FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 (Mark One) /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Nine month period ended September 30, 1998 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: 0-16084 CITIZENS & NORTHERN CORPORATION (Exact name of Registrant as specified in its charter) Pennsylvania 23-2451943 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 90-92 Main Street Wellsboro, Pa. 16901 (Address of principal executive offices) (Zip code) 717-724-3411 (Registrant's telephone number including area code) Not applicable (Former name, former address, and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS: Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes ____ No ____ (APPLICABLE ONLY TO CORPORATE REGISTRANTS) Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date. <TABLE> <CAPTION> Title Outstanding <S> <C> Common Stock ($1.00 par value) 5,220,038 Shares Issued and Outstanding October 1, 1998 1 </TABLE>
CITIZENS & NORTHERN CORPORATION Index <TABLE> <S> <C> Part I. Financial Information Item 1. Financial Statements Consolidated Statement of Condition - September 30, 1998 and December 31, 1997 Page 3 Consolidated Statement of Income - Nine Months Ended September 30, 1998 and September 30, 1997 Page 4 Consolidated Statement of Cash Flows - Nine Months Ended September 30, 1998 and September 30, 1997 Page 5 Notes to Consolidated Financial Statements Page 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operation Pages 7 through 18 Item 3. Information About Market Risk Pages 19 And 20 Item 4. Year 2000 Compliance Pages 21 through 23 Part II. Other Information Page 24 Item 1. Legal Proceedings Items 2 and 3 have been omitted as they are not applicable to registrant. Item 6. Exhibits and Reports on Form 8-K Signatures Page 25 </TABLE> 2
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information Item 1. Financial Statements CONSOLIDATED BALANCE SHEET (In Thousands Except Per Share Data) <TABLE> <CAPTION> Unaudited Audited (In Thousands) September 30, December 31, 1998 1997 ---------------------------------------- <S> <C> <C> ASSETS Cash & Due From Banks 11,667 13,449 Interest Bearing Deposits 676 804 Available-for-Sale Securities: U.S. Treasury Securities 2,573 2,538 Securities of Other U.S. Government Agencies 54,469 74,449 Mortgage Backed Securities 139,876 129,190 Obligations of States and Municipal Subdivisions 76,968 64,614 Other Securities 49,658 35,796 --------------------------------------- Total Available-for-Sale Securities 323,544 306,587 Held-to-Maturity Securities: U.S. Treasury Securities 624 632 Securities of Other U.S. Government Agencies 699 350 Mortgage Backed Securities 476 615 --------------------------------------- Total Held-to-Maturity Securities 1,799 1,597 Loans: Loans to Political Subdivisions 6,006 5,975 Other Loans 281,184 279,488 --------------------------------------- Total Loans 287,190 285,463 Less - Allowance for Possible Loan Losses (4,748) (4,913) Unearned Income (34) (37) --------------------------------------- Loans, Net 282,408 280,513 Bank Premises and Equipment 7,163 6,720 Other Real Estate 606 230 Accrued Interest on Bonds and Loans 4,263 4,808 Other Assets 717 645 --------------------------------------- TOTAL ASSETS 632,843 615,353 --------------------------------------- --------------------------------------- LIABILITIES Deposits: Demand 46,173 46,916 Interest Checking 35,751 40,880 Money Market 118,341 104,894 Savings 44,313 45,332 Other Time 210,780 204,234 --------------------------------------- Total Deposits 455,358 442,256 Dividends Payable 1,020 1,013 Borrowed Funds 50,651 40,661 Securities Sold Under Agreement to Repurchase 24,400 29,800 Federal Funds Purchased 2,000 10,000 Other Liabilities 9,793 6,088 --------------------------------------- TOTAL LIABILITIES 543,222 529,818 SHAREHOLDERS' EQUITY Common Stock, Par Value $ 1.00 per Share 5,220 5,168 Authorized 10,000,000; Issued 5,220,038 and 5,168,354 in 1998 and 1997, respectively Stock Dividend Distributable 1,706 Paid in Capital 15,468 13,799 Retained Earnings 58,111 52,519 --------------------------------------- Total 78,799 73,192 Unrealized Gains (Losses) on 12,272 13,335 Available-for-Sale Securities Less: Treasury Stock at Cost 118,010 shares at September 30, 1998 (1,450) 104,311 Shares at December 31, 1997 (992) --------------------------------------- TOTAL SHAREHOLDERS' EQUITY 89,621 85,535 --------------------------------------- TOTAL LIABILITIES & SHAREHOLDERS' EQUITY 632,843 615,353 --------------------------------------- --------------------------------------- </TABLE> The accompanying notes are an integral part of these condensed financial statements. 3
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 1. Financial Statements (Continued) CONSOLIDATED STATEMENT OF INCOME (In Thousands, Except Per Share Data) (Unaudited) <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, 1998 1997 1998 1997 INTEREST INCOME (Current) (Prior Year) (Current) (Prior Year) <S> <C> <C> <C> <C> Interest and Fees on Loans $7,395 $7,254 $21,585 $21,382 Interest on Balances with 9 16 29 35 Depository Institutions Interest on Loans to Political 93 100 278 295 Subdivisions Interest on Federal Funds Sold 51 118 215 242 Income from Available-for-Sale and Held-to-Maturity Securities: Taxable 3,612 3,525 10,584 10,699 Tax Exempt 1,005 916 2,918 2,668 Dividends 230 217 681 629 ---------------------------------------------------------- Total Interest and Dividend Income 12,395 12,146 36,290 35,950 INTEREST EXPENSE Interest on Deposits 4,691 4,697 13,697 13,670 Interest on Other Borrowings 1,078 1,189 3,497 3,799 ---------------------------------------------------------- Total Interest Expense 5,769 5,886 17,194 17,469 ---------------------------------------------------------- Interest Margin 6,626 6,260 19,096 18,481 Provision for Possible Loan Losses 191 181 573 543 ---------------------------------------------------------- Interest Margin After Provision 6,435 6,079 18,523 17,938 for Possible Loan Losses OTHER INCOME Service Charges on Deposit Accounts 261 272 775 812 Service Charges and Fees 73 79 212 210 Trust Department Income 307 264 952 774 Insurance Commissions, Fees 126 110 323 343 and Premiums Other Operating Income 16 19 75 382 ---------------------------------------------------------- Total Other Income Before Realized 783 744 2,337 2,521 Gains on Securities, Net Realized Gains on Securities, (Net) 235 62 2,849 869 ---------------------------------------------------------- Total Other Income 1,018 806 5,186 3,390 OTHER EXPENSES Salaries and Wages 1,618 1,493 4,813 4,459 Pensions and Other Employee 424 396 1,295 1,266 Benefits Occupancy Expense, Net 203 180 617 535 Furniture and Equipment 207 178 599 513 Expense Other Operating Expense 1,702 1,475 4,856 4,501 ---------------------------------------------------------- Total Other Expenses 4,154 3,722 12,180 11,274 ---------------------------------------------------------- Income Before Income Tax 3,299 3,163 11,529 10,054 Provision Income Tax Provision 785 724 2,872 2,368 ---------------------------------------------------------- NET INCOME $2,514 $2,439 $8,657 $7,686 ---------------------------------------------------------- ---------------------------------------------------------- PER SHARE DATA: Net Income - Basic $0.49 $0.48 $1.69 $1.50 Net Income - Diluted $0.49 $0.48 $1.69 $1.50 ---------------------------------------------------------- Dividend Per Share $0.20 $0.18 $0.60 $0.53 ---------------------------------------------------------- Number Shares Used in Computation 5,102,028 5,113,224 5,108,784 5,113,138 - Basic Number Shares Used in Computation 5,120,085 5,123,052 5,122,426 5,117,740 - Diluted Number Shares Issued 5,220,038 5,168,354 5,220,038 5,168,354 Number Shares Authorized 10,000,000 10,000,000 10,000,000 10,000,000 ---------- ---------- ---------- ---------- Dividends Actually Paid $0.20 $0.18 $0.60 $0.54 ---------- ---------- ---------- ---------- CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME Net Income $2,514 $2,439 $8,657 $7,686 Other Comprehensive Income: Unrealized holding gains (losses) on available-for-sale securities Gains (Losses) arising during (2,567) 5,070 1,238 8,091 the period Reclassification adjustment (235) (62) (2,849) (869) ----------------------------------------------------------- Other comprehensive income (loss) (2,802) 5,008 (1,611) 7,222 before income tax Income tax related to other 953 (1,703) 548 (2,455) comprehensive income ----------------------------------------------------------- Other comprehensive income (loss) (1,849) 3,305 (1,063) 4,767 ------------------------------------------------------------ Comprehensive Income $665 $5,744 $7,594 $12,453 ------------------------------------------------------------ ------------------------------------------------------------ </TABLE> The accompanying notes are an integral part of these condensed financial statements. 4
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 1. Financial Statements (Continued) CONSOLIDATED STATEMENT OF CASH FLOWS (In Thousands) <TABLE> <CAPTION> Nine Months Ended September 30, ---------------------- 1998 1997 <S> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES: Net Income 8,657 7,686 Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities Provision for Possible Loan Losses 573 543 Realized Gain on Available-for-Sale and Held-to-Maturity Securities, Net (2,849) (869) Provision for Depreciation 592 530 Accretion and Amortization (164) 507 Deferred Income Tax 110 (118) Decrease in Accrued Interest Receivable and Other 473 759 Liabilities Increase in Accrued Interest Payable and Other 4,150 3,246 Liabilities Net Cash Provided by Operating Activities 11,542 12,284 CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from the Maturity of Held-to-Maturity Securities 140 206 Purchase of Held-to-Maturity Securities (348) (250) Proceeds from Sales of Available-for-Sale Securities 73,411 131,333 Proceeds from Maturities of Available-for-Sale 107,404 36,371 Securities Purchase of Available-for-Sale Securities (196,363) (160,547) Net Increase in Loans (2,468) (7,110) Purchase of Premises and Equipment (1,035) (549) Sale of Foreclosed Assets 224 487 Purchase of Other Real Estate (600) (93) Net Cash Used in Investing Activities (19,635) (152) CASH FLOWS FROM FINANCING ACTIVITIES: Net Increase in Deposits 13,102 7,575 Increase (Decrease) in Short Term Borrowings (13,400) (7,850) Proceeds from (Repayment of) Long Term Borrowings 9,990 (8,935) Sale of Treasury Stock 24 3 Purchase of Treasury Stock (468) Dividends Declared (3,064) (2,734) Net Cash Provided by Financing Activities 6,184 (11,941) INCREASE IN CASH AND CASH EQUIVALENTS (1,909) 191 CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 14,253 14,975 CASH AND CASH EQUIVALENTS, END OF YEAR 12,344 15,166 SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Interest Paid 13,942 14,048 Income Taxes Paid 2,678 2,466 </TABLE> The accompanying notes are an integral part of the consolidated financial statements. 5
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 1. Financial Statements (Continued) Notes to Consolidated Financial Statements 1. The financial information included herein, with the exception of the Consolidated Balance Sheet dated December 31, 1997, is unaudited; however, such information reflects all adjustments (consisting solely of normal recurring adjustments) that are, in the opinion of management, necessary to a fair presentation of the financial position, results of operations and changes in financial position for the interim periods. Results reported for the nine-month period ended September 30, 1998 might not be indicative of the results for the year ended December 31, 1998. This document has not been reviewed or confirmed for accuracy or relevance by the Federal Deposit Insurance Corporation or any other regulatory agency. 2. New Statement of Financial Accounting Standards SFAS No. 130 "Reporting Comprehensive Income", adopted in 1997, is effective for all fiscal years beginning after December 15, 1997, and as such, it will be effective for reporting periods in 1998. Comprehensive income includes all changes in equity during a period from transactions and events from nonowner sources. Before SFAS No. 130, some elements of comprehensive income were presented in the income statement and others were reported in the equity section of the statement of financial position. All elements now are required to be brought together in a single amount of comprehensive income. SFAS No. 131 "Disclosures About Segments of an Enterprise and Related Information" was also adopted in 1997. SFAS No. 131 establishes standards for disclosures about products, services, geographic areas and major customers. The standard is effective for fiscal years beginning after December 15, 1997. The adoption of SFAS No. 131 will not have a material effect on Citizens and Northern's financial condition or results of operations. SFAS No. 132 "Employers' Disclosure About Pensions and Other Post Retirement Benefits" was adopted in January 1998. SFAS No. 132 revises current note disclosure requirements for employers' pensions and other retiree benefits. It does not address recognition or measurement issues. SFAS No. 132 is effective for fiscal years beginning after December 15, 1997. The adoption of SFAS No. 132 will not have a material effect on Citizens and Northern's financial condition or results of operations. 6
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Within this report and included in past reports are "forward-looking" statements. The statements may concern plans, objectives, future events (Year 2000 issues) or performance and assumptions and other statements that are other than statements of historical fact. Citizens and Northern Corporation and its subsidiaries wish to caution readers that the following important factors, among others, may have affected and could in the future affect the Corporation's actual results and cause the Corporation's actual results for subsequent periods to differ materially from those expressed in any forward-looking statement made by or on behalf of the Corporation herein: the effect of changes in laws and regulations, including federal and state banking laws and regulations, with which the Corporation must comply, and the associated cost of compliance with such laws and regulations either currently or in the future as applicable; the effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies as well as the Financial Accounting Standards Board, or of changes in the Corporation's organization, compensation and benefit plans; the effect on the Corporation's competitive position within its market area of the increasing consolidation within the banking and financial services industries, including the increased competition from the larger regional banking organizations as well as nonbank providers of various financial services; the effect of changes in interest rates; and the effect of changes in the business cycle and downturns in the local, regional and national economies. EARNINGS OVERVIEW Net after-tax income for the nine-month period ended September 30, 1998 amounted to $8,657 million or $1.69 per share (on a basic and diluted basis). This compares to $7,686 million or $1.50 per share (on a basic and diluted basis) for the same period in 1997. Total assets at September 30, 1998 were $632,843 million compared to total assets at September 30,1997 of $616,406 million. Net income for the period includes the after-tax gain on the sale of stock of a closely held company that had been carried on the books of the Corporation for $1.00. The stock was obtained in 1919 as collateral for a loan that later became a loss. The company represented by the stock was sold in June 1998 and the stock was purchased for cash. The realized gain, after tax, amounted to approximately $1,132 million or $.22 per basic share. The same period in 1997 also benefited from the sale of a registered trademark amounting to $199,000 after tax or $.04 per basic share. Excluding investment security gains and other extraordinary income for the nine-month periods ended September 30, 1998 and September 30, 1997, earnings per common share would have amounted to $1.47 and $1.46, respectively. Results for the first nine months of 1998, although slightly under budget, were in-line with management's expectations that net income for the nine-month period ended September 30, 1998 would be about the same as that of the same period in 1997. These expectations are contingent upon the current interest rate environment and could change if interest rates increase or decrease abnormally. NET INTEREST MARGIN Net interest margin or net interest income is the dollar amount of difference between all interest income received and interest expense paid. The net interest spread or interest margin is the difference, stated as a percentage, between the average rate received on all interest-earning assets and the average rate paid on all interest-bearing liabilities. The net interest margin as reflected in the income statement has not been adjusted for federal income taxes. Nine Months Period Ended September 30, 1998/1997 Net interest income for the nine-months ended September 30, 1998 increased $615,000 or 3 percent when compared to the same period in 1997. Respectively, gross interest income for the periods ended September 30, 1998 and September 30, 1997 amounted to $36,290,000 and $35,950,000, an increase of 1 percent. Gross interest expense for the same periods amounted to $17,194,000 and $17,469,000, a decrease of 1.5 percent. The net interest margin as a percentage for the current nine month-period was 3.58 percent ; the interest margin for the same period last year was 3.47 percent. 7
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Average earning assets did not change appreciably between the comparable periods. Average earning assets for the current nine-month period were $579,822,000 and $578,014,000 for the nine-month period ended September 30, 1997. The meager growth between the periods was due to a lack of deposit growth and the repayment of borrowings with the growth that was available. Money Market accounts and Certificates of Deposit did post some growth while other deposit categories remained unchanged or declined slightly. Average borrowed funds during the period were reduced by $3,693,000. The overall rate of return on earning assets for the nine months ended September 30, 1998 was 8.37 percent; the return for last year's comparable period was 8.32 percent. The cost of interest-bearing liabilities for the current nine-month period was 4.79 percent and 4.84 percent for the same period last year. The increase in net interest income between the comparable periods is attributable primarily to changes in interest rates as changes in the volume of interest-bearing assets and interest-bearing liabilities posted were minimal. Three Months Ended September 30, 1998/1997 When comparing the respective quarters ended September 30, the net interest margins are $6,626,000 and $6,260,000. Gross interest income for the current three-month period amounted to $12,395,000 and $12,146,000 for the prior year's same three-month period. Gross interest expense for the same periods was $5,769,000 and $5,886,000, respectively. The net interest margins for the three-month periods was approximately 3.55 percent and 3.48 percent, respectively. Again the increase in net interest income and net interest margin for the quarterly periods can be attributed to changes in interest rates. Average interest-bearing assets for the three-month periods ended September 30, 1998 and September 30, 1997 were, respectively, $588,382,000 and $577,885,000. Average interest-bearing liabilities for the three-month periods ended September 30, 1998, and September 30, 1997 amounted to $481,125,000 and $477,406,000, respectively. The composition of average earning assets did not change significantly when comparing the quarters ended September 30, 1998 and September 30, 1997. Gross loans account for 46 percent of the asset base and the investment portfolio accounts for 47 percent. The make up of the available-for-sale investment portfolio did change however, as a portion of the holdings of mortgage-backed securities was sold and reinvested in U.S. Agency investments. The restructuring was necessary to maintain the yield on the portfolio. Neither the composition nor the average balance of the loan portfolio changed significantly during the comparable periods. Average interest-bearing deposit liabilities for the three-months ended September 30, 1998 totaled $481,125,000; this compares to average interest-bearing liabilities for the quarter ended September 30, 1997 of $477,406,000, an increase of $3,719,000. The change consists of an increase in average deposits of $10,799,000 and a decrease in average borrowings of $7,080,000. The increase in deposits for the quarter was one of the largest in recent memory. A large portion of the increase was the result of a Certificate of Deposit marketing campaign and a new Municipal Money Market account that paid rates competitive to nonbank purchasers of municipal accounts. It is also highly likely that a portion of the funds came from customers who had pulled money from the stock market or mutual funds as the markets were in turmoil. Other deposit categories, Interest Checking accounts and Regular Savings accounts posted slight declines. The net interest spread, the difference between total interest earned on all earning assets and the interest paid on all interest-bearing liabilities, was 3.58 percent, 3.48 percent and 3.50 percent for the nine-months ended September 30, 1998, September 30, 1997 and the year ended December 31, 1997, respectively. On March 2, 1998 management lowered its prime lending rate from 8.50 percent to 8.25 percent, offsetting the decrease with a reduction in rates paid on long-term certificates of deposit. Management expects that the net interest spread for the balance of 1998 will remain in the 3.50 percent to 3.60 percent range and that net interest income will approximate that of 1997. 8
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Table I - Analysis of Average Daily Balances and Rates <TABLE> <CAPTION> Rate of Rate of Rate of (In Thousands) Return/ Return/ Return/ Cost of Cost of Cost of funds Funds funds 09/30/98 % 12/31/97 % 09/30/97 % <S> <C> <C> <C> <C> <C> <C> EARNING ASSETS Available-for-Sale Securities: U. S. Treasury Securities 2,518 6.00 2,514 5.53 2,511 5.38 Securities of Other U.S. 74,654 7.00 41,968 7.15 32,502 7.03 Government Agencies and Corporations Mortgage Backed Securities 116,262 6.67 163,942 6.75 174,409 6.71 Obligations of States and 65,671 5.94 59,554 6.04 58,840 6.06 Political Subdivisions Stock 17,250 5.28 15,039 5.81 14,941 5.64 Other Securities 11,771 7.64 4,536 1.15 4,756 1.38 Total Available-for-Sale 288,126 6.54 287,553 6.51 287,959 6.46 Securities Held-to-Maturity Securities: U. S. Treasury Securities 628 5.96 601 5.66 598 6.26 Securities of Other U. S. 508 7.63 297 7.41 279 7.19 Government Agencies and Corporations Mortgage Backed Securities 548 7.32 689 7.55 707 7.56 Total Held-to-Maturity 1,684 6.91 1,587 6.81 1,584 7.01 Securities Interest -bearing Due from Banks 796 4.87 795 6.79 698 6.70 Federal Funds Sold 5,913 4.86 6,132 5.45 5,999 5.39 Loans: Real Estate Loans 225,221 9.05 223,510 9.05 222,935 9.03 Consumer 30,962 21.12 32,293 20.08 32,122 20.24 Agricultural 2,425 9.59 2,689 10.12 2,720 10.08 Commercial/Industrial 17,623 9.26 16,743 9.59 16,682 9.65 Other 708 7.74 754 8.22 679 8.27 Political Subdivisions 6,147 6.05 6,355 6.15 6,397 6.17 Leases 217 9.24 236 7.63 239 7.83 Total Loans 283,303 10.32 282,580 10.28 281,774 10.29 Total Earning Assets 579,822 8.37 578,647 8.34 578,014 8.32 Cash 12,352 12,228 12,252 Securities Valuation Reserve 20,040 9,907 7,968 Allowance for Possible Loan Losses (4,868) (4,844) (4,814) Other Assets 5,317 5,745 5,858 Bank Premises & Equipment 6,764 6,594 6,549 Total Assets 619,427 608,277 605,827 INTEREST-BEARING LIABILITIES Interest Checking 36,773 2.40 38,334 2.47 38,614 2.47 Money Market 110,183 4.67 107,287 4.55 106,712 4.54 Savings 45,380 2.48 46,338 2.48 46,629 2.48 Certificates of Deposit 121,380 5.62 119,226 5.49 118,599 5.48 Individual Retirement Accounts 78,313 5.48 78,662 5.99 78,999 6.03 Other Time Deposits 2,076 2.45 2,223 2.52 2,417 2.43 Federal Funds Purchased 2,036 5.65 663 4.98 498 6.17 Other Borrowed Funds 83,482 5.46 88,548 5.63 89,793 5.62 Total Interest-bearing 479,623 4.79 481,281 4.84 482,261 4.84 Liabilities Demand Deposits 44,381 42,780 42,296 Other Liabilities 9,040 8,211 7,121 TOTAL LIABILITIES 533,044 532,272 531,678 Stockholders' Equity 73,101 69,440 68,855 Securities Valuation Reserve 13,282 6,565 5,294 Total Liabilities and Stockholders' Equity 619,427 608,277 605,827 Interest Rate Spread 3.58 3.50 3.48 </TABLE> 9
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Table II - Effect of Volume and Rate Changes in Interest Income and Interest Expense <TABLE> <CAPTION> Nine-month Periods Ended September 30, 1998/1997 (In Thousands) Change in Change in Total Volume Rate Change <S> <C> <C> <C> EARNING ASSETS Available-for-Sale Securities: U. S. Treasury Securities 12 12 Securities of Other U.S. Government Agencies and 2,207 (9) 2,198 Corporations Mortgage Backed Securities (2,903) (48) (2,951) Obligations of States and Political Subdivisions 302 (52) 250 Stock 87 (36) 51 Other Securities 153 471 624 Total Available-for-Sale Securities (154) 338 184 Held-to-Maturity Securities: U. S. Treasury Securities Securities of Other U.S. Government Agencies and 13 13 Corporations Mortgage Backed Securities (9) (1) (10) Total Held-to-Maturity Securities 4 (1) 3 Interest-bearing Due from Banks 6 (12) (6) Federal Funds Sold (3) (24) (27) Loans: Real Estate Loans 155 34 189 Consumer (138) 166 28 Agricultural (21) (10) (31) Commercial/Industrial 59 (42) 17 Other 2 (3) (1) Political Subdivisions (11) (6) (17) Leases (1) 2 1 Total Loans 43 143 186 Total Interest Income (104) 444 340 INTEREST BEARING LIABILITIES Interest Checking (33) (18) (51) Money Market 120 102 222 Savings (23) (2) (25) Certificates of Deposit 115 127 242 Individual Retirement Accounts (31) (326) (357) Other Time Deposits (6) (6) Federal Funds Purchased 65 (2) 63 Other Borrowed Funds (260) (103) (363) Total Interest Expense (53) (222) (275) NET INTEREST INCOME (51) 666 615 </TABLE> The change in interest due to both volume and rates has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amount of the change in each. 10
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) ALLOWANCE FOR POSSIBLE LOAN LOSSES The Allowance for Possible Loan Losses is a reserve established by management and the Board of Directors, which they believe will absorb future loan losses, based on management's assessment of the quality and volume of the loan portfolio. The assessment is performed on an ongoing basis and reviewed by the Board of Directors quarterly. The quarterly review process is performed by a loan quality committee consisting of the President, Chief Financial Officer, Executive Vice-Presidents in charge of loans and branch administration and monitored by the Corporation's Auditor. The committee reviews the "Watch List" (a collection of loans that have had a history of delinquency), past due reports, non-performing loans and historical information related to charge-offs and recoveries by loan category. The reserve balance is then allocated across the various loan categories to determine the unallocated or excess reserve balance. The allocation is performed using two different methods. The first method, a historical method based on five years of information, calculates the ratio of average losses by type to the average outstanding balance by type. The ratio is then applied to the current outstanding balance of the various loan categories to determine the amount of reserve to be allocated to the loan category. In addition to the historical calculated amount, at times the committee will add additional amounts to the calculated total if it is aware of a particular problem or the five-year average is not representative of current conditions. The second allocation method extracts loans by a quality rating system. The ratings are substandard, doubtful and loss. Regulatory guidelines are then applied: 15 percent of the substandard category, 50 percent of the doubtful category and 100 percent of the loss category loans. Other factors used to measure the level of the reserve are loan growth, economic conditions of the market area and peer group comparisons. The Corporation also retains the services of an independent loan appraiser who reviews all credit relationships in excess of $175,000 and loans of $100,000 or more in offices where there is perceived to be excess delinquency. The latest review was started on May 15, 1998 and concluded June 15, 1998. The results of the latest review are disclosed in Table VI The following tables present current and historical information on the loan portfolio and the Reserve for Possible Loan Losses. TABLE III Reserve for Possible Loan Losses Reconciliation <TABLE> <CAPTION> Estimated Actual Actual Actual Actual Actual Dec. 31, 1998 Sept. 30, 1998 Dec. 31, 1997 Dec. 31, 1996 Dec. 31, 1995 Dec 31, 1994 <S> <C> <C> <C> <C> <C> <C> Beginning Balance January 1, $ 4,913,334 $ 4,913,334 $ 4,775,960 $ 4,579,210 $ 4,228,741 $ 3,816,982 Provision Charged to Earnings 763,416 572,562 797,032 700,500 736,500 737,496 Year-to-Date Recoveries 140,000 86,713 124,407 167,926 187,473 194,312 Year-to-Date Charge-Offs (1,225,000) (823,861) (784,065) (671,676) (573,504) (520,049) Ending Balance $ 4,591,750 $ 4,748,748 $ 4,913,334 $ 4,775,960 $ 4,579,210 $ 4,228,741 </TABLE> 11
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) <TABLE> <CAPTION> TABLE IV - FIVE YEAR HISTORY OF LOAN LOSSES Projected (In Thousands) 1998 1997 1996 1995 1994 1993 AVERAGE <S> <C> <C> <C> <C> <C> <C> <C> Net Loans * 292,000 285,426 278,597 264,182 258,472 238,755 265,086 Net Charge-Offs 1,085 660 504 387 326 247 425 Allowance for Possible Loan Losses Balance 4,592 4,913 4,776 4,579 4,229 3,817 4,463 Provision for Loan Losses Charged to Earnings 763 797 701 737 737 708 736 Earnings 10,893 10,107 9,255 7,866 7,494 8,127 8,570 Earnings Coverage of Net Charge-Offs 10.0 x 15.3 x 18.4 x 20.3 x 23.0 x 32.9 x 22 x Allowance Coverage of Net Charge-Offs 4.5 x 7.4 x 9.5 x 11.8 x 13.0 x 15.5 x 11 x Loans Ninety Days or More Past Due and Still Accruing 2,925 2,900 2,994 2,915 2,743 2,899 2,890 Net Charge-Offs as a Percent of the Provision 142.2% 82.8% 71.9% 52.5% 44.2% 34.9% 57% Year-End Nonperforming Loans** 1,130 1,412 864 279 624 843 804 Allowance as a Percentage of Gross Loans: * Bank (1) 1.64% 1.72% 1.71% 1.73% 1.64% 1.60% 2% Peer Group (2) 1.53% 1.43% 1.50% 1.61% 1.65% 1.82% 2% </TABLE> * Gross Loans less Unearned Discount (1) At September 30, 1998 (2) At June 30, 1998 ** At September 30, 1998 12
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) TABLE V - Reserve Allocation - Historical Reserve Allocation-Historical <TABLE> <CAPTION> Est. LOAN CLASSIFICATION 1998 1997 1996 1995 1994 1993 Average <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> Commercial, Agricultural, 30,338 25,751 30,054 26,481 22,794 26,530 26,322 0.00115X 30,338= 35 Municipal & Other Real Estate - Mortgage 225,000 220,358 215,123 201,350 195,688 172,756 201,055 0.00043X 225,000= 97 Credit Card & Related Plan 10,000 9,084 8,902 9,934 9,896 9,212 9,406 0.01667X 10,000= 440 All Other Loans to Individuals 33,500 30,270 24,518 26,417 30,094 30,282 28,316 0.00587X 33,500= 262 Total Loans 298,838 285,463 278,597 264,182 258,472 238,780 265,099 0.00166 298,838 Letter of Credit Commitments 5,500 5,012 5,106 2,633 4,415 5,046 4,442 0.00115X 5,500= 6 All Other Commitments Consumer 30,000 27,728 28,049 24,811 24,202 23,323 25,623 0.00587X 30,000= 176 Mortgage 11,000 10,497 5,802 7,276 9,566 9,466 8,521 0.00043X 11,000= 5 Commercial 13,000 13,045 10,825 10,201 9,901 9,790 10,752 0.00115X 13,000= 15 Impaired Loans 742 274 113 228 742 Total allocated 1,77 8 Unallocated 2,971 Reserve Balance 4,749 </TABLE> The reserve balance allocation ratio is determined using the six-year average net charge-offs divided by the six-year average loan balance by type. TABLE VI -Reserve Allocation Based on Regulatory Standards September 30,1998 Regulatory Reserve Allocation <TABLE> <CAPTION> September 30, 1998 Loan Classifications - -------------------- <S> <C> Substandard 15% 1,234,129 Doubtful 50% 727,873 Loss 100% 50,605 FASB 114 Allocation 742,430 - ------------------------------------------------------------- Required Reserve 2,755,037 Unallocated 1,993,707 - ------------------------------------------------------------- Total Reserve 4,748,744 </TABLE> 13
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) TABLE VII - COMPARISON OF NONINTEREST INCOME <TABLE> <CAPTION> Nine-Month Periods Ended September 30 September 30 % $ 1998 1997 Change Change <S> <C> <C> <C> <C> Service Charges on Deposit Accounts $775 $812 (4.6%) ($37) Service Charges and Fees 212 210 1.0% 2 Trust Department Income 952 774 23.0% 178 Insurance Commissions, Fees and Premiums 323 343 (5.8%) (20) Other Operating Income 75 382 (80.4%) (307) Total Other Operating Income before Realized Securities Gains (Losses) on Securities, Net 2,337 2,521 (7.3%) (184) Gains (Losses) on Securities, Net 2,849 869 227.8% 1,980 Total Other Income $5,186 $3,390 53.0% $1,796 </TABLE> Total Other Operating Income before Realized Gains on Securities decreased 7 percent or $184,000 during the nine-month period ended September 30, 1998 when compared to the nine-month period ended September 30, 1997. The decrease was caused by the recognition of extraordinary income from the sale of a copyright or trademark during the nine-month period ended September 30, 1997. The before-tax effect was $301,000. Categories of Other Operating Income include Service Charges on Deposit Accounts, Other Service Charges and Fees, Trust Department Income, Bucktail Life Insurance Co. Premiums and Other Operating Income. Service Charges on Deposit Accounts, consisting of account activity charges and overdraft charges, has declined slightly during the past two years. During the nine-month periods ended September 30, 1997 and September 30, 1998 average monthly service charges generated amounted to $86,000 and $90,000 , respectively. The fees consistently average about 56 percent service charges and 44 percent overdraft fees. The decrease is due to a decline in the number of daily overdrafts and an increase in the number of customers utilizing Money Market Accounts, free payroll accounts and senior citizens accounts. Payroll accounts are free if direct deposit is utilized; the total number of accounts has increased by nearly 400 since September 30, 1997. Also, the number of accounts utilizing free services has increased by 724 during the past year. This includes new accounts and accounts that have changed service charge type. Service Charges and Fees, consisting of debit card fees, credit card annual fees, official check sales and check cashing fees, has not changed significantly when comparing the nine-month periods ended September 30, 1998 and September 30, 1997. Those fees average between $23,000 and $25,000 per month. Trust Department Income is the largest contributor to Other Operating Income and has posted a gain of 23 percent or $178,000 during the nine-month period ended September 30, 1998 when compared to the same period in 1997. The significant increase posted during the current period is directly related to the amount of trust assets under management. For the periods ended September 30, 1998 and September 30, 1997, trust assets under management amounted to $254,162, 000 and $228,119,000, respectively. The growth in trust assets is the result of an aggressive sales program and investment management. Insurance Commissions, Fees and Premiums decreased $20,000 when comparing the nine-month periods ended September 30, 1998 and September 30, 1997. The decrease is the result of a lack of loan activity and alternate sources of credit life and accident and health insurance. 14
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Other Operating Income is made up primarily of safe deposit box rentals, earnings or losses on the "Supplemental Employees Retirement Plan" ("SERP") and gains received on the sale of bank assets. The amounts reflected for the nine-month periods ended September 30, 1998 and September 30, 1997 were $75,000 and $382,000, respectively. Normally, Other Operating Income will average about $20,000 per quarter. The nine-month period ended September 30, 1997 includes a gain of $301,000 from the sale of a Corporation owned copyright. Realized Securities Gains during the nine-month period ended September 30, 1998 amounted to $2,849,000. A substantial portion, or $1,711,000, was due to the sale of stock that was carried on the books at $1.00. The stock was acquired as collateral on a loan that defaulted in 1919. The Corporation was recently liquidated with the resulting gain. The balance of the realized gains is from the sale of equity investments that management felt would be prudent to liquidate and lock in realized gains. Also included were losses amounting to $50,000 that were part of a small restructuring of the available-for-sale investment portfolio. During the nine months ended September 30, 1997 realized gains on the sale of equity investments totaled $869,000. Gains realized on equity investments are part of the total investment return on equity securities, which include both dividends and appreciation. Dividends alone from equity investments are inadequate to compensate the Corporation for its investment. TABLE VIII- COMPARISON OF NONINTEREST EXPENSE <TABLE> <CAPTION> Nine-month Periods Ended September 30 September 30 % $ (In Thousands) 1998 1997 Change Change <S> <C> <C> <C> <C> Salaries and Wages $4,813 $4,459 7.94% $354 Pensions and Other Employee Benefits 1,295 1,266 2.29% 29 Occupancy Expense, Net 617 535 15.33% 82 Furniture and Equipment Expense 599 513 16.76% 86 Other Operating Expense 4,856 4,501 7.89% 355 Total Other Expense $12,180 $11,274 8.04% 906 </TABLE> Salaries and Wages increased 7.8 percent or $229,000 during the nine-month period ended September 30, 1998 when compared to the nine-month period ended September 30, 1997. The increase is the result of annual merit raises and the number of full time equivalent employees increased to 206. Pensions and Other Employee Benefits consists primarily of social security taxes, group life and health insurance, contributions to the 401 (k) plan and pension expense. The cost of Pensions and Other Employee Benefits did not change significantly when comparing the nine-month periods ended September 30, 1998 and September 30, 1997. The total change amounted to $29,000 or just over 2 percent. Occupancy Expense, consisting of insurance, maintenance, real estate taxes, depreciation and other utilities, increased 15 percent or $82,000 when comparing the nine-month periods ended September 30, 1998 and September 30, 1997. The increase was due to increased depreciation costs caused by the replacement of roofs on two branch offices, an extensive remodeling of one of the branch locations and ATM site preparation. An adjacent property was also purchased at our Wellsboro location at a cost of $75,000. 15
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Furniture and Equipment Expense increased $86,000 or 16.7 percent when comparing the nine-month periods ended September 30, 1998 and September 30, 1997. The increase is due to the replacement of several vehicles and the purchases of a statement folder inserter, a new data card embosser and a new item processing image storage system. The combined cost of the equipment was in excess of $150,000. It is expected that for the balance of 1998 equipment maintenance will continue to increase with the installation of 12 ATMs and plans for the installation of additional machines. Other Operating Expense increased 8 percent or $355,000 when comparing the nine-month period ended September 30, 1998 to the same period in 1997. Other Operating Expense is comprised of several components. The largest components are the Pennsylvania Shares Tax and credit card expense; combined they constitute just over half of Other Operating Expense. Those components posted a combined increase of 15 percent or $358,000 when the nine-month periods ended September 30, 1998 and September 30, 1997 are compared. The increased credit card costs are the result of increases in credit card interchange fees or increased merchant usage fees. It should be noted that the increase in interchange fees is more than offset in increased income. The increase in Pennsylvania Shares Tax is due to bank earnings and an increase in the market value adjustment of the Bank's investment portfolio. Also included in Other Operating Expense are expenses related to Bucktail Life Insurance Company, a subsidiary of Citizens & Northern Corporation. Expenses incurred by the subsidiary dropped $89,000 between the comparable nine-month periods due to the decline in underwriting business. There were no other material increases in expenses classified as Other Operating Expense. The Corporation continually monitors Other Operating Expense and has been successful in holding those expenses to a minimum. STATEMENT OF CONDITION Nine-Month Period Ended September 30, 1998/1997 -- Twelve-Month Period Ended December 31, 1997 Average total assets of the Corporation were $619,427,000 and $605,827,000 for the comparable periods ended September 30, 1998/1997, respectively. The increase in average assets between the two periods can be attributed to an increase in average deposits of $4,220,000 and an increase in the average after-tax market value adjustment of the investment portfolio amounting to 5,000,000. Average total assets for the year ended December 31, 1997 totaled $608,277,000. When comparing the year ended December 31, 1997 to the current period, average total assets increased $11,150,000, which also is attributable to an increase in the market value adjustment of the investment portfolio and increased average deposit totals. Unrealized gains included in total assets for the periods ended September 30, 1998/1997 respectively, amounted to $13,282,000 and $5,294,000. At December 31, 1997 the average adjustment was $6,565,000. The asset structure of the Corporation changed very little during the periods being compared; average total loans comprise 46 percent of the asset base and the investment portfolio 47 percent . The same percentages are applicable to all comparable periods. The structure of the investment portfolio has changed somewhat during 1998. Principal prepayments precipitated by a decline in interest rates caused the return on the holdings of mortgage-backed investments to be reduced to unacceptable levels. To increase the rate of return approximately $71,000,000 of the mortgage-backed instruments were sold at a loss of approximately $50,000; the funds made available by the sale were reinvested in U. S. Agency securities, primarily FNMA zero coupon bonds and Federal Home Loan Bank bonds. Also, for tax purposes the level of municipal bond holdings was increased nearly $7,000,000 between the nine-month comparable periods. The loan portfolio has remained nearly unchanged both in total loans and make-up of total loans. Real estate secured loans still comprise nearly 80 percent of total loans. The average loan-to-deposit ratio of the Corporation for the nine-month periods and the year ended December 31, 1997 was 64 percent. Loan demand has shown some improvement since September 30, 1998; at this writing total loans amount to just over $289,000,000. 16
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) The Corporation has installed 12 new automated teller machines at strategic locations in the market area with an additional 1 or 2 units scheduled for installation later this year. Also, the Corporation has opened a new office in Mansfield, Pennsylvania. The new office opened in October 1998. The cost of the new facility was approximately $525,000. On the liability side of the balance sheet the growth of average interest-bearing deposits September 30, 1997 through September 30, 1998 has been relatively flat at less than 1 percent; however, during the months of July, August, and September of this year deposits have grown by 5 percent. The deposit growth has been primarily Money Market accounts and Certificates of Deposit . The growth can be attributed to an aggressive marketing effort and higher interest rates. Management expects that 1998 will bring continued competition for deposits from credit unions, brokerage houses and other nonbank competitors and it will continue to look for innovative deposit products to hold current customers and attract new business. Average borrowed funds have declined about 4 percent between the comparable periods primarily because of the lack of investment opportunities with the flatness of the yield curve. However, it appears at this time, as short term rates continue to decline that a spread is beginning to open between short and longer term rates and that leverage opportunities may be forthcoming. LIQUIDITY Liquidity is the ability to raise cash quickly and at a reasonable cost. An adequate liquidity position permits the Corporation to pay creditors, compensate for unforeseen deposit fluctuations and fund unexpected loan demand. Daily deposit decreases normally do not exceed $4,000,000 to $6,000,000 and new loan advances net of loan repayments have not been significant. In addition to the daily sources of cash, such as loan repayments, amortization of mortgage-backed investments, maturing bonds and deposit growth, the Corporation has several additional sources of liquidity: the sale of assets (primarily available-for-sale investment securities), short-term or long-term borrowing. Sources of borrowing include the Federal Home Loan Bank of Pittsburgh and several correspondent bank relationships. CAPITAL ADEQUACY Under regulations published by the Federal Deposit Insurance Corporation and other bank regulators, a bank's capital must be divided into two tiers. The first tier or tier one capital consists primarily of common stock, retained earnings, surplus and non-cumulative perpetual preferred stock. Tier two includes the allowance for possible loan losses (limited to 1.25 percent of risk-weighted assets), cumulative preferred stock and subordinated debt. Risk-based capital guidelines published in 1990 require banks to maintain a risk-based capital ratio of 8 percent, 4 percent of which must be tier one; the remainder may be tier two. The total risk-based capital ratios at September 30, 1998, September 30, 1997 and December 31, 1997 were 22.66 percent, 22.92 percent and 23.86 percent, respectively. The primary source of capital growth for the Corporation is earnings. Capital growth for the nine-month periods ended September 30, 1998 and September 30, 1997 on an annualized basis was 9.50 percent and 10.06 percent, respectively; capital growth for the year ended December 31, 1997 was 9.7 percent. Dividend payments as a percentage of net income amounted to 35.4 percent for the nine months ended September 30, 1998 and 35.6 percent for the same period in 1997. Total capital of the Corporation (excluding unrealized gains on available-for-sale securities) at September 30, 1998, September 30, 1997 and December 31, 1997 was $77,349,000, $70,781,000 and $72,200,000, respectively. The leverage ratio (capital divided by total liabilities), excluding unrealized gains on available-for-sale securities, at September 30, 1998, September 30, 1997 and December 31, 1997, was 14.2 percent, 13.2 percent and 13.6 percent, respectively. Planned capital expenditures during the next 12 months will amount to an estimated $1,000,000. These expenditures will not have a detrimental effect on capital ratios or results of operations. 17
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) INFLATION Inflation affects nearly every aspect of banking, primarily interest rates. The effect of inflation, when it is high, also has an impact on the cost of goods, such as supplies, services and labor. Growth in the Consumer Price Index for 1998 is projected at about 2 percent which is considered not to be inflationary. In essence, inflation does not appear to be a problem in the near-term and should not impact the results of operations for the balance of 1998. 18
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 3. Interest Rate Risk and Market Risk INTEREST RATE RISK AND MARKET RISK The risk that arises from changes in interest rates is an inherent factor in operating a bank. The risk associated with changes in interest rates is two fold: the risk to earnings and the risk to the market values of assets and liabilities. From an earnings risk perspective, an asset sensitive institution (positive gap) will normally benefit from rising rates and a liability sensitive (negative gap) will benefit from falling interest rates. Citizens & Northern Corporation uses a simulation model that calculates earnings under varying interest rate shock scenarios, most commonly up 100, 200 and 300 basis points and the same rate scenarios in a falling rate environment. The Asset and Liability Committee and the Board of Directors have established a 20 percent decrease in net interest income as a parameter at a 200 basis point (2 percent) increase in interest rates. The model is run monthly using the current maturity schedule of the Corporation's assets and liabilities and certain prepayment assumptions. The risk associated with interest rate increases and decreases as they relate to the market value of the assets and liabilities of the Corporation is also calculated using the same model and the same rate shock of plus and minus 100, 200, and 300 basis point swings in rates. Market values are estimated by applying present value calculations to the cash flow generated by the Corporation's balance sheet. The Asset and Liability Committee and Board of Directors have also imposed a market loss limit of 25 percent at a 200 basis point rate shock. The model utilized to create Table IX makes estimates, at each level of interest rate change, regarding cash flows from principal repayments on loans and mortgage-backed securities and call activity on other investment securities. Actual results could vary significantly from these estimates which could result in significant differences in the calculation of projected changes in net interest margin and market value of portfolio equity. Also, the model does not make estimates related to changes in the composition of the deposit portfolio that could occur due to rate competition and the table does not necessarily reflect changes that management would make to realign the portfolio as a result of changes in interest rates. TABLE IX - EFFECT OF HYPOTHETICAL CHANGES IN INTEREST RATES NIM = Net Interest Margin MVPE = Market Value of Portfolio Equity <TABLE> <CAPTION> (In Thousands) At September 30, 1999 At September 30, 1998 Estimated Estimated Estimated Estimated Change in Estimated Change in Change in Estimated Change in Change in Interest Rates NIM NIM NIM MVPE MVPE MVPE (Basis Points) $ $ % $ $ % <S> <C> <C> <C> <C> <C> <C> <C> Plus 300 20,851 (3,402) (12.73) 59,925 (29,055) (32.65) Plus 200 21,926 (1,967) (8.23) 69,180 (19,800) (22.25) Plus 100 22,967 (926) (3.88) 78,963 (10,017) (11.26) Flat 23,893 88,980 Minus 100 24,653 760 3.18 98,828 9,848 11.07 Minus 200 25,357 1,464 6.13 109,230 20,250 22.76 Minus 300 26,224 2,331 9.76 116,540 27,560 30.97 </TABLE> 19
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 3. Interest Rate Risk and Market Risk (Continued) EQUITY SECURITIES RISK The Corporation's equity securities portfolio consists of restricted stock, primarily of the Federal Home Loan Bank of Pittsburgh ("FHLB") and investments in stock of banks and bank holding companies located mainly in Pennsylvania. FHLB stock can only be sold back to the FHLB or to another member institution at par value. Accordingly, the Corporation's investment in FHLB stock is carried at cost, which equals par value, and is evaluated for impairment. Factors that might cause FHLB stock to become impaired are primarily regulatory in nature and are related to potential problems in the residential lending market; for example, the FHLB may be required to make dividend or other payments to the Financing Corporation, the Resolution Funding Corporation, or other entities, in amounts that could exceed the FHLB's total equity. Investments in bank stocks are subject to the risk factors that affect the banking industry in general, including competition from nonbank entities, credit risk, interest rate risk and other factors, which could result in a decline in market prices. Also, losses could occur in individual stock held by the Corporation because of specific circumstances related to each bank. Further, since the stocks held are bank and bank holding companies concentrated in Pennsylvania, these investments could decline in market value if there is a downturn in the state's economy. Equity securities held as of September 30, 1998 and September 30, 1997 are presented in Table X. TABLE X - EQUITY SECURITIES <TABLE> <CAPTION> Hypothetical Hypothetical 10 % 20 % Decline Decline In In (In Thousands) Fair Market Market At September 30, 1998 Cost Value Value Value <S> <C> <C> <C> <C> Bank & Bank Holding Companies 15,642 28,648 (2,865) (5,730) Fed. Home Loan Bank and Other Restricted Stocks 4,367 4,367 (437) (873) Total 20,009 33,015 (3,302) (6,603) </TABLE> <TABLE> <CAPTION> Hypothetical Hypothetical 10 % 20 % Decline Decline In In (In Thousands) Fair Market Market At September 30, 1997 Cost Value Value Value <S> <C> <C> <C> <C> Bank & Bank Holding Companies 10,801 23,324 (2,332) (4,665) Fed. Home Loan Bank and Other Restricted Stocks 3,533 3,533 (353) (707) Total 14,334 26,857 (2,685) (5,372) </TABLE> 20
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 4. Year 2000 Compliance YEAR 2000 COMPLIANCE The "Year 2000" or "Y2K" problem is a computer problem that began when computers began to store and process information. The problem occurs as a result of the date format used in most older software and older computers. The year has often been stored as a two digit number, e.g., 1998 as 98. When the date rolls forward to 2000, most computers and computer software will look at the date as 00 or 1900. This could have a major impact on many calculations if not corrected. Citizens & Northern Corporation began working on the problem in 1996 with the formation of a "Year 2000 Committee" that meets periodically and reports to the Board of Directors regularly. The most critical phase of the "Year 2000" problem is the testing function, to be implemented as follows: 1. Computers A. Hewlett Packard Mainframe 1. Application software 2. System software 3. Hardware B. Personal computers 1. Purchased software 2. Hardware 2. Environmental Systems A. Heating and cooling systems B. Vaults C. Security systems D. Elevators E. Utilities 3. Other Third Parties A. Customers B. Financial Institutions C. Automated Clearing House System (Federal Reserve) D. Vendors Testing Strategy The testing strategy will vary depending on the area being tested. Various detailed elements of this plan will be developed as the particular areas are being reviewed. The proposed testing schedule follows: 6/30/98 Completion of testing strategies and plans 12/31/98 Application and integrated application testing complete 3/31/99 External testing with third parties (customers, financial institutions, etc.) 6/30/99 Testing and implementation of all mission critical systems complete 21
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 4. Year 2000 Compliance (Continued) Critical Dates to be Tested 1. Dates less than 2000 2. System roll dates from 12/31/99 to 1/1/2000 3. Validate all accrual calculations made from last business day of 1999, December 31, 1999, to the first day of business on January 3, 2000 4. Test date rollover from 1/31/2000 to 2/1/2000 5. Test date rollovers from 2/28/2000 to 2/29/2000 and on to 3/1/2000 6. Test 1/7/2000 and 1/10/2000 to verify first Friday and first Monday Other date testing procedures 1. Test end of quarter processing 2. Test year display fields on profiles and maintenance records 3. Test system sorts 4. Test date calculations 5. Test acceptance of date from operating systems 6. Calculate resultant values from dates 7. Test age calculations 8. Validate financial calculations (Interest, etc.) 9. Test expiration date processing 10. Test historical decision analysis 11. Test inventory processing 12. Test billing calculations 13. Validate cycle processing dates 14. Test archival date processing 15. Test system record purges Documentation For each area of testing, the following information shall be maintained by the Compliance Department. (1) Tests performed, (2) how the test types are determined, (3), test results, (4) plans for further remediation and testing, if required and (5) individuals responsible for testing and acceptance of testing results. Testing of Main Frame Computer. The objective is to test all applicable hardware, system software, purchased software and software developed in-house to determine that appropriate steps and changes have been made to minimize "Year 2000" risk. The testing strategy is to test all applications, giving major consideration to mission critical systems. A list of all applications will be reviewed to determine the testing order. To facilitate the testing, our backup system will be utilized to run the tests. The tests will be performed by the Data Processing Department and monitored by the Audit and Compliance Departments. For each application, testing criteria, including critical test dates and testing methodology, will be developed and a certification form will be completed stating the level of compliance and any remedial efforts required. After the completion of application testing, integration testing will begin. These tests will determine if all application systems will run properly as they interact with each other in a simulation environment. 22
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part I - Financial Information (Continued) Item 4. Year 2000 Compliance (Continued) Personal Computers The Corporation uses approximately 70 personal computers to perform a variety of functions. The uses of personal computers follow: <TABLE> <S> <C> <C> Demand Deposit Imaging System (2 Locations) ATMs Telephone Banking Trust Department Bankcard Services Personnel Asset and Liability System Fixed Asset Accounting Call Report Software Credit Bureau System Appraisal Department Automated Clearinghouse Correspondent Banking Corporate and Subsidiary Accounting Investment Accounting </TABLE> Personal Computer Software Letters were sent to all software vendors to determine if the software is "Year 2000" compliant or will be in the near future. All results will be reviewed and second letters sent if no response is forthcoming. If the software is not compliant new software will be purchased. Personal Computer Hardware All personal computers have been tested to determine if the BIOS is compliant; those that did not pass the test were flagged and will be fitted with a new BIOS or replaced. Environmental Systems All environmental systems, e.g., elevators, heating and cooling, security systems utilities and fax equipment will be checked to see what impact the year change might have on them. Third Parties A list of third parties has been prepared and will be reviewed for compliance. The list includes, but is not limited to, Credit Bureaus, Federal Reserve, Clearinghouses, Fedline (part of the Federal Reserve) and larger Customers. Vendors (nonsoftware) Vendor testing for compliance will be nearly impossible. A list of major suppliers will be prepared and contacts will be made to determine if the vendors will be able to provide the required services or products at the century date change. Citizens and Northern Corporation employs a staff of system analysts and programmers and it is difficult to estimate the total cost of compliance since the work has been done in-house and over a long period of time, beginning in 1996. The main frame computer and network modems will be replaced in late 1998 or early 1999 at a cost of about $300,000. Several PCs and PC software will be replaced and item processing software will have to be updated. The cost of PC replacement is estimated to be between $50,000 and $75,000; software upgrades will probably be equal to that. Upgrading the item processing image system will cost approximately $32,000. 23
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Part II - Other Information Item 1. Legal Proceedings There are currently no pending lawsuits against Citizens & Northern Corporation. Item 4. Not Applicable Item 5. Other Events a. None Item 6. Exhibits and Reports on Form 8 - K a. Exhibits filed as a part of this report - None b. No reports on Form 8 - K were filed during the period ended September 30, 1998. 24
CITIZENS AND NORTHERN CORPORATION - FORM 10 - Q Signature Page SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CITIZENS & NORTHERN CORPORATION November 9, 1998 By: /s/ Craig G. Litchfield - ---------------- ----------------------- Date President and Chief Executive Officer November 9, 1998 By: /s/ James W. Seipler - ---------------- -------------------- Date Executive Vice President and Treasurer 25