007 when the yield curve was flat to inverted. Our earnings also could be adversely affected if the rates on our loans and other investments fall more quickly than those on our deposits and other borrowings.

 

Because our operations are concentrated in Cambria and Somerset Counties, Pennsylvania, we are subject to economic conditions in this area, which typically lag behind economic activity in other areas.

 

Our loan and deposit activities are largely based in Cambria and Somerset Counties, located in southwestern Pennsylvania. As a result, our financial performance will depend largely upon economic conditions in this area. Economic activity in this geographic market generally lags behind the economic activity in Pennsylvania and the nation. Similarly, unemployment in this market area is typically higher than the unemployment rate in Pennsylvania and the nation, although this difference has declined in recent years as our local economy has become more diversified. Adverse local economic conditions could cause us to experience a reduction in deposits, an increase in the number of borrowers who default on their loans and a reduction in the value of the collateral securing their loans, all of which could adversely affect our profitability.

 

We are subject to lending risks.

 

There are risks inherent in making all loans. These risks include interest rate changes over the time period in which loans may be repaid and changes in the national economy or the economy of our regional market that affect the ability of our borrowers to repay their loans or the value of the collateral securing these loans.

 

At December 31, 2007, 63.5% of our net loan portfolio consisted of commercial and commercial mortgage loans, including construction loans. Commercial loans are generally viewed as having more risk of default than residential real estate loans or consumer loans. These types of loans also are typically larger than residential real estate loans and consumer loans. Because our loan portfolio contains a significant number of commercial and commercial mortgage loans with relatively large balances, the deterioration of one or a few of these loans would cause a significant increase in nonperforming loans. An increase in nonperforming loans could result in a net loss of earnings from these loans, an increase in our provision for loan losses and an increase in loan charge-offs.

 

Our financial condition and results of operations would be adversely affected if our allowance for loan losses is not sufficient to absorb actual losses or if we are required to increase our allowance.

 

Despite our underwriting criteria, we may experience loan delinquencies and losses for reasons beyond our control, such as general economic conditions. At December 31, 2007, we had nonperforming assets equal to 0.83% of total loans, and loans held for sale, net of unearned income and other real estate owned. In order to absorb losses associated with nonperforming assets, we maintain an allowance for loan losses based on, among other things, historical experience, an evaluation of economic conditions, and regular reviews of delinquencies and loan portfolio quality. Determination of the allowance inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. We may be required to increase our allowance for loan losses for any of several reasons. State and federal regulators, in reviewing our loan portfolio as part of a regulatory examination, may request that we increase our allowance for loan losses. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in our allowance. In addition, if charge-offs in future periods exceed our allowance for loan losses, we will need additional increases in our allowance for loan losses. Any increases in our allowance for loan losses will result in a decrease in our net income and, possibly, our capital, and may materially affect our results of operations in the period in which the allowance is increased.

Our future success will depend on our ability to compete effectively in a highly competitive market and geographic area.

 

We face substantial competition in all phases of our operations from a variety of different competitors, including commercial banks, savings and loan associations, mutual savings banks, credit unions, consumer finance companies, factoring companies, insurance companies and money market mutual funds. There is very strong competition among financial services providers in our principal service area. Due to their size, many competitors can achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than we can.

 

We believe that our ability to compete successfully depends on a number of factors, including:

 

 

If we experience difficulty in any of these areas, our competitive position could be materially adversely affected, which will affect our growth and profitability.

 

Some of the financial services organizations with which we compete are not subject to the same degree of regulation as is imposed on federally insured financial institutions. As a result, those non-bank competitors may be able to access funding and provide various services more easily or at less cost than we can, adversely affecting our ability to compete effectively.

 

Environmental liability associated with lending activities could result in losses.

 

In the course of our business, we may foreclose on and take title to properties securing our loans. If hazardous substances were discovered on any of these properties, we may be liable to governmental entities or third parties for the costs of remediation of the hazard, as well as for personal injury and property damage. Many environmental laws can impose liability regardless of whether we knew of, or were responsible for, the contamination. In addition, if we arrange for the disposal of hazardous or toxic substances at another site, we may be liable for the costs of cleaning up and removing those substances from the site, even if we neither own nor operate the disposal site. Environmental laws may require us to incur substantial expenses and may materially limit use of properties we acquire through foreclosure, reduce their value or limit our ability to sell them in the event of a default on the loans they secure. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability.

 

We may be adversely affected by government regulation.

 

We are subject to extensive federal and state banking regulation and supervision. Banking regulations are intended primarily to protect our depositors’ funds and the federal deposit insurance funds, not shareholders. Regulatory requirements affect our lending practices, capital structure, investment practices, dividend policy and growth. Failure to meet minimum capital requirements could result in the imposition of limitations on our operations that would adversely impact our operations and could, if capital levels drop significantly, result in our being required to cease operations. Changes in governing law, regulations or regulatory practices could impose additional costs on us or adversely affect our ability to obtain deposits or make loans and, as a consequence, our revenues and profitability.

RISKS ASSOCIATED WITH THE COMPANY’S COMMON STOCK

 

The Company’s stock price can be volatile.

 

Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive. The Company’s stock price can fluctuate significantly in response to a variety of factors including, among other things:

 

 

General market fluctuations, industry factors and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes or credit loss trends, could also cause the Company’s stock price to decrease regardless of operating results.

 

The trading volume in the Company’s common stock is less than that of other larger financial services companies.

 

Although the Company’s common stock is listed for trading on the National Market System (NASDAQ), the trading volume in its common stock is less than that of other larger financial services companies. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of the Company’s common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which the Company has no control. Given the lower trading volume of the Company’s common stock, significant sales of the Company’s common stock, or the expectation of these sales, could cause the Company’s stock price to fall.

 

An investment in our common stock is not an insured deposit.

 

Our common stock is not a bank deposit and, therefore, is not insured against loss by the Federal Deposit Insurance Corporation, commonly referred to as the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is inherently risky for the reasons described in this “Risk Factors” section and is subject to the same market forces that affect the price of common stock in any company. As a result, if you acquire our common stock, you may lose some or all of your investment.

 

 

The Company has no unresolved staff comments from the SEC for the reporting period presented.

 

 

The principal offices of the Company and the Bank occupy the five-story AmeriServ Financial building at the corner of Main and Franklin Streets in Johnstown plus twelve floors of the building adjacent thereto. The Company occupies the main office and its subsidiary entities have 13 other locations which are owned. Ten additional locations are leased with terms expiring from January 1, 2008 to March 31, 2018.

 

 

The Company is subject to a number of asserted and unasserted potential legal claims encountered in the normal course of business. In the opinion of both management and legal counsel, there is no present basis to

conclude that the resolution of these claims will have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows.

 

 

No matter was submitted by the Company to its shareholders through the solicitation of proxies or otherwise during the fourth quarter of the fiscal year covered by this report.

 

 

COMMON STOCK

 

As of January 31, 2008, the Company had 5,795 shareholders of its common stock. AmeriServ Financial, Inc.’s common stock is traded on the NASDAQ National Market System under the symbol ASRV. The following table sets forth the actual high and low closing prices and the cash dividends declared per share for the periods indicated:

 

PERFORMANCE GRAPH

 

The following Performance Graph and related information shall not be deemed “Soliciting material” or to be “filed” with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent that the Company specifically incorporates it by reference into such filing.

 

Comparison of Five Year Cumulative Total Returns
Among AmeriServ Financial, Inc., NASDAQ Stock Market,
and NASDAQ Bank Stocks

 

 

The following table compares total shareholder returns for the Company over the past five years to the NASDAQ Stock Market and the NASDAQ Bank Stocks assuming a $100 investment made on December 31, 2002. Each of the three measures of cumulative return assumes reinvestment of dividends. The stock performance shown on the graph above is not necessarily indicative of future price performance.

 

 

SELECTED FIVE-YEAR CONSOLIDATED FINANCIAL DATA

 

 

 

 

 

 

 

 

The following discussion and analysis of financial condition and results of operations of AmeriServ Financial, Inc. should be read in conjunction with the consolidated financial statements of AmeriServ Financial, Inc. including the related notes thereto, included elsewhere herein.

 

RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2007, 2006, AND 2005

 

SUMMARY OVERVIEW:

 

There was significant financial turmoil in the national and global market place during the fourth quarter of 2007. Concerns that a credit and liquidity crunch within the banking sector and a weak housing market impacted by risky sub prime lending practices could combine to cause the United States economy to enter a recession in 2008. Because of the actions taken early in the Turnaround effort in 2003, 2004 and 2005, AmeriServ enters this period of uncertainty with strong capital, good asset quality, reduced operating expenses and continued improvement in net income. Additionally, AmeriServ has never made a sub prime mortgage, therefore, it has never sold a sub prime mortgage and it owns no investment securities for which the collateral is sub prime mortgages. A few of the highlights of the fourth quarter of 2007 and some comments about the year as a whole follow.

 

 

 

These fourth quarter highlights, combined with the improvements reported in the preceding quarters of 2007, enabled AmeriServ to report net income for the full year of $3.0 million or $0.14 per share, an increase of $702,000 or 30.1% better than the $2.3 million or $0.11 per share reported for 2006. We believe that this is tangible evidence that the AmeriServ Turnaround continued in 2007 even as conditions in our industry deteriorated. However, it is important to say that while we are pleased to report the continuing recovery of the franchise, we recognize that this level of earnings is still well below the level AmeriServ should be reporting. We remain committed to continue the unrelenting focus on building upon our growing strength in the community banking and trust activities which have been the focus of the Turnaround.

 

On January 22, 2008, AmeriServ also announced a stock repurchase program with a goal to buy back up to 5% — or approximately 1.1 million — of the outstanding common shares. The Board and management believe this is a positive strategy that will benefit shareholders. During 2007 the common stock prices of most banks were severely punished by investors who were concerned about the spreading turmoil in financial markets. By the end of 2007 many bank stocks, including that of AmeriServ, were selling below their stated book value. With the balance sheet restructuring activities of 2004 and 2005, AmeriServ not only reduced the size of the Company but also reduced the level of risk present on the restructured balance sheet. Concurrently, a maximum effort was effective in reducing the level of non-performing assets below that of AmeriServ’s peer banks. We believe this stock repurchase program will result in positive changes. The number of shares outstanding will be reduced with the goal of improving future earnings per share. This will also allow us to return a portion of Company capital to shareholders while maintaining conservative capital ratios.

 

For the year ended December 31, 2006, the Company returned to profitability by reporting net income of $2.3 million or $0.11 per share. This compared favorably to the net loss of $9.1 million or ($0.45) per share reported for 2005. These positive 2006 earnings were generated from traditional community banking and trust activities with no complex financial transactions or unusual strategies. These earnings are an indication that the operating losses of 2002 and 2003 have ended and that the balance sheet restructuring losses of 2004 and 2005 have accomplished their stated goal — to reconstitute AmeriServ as a safe and sound community bank with a growing trust and asset management subsidiary.

 

Specifically when analyzing 2005, the successful completion of a $10.3 million private placement common stock offering on September 29, 2005 provided the Company with the capital to facilitate a series of transactions which were designed to significantly improve the Company’s interest rate risk position and position the Company for future increased earnings performance. These transactions and their related impact on 2005 earnings were as follows: 1) We retired all remaining $100 million of Federal Home Loan Bank (FHLB) convertible advances that had a cost of approximately 6.0% and a 2010 maturity. The Company incurred a $6.5 million pre-tax prepayment penalty to accomplish this transaction. 2) We terminated all interest rate hedges associated with the FHLB debt. The Company incurred a pre-tax termination fee of $5.8 million to eliminate these hedges on which the Company was a net payer. 3) We sold $112 million of investment securities to provide the additional cash needed by the Bank for these FHLB debt and interest rate swap prepayments. The Company incurred a $2.5 million pre-tax loss on these investment security sales. 4) We redeemed at par $7.2 million of our high coupon trust preferred securities for which the Company incurred a $210,000 charge to write-off related unamortized issuance costs which is included within other expense. These transactions were significant factors that caused the Company to report losses in 2005.

However, the execution of these transactions combined with the capital provided from the successful private placement common stock offerings strengthened the Company’s balance sheet and reduced its risk profile.

 

PERFORMANCE OVERVIEW. . .The following table summarizes some of the Company’s key profitability performance indicators for each of the past three years.

 

 

The Company reported net income of $3.0 million or $0.14 per diluted share for 2007. This represents an increase of $702,000 or 30.1% when compared to net income of $2.3 million or $0.11 per diluted share for the full year 2006. The increase in net income in 2007 was due to increased non-interest revenue and lower non-interest expense which more than offset the negative impact of reduced net interest income, a higher provision for loan losses and increased income tax expense. The increase in non-interest revenue was driven by the benefit of the West Chester Capital Advisors acquisition which was completed in March of 2007. Also, the Company benefited from higher trust revenue and increased gains on asset sales in 2007.

 

The Company reported net income of $2.3 million or $0.11 per diluted share for 2006 compared to a net loss of $9.1 million or ($0.45) per diluted share in 2005. The Company increased earnings in 2006 by generating more revenue from traditional community banking and its trust company while reducing its non-interest expense base. This revenue improvement was evidenced by increased levels of both net interest income and non-interest income. The Company also benefited from a negative loan loss provision for the second consecutive year in 2006 due to the demonstrated sustained improvement in its asset quality. The Company’s financial performance was negatively impacted by increased income tax expense in 2006 after recording an income tax benefit in 2005 due to the large pre-tax loss realized that year from the balance sheet restructuring actions discussed earlier.

 

NET INTEREST INCOME AND MARGIN. . . .The Company’s net interest income represents the amount by which interest income on earning assets exceeds interest paid on interest bearing liabilities. Net interest income is a primary source of the Company’s earnings; it is affected by interest rate fluctuations as well as changes in the amount and mix of earning assets and interest bearing liabilities. The following table summarizes the Company’s net interest income performance for each of the past three years:

 

 

2007 NET INTEREST PERFORMANCE OVERVIEW. . . The Company’s 2007 net interest income on a tax-equivalent basis decreased by $260,000 or 1.1% from 2006 due to a six basis point drop in the net interest margin to 3.06%. The decline in both net interest income and net interest margin resulted from the Company’s cost of funds increasing at a faster pace than the earning asset yield particularly during the first six months of 2007. This resulted from deposit customer preference for higher yielding certificates of deposit and money market accounts due to the inverted/flat yield curve with short-term interest rates exceeding intermediate to longer term rates during that period. This net interest margin pressure overshadowed solid loan and deposit growth within our community bank. Average loans in 2007 grew by $43 million or 7.7% while average deposits increased by $14 million or 1.9% when

compared to 2006. However, it is important to note that the Federal Reserve reductions in short-term interest rates that began late in the third quarter of 2007 favorably impacted the Company. On a quarterly basis, the Company’s net interest margin has shown improvement throughout 2007 increasing from 2.97% in the first quarter to 3.08% in the fourth quarter. This helped to reverse a trend of four consecutive quarters of net interest income and margin contraction experienced in 2006 where the margin declined from 3.20% to a low of 2.93% in the fourth quarter. The Company believes it is well positioned for net interest income and margin expansion in 2008.

 

COMPONENT CHANGES IN NET INTEREST INCOME:  2007 VERSUS 2006...Regarding the separate components of net interest income, the Company’s total interest income for 2007 increased by $2.8 million or 6.0% when compared to 2006. This increase was due to a 30 basis point increase in the earning asset yield to 6.23%, and was aided by an $8 million increase in average earning assets. Within the earning asset base, the yield on the total loan portfolio increased by 18 basis points to 6.82% and reflects the higher interest rate environment in place during most of 2007 which has allowed the Company to book new loans at rates moderately higher than those currently in the portfolio. The yield on the total investment securities portfolio increased by 12 basis points to 4.08% as the Company has generally elected to not replace maturing lower yielding securities. Also reduced amortization expense on the Company’s lower balance of mortgage-backed securities has favorably impacted the portfolio yield.

 

The $8 million increase in average earning assets was due to a $43 million or 7.7% increase in average loans partially mitigated by a $38 million or 17.0% reduction in average investment securities. This loan growth was driven by increased commercial and commercial real estate loans as a result of successful new business development efforts. Note that the Company has focused on growing the higher yielding and more rate sensitive commercial loans at a faster rate than the commercial real-estate loans. The decline in investment securities was caused by regularly scheduled maturities and ongoing cash flow from mortgage-backed securities. The Company has elected to utilize this cash from lower yielding investment securities to fund higher yielding loans in an effort to increase the Company’s earning asset yield.

 

The Company’s total interest expense for 2007 increased by $3.1 million or 13.9% when compared to 2006. This increase in interest expense was due to a higher cost of funds and an increase in total average interest bearing liabilities which were $4.0 million higher in 2007. The total cost of funds for 2007 increased by 43 basis points to 3.69% and was driven up by higher short-term interest rates and increased deposits when compared to 2006. Specifically, total average deposits increased by $14 million or 1.9% compared to 2006, while the cost of interest bearing deposits increased by 49 basis points to 3.54%. The increased cost of deposits reflects the higher short-term interest rate environment for the majority of 2007 as well as a customer movement of funds from lower cost savings accounts into higher yielding certificates of deposit. Average wholesale borrowings declined by $9 million in 2007 and averaged only 2.8% of total assets in 2007.

 

2006 NET INTEREST PERFORMANCE OVERVIEW. . . The Company’s 2006 net interest income on a tax-equivalent basis increased by $354,000 or 1.5% from 2005. This improvement reflected the benefit of an increased net interest margin which more than offset a reduced level of average earning assets. Specifically, the net interest margin increased by 36 basis points to 3.12% while average earning assets declined by $91 million or 10.4%. Both of these items reflected the benefits of the previously mentioned balance sheet restructuring where the removal of high cost debt from the Company’s balance sheet had resulted in lower levels of both borrowed funds and investment securities. Wholesale borrowings averaged only 3.9% of total assets in 2006 compared to 15.8% of total assets in 2005 while investment securities as a percentage of total assets had declined from 36.5% to 25.4% during this same period. The Company’s net interest margin and net interest income also benefited from increased loans in the earning asset mix as total loans outstanding averaged $564 million in 2006, a $39 million or 7.4% increase from 2005. This loan growth was driven by increased commercial and commercial real estate loans. Total deposits averaged $735 million in 2006, a $35 million or 5.0% increase from 2005 due primarily to increased deposits from the trust company’s operations and increased certificates of deposit as customers demonstrated a preference for this product due to higher short-term interest rates. Overall, the Company generated increased net interest income from a smaller but stronger balance sheet despite the negative impact resulting from a flat to inverted yield curve which pressured the Company’s net interest margin on a quarterly basis throughout 2006.

 

COMPONENT CHANGES IN NET INTEREST INCOME:  2006 VERSUS 2005... Regarding the separate components of net interest income, the Company’s total interest income for 2006 increased by $688,000 or 1.5%

when compared to 2005. This increase was due to a 69 basis point increase in the earning asset yield to 5.93%, but was partially offset by a $91 million decrease in average earning assets. Within the earning asset base, the yield on the total loan portfolio increased by 39 basis points to 6.64% and reflected the higher interest rate environment in 2006 which allowed the Company to book new loans at rates higher than those in the portfolio. The yield on the total investment securities portfolio increased by 26 basis points to 3.96% due to the repricing of variable rate securities in the higher rate environment and reduced amortization expense on the Company’s lower balance of mortgage-backed securities.

 

The $91 million decline in average earning assets was due to a $130 million or 37% reduction in average investment securities partially mitigated by a $39 million increase in average loans. The average investment securities decline in 2006 reflects the impact of the Company’s deleveraging and balance sheet repositioning strategies which began in the second half of 2004 and continued throughout 2005. This repositioning involved selling investment securities and using the proceeds to retire borrowings. The increase in average loans reflects successful commercial loan growth as the Company was able to generate new business particularly in commercial real estate loans. This commercial loan growth led to a greater composition of loans in the earning asset mix that favorably impacted the Company’s net interest margin.

 

The Company’s total interest expense for 2006 increased by $334,000 or 1.5% when compared to 2005. This increase in interest expense was due to a higher cost of funds which more than offset the decline in total average interest bearing liabilities which were $87 million lower in 2006. We deleveraged our balance sheet by reducing high cost FHLB debt and trust preferred securities in the second half of 2005.

 

The total cost of funds for 2006 increased by 41 basis points to 3.26% and was driven up by higher short-term interest rates and increased deposits when compared to 2005. Specifically, total average deposits increased by $35 million or 5.0% compared to 2005, while the cost of interest bearing deposits increased by 87 basis points to 3.05%. The increased cost of deposits reflects the higher short-term interest rate environment as well as a customer movement of funds from lower cost savings and demand deposit accounts into higher yielding certificates of deposit.

The table that follows provides an analysis of net interest income on a tax-equivalent basis setting forth (i) average assets, liabilities, and stockholders’ equity, (ii) interest income earned on interest earning assets and interest expense paid on interest bearing liabilities, (iii) average yields earned on interest earning assets and average rates paid on interest bearing liabilities, (iv) interest rate spread (the difference between the average yield earned on interest earning assets and the average rate paid on interest bearing liabilities), and (v) net interest margin (net interest income as a percentage of average total interest earning assets). For purposes of these tables loan balances exclude non-accrual loans, but interest income recorded on non-accrual loans on a cash basis, which is deemed to be immaterial, is included in interest income. Regulatory stock is included within available for sale investment securities for this analysis. Additionally, a tax rate of approximately 34% is used to compute tax-equivalent yields.