UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ending: June 30, 2001 Commission file number: 000-28449 UNION BANKSHARES, INC. VERMONT 03-0283552 P.O. BOX 667 MAIN STREET MORRISVILLE, VT 05661 Registrant's telephone number: 802-888-6600 Former name, former address and former fiscal year, if changed since last report: Not applicable Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----- ----- Indicate the number of shares outstanding of each of the issuer's classes of common stock as of June 30, 2001: Common Stock, $2 par value 3,029,929 shares UNION BANKSHARES, INC. TABLE OF CONTENTS <TABLE> <s> <c> PART 1 FINANCIAL INFORMATION Financial Statements Union Bankshares, Inc. Consolidated Balance Sheet 3 Consolidated Statement of Income - Year to Date 4 Consolidated Statement of Changes in Stockholder's Equity 5 Consolidated Statement of Cash Flows 6 Notes to Financial Statements 8 Management's Discussion and Analysis of Financial Condition and Results of Operations 10 PART II OTHER INFORMATION Item 6 EXHIBITS AND REPORTS ON FORM 10-Q 26 Signatures 26 </TABLE> Union Bankshares, Inc. and Subsidiaries Consolidated Balance Sheets (Unaudited) <TABLE> <CAPTION> June 30 December 31 (Dollars in Thousands) 2001 2000 ------- ----------- <s> <c> <c> Assets Cash and due from banks $ 11,887 $ 10,353 Federal funds sold and overnight deposits 4,069 1,070 ---------------------- Total cash and cash equivalents 15,956 11,423 Interest bearing deposits 2,732 1,721 Securities available-for-sale 49,956 56,642 Federal Home Loan Bank stock 1,064 1,017 Loans held for sale 10,629 9,153 Loans 224,649 215,893 Unearned loan fees (259) (250) Allowance for loan losses (2,770) (2,863) ---------------------- Loans, net 221,620 212,780 ---------------------- Accrued interest receivable 2,262 2,597 Bank premises and equipment, net 3,738 3,964 Other real estate owned 135 116 Other assets 3,797 3,738 ---------------------- Total assets $311,889 $303,151 ====================== Liabilities and Stockholders' equity: Liabilities: Deposits: Non-interest bearing $ 33,110 $ 33,547 Interest bearing 228,141 225,189 ---------------------- Total deposits 261,251 258,736 Borrowed funds 10,877 6,382 Accrued interest and other liabilities 3,293 2,876 ---------------------- Total liabilities 275,421 267,994 ---------------------- Stockholders' equity: Common stock, $2 par value; 5,000,000 shares authorized; 3,263,889 shares issued at 6/30/01, 3,263,689 shares issued at 12/31/00. 6,528 6,527 Paid-in capital and surplus 241 240 Retained earnings 30,848 30,010 Treasury stock at cost (233,960 shares at 6/30/01 and 12/31/00) (1,592) (1,592) Accumulated other comprehensive income 443 (28) ---------------------- Total stockholders' equity 36,468 35,157 ---------------------- Total liabilities and stockholders' equity $311,889 $303,151 ====================== </TABLE> See accompanying notes to unaudited financial statements. Union Bankshares, Inc. and Subsidiaries Consolidated Statements of Income (Unaudited) <TABLE> <CAPTION> 3 Months Ended Six Months Ended June 30 June 30 ----------------------- ----------------------- (Dollars in Thousands) 2001 2000 2001 2000 ---- ---- ---- ---- <s> <c> <c> <c> <c> Interest income: Interest and fees on loans $ 5,178 $ 4,908 $ 10,272 $ 9,649 Interest and dividends on investment securities 784 900 1,609 1,824 Interest on federal funds sold 103 73 180 122 Interest on interest bearing deposits 33 31 60 60 --------------------------------------------------- 6,098 5,912 12,121 11,655 Interest expense: Interest on deposits 2,328 2,319 4,742 4,546 Interest on federal funds purchased 1 3 3 4 Interest on borrowed funds 132 57 243 95 --------------------------------------------------- 2,461 2,379 4,988 4,645 --------------------------------------------------- Net interest income 3,637 3,533 7,133 7,010 Provision for loan losses 57 63 113 125 --------------------------------------------------- Net interest income after provision for loan losses 3,580 3,470 7,020 6,885 Noninterest income: Trust department income 63 34 150 76 Service fees 615 597 1,186 1,146 Security gains (losses) 76 (3) 74 34 Gain on sale of loans 0 0 73 9 Other 20 (3) 22 3 --------------------------------------------------- 774 625 1,505 1,268 Noninterest expense: Salaries and wages 1,140 1,212 2,300 2,311 Pension and other employee benefits 336 279 675 577 Occupancy expense, net 172 135 337 292 Equipment expense 217 230 429 530 Other operating expense 755 753 1,403 1,420 --------------------------------------------------- 2,620 2,609 5,144 5,130 --------------------------------------------------- Income before income tax expense 1,734 1,486 3,381 3,023 Income tax expense 489 318 968 777 --------------------------------------------------- Net income $ 1,245 $ 1,168 $ 2,413 $ 2,246 =================================================== Earnings per common share $ .41 $ .38 $ .80 $ .74 --------------------------------------------------- Weighted average number of common shares outstanding 3,029,784 3,029,529 3,029,757 3,029,529 =================================================== Dividends declared per share $ .26 $ .24 $ .52 $ .48 =================================================== </TABLE> See accompanying notes to unaudited financial statements Union Bankshares, Inc. and Subsidiaries Consolidated Statement of Changes in Stockholders Equity (Unaudited) <TABLE> <CAPTION> Accumulated Other Total Common Paid-in Capital Retained Treasury Comprehensive Stockholders' Stock & Surplus Earnings Stock Income (Loss) Equity -------------------------------------------------------------------------------- (Dollars in Thousands) <s> <c> <c> <c> <c> <c> <c> Balance, December 31, 2000 $6,527 $240 $30,010 $(1,592) $ (28) $35,157 Net income 2,413 2,413 Change in net unrealized holding gain (loss) on securities available-for-sale, net of tax 471 471 ------- Comprehensive income 2,884 ------- Cash dividends declared (1,575) (1,575) Treasury stock purchased 0 Exercise of stock option 1 1 2 ----------------------------------------------------------------------------- Balance June 30, 2001 $6,528 $241 $30,848 $(1,592) $ 443 $36,468 ============================================================================= </TABLE> See accompanying notes to unaudited financial statements. Union Bankshares, Inc. and Subsidiaries Consolidated Statement of Cash Flows (UNAUDITED) <TABLE> <CAPTION> Year to Date ------------------ June 30 June 30 (Dollars in Thousands) 2001 2000 ------------------ <s> <c> <c> Cash Flows From Operating Activities Net Income $ 2,413 $ 2,246 Adjustments to reconcile net income to net cash provided by operating activities Depreciation 314 428 Provision for loan losses 113 125 Credit for deferred income taxes (152) (25) Amortization, net Securities 25 30 Amortization, net Limited Partnerships 31 17 Write-downs of Other Real Estate Owned 0 8 Increase (decrease) in unamortized loan fees 9 (6) (Increase) decrease in loans held for sale (1,403) 577 (Increase) decrease in accrued interest receivable 335 (23) (Increase) decrease in other assets (374) 201 Increase (decrease) in income taxes payable 375 (128) Decrease in accrued interest payable (204) (80) Increase in other liabilities 246 394 Gain on securities sold (74) (34) Gain on sale of loans (73) (9) Gain on sale of OREO (16) (2) Loss on disposal of fixed assets 9 3 ------------------ Net cash (used) provided by operating activities 1,574 3,722 Cash Flows From Investing Activities Interest bearing deposits Maturities and redemptions 396 694 Purchases (1,481) (690) Securities available for sale Maturities and redemptions 18,554 8,399 Purchases (10,760) (3,170) Purchase of Federal Home Loan Bank Stock (47) (78) Increase in loans, net (9,068) (3,527) Recoveries of loans charged off 64 79 Purchases of premises and equipment, net (97) (351) Proceeds from sale of OREO 80 0 Investment in Ltd Partnerships (136) (54) Proceeds from sale of repossessed property 17 11 ------------------ Net cash (provided) used in investing activities (2,478) 1,313 Cash Flows From Financing Activities Borrowings, net of repayments 4,495 7,174 Proceeds from exercise of stock options 2 0 Net increase (decrease) in demand, NOW, savings, and money market accounts 3,818 (9,555) Net increase (decrease) in time deposits (1,303) 494 Dividends paid (1,575) (1,454) ------------------ Net cash provided by financing activities 5,437 (3,341) Increase in cash and cash equivalents 4,533 1,694 Cash and cash equivalents Beginning 11,423 15,101 Ending 15,956 16,795 Supplemental Disclosure of Cash Flow Information: Interest Paid $ 5,155 $ 4,725 ================== Income Taxes Paid $ 735 $ 930 ================== </TABLE> See accompanying notes to unaudited financial statements. UNION BANKSHARES, INC. NOTES TO FINANCIAL STATEMENTS: Note 1. The accompanying unaudited interim consolidated financial statements of Union Bankshares, Inc. (the Company) for the interim period ended June 30, 2001 and 2000 and for the quarters then ended have been prepared in accordance with the accounting policies described in the company's annual report to shareholders and Form 10K. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the information contained herein have been made. Certain amounts reported in prior periods have been reclassified for comparative purposes. This information should be read in conjunction with the Company's 2000 Annual report and Form 8K. Note 2. Commitments and Contingencies In the normal course of business, the Company is involved in various legal proceedings. In the opinion of management, after consulting with the Company's legal counsel, any liability resulting from such proceedings would not have a material adverse effect on the Company's financial statements. Note 3 Earnings Per Share Earnings per common share amounts are computed based on the weighted average number of shares of common stock outstanding during the period (retroactively adjusted for stock dividends) and reduced for shares held in Treasury. The assumed conversion of available stock options does not result in material dilution. Note 4 Reportable Segments The company has two reportable operating segments, Union Bank (Union) and Citizens Savings Bank and Trust Company (Citizens). Management regularly evaluates separate financial information for each segment in deciding how to allocate resources and in assessing performance. The Company accounts for intersegment sales and transfers as if the sales or transfers were to third parties, that is, at current market prices. Information about reportable segments, and reconciliation of such information to the consolidated financial statements as of and for the periods ended June 30, follows: <TABLE> <CAPTION> Intersegment Consolidated 2001 Union Citizens Elimination Other Totals - --------------------------------------------------------------------------------------------- <s> <c> <c> <c> <c> <c> Interest income $ 8,312 $ 3,809 $ 0 $ 0 $ 12,121 Interest expense 3,328 1,660 0 0 4,988 Provision for loan losses 0 113 0 0 113 Service fee income 913 273 0 0 1,186 Income tax expense (benefit) 754 252 0 (38) 968 Net income (loss) 1,956 518 0 (61) 2,413 Assets 210,937 100,601 (42) 393 311,889 <CAPTION> Intersegment Consolidated 2000 Union Citizens Elimination Other Totals - --------------------------------------------------------------------------------------------- <s> <c> <c> <c> <c> <c> Interest income $ 7,814 $ 3,841 $ 0 $ 0 $ 11,655 Interest expense 2,967 1,677 0 1 4,645 Provision for loan losses 0 125 0 0 125 Service fee income 892 254 0 0 1,146 Income tax expense (benefit) 622 199 0 (44) 777 Net income (loss) 1,943 392 0 (89) 2,246 Assets 194,963 99,432 (47) 464 294,812 </TABLE> Amounts in the "Other" column encompass activity in Union Bankshares, Inc., the "parent company." Holding company assets are stated after intercompany eliminations. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL The following discussion and analysis provides information regarding Union Bankshares, Inc.'s (Union's) financial position as of June 30, 2001 and as of December 31, 2000, and its results of operations for the three and six months ended June 30, 2001 and 2000. This discussion should be read in conjunction with the information in this document under Financial Statements and related notes and with other financial data appearing elsewhere in this filing. In the opinion of Union's management, the unaudited interim data reflect all adjustments, consisting only of normal recurring adjustments, necessary to fairly present Union's consolidated financial position and results of operations to be expected for the interim period. Management is not aware of the occurrence of any events after June 30, 2001, which would materially affect the information presented below. Union's common stock was listed on the American Stock Exchange on July 13, 2000 with an opening price of $15.125 and the price on August 9, 2001 was $19.70. In May of 2001, Citizens Savings Bank and Trust Company opened a loan production office in Littleton, New Hampshire. Littleton is 19 miles east of St. Johnsbury, Vermont where Citizens is based and is a rapidly growing community with a diverse economic base. This office will generate loans for both consumers and commercial purposes. The Company may from time to time make written or oral statements that are considered "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements may include financial projections, statements of plans and objectives for future operations, estimates of future economic performance and assumptions relating thereto. The Company may include forward-looking statements in its filings with the Securities and Exchange Commission, in its reports to stockholders, including this Quarterly Report, in other written materials, and in statements made by senior management to analysts, rating agencies, institutional investors, representatives of the media and others. By their very nature, forward-looking statements are subject to uncertainties, both general and specific, and risk exists that predictions, forecasts, projections and other estimates contained in forward-looking statements will not be achieved. Also when we use any of the words "believes," "expects," "anticipates" or similar expressions, we are making forward-looking statements. Many possible events or factors could affect the future financial results and performance of our company. This could cause results or performance to differ materially from those expressed in our forward-looking statements. The possible events or factors that might affect our forward-looking statements include, but are not limited to, the following: * uses of monetary, fiscal and tax policy by various governments * political, legislative or regulatory developments in Vermont, New Hampshire or the United States including changes in laws concerning taxes, banking and other aspects of the financial services industry * developments in general economic or business conditions, including interest rate fluctuations, market fluctuations and perceptions, and inflation * changes in the competitive environment for financial services organizations * the Company's ability to retain key personnel * changes in technology including demands for greater automation * adverse changes in the securities market When relying on forward-looking statements to make decisions with respect to the Company, investors and others are cautioned to consider these and other risks and uncertainties. RESULTS OF OPERATIONS The Company's net income for the quarter ended June 30, 2001 was $1.245 million, compared with net income of $1.168 million for the second quarter of 2000. Net income per share was $.41 for the second quarter of 2001 compared to $.38 for the same quarter of 2000. Net income for the first six months of 2001 was $2.413 million, compared with $2.246 million for the same period in 2000. Net income per share was $.80 for the first six months of 2001 compared to $.74 for the comparable period in 2000. Net Interest Income. The largest component of Union's operating income is net interest income, which is the difference between interest and dividend income received from interest-earning assets and the interest expense paid on its interest-bearing liabilities. Yields Earned and Rates Paid. The following tables show, for the periods indicated, the total amount of income recorded from interest-earning assets, and the related average yields, the interest expense associated with interest-bearing liabilities, expressed in dollars and average rates, and the relative net interest spread and net interest margin. All yield and rate information is calculated on an annualized basis. Yield and rate information for a period is average information for the period, and is calculated by dividing the income or expense item for the period by the average balances of the appropriate balance sheet item during the period. Net interest margin is net interest income divided by average interest- earning assets. Nonaccrual loans are included in asset balances for the appropriate periods, but recognition of interest on such loans is discontinued and any remaining accrued interest receivable is reversed, in conformity with federal regulations. The yields and net interest margins appearing in the following tables have been calculated on a pre-tax basis: <TABLE> <CAPTION> Three months ended June 30, 2001 2000 ------------------------------- ------------------------------- Interest Average Interest Average Average Earned/ Yield/ Average Earned/ Yield/ Balance Paid Rate Balance Paid Rate ------------------------------------------------------------------ (dollars in thousands) <s> <c> <c> <c> <c> <c> <c> Average Assets: Federal funds sold $ 9,356 $ 103 4.40% $ 4,800 $ 73 6.08% Interest bearing deposits 2,416 33 5.46% 2,009 31 6.17% Investments (1) (2) 51,082 784 6.34% 58,650 900 6.31% Loans, net (1) (3) 231,909 5,178 9.04% 211,922 4,908 9.36% ---------------------------------------------------------------- Total interest-earning assets (1) 294,763 6,098 8.40% 277,381 5,912 8.63% Cash and due from banks 8,589 8,582 Premises and equipment 3,927 4,064 Other assets 5,868 6,294 -------- -------- Total assets $313,147 $296,321 ======== ======== Average Liabilities and Shareholders' Equity: NOW accounts $ 34,760 $ 146 1.68% $ 33,361 $ 164 1.97% Savings and money market accounts 90,015 723 3.21% 89,383 833 3.73% Certificates of deposit 107,021 1,459 5.45% 100,639 1,322 5.25% Borrowed funds 9,834 133 5.41% 3,742 60 6.41% ---------------------------------------------------------------- Total interest-bearing Liabilities 241,630 2,461 4.07% 227,125 2,379 4.19% Non-interest bearing deposits 33,489 31,434 Other liabilities 2,669 5,241 -------- -------- Total liabilities 277,788 263,800 Shareholders' equity 35,359 32,521 -------- -------- Total liabilities and shareholders' equity $313,147 $296,321 ======== ======== Net interest income (1) $3,637 $3,533 ====== ====== Net interest spread (1) 4.33% 4.44% Net interest margin (1) 5.06% 5.20% <CAPTION> Six months ended June 30, 2001 2000 ------------------------------- ------------------------------- Interest Average Interest Average Average Earned/ Yield/ Average Earned/ Yield/ Balance Paid Rate Balance Paid Rate ------------------------------------------------------------------ (dollars in thousands) <s> <c> <c> <c> <c> <c> <c> Average Assets: Federal funds sold $ 7,570 $ 180 4.76% $ 4,218 $ 122 5.78% Interest bearing deposits 2,055 60 5.84% 2,024 60 5.93% Investments (1) (2) 52,246 1,609 6.35% 59,667 1,824 6.29% Loans, net (1) (3) 227,185 10,272 9.15% 209,456 9,649 9.30% ---------------------------------------------------------------- Total interest-earning assets (1) 289,056 12,121 8.51% 275,365 11,655 8.57% Cash and due from banks 9,186 8,646 Premises and equipment 3,952 4,048 Other assets 5,713 6,361 -------- -------- Total assets $307,907 $294,420 ======== ======== Average Liabilities and Shareholders' Equity: NOW accounts $ 34,037 $ 310 1.82% $ 32,684 $ 317 1.94% Savings and money market accounts 88,846 1,515 3.41% 90,125 1,658 3.68% Certificates of deposit 105,314 2,917 5.54% 99,282 2,571 5.18% Borrowed funds 8,583 246 5.73% 3,093 99 6.40% ---------------------------------------------------------------- Total interest-bearing Liabilities 236,780 4,988 4.21% 225,184 4,645 4.13% Non-interest bearing deposits 33,275 31,842 Other liabilities 2,836 5,136 -------- -------- Total liabilities 272,891 262,162 Shareholders' equity 35,016 32,258 -------- -------- Total liabilities and shareholders' equity $307,907 $294,420 ======== ======== Net interest income (1) $ 7,133 $ 7,010 ======= ======= Net interest spread (1) 4.30% 4.44% Net interest margin (1) 5.06% 5.20% <FN> - -------------------- <F1> Average yield reported on a tax-equivalent basis. <F2> The average balance of investments is calculated using the amortized cost basis. <F3> Net of unearned income and allowance for loan loss. </FN> </TABLE> Union's net interest income increased by $104 thousand, or 2.94%, to $3.6 million for the three months ended June 30, 2001, from $3.5 million for the three months ended June 30, 2000. This increase was due to the increase in total interest earning assets to $295 million from $277 million for the second quarter of 2000 offset partially by the drop in yield from 8.63% to 8.40%. The net interest spread decreased by 11 basis points to 4.33% for the three months ended June 30, 2001, from 4.44% for the three months ended June 30, 2000. The net interest margin for the 2001 period decreased by 14 basis points to 5.06% from 5.20% for the 2000 period. Union's net interest income year to date was $7.1 million compared to the prior year of $7.0 million or an increase of 1.75% between the two years. The net interest spread decreased by 14 basis points to 4.30% for the six months ended June 30, 2001 from 4.44% for the six months ended June 30, 2000. The net interest margin for the 2001 period decreased to 5.06% from 5.20% for the 2000 period or a decrease of 14 basis points. Rate/Volume Analysis. The following table describes the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected Union's interest income and interest expense during the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to: * changes in volume (change in volume multiplied by prior rate); * changes in rate (change in rate multiplied by current volume); and * total change in rate and volume. Changes attributable to both rate and volume have been allocated proportionately to the change due to volume and the change due to rate. <TABLE> <CAPTION> Three Months Ended June 30, 2001 Compared to Three Months Ended June 30, 2000 ----------------------------------------- Increase/(Decrease) Due to Change In Volume Rate Net ----------------------------------------- (dollars in thousands) <s> <c> <c> <c> Interest-earning assets: Federal funds sold $ 69 $ (39) $ 30 Interest bearing deposits 6 (4) 2 Investments (119) 3 (116) Loans, net 460 (190) 270 -------------------------------- Total interest-earning assets 416 (230) 186 Interest-bearing liabilities: NOW accounts 7 (25) (18) Savings and money market accounts 6 (116) (110) Certificates of deposit 84 53 137 Borrowed funds 98 (25) 73 -------------------------------- Total interest-bearing liabilities 195 (113) 82 -------------------------------- Net change in net interest income $ 221 $(117) $ 104 ================================ <CAPTION> Six Months Ended June 30, 2001 Compared to Six Months Ended June 30, 2000 ----------------------------------------- Increase/(Decrease) Due to Change In Volume Rate Net ----------------------------------------- (dollars in thousands) <s> <c> <c> <c> Interest-earning assets: Federal funds sold $ 97 $ (39) $ 58 Interest bearing deposits 1 (1) 0 Investments (233) 18 (215) Loans, net 801 (178) 623 -------------------------------- Total interest-earning assets 666 (200) 466 Interest-bearing liabilities: NOW accounts 13 (20) (7) Savings and money market accounts (23) (120) (143) Certificates of deposit 156 190 346 Borrowed funds 176 (29) 147 -------------------------------- Total interest-bearing liabilities 322 21 343 -------------------------------- Net change in net interest income $ 344 $(221) $ 123 ================================ </TABLE> Quarter Ended June 30, 2001 compared to Quarter Ended June 30, 2000. Interest and Dividend Income. Union's interest and dividend income increased by $186,000, or 3.15%, to $6.1 million for the three months ended June 30, 2001, from $5.9 million for the three months ended June 30, 2000. Average earning assets increased by $17.4 million, or 6.27%, to $294.8 million for the three months ended June 30, 2001, from $277.4 million for the three months ended June 30, 2000. Average loans approximated $231.9 million for the three months ended June 30, 2001 up from $211.9 million for the three months ended June 30, 2000. Increases in construction loans of $3.9 million or 67.4%, the $1.4 million or 1.9% increase in residential real estate secured loans, the $15.5 million or 16.2% increase in commercial and commercial real estate loans, and the $2.1 million or 19.7% increase in loans to municipalities was partially offset by the $2.8 million or 17.4% decrease in personal loans. Construction lending was strong throughout 2000 and to date through 2001. A conscious decision to retain the majority of loans packaged for sale in our portfolio in mid 1999 accounts for the majority of the increase in both the residential real estate and commercial loan portfolios. We expanded our commercial lending staff in 1999 at Union Bank and in 2000 and 2001 at Citizens, which is one reason for our growth in that area. The decrease in personal loans is due to a late 1998 decision to exit the Dealer floorplan business at Citizens. The average balance of investment securities (including mortgage-backed securities) decreased by $7.6 million, or 12.9%, to $51.1 million for the three months ended June 30, 2001, from $58.6 million for the three months ended June 30, 2000. The average balance in Interest Bearing Deposits increased by $407 thousand to $2.4 million from $2.0 million or 20.3%. The average level of federal funds sold increased by $4.6 million or 94.9%, to $9.4 million for the three months ended June 30, 2001, from $4.8 million for the three months ended June 30, 2000. The net decrease in the investment portfolio, Federal Funds Sold and Interest Bearing Deposits was more than offset by the continuing growth in our loan portfolio. Interest Income on non-loans was $.92 million in 2001 compared to $1 million for 2000 reflecting the decrease in yields and in volume. Interest Expense. Union's interest expense increased by $82 thousand, or 3.45%, to $2.5 million for the three months ended June 30, 2001 from $2.4 million for the three months ended June 30, 2000. Average interest-bearing liabilities increased by $14.5 million, or 6.4% to $241.6 million for the three months ended June 30, 2001, from $227.1 million for the three months ended June 30, 2000. Average time deposits increased $6.4 million, or 6.3%, to $107.0 million for the three months ended June 30, 2001, from $100.6 million for the three months ended June 30, 2000 and the average balances for N.O.W. accounts increased by $1.4 million to $34.8 million for the three months ended June 30, 2001, from $33.4 million for the three months ended June 30, 2000. Customers have maintained very liquid positions during the last 6 months as they anticipate the interest rates paid on all deposit instruments will rise. The average balance on funds borrowed has increased from $3.7 million on average in 2000 to $9.8 million in 2001 as Union's subsidiaries took some long term Federal Home Loan Bank borrowings during the second quarter of 2001 to specifically match with some commercial loans originated. Noninterest Income. Union's noninterest income increased $149,000, or 23.8%, to $774 thousand for the three months ended June 30, 2001, from $625 thousand for the three months ended June 30, 2000. The results for the period reflected a net gain of $76 thousand from the sale of securities compared to a net loss of $3 thousand from sales during 2000. Trust department income rose to $63 thousand in the second quarter of 2001 from $34 thousand in the same period of 2000 or a 85.3% increase due to an increase in fees charged in 2001. Other noninterest income and service fees (sources of which include deposit and loan fees, ATM fees, and safe deposit fees) increased by $41 thousand, or 6.9%, to $635 thousand for the three months ended June 30, 2001, from $594 thousand for the three months ended June 30, 2000. This was primarily caused by a small increase in Overdraft Fees and by the increase in ATM income and Merchant Program Income. Noninterest Expense. Union's noninterest expense was only up $11 thousand, at $2.6 million for the three months ended June 30, 2001, and for the three months ended June 30, 2000. Salaries decreased $72,000, or 5.9%, to $1.1 million for the three months ended June 30, 2001, from $1.2 million for the three months ended June 30, 2000, due to the non-recurrence of severance pay for three employees whose positions were eliminated at Citizens in 2000 due to the consolidation of certain operations within the organization. Pension and employee benefits increased $57 thousand or 20.4% to $336 thousand for the three months ended June 30, 2001, from $279 thousand for the three months ended June 30, 2000 mainly due to a $40,000 increase in health insurance costs and a $13,000 increase in retirement plans expense. Occupancy expense increased $37,000 or 27.4% to $172,000 from $135,000 in 2000 due to the completion of delayed maintenance on various facilities and normal increases in other occupancy expenses. Equipment expense decreased $13 thousand to $217 thousand for the three months ended June 30, 2001, from $230 thousand for the same period in 2000 resulting from decreased depreciation cost of $42 thousand on computer equipment and software which are depreciated as an expense over a time period of three to five years mainly offset by a $12,000 increase in equipment repair expense, a $6,000 increase in maintenance contract expense and a $4,500 increase in loss on the disposal of fixed assets. Other operating expense for the quarter was $755 thousand up from $753 thousand for the same quarter in 2000. Income Tax Expense. Union's income tax expense increased by $171,000, or 53.8%, to $489,000 for the three months ended June 30, 2001, from $318 thousand for the comparable period of 2000 because of our increased income and the $114,000 historic rehabilitation credit available to us for the second quarter of the 2000 tax year due to our partnership investment in a low income housing project sponsored by Housing Vermont in our market area. Year to Date June 30, 2001 compared to Year to Date June 30, 2000. Interest and Dividend Income. Union's interest and dividend income increased by $466 thousand, or 4.0%, to $12.1 million for the six months ended June 30, 2001, from $11.6 million for the six months ended June 30, 2000. Average earning assets increased by $13.7 million, or 5.0%, to $289.1 million for the six months ended June 30, 2001, from $275.4 million for the six months ended June 30, 2000. Average loans approximated $227.2 million for the six months ended June 30, 2001 up from $209.4 million for the six months ended June 30, 2000. Increases in construction loans of $3.8 million or 62.3%, the $1.4 million or 1.6% increase in residential real estate secured loans, the $13.6 million or 14.6% increase in commercial and commercial real estate loans, and the $2.1 million or 20.4% increase in loans to municipalities was partially offset by the $3.0 million or 18.0% decrease in personal loans. Construction lending was strong throughout 2000 and to date through 2001. A conscious decision to retain the majority of loans packaged for sale in our portfolio in mid 1999 accounts for the majority of the increase in both the residential real estate and commercial loan portfolios. We expanded our commercial lending staff in 1999 at Union Bank and in both 2000 and 2001 at Citizens, which is one reason for our growth in that area. The decrease in personal loans is due to a late 1998 decision to exit the Dealer floorplan business at Citizens. The average balance of investment securities (including mortgage-backed securities) decreased by $7.4 million, or 12.4%, to $52.2 million for the six months ended June 30, 2001, from $59.7 million for the six months ended June 30, 2000. The average level of federal funds sold increased by $3.4 million or 79.5%, to $7.6 million for the six months ended June 30, 2001, from $4.2 million for the six months ended June 30, 2000. The net decrease in the investment portfolio, Federal Funds Sold and Interest Bearing Deposits in 2001 reflects the continuing growth in our loan portfolio. Interest Income on non-loans was $1.8 million in 2001 and $2.0 million for 2000 reflecting the decrease in yields and overall decrease in volume. Interest Expense. Union's interest expense increased by $343 thousand, or 7.4%, to $5.0 million for the six months ended June 30, 2001 from $4.6 million for the six months ended June 30, 2000. Average interest-bearing liabilities increased by $11.6 million, or 5.1%, to $236.8 million for the six months ended June 30, 2001, from $225.2 million for the six months ended June 30, 2000. Average time deposits increased $6.0 million, or 6.1%, to $105.3 million for the six months ended June 30, 2001, from $99.3 million for the six months ended June 30, 2000, while the average balances for money market and savings accounts decreased by $1.3 million to $88.8 million for the six months ended June 30, 2001, from $90.1 million for the six months ended June 30, 2000. The average balance in N.O.W. accounts grew $1.3 million, or 4.1%, from $32.7 million to $34.0 million. Customers have maintained very liquid positions during the last 6 months as they anticipate the interest rates paid on all deposit instruments will rise. The average balance on funds borrowed has increased from $3.1 million on average in 2000 to $8.6 million in 2001 as Union's subsidiaries took some long-term Federal Home Loan Bank borrowings during the second quarter of 2001 to specifically match against commercial loans originated. Noninterest Income. Union's noninterest income increased $237,000, or 18.7%, to $1.5 million for the six months ended June 30, 2001. The results for the period reflected a net gain of $74 thousand from the sale of securities compared to a $34,000 gain from sales during 2000. Trust department income rose to $150,000 in the first half of 2001 from $76,000 in the same period of 2000 or a 97.3% increase due to an increase in fees charged in 2001. Gain on Sale of Loans increased $64,000 to $73,000 for 2001 from $9,000 for 2000. Other noninterest income and service fees (sources of which include deposit and loan fees, ATM fees, and safe deposit fees) increased by $59,000, or 5.1%, to $1.21 million for the six months ended June 30, 2001, from $1.15 million for the six months ended June 30, 2000. This was primarily caused by increased ATM income and Merchant Program income, partially offset by lower overdraft fees. Noninterest Expense. Union's noninterest expense decreased $14,000 to $5.144 million for the six months ended June 30, 2001. Salaries decreased $11,000, or .5%, to $2.300 million for the six months ended June 30, 2001, from $2.311 million for the six months ended June 30, 2000, reflecting normal salary activity, pay for overtime during the first quarter of 2000 related to a Systems Conversion at Citizens, and severance pay in 2000 for three employees whose positions were eliminated at Citizens due to the consolidation of certain operations within the organization. Pension and employee benefits increased $98 thousand, or 17.0%, to $675 thousand for the six months ended June 30, 2001, from $577 thousand for the six months ended June 30, 2000 mainly due to a $50,000 increase in health insurance costs, a $30,000 increase in retirement plans expense, and a $8,600 increase in dental insurance. Net occupancy expense increased $45 thousand, or 15.4%, to $337 thousand for the six months ended June 30, 2001, from $292,000 for the six months ended June 30, 2000 due mainly to the increase in building maintenance expense and depreciation. Equipment expense decreased $101 thousand to $429 thousand for the six months ended June 30, 2001, from $530 thousand for the same period in 2000 primarily resulting from decreased depreciation expense on computers and software partially offset by an increase for maintenance contracts. Other operating expenses were $1.403 million for the first six months of 2001 compared to $1.420 million for the same period in 2000. Union incurred a one-time listing fee in June of 2000 of $22,500 from the American Stock Exchange. Income Tax Expense. Union's income tax expense increased by $191 thousand, or 24.6%, to $968 thousand for the six months ended June 30, 2001, from $777,000 for the comparable period of 2000 because of the $114,000 historic rehabilitation credit that was available to us for the second quarter of the 2000 tax year due to our partnership investment in a low income housing project sponsored by Housing Vermont in our market area and our increased income before taxes. FINANCIAL CONDITION At June 30, 2001, Union had total consolidated assets of $311.9 million, including net loans and loans held for sale of $232.2 million, deposits of $261.3 million and stockholders' equity of $36.5 million. Based on the most recent information published by the Vermont Banking Commissioner, in terms of total assets at December 31, 2000, Union Bank ranked as the 10th largest institution of the 23 commercial banks and savings institutions headquartered in Vermont, and Citizens ranked as the 19th. Union's total assets increased by $8.7 million or 2.9% to $311.9 million at June 30, 2001 from $303.2 million at December 31, 2000. Historically, June 30th of each year is our low point in terms of total assets, net loans and deposits. This is a one-day aberration as the Towns, Villages and School Districts that we lend to must be out of debt one day during the year. These loans totaled $12.3 million on December 31, 2000, $13.0 million on June 28, 2001, $6.0 million on June 29, 2001 and $8.8 million on July 2. In spite of this drop, total net loans and loans held for sale increased by $10.3 million or 4.6% to $232.2 million or 74.5% of total assets at June 30, 2001 as compared to $221.9 million or 73.2% of total assets at December 31, 2000. Cash and cash equivalents, including Federal funds sold, increased approximately $4.5 million or 39.7% to $16.0 million at June 30, 2001 from $11.4 million at December 31, 2000, which was primarily attributable to the one day increase in liquidity caused by the municipal variation discussed above. Securities available for sale decreased from $56.6 million at December 31, 2000 to $49.9 million at June 30, 2001, a $6.7 million or 11.8% decrease. Securities maturing have not been replaced dollar for dollar and some securities have been sold in order to fund increasing loan demand and our decision to hold in portfolio the majority of loans available for sale. Deposits increased $2.5 million or 1.0% to $261.3 million at June 30, 2001 from $258.7 million at December 31, 2000. A $5.4 million increase in money market accounts was partially offset by a $1.2 million drop in municipal N.O.W. accounts and a $2.7 million drop in municipal certificates of deposits which are one day anomalies as discussed previously. Total borrowings increased $4.5 million to $10.9 million at June 30, 2001 from $6.4 million at December 31, 2000. The increase was in borrowing from the Federal Home Loan Bank for matched funding for certain commercial loans originated. Loan Portfolio. Union's loan portfolio (including loans held for sale) primarily consists of adjustable- and fixed-rate mortgage loans secured by one-to-four family, multi-family residential or commercial real estate. As of June 30, 2001, Union's loan portfolio totaled $232.2 million, or 74.5%, of assets, of which $117.3 million, or 49.9% of gross loans, consisted of residential mortgages and construction loans, and $77.4 million, or 32.9%, of total loans consisted of commercial real estate loans. As of such date, Union's loan portfolio also included $20.0 million of commercial loans, $6.0 million of municipal loans, and $14.5 million of consumer loans representing, in order, 8.5%, 2.6% and 6.2% of total loans outstanding on June 30, 2001. The following table shows information on the composition of Union's loan portfolio as of June 30, 2001 and December 31, 2000: <TABLE> <CAPTION> June 30, December 31, Loan Type 2001 2000 - --------- ------------------------ <s> <c> <c> Real Estate $111,080 $104,417 Commercial real estate 73,293 66,186 Commercial 19,694 18,214 Consumer 14,535 14,628 Municipal loans 6,047 12,448 Loans held for sale 10,629 9,153 ---------------------- Total loans 235,278 225,046 Deduct: Allowance for loan losses 2,770 2,863 Net deferred loan fees, premiums & discounts 259 250 ---------------------- 3,029 3,113 ---------------------- $232,249 $221,933 ====================== </TABLE> Union originates and sells residential mortgages into the secondary market, with most such sales made to the Federal Home Loan Mortgage Corporation (FHLMC) and the Vermont Housing Finance Agency (VHFA). Union services a $158.3 million residential mortgage portfolio, approximately $47.2 million of which is serviced for unaffiliated third parties at June 30, 2001. Additionally, Union originates commercial loans under various SBA programs that provide an agency guarantee for a portion of the loan amount. Union will sometimes sell the guaranteed portion of the loan to other financial concerns and will retain servicing rights, which generates fee income. Union capitalizes mortgage servicing rights on these fees and recognizes gains and losses on the sale of the principal portion of these notes as they occur. As of June 30, 2001, Union serviced $8.8 million of commercial and commercial real estate loans for unaffiliated third parties. An increase of $6.7 million or 6.4% in residential real estate loans and an increase of $1.5 million or 8.1% in commercial loans, a $7.1 million or 10.7% increase in commercial real estate loans and an increase in loans held for sale of $1.5 million or 16.1% was partially offset by a $.9 million or .6% decrease in consumer loans and a temporary, seasonal drop in municipal loans outstanding of $6.4 million or 51.4%. Asset Quality. Union, like all financial institutions, is exposed to certain credit risks related to the value of the collateral that secures its loans and the ability of borrowers to repay their loans. Management closely monitors Union's loan and investment portfolios and other real estate owned for potential problems on a periodic basis and reports to Union's Board of Directors at regularly scheduled meetings. Union had loans on nonaccrual status totaling $1.9 million at June 30, 2001, $1.5 million at December 31, 2000 and $1.6 million at June 30, 2000. Interest income not recognized on such loans amounted to approximately $486 thousand and $322 thousand as of June 30, 2001 and 2000, respectively and $289 thousand as of December 31, 2000. Union had $2.1 million and $2.9 million in loans past due 90 days or more and still accruing at June 30, 2001 and December 31, 2000, respectively. At June 30, 2001, Union had internally classified certain loans totaling $774 thousand. In management's view, such loans represent a higher degree of risk and could become nonperforming loans in the future. While still on a performing status, in accordance with Union's credit policy, loans are internally classified when a review indicates any of the following conditions making the likelihood of collection highly questionable: * the financial condition of the borrower is unsatisfactory; * repayment terms have not been met; * the borrower has sustained losses that are sizable, either in absolute terms or relative to net worth; * confidence is diminished; * loan covenants have been violated; * collateral is inadequate; or * other unfavorable factors are present. At June 30, 2001, Union had acquired by foreclosure or through repossession real estate worth $135,000, consisting of 2 commercial properties and one residential home. Allowance for Loan Losses. Some of Union's loan customers ultimately do not make all of their contractually scheduled payments, requiring Union to charge off the remaining principal balance due. Union maintains an allowance for loan losses to absorb such losses. The allowance for loan losses is maintained at a level, which in management's judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management's evaluation of the collectibility of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, and economic conditions. Allowances for impaired loans are generally determined based on collateral values or the present value of estimated cash flows. The allowance is increased by a provision for loan losses, which is charged to expense and reduced by charge-offs, net of recoveries. While Union allocates the allowance for loan losses based on the percentage category to total loans, the portion of the allowance for loan losses allocated to each category does not represent the total available for future losses which may occur within the loan category since the total allowance for possible loan losses is a valuation reserve applicable to the entire portfolio. The following table reflects activity in the allowance for loan losses for the quarter and six months ended June 30, 2001 and 2000: <TABLE> <CAPTION> Quarter Ended, June 30 Six Months Ended, June 30, ---------------------- -------------------------- 2001 2000 2001 2000 ---------------------------------------------------- (dollars in thousands) <s> <c> <c> <c> <c> Balance at the beginning of period $2,859 $2,899 $2,863 $2,870 Charge-offs: Real Estate 31 0 31 0 Commercial 133 2 171 16 Consumer and other 17 60 68 124 -------------------------------------------- Total charge-offs 181 62 270 140 -------------------------------------------- Recoveries: Real Estate 1 1 1 1 Commercial 14 8 17 29 Consumer and other 20 25 46 49 -------------------------------------------- Total recoveries 35 34 64 79 -------------------------------------------- Net charge-offs (146) (28) (206) (61) Provision for loan losses 57 63 113 125 -------------------------------------------- Balance at end of period $2,770 $2,934 $2,770 $2,934 ============================================ </TABLE> The following table shows the breakdown of Union's allowance for loan losses by category of loan and the percentage of loans in each category to total loans in the respective portfolios at the dates indicated: <TABLE> <CAPTION> June 30, December 31, 2001 2000 ----------------- ----------------- (dollars in thousands) Amount Percent Amount Percent -------------------------------------- <s> <c> <c> <c> <c> Real Estate Residential $ 622 40.3% $ 595 40.5% Commercial 1,224 34.2% 1,193 32.3% Construction 118 5.0% 102 4.5% Other Loans Commercial 460 10.9% 401 9.1% Consumer installment 283 5.6% 319 6.5% Home equity loans 29 1.6% 31 1.8% Municipal, Other and Unallocated 34 2.4% 222 5.3% ------------------------------------ Total $2,770 100.0% $2,863 100.0% ==================================== Ratio of Net Charge Offs to Average Loans (1) 0.18% 0.12% ------ ------ Ratio of Allowance for Loan Losses to Loans 1.22% 1.33% ------ ------ <FN> - -------------------- <F1> Annualized </FN> </TABLE> Investment Activities. At June 30, 2001, the reported value of investment securities available-for-sale was $50.0 million or 16.0% of total assets. Union had no securities classified as held-to-maturity or trading securities. The reported value of securities available-for-sale at June 30, 2001, reflects a positive valuation adjustment of $671 thousand. The offset of this adjustment, net of income tax effect, was a $443 thousand increase in Union's other comprehensive income component of shareholders' equity and a decrease in net deferred tax assets of $228 thousand. Deposits. The following table shows information concerning Union's deposits by account type, and the weighted average nominal rates at which interest was paid on such deposits as of June 30, 2001 and December 31, 2000: <TABLE> <CAPTION> Six Months Ended, June 30 Year Ended December 31, 2001 2000 -------------------------------- ------------------------------- (dollars in thousands) Percent Percent Average of Total Average Average of Total Average Amount Deposits Rate Amount Deposits Rate ------------------------------------------------------------------- <s> <c> <c> <c> <c> <c> <c> Non-certificate deposits: Demand deposits $ 33,275 12.72% $ 32,906 12.81% Now accounts 34,037 13.02% 1.82% 34,383 13.39% 2.04% Money Markets 54,015 20.66% 4.09% 53,770 20.94% 4.45% Savings 34,831 13.32% 2.35% 37,153 14.47% 2.72% ------------------ ------------------ Total non-certificate deposits: 156,158 59.72% 158,212 61.61% ------------------ ------------------ Certificates of deposit: Less than $100,000 76,902 29.41% 5.38% 75,483 29.40% 5.29% $100,000 and over 28,412 10.87% 5.96% 23,088 8.99% 5.89% ------------------ ------------------ Total certificates of deposit 105,314 40.28% 98,571 38.39% ------------------ ------------------ Total deposits 261,472 100.00% 3.63% $256,783 100.00% 3.68% ================================================================= </TABLE> The following table sets forth information regarding the amounts of Union's certificates of deposit in amounts of $100,000 or more at June 30, 2001 and December 31, 2000 that mature during the periods indicated: <TABLE> <CAPTION> June 30, 2001 December 31, 2000 ---------------------------------- (dollars in thousands) <s> <c> <c> Within 3 months $ 5,195 $ 6,757 3 to 6 months 11,135 11,259 6 to 12 months 4,315 4,439 Over 12 months 1,561 3,739 -------------------------- $22,206 $26,194 ========================== </TABLE> Borrowings. Borrowings from the Federal Home Loan Bank of Boston were $10.9 million at June 30, 2001 at a weighted average rate of 5.75%. Borrowings from the Federal Home Loan Bank of Boston were $6.4 million at December 31, 2000 at a weighted average rate of 6.60%. The change between year end 2000 and the end of the second quarter of 2001 is a net increase of $4.5 million in matched borrowings to fund loan demand. Other Financial Considerations Market Risk and Asset and Liability Management. Market risk is the risk of loss in a financial instrument arising from adverse changes in market prices and rates, foreign currency exchange rates, commodity prices and equity prices. Union's market risk arises primarily from interest rate risk inherent in its lending and deposit taking activities. To that end, management actively monitors and manages its interest rate risk exposure. Union does not have any market risk sensitive instruments acquired for trading purposes. Union attempts to structure its balance sheet to maximize net interest income while controlling its exposure to interest rate risk. Union's Asset/Liability Committee formulates strategies to manage interest rate risk by evaluating the impact on earnings and capital of such factors as current interest rate forecasts and economic indicators, potential changes in such forecasts and indicators, liquidity, and various business strategies. Union's Asset/Liability Committee's methods for evaluating interest rate risk include an analysis of Union's interest-rate sensitivity "gap", which provides a static analysis of the maturity and repricing characteristics of Union's entire balance sheet, and a simulation analysis, which calculates projected net interest income based on alternative balance sheet and interest rate scenarios, including "rate shock" scenarios involving immediate substantial increases or decreases in market rates of interest. Union's Asset/Liability Committee meets at least weekly to set loan and deposit rates, make investment decisions, monitor liquidity and evaluate the loan demand pipeline. Deposit runoff is monitored daily and loan prepayments evaluated monthly. Union historically has maintained a substantial portion of its loan portfolio on a variable rate basis and plans to continue this ALM strategy in the future. The investment portfolio is classified as available for sale and the modified duration is relatively short. Union does not utilize any derivative products or invest in any "high risk" instruments. Our interest rate sensitivity analysis (simulation) as of December 2000 for a flat rate environment projected a Net Interest Income of $7.4 million for the first six months of 2001 compared to actual results of $7.1 million in a falling rate environment, or a 3.6% difference. Union would have anticipated a decrease in our net interest margin in a 200 basis point falling rate environment of $354 thousand or 4.78% and in a 300 basis point falling rate environment of $496 thousand or 6.7%. The Prime rate dropped 275 basis points from 9.5% on January 1, 2001 to 6.75% at quarter end. Our results were stronger than anticipated because of continuing strong loan demand. Net income was projected to be $2.7 million in a flat rate environment compared to actual results of $2.4 million. Net income expected in a 200 basis point falling rate environment was $2.5 million and in a 300 basis point fall was $2.4 million. Therefore, our results for the first six months of 2001 were close to our projections in a falling rate environment. Return on Assets was projected to be 1.84% in a flat rate environment and actual results were 1.57%. Return on Equity was projected to be 15.63% in a flat rate environment compared to actual of 13.61%. The lower results of these ratios are based on lower net interest income and net income as explained above. The Company generally requires collateral or other security to support financial instruments with credit risk. As of June 30, 2001, the contract or notional amount of financial instruments whose contract amount represents credit risk were as follows: <TABLE> <s> <c> Commitments to extend credit $23,496,000 ----------- Standby letters of credit and commercial letters of credit $ 1,258,000 ----------- Credit Card arrangements $ 2,079,000 ----------- Home Equity Lines of Credit $ 3,768,000 ----------- </TABLE> Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Interest Rate Sensitivity "Gap" Analysis. An interest rate sensitivity "gap" is defined as the difference between interest-earning assets and interest-bearing liabilities maturing or repricing within a given time period. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. A gap is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets. During a period of rising interest rates, a negative gap would tend to adversely affect net interest income, while a positive gap would tend to result in an increase in net interest income. During a period of falling interest rates, a negative gap would tend to result in an increase in net interest income, while a positive gap would tend to affect net interest income adversely. Because different types of assets and liabilities with the same or similar maturities may react differently to changes in overall market interest rates or conditions, changes in interest rates may affect net interest income positively or negatively even if an institution were perfectly matched in each maturity category. Union prepares its interest rate sensitivity "gap" analysis by scheduling interest-earning assets and interest-bearing liabilities into periods based upon the next date on which such assets and liabilities could mature or reprice. The amounts of assets and liabilities shown within a particular period were determined in accordance with the contractual terms of the assets and liabilities, except that: * adjustable-rate loans, securities, and FHLB advances are included in the period when they are first scheduled to adjust and not in the period in which they mature; * fixed-rate mortgage-related securities reflect estimated prepayments, which were estimated based on analyses of broker estimates, the results of a prepayment model utilized by Union, and empirical data; * fixed-rate loans reflect scheduled contractual amortization, with no estimated prepayments; and * NOW, money markets, and savings deposits, which do not have contractual maturities, reflect estimated levels of attrition, which are based on detailed studies by Union of the sensitivity of each such category of deposit to changes in interest rates. Management believes that these assumptions approximate actual experience and considers them reasonable. However, the interest rate sensitivity of Union's assets and liabilities in the tables could vary substantially if different assumptions were used or actual experience differs from the historical experience on which the assumptions are based. The following tables show Union's rate sensitivity analysis as of June 30, 2001: <TABLE> <CAPTION> June 30, 2001 Cumulative repriced within 3 Months 4 to 12 1 to 3 3 to 5 Over 5 or Less Months Years Years Total Total ---------------------------------------------------------------- (dollars in thousands, by repricing date) <s> <c> <c> <c> <c> <c> <c> Interest sensitive assets: Federal Funds Sold $ 4,069 $ -0- $ -0- $ -0- $ -0- $ 4,069 Interest bearing deposits 289 1,071 985 387 -0- 2,732 Investments available for sale (1) 2,683 8,064 11,424 9,664 17,173 49,008 FHLB Stock -0- -0- -0- -0- 1,064 1,064 Loans (fixed and adjustable rate) 69,664 37,716 39,580 31,922 56,396 235,278 ---------------------------------------------------------------- Total interest sensitive assets $76,705 $46,851 $51,989 $41,973 $74,633 $292,151 ---------------------------------------------------------------- Interest sensitive liabilities: Certificates of deposit $30,675 $48,289 $16,207 $ 4,441 $ 3 $ 99,615 Money markets 11,940 -0- -0- -0- 44,172 56,112 Regular savings 5,398 -0- -0- -0- 29,846 35,244 Now accounts 27,879 -0- -0- -0- 9,291 37,170 Borrowed funds 1,185 3,059 3,808 2,397 428 10,877 ---------------------------------------------------------------- Total interest sensitive liabilities $77,077 $51,348 $20,015 $ 6,838 $83,740 $239,018 ---------------------------------------------------------------- Net interest rate sensitivity gap (372) (4,497) 31,974 35,135 (9,107) 53,133 Cumulative net interest rate sensitivity gap (372) (4,869) 27,105 62,240 53,133 Cumulative net interest rate sensitivity gap as a percentage of total assets (.12%) (1.56%) 8.69% 19.96% 17.04% Cumulative interest sensitivity gap as a percentage of total interest-earning assets (.13%) (1.67%) 9.28% 21.30% 18.19% Cumulative net interest earning assets as a percentage of cumulative interest-bearing liabilities (.16%) (2.04%) 11.34% 26.04% 22.23% <FN> - -------------------- <F1> Investments available for sale exclude marketable equity securities with a fair value of $948,000 which may be sold by Union at any time. </FN> </TABLE> Simulation Analysis. In its simulation analysis, Union uses computer software to simulate the estimated impact on net interest income and capital under various interest rate scenarios, balance sheet trends, and strategies. These simulations incorporate assumptions about balance sheet dynamics such as loans and deposit growth, product pricing, changes in funding mix, and asset and liability repricing and maturity characteristics. Based on the results of these simulations, Union is able to quantify its interest rate risk and develop and implement appropriate strategies. The following chart reflects the results of our latest simulation analysis for each of the next two year ends on Net Interest Income, Net Income, Return on Assets, Return on Equity and Capital Value. The projection utilizes a rate shock of 300 basis points from the current prime rate of 6.75%, this is the highest internal slope monitored and shows the best and worse scenarios analyzed. This slope range was determined to be the most relevant during this economic cycle. INTEREST RATE SENSITIVITY ANALYSIS MATRIX JUNE 30, 2001 (in thousands) <TABLE> <CAPTION> Return Return on on Year Prime Net Interest Change Net Assets Equity Capital Change Ending Rate Income % Income % % Value % - -------------------------------------------------------------------------------------------------- <s> <c> <c> <c> <c> <c> <c> <c> <c> December-01 9.75 15,142 5.15 5,574 1.77 15.50 28,041 (36.14) 6.75 14,400 0.00 5,077 1.61 14.19 43,909 00.00 3.75 13,655 (5.17) 4,578 1.46 12.86 61,949 41.09 December-02 9.75 17,900 14.68 7,265 2.21 18.44 29,773 (34.93) 6.75 15,609 0.00 5,742 1.75 15.05 45,756 00.00 3.75 13,308 (14.74) 4,212 1.29 11.41 64,655 41.31 </TABLE> Liquidity. Liquidity is a measurement of Union's ability to meet potential cash requirements, including ongoing commitments to fund deposit withdrawals, repay borrowings, fund investment and lending activities, and for other general business purposes. Union's principal sources of funds are deposits, amortization and prepayment of loans and securities, maturities of investment securities and other short-term investments, sales of securities available-for-sale, and earnings and funds provided from operations. In addition, as members of the FHLB, Union's subsidiaries have access to preapproved lines of credit up to 2.1% of total assets. In addition, subsidiaries maintain Federal Fund lines of credit with upstream correspondent banks and repurchase agreement lines with selected brokerage houses. While scheduled loan and securities payments and FHLB advances are relatively predictable sources of funds, deposit flows and prepayments on loans and mortgage-backed securities are greatly influenced by general interest rates, economic conditions, and competition. Union's liquidity is actively managed on a daily basis, monitored by the Asset/Liability Committee, and reviewed periodically with the Board of Directors. Union's Asset/Liability Committee sets liquidity targets based on Union's financial condition and existing and projected economic and market conditions. The committee measures net loans to deposit ratio, cumulative 90 day and 1 year maturity gaps, and long term asset repricing. The committee's primary objective is to manage Union's liquidity position and funding sources in order to ensure that it has the ability to meet its ongoing commitment to its depositors, to fund loan commitments, and to maintain a portfolio of investment securities. Since many of the loan commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Union's management monitors current and projected cash flows and adjusts positions as necessary to maintain adequate levels of liquidity. Although approximately 78.7% of Union's certificates of deposit will mature within twelve months, management believes, based upon past experience, that Union will retain a substantial portion of these deposits. Management will continue to offer a competitive but prudent pricing strategy to facilitate retention of such deposits. Any reduction in total deposits could be offset by purchases of federal funds, short-term FHLB borrowings, or liquidation of investment securities or loans held for sale. Such steps could result in an increase in Union's cost of funds and adversely impact the net interest margin. Regulatory Capital Requirements.: Union Bank and Citizens (the Banks) are subject to various regulatory capital requirements administered by the federal banking agencies. Management believes, as of June 30, 2001 that the Banks meet all capital adequacy requirements to which they are subject. As of June 30, 2001, the most recent notification from the FDIC categorized the Banks as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Banks must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table below. There are no conditions or events since the notification that management believes have changed either Bank's category. The Banks' actual capital amounts (000's omitted) and ratios are presented in the table: <TABLE> <CAPTION> Minimums To Be Well Minimums Capitalized Under For Capital Prompt Corrective Actual Requirements Action Provisions ----------------- ---------------- ----------------- Amount Ratio Amount Ratio Amount Ratio ---------------------------------------------------------- <s> <c> <c> <c> <c> <c> <c> As of June 30, 2001: Total capital to risk weighted assets Union Bank $26,559 17.93% $11,850 8.0% $14,813 10.0% Citizens 11,978 17.13% 5,594 8.0% 6,992 10.0% Tier I capital to risk weighted assets Union Bank $24,644 16.64% $ 5,924 4.0% $ 8,886 6.0% Citizens 11,102 15.87% 2,798 4.0% 4,197 6.0% Tier I capital to average assets Union Bank $24,644 11.47% $ 8,594 4.0% $10,743 5.0% Citizens 11,102 11.28% 3,937 4.0% 4,921 5.0% </TABLE> Impact of Inflation and Changing Prices. Union's consolidated financial statements, included in this document, have been prepared in accordance with generally accepted accounting principles, which require the measurements of financial position and results of operations in terms of historical dollars, without considering changes in the relative purchasing power of money over time due to inflation. Banks have asset and liability structures that are essentially monetary in nature, and their general and administrative costs constitute relatively small percentages of total expenses. Thus, increases in the general price levels for goods and services have a relatively minor effect on Union's total expenses. Interest rates have a more significant impact on Union's financial performance than the effect of general inflation. Interest rates do not necessarily move in the same direction or change in the same magnitude as the prices of goods and services, although periods of increased inflation may accompany a rising interest rate environment. PART II OTHER INFORMATION ITEM 6: EXHIBITS AND REPORTS IN FORM 10-Q A. Current Reports on Form 8-K Report to Shareholders on Second Quarter Results filed on July 23, 2001 Press Release announcing dividend declaration and second quarter earnings filed on July 23, 2001 Dividend announcement filed on July 23, 2001 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. August 13, 2001 Union Bankshares, Inc. s/ Kenneth D. Gibbons --------------------- Kenneth D. Gibbons Director and Chief Executive Officer s/ Marsha A. Mongeon -------------------- Marsha A. Mongeon Chief Financial Officer and Treasurer