ITEM 1A. RISK FACTORS
Our Commercial Real Estate, Commercial and Consumer Loans Expose Us To Increased Lending Risks
At December 31, 2006, the composition of our loan portfolio was as follows:
- residential real estate loans of $1.19 billion, or 51.8% of total loans;
- commercial real estate loans of $315.4 million, or 13.7% of total loans;
- commercial and industrial loans of $158.5 million, or 6.9% of total loans; and
- consumer loans of $633.9 million, or 27.6% of total loans.
Commercial real estate, commercial and industrial and consumer loans expose a lender to a greater risk of loss than one- to four-family residential loans. Commercial real estate and commercial and industrial loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to one- to four-family residential loans. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss compared to an adverse development with respect to one residential mortgage loan. Similarly, consumer loans generally have a higher credit risk than residential loans due to the loan being unsecured or secured by rapidly depreciable assets. See the Business - Lending Activities section of this Form 10-K.
If Our Allowance For Loan Losses Is Not Sufficient to Cover Actual Loan Losses, Our Earnings Could Decrease
Our loan customers may not repay their loans according to their terms, and the collateral securing the payment of these loans may be insufficient to pay any remaining loan balance. We may experience significant loan losses, which could have a material adverse effect on our operating results. We make various assumptions and judgments about the collectibility of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. At December 31, 2006, our allowance for loan losses to non-performing loans was 860.49%, and our allowance for loan losses to total loans was 1.51%. In determining the amount of the allowance for loan losses, we rely on an allowance valuation model that considers a review of loans, our experience and our evaluation of economic conditions. At December 31, 2006 we believe our allowance for loan losses is adequate to cover losses inherent in our loan portfolio.
In addition, bank regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs. Historically, however, our regulators have not required us to make any such material adjustments and we do not expect any material adjustments in the future. See the Business-Lending Activities - Allowance for Loan Losses section of this Form 10-K.
Our Local Economy has Limited Growth Potential and This May Hurt Our Ability to Generate Profits and Grow our Business
The success of our business depends on our ability to generate profits and grow our franchise. Our primary market area in central New York has experienced a decline in population, reflecting a decrease in the manufacturing sector, and the loss of major employers during the past decade. Moreover, economic and population growth in central New York is expected to be limited for the foreseeable future. The relatively weak economy will make it more difficult for us to grow our earnings and to generate internal asset growth.
Changes in Market Interest Rates Could Adversely Affect Our Results of Operations and Financial Condition
Our results of operations and financial condition are significantly affected by changes in interest rates. Our results of operations are substantially dependent on our net interest income, which is the difference between the interest income earned on our interest-earning assets and the interest expense paid on our interest-bearing liabilities. Because as a general matter our interest-bearing liabilities reprice or mature more quickly than our interest-earning assets, an increase in interest rates across the yield curve generally would result in a decrease in our average interest rate spread and net interest income. The yield curve was inverted at December 31, 2006. If it inverts even further this would cause even greater compression of our net interest margin.
Changes in interest rates also affect the value of our interest-earning assets, and in particular our securities portfolio. Generally, the value of debt securities fluctuates inversely with changes in interest rates. At December 31, 2006, the value of our available-for-sale securities portfolio totaled $957.1 million, with net unrealized losses of $10.2 million. Changes in the unrealized gains and losses on our securities available-for-sale could have an adverse effect on stockholders' equity.
We are also subject to reinvestment risk relating to interest rate movements. Changes in interest rates can affect the average life of loans and mortgage related securities. Decreases in interest rates can result in increased prepayments of loans and mortgage related securities, as borrowers refinance to reduce borrowing costs. Under these circumstances, we are subject to reinvestment risk to the extent that we are unable to reinvest such prepayments at rates that are comparable to the rates on existing loans or securities.
If Economic Conditions Deteriorate, Our Results of Operations and Financial Condition Could Be Adversely Impacted As Borrowers' Ability to Repay Loans Declines and the Value of the Collateral Securing Our Loans Decreases
Our financial results may be adversely affected by changes in prevailing economic conditions, including decreases in real estate values, adverse employment conditions, the monetary and fiscal policies of the federal government and other significant external events. Because we have a significant amount of real estate loans, decreases in real estate values could adversely affect the value of property used as collateral. Adverse changes in the economy may also have a negative effect on the ability of our borrowers to make timely repayments of their loans, which would have an adverse impact on our earnings.
In addition, substantially all of our loans are to individuals and businesses in Oneida, Onondaga, Herkimer, Broome, Tioga and Chenango Counties, New York. Consequently, any decline in the economy of these market areas could have an adverse impact on our earnings.
Strong Competition Within Our Market Area May Limit Our Growth and Profitability
Competition in the banking and financial services industry is intense. The central New York area has a high concentration of financial institutions including large money center and regional banks, community banks, credit unions, online banks and banking subsidiaries of insurance companies. Some of our competitors offer products and services that we currently do not offer, such as private banking. Some of these competitors have substantially greater resources and lending limits than we do and may offer certain services that we do not or cannot provide. This competition has made it more difficult for us to make new loans and at times has forced us to offer higher deposit rates. Price competition for loans and deposits might result in us earning less on our loans and paying more on our deposits, which reduces net interest income. We expect competition to increase in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Our profitability depends upon our continued ability to successfully compete in our market area.
A Breach Of Information Security Could Negatively Affect Our Earnings
Increasingly, we depend on data processing, communication and information exchange on a variety of computing platforms and networks, and over the Internet. We cannot be certain all of our systems are entirely free from vulnerability to attack, despite safeguards we have instituted. In addition, we rely on the services of a variety of vendors to meet our data processing and communication needs. If information security is breached, information can be lost or misappropriated, resulting in financial loss or costs to us or damages to others. These costs or losses could materially exceed the amount of insurance coverage, if any, which would adversely affect our earnings.
We Operate in a Highly Regulated Environment and We May Be Adversely Affected by Changes in Laws and Regulations
We are subject to extensive regulation, supervision and examination by the Office of Thrift Supervision, our chartering authority, and by the Federal Deposit Insurance Corporation, as insurer of deposits. Such regulation and supervision govern the activities in which an institution and its holding company may engage and are intended primarily for the protection of the insurance fund and depositors. Regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the imposition of restrictions on the operation of an institution, the classification of assets by the institution and the adequacy of an institution's allowance for loan losses. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, or legislation, including changes in the regulations governing holding companies, could have a material impact on the combined banks, Partners Trust Financial Group, and our operations.
Our Ability to Pay Dividends May Be Affected If We Are Not Able To Receive Dividends From Our Subsidiary, Partners Trust Bank
Cash dividends from Partners Trust Bank is the Company's principal source of funds for paying cash dividends on our common stock. Unless we receive dividends from Partners Trust Bank, we may not be able to pay dividends to shareholders. Partners Trust Bank's ability to pay dividends is subject to its ability to earn net income and to meet certain regulatory requirements.
The Company's main sources of liquidity are dividends from Partners Trust Bank and net proceeds from capital offerings. The main uses of liquidity are the payment of dividends to common stockholders, repurchases of the Company's common stock and the payment of interest on capital securities. There are certain regulatory restrictions on the payment of dividends by Partners Trust Bank to the Company. See Note 13 of the Notes to Consolidated Financial Statements contained in Item 8 of this Form 10-K for further information on such dividend restrictions.
New York State Taxation
The 2007 New York State Proposed Budget Bill includes several provisions that would impact the taxation of the Company and its subsidiaries. Specifically, the bill would disallow the 60% exclusion for dividends paid by a real estate investment trust ("REIT"). Additionally, the bill may impact the treatment of certain Article 9A subsidiaries. This provision is not expected to impact the Company's 9A subsidiary as we do not currently meet the criteria in the budget proposal, but could have an impact if the activity of such subsidiary changes in the future.
ITEM 1B. UNRESOLVED STAFF COMMENTS
The Company has no unresolved comments from the SEC staff.
