| NORTHWAY FINANCIAL INC ITEM 1A RISK FACTORS Recent accounting changes could give rise to adverse changes in the regulatory capital treatment of our outstanding junior subordinated debenture, which, in turn, could adversely affect our regulatory capital position |
| In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation Nodtta 46, “Consolidation of Variable Interest Entities” (“FIN 46”) that addresses the consolidation rules to be applied to “variable interest entities” as defined in FIN 46 |
| FIN 46, which applies to certain variable interest entities as of February 1, 2003 and to all variable interest entities as of December 14, 2003, provides that certain variable interest entities should not be treated as consolidated subsidiaries |
| Northway Capital Trust I and Northway Capital Trust II, our Delaware statutory business trusts, may constitute variable interest entities |
| Historically, issuer trusts, such as Northway Capital Trust I and Northway Capital Trust II that issued junior subordinated debentures have been consolidated by their parent companies |
| In addition, junior subordinated debentures have been treated as eligible for Tier 1 capital treatment by bank holding companies under the FRB’s rules and regulations relating to minority interests in equity accounts of consolidated subsidiaries |
| Accordingly, we have consolidated our existing issuer trusts in preparing our consolidated financial statements in the past, and our outstanding junior subordinated debentures have been treated as Tier 1 capital |
| On December 24, 2003, FASB issued a revision to FIN 46 (“FIN46R”), to clarify some of the provisions of FIN 46 |
| Based on FIN46R, we deconsolidated our existing issuer trusts as of December 31, 2003, and restated our historical financial statements |
| The adoption of FIN46R results in the reclassification of the redeemable junior subordinated debentures from mezzanine capital to other liabilities as well as the reclassification of interest cost from minority interest to interest expense |
| This deconsolidation could result in a change to the regulatory capital treatment of junior subordinated debentures issued by us and other US bank holding companies |
| Specifically, it is possible that since the issuer trusts would no longer be consolidated by us the junior subordinated debentures issued by each such issuer trust would not be considered a minority interest in equity accounts of a consolidated subsidiary and therefore not be accorded Tier 1 capital treatment by the FRB Trust preferred securities have historically been eligible for Tier 1 capital treatment by bank holding companies under FRB rules and regulations relating to minority interests in equity accounts of consolidated subsidiaries |
| Following the issuance of FIN 46, including the consolidation rules with respect to variable interest entities, the FRB requested public comment on a proposed rule that would limit trust preferred securities in the Tier 1 capital of bank holding companies, but with stricter limits and clearer qualitative standards |
| After considering the public comments, the FRB issued a final rule on March 1, 2005, which provides that after a five-year transition period ending on March 31, 2009, the aggregate amount of the trust preferred securities and certain other capital elements would be limited to 25prca of Tier 1 capital elements, net of goodwill and intangibles |
| As of December 31, 2005, assuming the aggregate amount of the trust preferred securities is limited to 25prca of Tier 1 capital, we would still exceed the regulatory required minimums for capital adequacy purposes |
| We could be adversely impacted by changes in applicable regulations |
| We are subject to extensive federal and state laws and regulations and are subject to supervision, regulation and examination by various federal and state bank regulatory agencies |
| The restrictions imposed by such laws and regulations limit the manner in which we and our bank subsidiary may conduct business and obtain financing |
| There can be no assurance that any modification of these laws and regulations, or new legislation that may be enacted, in the future will not make compliance more difficult or expensive, restrict our ability to originate, broker or sell loans or otherwise adversely affect our operations |
| See “Supervision and Regulation” on page 4 of this report |
| Our business is largely dependent upon the hospitality industry |
| A number of our loan customers are in the hospitality industry |
| The hospitality industry is dependent on personal discretionary spending levels |
| As a result, the hospitality industry may be adversely impacted by economic trends, including recession and increased unemployment |
| Additionally, unforeseen events including acts of terrorism, war, increases in fuel prices, travel-related accidents and unusual weather patterns also may adversely affect the hospitality industry |
| As a result, our business also is likely to be adversely affected by those events |
| Interest rate volatility may adversely impact our results of operations |
| The principal component of our income stream is net interest and dividend income |
| Net interest and dividend income is the difference between interest and fee income on earning assets, such as loans and investments, and the interest expense paid on interest bearing liabilities, such as deposits and borrowed funds |
| Our net interest and dividend income may be significantly affected by changes in market interest rates |
| A decrease in interest rates could reduce our net interest and dividend income as the difference between interest and fee income and interest expense decreases |
| An increase in interest rates could also negatively impact our results of operations by reducing borrowers’ ability to repay their current loan obligations, resulting in increased loan defaults, foreclosures and write-offs and could necessitate increases to our allowance for loan losses |
| 9 _________________________________________________________________ [50]Table of Contents Our allowance for loan losses may not be adequate to cover actual losses |
| We make various assumptions and judgments about the collectibility of our loan portfolio and provide an allowance for potential loan losses based on several factors |
| If our assumptions are incorrect, our allowance for loan losses may be insufficient to cover our actual losses, which would have an adverse effect on our results of operations, and may cause us to increase the allowance in the future |
| Changes in the securities market may adversely impact our results of operations |
| In recent years the securities market has experienced a significant downturn and will likely continue to experience volatility as a result of, among other things, global economic and political conditions |
| Continued declines in equity prices, as well as declines in the performance of certain sectors or specific companies, may result in a corresponding decline in the value of Company-held securities |
| The decline in the value of Company-held securities may decrease our earnings |
| Our loans are concentrated in certain areas of New Hampshire and adverse conditions in those markets could adversely affect our operations |
| We are exposed to real estate and economic factors in the northern and central areas of New Hampshire, as virtually the entire loan portfolio is concentrated among borrowers in these markets |
| Further, because a substantial portion of the loan portfolio is secured by real estate in this area, the value of the associated collateral is also subject to regional real estate market conditions |
| Adverse economic, political or business developments or natural hazards may affect these areas and the ability of property owners in these areas to make payments of principal and interest on the underlying mortgages |
| If these regions experience adverse economic, political or business conditions, we would likely experience higher rates of loss and delinquency on these mortgage loans than if the loans were more geographically diverse |
| If we do not maintain net income growth, the market price of our common stock could be adversely affected |
| Our return on shareholders’ equity and other measures of profitability, which affect the market price of our common stock, depend in part on our continued growth and expansion |
| Our growth strategy has two principal components—internal growth and external growth |
| Our ability to generate internal growth is affected by the competitive factors described below as well as by the primarily rural characteristics and related demographic features of the markets we serve |
| Our ability to continue to identify and invest in suitable acquisition candidates on acceptable terms is crucial to our external growth |
| In pursuing acquisition opportunities, we may be in competition with other companies having similar growth strategies |
| As a result, we may not be able to identify or acquire promising acquisition candidates on acceptable terms |
| Competition for these acquisitions could result in increased acquisition prices and a diminished pool of acquisition opportunities |
| An inability to find suitable acquisition candidates at reasonable prices could slow our growth rate and have a negative effect on the market price of our common stock |
| We experience strong competition within our markets, which may impact our profitability |
| Competition in the banking and financial services industry is strong |
| In our market areas, we compete for loans and deposits with local independent banks, thrift institutions, savings institutions, mortgage brokerage firms, credit unions, finance companies, mutual funds, insurance companies and brokerage and investment banking firms operating locally as well as nationally |
| Many of these competitors have substantially greater resources and lending limits than those of our subsidiaries and may offer services that our subsidiaries do not or cannot provide |
| Our long-term success depends on the ability of our subsidiaries to compete successfully with other financial institutions in their service areas |
| Because we maintain a smaller staff and have fewer financial and other resources than larger institutions with which we compete, we may be limited in our ability to attract customers |
| If we are unable to attract and retain customers, we may be unable to sustain growth in the loan portfolio and our results of operations and financial condition may otherwise be negatively impacted |
| Our cost of funds for banking operations may increase as a result of general economic conditions, interest rates and competitive pressures |
| Our banking subsidiary has traditionally obtained funds principally through deposits and borrowings |
| As a general matter, deposits are a less costly source of funds than borrowings because interest rates paid for deposits are typically less than interest rates charged for borrowings |
| If, as a result of general economic conditions, market interest rates, competitive pressures or otherwise, the value of deposits at our banking subsidiary decreases relative to our overall banking operations, we may have to rely more heavily on borrowings as a source of funds in the future |
| Our banking business is highly regulated |
| Bank holding companies, national banking associations and state-chartered banks operate in a highly regulated environment and are subject to supervision, regulation and examination by various federal and state bank regulatory agencies, as well as other governmental agencies in the states in which they operate |
| Federal and state laws and regulations govern numerous matters including changes in the ownership or control of banks and BHCs, maintenance of adequate capital and the financial condition of a financial institution, permissible types, amounts and terms of extensions of credit and investments, permissible non-banking activities, the level of reserves against deposits and restrictions on dividend payments |
| The FDIC possesses cease and desist powers to prevent or remedy unsafe or unsound practices or violations of law by banks subject to their regulation, and the FRB possesses similar powers with respect to BHCs |
| These and other restrictions limit the manner in which we may conduct business and obtain financing |
| 10 _________________________________________________________________ [51]Table of Contents Furthermore, our business is affected not only by general economic conditions, but also by the economic, fiscal and monetary policies of the United States and its agencies and regulatory authorities, particularly the FRB The economic and fiscal policies of various governmental entities and the monetary policies of the FRB may affect the interest rates our bank subsidiaries must offer to attract deposits and the interest rates they must charge on loans, as well as the manner in which they offer deposits and make loans |
| These economic, fiscal and monetary policies have had, and are expected to continue to have, significant effects on the operating results of depository institutions generally, including our bank subsidiaries |
| We could be held responsible for environmental liabilities of properties we acquire through foreclosure |
| If we are forced to foreclose on a defaulted mortgage loan to recover our investment, we may be subject to environmental liabilities related to the underlying real property |
| Hazardous substances or wastes, contaminants, pollutants or sources thereof may be discovered on properties during our ownership or after a sale to a third party |
| The amount of environmental liability could exceed the value of the real property |
| There can be no assurance that we would not be fully liable for the entire cost of any removal and clean-up on an acquired property, that the cost of removal and clean-up would not exceed the value of the property, or that we could recoup any of the costs from any third party |
| Although we do not have an aggressive acquisition strategy, we have acquired, and in the future, will continue to consider the acquisition of, other financial services companies |
| To the extent that we acquire other companies in the future, our business may be negatively impacted by certain risks inherent with such acquisitions |
| These risks include the following: · The risk that the acquired business will not perform in accordance with management’s expectations; · The risk that difficulties will arise in connection with the integration of the operations of the acquired business with the operation of our businesses; · The risk that management will divert its attention from other aspects of our business; · The risk that we may lose key employees of the acquired business; and · The risks associated with entering into geographic and product markets in which we have limited or no direct prior experience |
| Due to the nature of our business, we may be subject to litigation from time to time, some of which may not be covered by insurance |
| Through our bank subsidiary, we operate in a highly regulated industry, and as a result, are subject to various regulations related to disclosures to our customers, our lending practices, and other fiduciary responsibilities |
| From time to time, we have been, and may become, subject to legal actions relating to our operations that have had, or could, involve claims for substantial monetary damages |
| Although we maintain insurance, the scope of this coverage may not provide us with full, or even partial, coverage in any particular case |
| As a result, a judgment against us in any such litigation could have a material adverse effect on our financial condition and results of operation |
| Changes in tax legislation could have a material impact on our results of operations |
| Changes in tax legislation could have a material impact on our results of operations |