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

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the Year Ended December 31, 2008

Commission File Number 0-19065

SANDY SPRING BANCORP, INC.
(Exact name of registrant as specified in its charter)

Maryland
 
52-1532952
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)

17801 Georgia Avenue, Olney, Maryland
 
20832
(Address of principal executive offices)
 
(Zip Code)

Registrant's telephone number, including area code:  301-774-6400.

Securities registered pursuant to Section 12(b) of the Act:
Title of each class
 
Name of each exchange on which registered
Common Stock, par value $1.00 per share
 
The NASDAQ Stock Market, LLC

Securities registered pursuant to Section 12(g) of the Act: None.

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

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

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.  x  Yes    ¨  No

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

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

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

The aggregate market value of the voting common stock of the registrant held by nonaffiliates on June 30, 2008, the last day of the registrant’s most recently completed second fiscal quarter, was approximately $264 million, based on the closing sales price of $16.58 per share of the registrant's Common Stock on that date.

As of the close of business on February 28, 2009, 16,403,955 shares of the registrant's Common Stock were outstanding.
Documents Incorporated By Reference
Part III: Portions of the definitive proxy statement for the Annual Meeting of Shareholders to be held on April 22, 2009 (the "Proxy Statement").
_________________
  * The registrant is required to file reports pursuant to Section 13 of the Act.

 

 
 
SANDY SPRING BANCORP, INC.
Table of Contents
 
Forward-Looking Statements
2
   
Form 10-K Cross Reference Sheet
3
   
Sandy Spring Bancorp, Inc.
4
   
About this Report
4
   
Five Year Summary of Selected Financial Data
5
   
Securities Listing, Prices and Dividends
6
   
Management's Discussion and Analysis of Financial Condition and Results of Operations
8
   
Controls and Procedures
25
   
Reports of Independent Registered Public Accounting Firms
26
   
Consolidated Financial Statements
29
   
Notes to the Consolidated Financial Statements
33
   
Other Material Required by Form 10-K:
 
   
Description of Business
64
   
Risk Factors
72
   
Competition
75
   
Employees
76
   
Executive Officers
76
   
Properties
77
   
Exhibits, Financial Statements, and Reports on Form 8-K
77
   
Signatures
79
 

Forward-Looking Statements
Sandy Spring Bancorp, Inc. (the “Company”) makes forward-looking statements in the Management's Discussion and Analysis of Financial Condition and Results of Operations and other portions of this Annual Report on Form 10-K that are subject to risks and uncertainties. These forward-looking statements include: statements of goals, intentions, earnings expectations, and other expectations; estimates of risks and of future costs and benefits; assessments of probable loan and lease losses; assessments of market risk; and statements of the ability to achieve financial and other goals.  These forward-looking statements are subject to significant uncertainties because they are based upon or are affected by: management's estimates and projections of future interest rates, market behavior, and other economic conditions; future laws and regulations; and a variety of other matters which, by their nature, are subject to significant uncertainties. Because of these uncertainties, the Company’s actual future results may differ materially from those indicated.  In addition, the Company's past results of operations do not necessarily indicate its future results. Please also see the discussion of “Risk Factors” on page 72.


 
2

 

SANDY SPRING BANCORP, INC.
FORM 10-K CROSS REFERENCE SHEET OF MATERIAL INCORPORATED BY REFERENCE
The following table shows the location in this Annual Report on Form 10-K or the accompanying Proxy Statement of the information required to be disclosed by the United States Securities and Exchange Commission (“SEC”) Form 10-K.  Where indicated below, information has been incorporated by reference in this Report from the Proxy Statement that accompanies it.  Other portions of the Proxy Statement are not included in this Report.  This Report is not part of the Proxy Statement. References are to pages in this report unless otherwise indicated.

   
Item of Form 10-K
 
Location
PART I
       
Item 1.
 
Business
 
“Forward-Looking Statements” on page 2, “Sandy Spring Bancorp, Inc.” and “About this Report” on page 4, and “Description of Business” on pages 64 through 72.
Item 1A.
 
Risk Factors
 
“Forward-Looking Statements” on page 2, “Risk Factors” on pages 72 through 75.
Item 1B.
 
Unresolved Staff Comments
 
Not applicable.
Item 2.
 
Properties
 
“Properties” on page 77.
Item 3.
 
Legal Proceedings
 
Note 19 “Litigation” on page 56.
Item 4.
 
Submission of Matters to a Vote of Security Holders
 
Not applicable. No matter was submitted to a vote of security holders during the fourth quarter of 2008.
PART II
       
Item 5.
 
Market for Registrant's Common Equity,  Related Stockholder Matters, and Issuer Purchases of Equity Securities
 
“Securities Listing, Prices, and Dividends” on page 6 and “Equity Compensation Plans” on page 7.
Item 6.
 
Selected Financial Data
 
“Five Year Summary of Selected Financial Data” on page 5.
Item 7.
 
Management's Discussion and Analysis of Financial Condition and Results of Operations
 
“Forward-Looking Statements” on page 2 and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” on pages 8 through 25.
Item 7A.
 
Quantitative and Qualitative Disclosures about Market Risk
 
“Forward-Looking Statements” on page 2 and “Market Risk Management” on pages 22 through 25.
Item 8.
 
Financial Statements and Supplementary Data
 
Pages 29 through 64.
Item 9.
 
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
 
Not applicable.
Item 9A.
 
Controls and Procedures
 
“Controls and Procedures” on page 25.
Item 9B.
 
Other Information
 
Not applicable.
PART III
       
Item 10.
 
Directors, Executive Officers and Corporate Governance
 
The material labeled “Information as to Nominees and Incumbent Directors,” “Corporate Governance,” “Code of Business Conduct,” “Compliance with Section 16(a) of the Securities Exchange Act of 1934,” “Shareholder Proposals and Communications,” and  “Report of the Audit Committee” in the Proxy Statement is incorporated in this Report by reference. Information regarding executive officers is included under the caption “Executive Officers” on page 77 of this Report.
Item 11.
 
Executive Compensation
 
The material labeled "Corporate Governance and Other Matters," "Executive Compensation," and "Compensation Committee Report" in the Proxy Statement is incorporated in this Report by reference.
Item 12.
 
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
 
The material labeled “Owners of More than 5% of Bancorp’s Common Stock” and, "Stock Ownership of Directors and Executive Officers" in the Proxy Statement is incorporated in this Report by reference. Information regarding securities authorized for issuance under equity compensation plans is included under “Equity Compensation Plans” on page 7.
Item 13.
 
Certain Relationships and Related Transactions and Director Independence
 
The material labeled “Director Independence” and "Transactions and Relationships with Management" in the Proxy Statement is incorporated in this Report by reference.
Item 14.
 
Principal Accounting Fees and Services
 
The material labeled Audit and Non-Audit Fees in the Proxy Statement is incorporated in this Report by reference.
PART IV
       
Item 15.
 
Exhibits, Financial Statement Schedules
 
“Exhibits, Financial Statement Schedules” on pages 77 and 78.
SIGNATURES
     
“Signatures” on page 79.
 
 
3

 

Sandy Spring Bancorp, Inc.

With $3.3 billion in assets, Sandy Spring Bancorp, Inc. is the holding company for Sandy Spring Bank and its principal subsidiaries, Sandy Spring Insurance Corporation, The Equipment Leasing Company, and West Financial Services, Inc.  Sandy Spring Bancorp, Inc. is the second largest publicly traded banking company headquartered in Maryland.  Sandy Spring Bank is a community banking organization that focuses its lending and other services on businesses and consumers in the local market area. Independent and community-oriented, Sandy Spring Bank was founded in 1868 and offers a broad range of commercial banking, retail banking, and trust services through 42 community offices in Anne Arundel, Carroll, Frederick, Howard, Montgomery, and Prince George’s counties in Maryland, and Fairfax and Loudoun counties in Virginia.  Through its subsidiaries, Sandy Spring Bank also offers a comprehensive menu of leasing, insurance, and investment management services.  Visit www.sandyspringbank.com to locate an ATM near you or for more information about Sandy Spring Bank.

About This Report

This report comprises the entire 2008 Form 10-K, other than exhibits, as filed with the SEC.  The 2008 annual report to shareholders, included in this report, and the proxy materials for the 2009 annual meeting are being distributed together to shareholders.  See page 78 for information regarding how to obtain copies of exhibits and additional copies of the Form 10-K.

This report is provided along with the annual proxy statement for convenience of use and to decrease costs, but is not part of the proxy materials.

The SEC has not approved or disapproved this report or passed upon its accuracy or adequacy.

 
4

 


FIVE YEAR SUMMARY OF SELECTED FINANCIAL DATA

 
2008
   
2007
   
2006
   
2005
   
2004
 
Results of Operations:
                             
Tax-equivalent interest income
  $ 173,389     $ 186,481     $ 159,686     $ 129,288     $ 117,137  
Interest expense
    60,386       76,149       58,687       33,982       34,768  
Tax-equivalent net interest income
    113,003       110,332       100,999       95,306       82,369  
Tax-equivalent adjustment
    4,545       5,506       6,243       7,128       8,156  
Provision for loan and lease losses
    33,192       4,094       2,795       2,600       0  
Net interest income after provision for loan and lease losses
    75,267        100,732       91,961       85,578       74,213  
Noninterest income
    46,243       44,289       38,895       36,909       30,949  
Noninterest expenses
    102,089       99,788       85,096       77,194       92,474  
Income before taxes
    19,421       45,233       45,760       45,293       12,688  
Income tax expense (benefit)
    3,642       12,971       12,889       12,195       (1,679 )
Net income
    15,779       32,262       32,871       33,098       14,367  
Net income available to common shareholders
    15,445       32,262       32,871       33,098       14,367  
Per  Share Data:
                                       
Net income- basic per share
  $ 0.96     $ 2.01     $ 2.22     $ 2.26     $ 0.99  
Net income – basic per common share
    0.94       2.01       2.22       2.26       0.99  
Net income-diluted per share
    0.96       2.01       2.20       2.24       0.98  
Net income  – diluted per common share
    0.94       2.01       2.20       2.24       0.98  
Dividends declared per common share
    0.96       0.92       0.88       0.84       0.78  
Book value per common share  (at year end)
    19.05       19.31       16.04       14.73       13.34  
Financial Condition (at year end):
                                       
Assets
  $ 3,313,638     $ 3,043,953     $ 2,610,457     $ 2,459,616     $ 2,309,343  
Deposits
    2,365,257       2,273,868       1,994,223       1,803,210       1,732,501  
Loans and leases
    2,490,646       2,277,031       1,805,579       1,684,379       1,445,525  
Securities
    492,491       445,273       540,908       567,432       666,108  
Borrowings
    522,658       426,525       351,540       417,378       361,535  
Stockholders’ equity
    391,862       315,640       237,777       217,883       195,083  
Financial Condition (average for the year):
                                       
Assets
    3,152,586       2,935,451       2,563,673       2,352,061       2,406,318  
Deposits
    2,284,648       2,253,979       1,866,346       1,771,381       1,652,306  
Loans and leases
    2,420,040       2,113,476       1,788,702       1,544,990       1,292,209  
Securities
    428,479       495,928       559,350       603,882       906,901  
Borrowings
    513,237       361,884       451,251       355,537       536,758  
Stockholders’ equity
    324,995       290,224       229,360       204,142       197,556  
Performance Ratios (for the year):
                                       
Return on average common equity
    4.84 %     11.12 %     14.33 %     16.21 %     7.27 %
Return on average assets
    0.49       1.10       1.28       1.41       0.60  
Yield on average interest-earning  assets
    6.02       6.98       6.73       5.95       5.23  
Rate on average interest-bearing liabilities
    2.56       3.50       3.08       2.02       1.94  
Net interest spread
    3.46       3.48       3.65       3.93       3.29  
Net interest margin
    3.92       4.13       4.26       4.39       3.68  
Efficiency ratio – GAAP (1)
    65.99       66.92       63.67       61.71       87.93  
Efficiency ratio – Non-GAAP (1)
    59.88       61.92       58.71       58.16       62.86  
Dividends declared per share to diluted net income per  common share
    102.12       45.77       40.00       37.50       79.59  
Capital and Credit Quality Ratios:
                                       
Average equity to average assets
    10.31 %     9.89 %     8.95 %     8.68 %     8.21 %
Total risk-based capital ratio
    13.82       11.28       13.62       13.22       13.82  
Allowance for loan losses to loans and leases
    2.03       1.10       1.08       1.00       1.01  
Non-performing assets to total assets
    2.18       1.15       0.15       0.06       0.08  
Net charge-offs to average loans and leases
    0.32       0.06       0.01       0.02       0.02  

(1)
See the discussion of the efficiency ratio in the section of Management’s Discussion and Analysis of Financial Condition and Results of Operations entitled “Operating Expense Performance.”
 
 
5

 

SECURITIES LISTING, PRICES AND DIVIDENDS

Stock Listing
Common shares of Sandy Spring Bancorp, Inc. are traded on the NASDAQ Global Select Market under the symbol SASR.

Transfer Agent and Registrar
American Stock Transfer and Trust Company,  59 Maiden Lane,  New York, New York 10038

Recent Stock Prices and Dividends
Shareholders received quarterly cash dividends totaling $15.8 million in 2008 and $15.0 million in 2007. Sandy Spring Bancorp, Inc. (the “Company”) has increased its dividends per share each year for the past twenty-eight years. Since 2002, dividends per share have risen at a compound annual growth rate of 5%. The increase in dividends per share was 4% in 2008.

The ratio of dividends per share paid on common stock to diluted net income available to common shareholders per share was 102% in 2008, compared to 46% for 2007. The dividend amount is established by the board of directors each quarter. In making its decision on dividends, the board considers operating results, financial condition, capital adequacy, regulatory requirements, shareholder returns, and other factors.

Shares issued under the employee stock purchase plan, which commenced on July 1, 2001, totaled 32,891 in 2008 and 25,147 in 2007, while issuances pursuant to exercises of stock options and grants of restricted stock were 22,546 and 84,342 in the respective years. Shares issued under the director stock purchase plan totaled 1,479 shares in 2008 and 2,402 shares in 2007.  There were no shares issued in connection with acquisitions in 2008 and 1,577,036 shares were issued in 2007.

The Company has a stock repurchase program that permits the repurchase of up to 5% (approximately 786,000 shares) of its outstanding common stock.  Repurchases are made in connection with shares expected to be issued under the Company's stock option, benefit and compensation plans, as well as for other corporate purposes.  A total of 1,332,869 shares have been repurchased since 1997, when stock repurchases began, through December 31, 2008 under the stock repurchase program. There were no shares repurchased in 2008 and 156,249 shares repurchased in 2007 under the stock repurchase program. As a result of participating in the Department of the Treasury’s Troubled Asset Relief Program (“TARP”) Capital Purchase Program, until December 5, 2011, the Company may not repurchase any shares of its common stock, other than in connection with the administration of an employee benefit plan, without the consent of the Treasury Department.

The number of common shareholders of record was approximately 2,600 as of February 27, 2009.

Quarterly Stock Information
   
2008
   
2007
 
   
Stock Price Range
   
Per Share
   
Stock Price Range
   
Per Share
 
Quarter
 
Low
   
High
   
Dividend
   
Low
   
High
   
Dividend
 
1st
  $ 24.38     $ 28.65     $ 0.24     $ 32.41     $ 38.97     $ 0.23  
2nd
    16.16       27.42       0.24       30.98       35.94       0.23  
3rd
    13.33       23.19       0.24       25.60       32.99       0.23  
4th
    14.82       22.46       0.24       26.00       31.57       0.23  
Total
                  $ 0.96                     $ 0.92  

Issuer Purchases of Equity Securities
Period
 
Total Number of
Shares Purchased (1)
   
Average Price
Paid per Share
   
Total Number of Shares
Purchased as Part of
Publicly Announced
Plans or Programs
   
Maximum Number that
May Yet Be Purchased
Under the Plans or
Programs (2)(3)
 
October 2008
    0       N/A       0       629,996  
November 2008
    0       N/A       0       629,996  
December 2008
    0       N/A       0       629,996  
 
(1) 
 Includes purchases of the Company’s stock made by or on behalf of the Company or any affiliated purchasers of the Company as defined in SEC Rule 10b-18.
(2) 
On March 28, 2007, the Company’s board of directors approved a continuation of the stock repurchase program that permits the repurchase of up to 5%, or 786,245 shares, of its outstanding common stock. The current program continued a similar plan that expired on March 31, 2007.  Due to its participation in the TARP, until December 5, 2011, the Company may not repurchase any shares of its common stock, other than in connection with the administration of an employees benefit plan, without the consent of the Treasury Department.
(3)
Indicates the number of shares remaining under the plan at the end of the indicated month.

 
6

 
 
The following graph and table show the cumulative total return on the Common Stock of Bancorp over the last five years, compared with the cumulative total return of a broad stock market index (the Standard and Poor’s 500 Index or “S&P 500”), and a narrower index of Mid-Atlantic bank holding company peers with assets of $2 billion to $7 billion.  The cumulative total return on the stock or the index equals the total increase in value since December 31, 2003, assuming reinvestment of all dividends paid into the stock or the index. The graph and table were prepared assuming that $100 was invested on December 31, 2003, in the Common Stock and the securities included in the indexes.


   
2003
   
2004
   
2005
   
2006
   
2007
   
2008
 
                                     
Sandy Spring Bancorp, Inc.
  $ 100.0     $ 104.9     $ 97.8     $ 109.7     $ 82.4     $ 67.5  
S&P 500 Index
  $ 100.0     $ 110.9     $ 116.3     $ 134.7     $ 142.1     $ 89.5  
Peer Group Index
  $ 100.0     $ 112.7     $ 107.6     $ 116.6     $ 90.5     $ 98.3  

The Peer Group Index includes twenty publicly traded bank holding companies, other than Bancorp, headquartered in the Mid-Atlantic Region as noted and with assets of $2 billion to $7 billion.  The companies included in this index are:  Carter Bank & Trust (VA); City Holding Company (WV); Pennsylvania Commerce Bancorp, Inc. (PA); First Bancorp, Inc. (NC); First Community Bancshares, Inc. (VA); Univest Corporation of Pennsylvania (PA); First Commonwealth Financial Corporation (PA); First Financial Bancorp (OH); F.N.B. Corporation (PA); Harleysville National Corporation (PA); Lakeland Bancorp, Inc. (NJ); NewBridge Bancorp (NC); Peoples Bancorp, Inc. (OH); Stellar One Corporation (VA);  Sun Bancorp, Inc. (NJ); S&T Bancorp, Inc. (PA); TowneBank (VA); Union Bankshares Corporation (VA); Virginia Commerce Bancorp, Inc. (VA); Wesbanco, Inc. (WV). Returns are weighted according to the issuer’s stock market capitalization at the beginning of each year shown.

Equity Compensation Plans
The following table presents disclosure regarding equity compensation plans in existence at December 31, 2008, consisting only of the 1999 Stock Option Plan (expired but with outstanding options that may still be exercised) and the 2005 Omnibus Stock Plan, each of which was approved by the shareholders.
 
Plan category
 
Number of securities to be
issued upon exercise of
outstanding options, warrants
and rights
   
Weighted average exercise
price of outstanding options,
warrants and rights
   
Number of securities
remaining available for future
issuance under equity
compensation plans
excluding securities reflected
in column
 
Equity compensation plans
approved by security holders
    973,730     $ 33.47       1,296,853  
                         
Equity compensation plans not
approved by security holders
    0       0       0  
Total
    973,730     $ 33.47       1,296,853  


 
7

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

Overview
Net income available to common shareholders for Sandy Spring Bancorp, Inc. and subsidiaries (the “Company”) for the year ended December 31, 2008, totaled $15.4 million ($0.94 per diluted common share), as compared to $32.3 million ($2.01 per diluted common share) for the prior year.  These results reflect the following events:

 
·
A 3% increase in net interest income due primarily to continued growth in the loan portfolio, which was largely offset by a decrease in the net interest margin from 4.13% in 2007 to 3.92% in 2008.
 
·
An increase in the provision for loan and lease losses to $33.2 million in 2008 from $4.1 million in 2007 due mainly to higher charge-offs, increases in internal risk rating downgrades and specific reserves on a higher level of nonperforming loans in the residential real estate development portfolio.
 
·
An increase of 4% in noninterest income over the prior year due to increased service charges on deposit accounts and higher fees on sales of investment products, offset by decreases in gains on sales of mortgage loans and insurance agency commissions.
 
·
An increase of 2% in noninterest expenses compared to the prior year due primarily to goodwill impairment charges totaling $4.2 million and a $1.3 million increase in FDIC insurance premiums compared to 2007.

The year 2008 brought about a severe decline in the national and regional economies as well as market volatility of historic proportions. These forces exerted extraordinary pressures on the interest rate performance, credit quality, liquidity and capital adequacy of banks in general and Sandy Spring Bank was not immune to the effects on these important banking performance metrics. Throughout this year of unparalleled financial and market turmoil, the Company’s experienced management team dealt with these critical risk factors with a view to managing for the long term.

The net interest margin declined to 3.92% in 2008 compared to 4.13% in 2007. Market rates declined throughout the year causing loan yields to decrease faster than the rates paid on deposits. In addition, the intense market competition for deposits by local, regional and national banks forced many banks to pay higher rates on deposits. The Company was required to sacrifice a measure of net interest margin by offering higher rates on certificates of deposit and creating new deposit products to maintain liquidity and market share.

The Company addressed the added liquidity risk by the actions mentioned above and also by the use of borrowing lines to lock in relatively low rates for longer terms and by carefully managing lending volumes later in the year. In addition, the Company restructured its primary borrowing lines with the Federal Home Loan Bank of Atlanta and the Federal Reserve in order to maximize the amounts of such available lines of credit.

The Company experienced a higher level of credit risk than in prior years due primarily to conditions in its residential real estate development portfolio. As pressures mounted due to the state of the housing market, many residential real estate developers could not survive the lack of sales and thus were unable to service their bank debt. The Company saw nonperforming assets increase to $72.2 million in 2008 from $34.9 million in 2007 primarily due to conditions in its residential real estate development portfolio. The Company has put into place additional staff and reporting tools to enhance its ability to monitor credit quality and identify problems expeditiously as they arise.

Lastly, but certainly most importantly, is the issue of capital adequacy. Despite the challenges discussed above, the Company has remained above all “well-capitalized” regulatory requirement levels. To provide an added margin of protection, the Company completed the sale of $83 million in preferred stock under the U.S. Treasury’s Capital Purchase Program.

We will discuss in further detail the Company’s response to each of the above mentioned risk factors in the following segments of Management’s Discussion and Analysis.

Comparing December 31, 2008 balances to December 31, 2007, total assets increased 9% to $3.3 billion. Loan balances increased by 9% over the prior year primarily due to growth of 13% in commercial loans. The rate of loan growth declined significantly over the second half of the year due to market conditions and management’s decision to improve its overall liquidity position. Customer funding sources, which include deposits plus other short-term borrowings from core customers, increased 3% over 2007. This growth was accomplished due to higher rates offered on select certificate of deposit accounts and the introduction of new deposit products in response to intense competition for deposits in the Company’s markets. During the same period, stockholders’ equity increased to $391.9 million or 12% of total assets.

 
8

 

Net interest income increased by $3.6 million, or 3%, mainly due to growth in interest-earning assets. The net interest margin decreased from 4.13% for the year 2007 to 3.92% for the year 2008. Noninterest income increased by 4% to $46.2 million compared to the prior year. This increase was due primarily to an increase of $1.6 million in service charges on deposit accounts and an increase of $0.5 million in fees on sales of investment products, partially offset by a decrease of $0.5 million in gains on sales of mortgage loans and $0.7 million in insurance agency commissions. Expressed as a percentage of total revenue (net interest income and noninterest income), noninterest income totaled 30%.  Noninterest expenses grew by $2.3 million or 2% versus the prior year primarily due to a pre-tax impairment charge of $4.2 million to write down the remaining value of goodwill in the Company’s leasing subsidiary, The Equipment Leasing Company. In addition, FDIC insurance premiums increased $1.3 million over the prior year.  These increases were partially offset by a prior service credit of $1.5 million relating to the Company’s pension plan and by a decrease of $1.5 million in merger expenses incurred in 2007.  Excluding the above mentioned one-time expenses, the Company’s successful implementation of its Project LIFT (“Looking Inward For Tomorrow”) initiative was primarily responsible for decreasing noninterest expense during 2008.

Non-performing assets increased substantially to $72.2 million at December 31, 2008 compared to $34.9 million at December 31, 2007. This increase was due primarily to the effect of current market conditions on the Company’s residential real estate development portfolio.  Non-performing assets represented 2.18% of total assets at year-end 2008, versus 1.15% at year-end 2007.  The ratio of net charge-offs to average loans and leases was 0.32% in 2008, compared to 0.06% in 2007.

Critical Accounting Policies
The Company’s consolidated financial statements are prepared in accordance with generally accepted accounting principles (“GAAP”) in the United States of America and follow general practices within the industry in which it operates.  Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes.  These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements may reflect different estimates, assumptions, and judgments.  Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported.  Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation allowance to be established, or when an asset or liability must be recorded contingent upon a future event.  Carrying assets and liabilities at fair value inherently results in more financial statement volatility.

The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when readily available.

The allowance for loan and lease losses is an estimate of the losses that may be sustained in the loan and lease portfolio.  The allowance is based on two basic principles of accounting: (1) Statement of Financial Accounting Standards (“SFAS”) No. 5, “Accounting for Contingencies,” which requires that losses be accrued when they are probable of occurring and estimable, and (2) SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” which requires that losses be accrued when it is probable that the Company will not collect all principal and interest payments according to the loan’s or lease’s contractual terms.

Management believes that the allowance is adequate. However, its determination requires significant judgment, and estimates of probable losses in the loan and lease portfolio can vary significantly from the amounts actually observed. While management uses available information to recognize probable losses, future additions to the allowance may be necessary based on changes in the loans and leases comprising the portfolio and changes in the financial condition of borrowers, such as may result from changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, and independent consultants engaged by the Company, periodically review the loan and lease portfolio and the allowance.  Such review may result in additional provisions based on their judgments of information available at the time of each examination.

The Company’s allowance for loan and lease losses has two basic components: the formula allowance reflecting historical losses by loan category, as adjusted by several factors whose effects are not reflected in historical loss ratios, and specific allowances.  Each of these components, and the systematic allowance methodology used to establish them, are described in detail in Note 1 of the Notes to the Consolidated Financial Statements.  The amount of the allowance is reviewed monthly by the Senior Loan Committee, and reviewed and approved quarterly by the board of directors.

The portion of the allowance that is based upon historical loss factors, as adjusted, establishes allowances for the major loan categories based upon adjusted historical loss experience over the prior eight quarters, weighted so that losses realized in the most recent quarters have the greatest effect.  The use of these historical loss factors is intended to reduce the differences between estimated losses inherent in the loan and lease portfolio and actual losses. The factors used to adjust the historical loss ratios address changes in the risk characteristics of the Company’s loan and lease portfolio that are related to (1) trends in delinquencies and other non-performing loans, (2) changes in the risk level of the loan portfolio related to large loans,  (3) changes in the categories of loans comprising the loan portfolio, (4) concentrations of loans to specific industry segments, (5) changes in economic conditions on both a local and national level, (6) changes in the Company’s credit administration and loan and lease portfolio management processes, and (7) quality of the Company’s credit risk identification processes. This component comprised 70% and 79% of the total allowance at December 31, 2008 and 2007, respectively.

 
9

 

The specific allowance is used primarily to establish allowances for risk-rated credits on an individual or portfolio basis, and accounted for 30% and 21% of the total allowance at December 31, 2008 and 2007, respectively.  The Company has historically had favorable credit quality.  The actual occurrence and severity of losses involving risk-rated credits can differ substantially from estimates, and some risk-rated credits may not be identified.

Table 1 – Consolidated Average Balances, Yields and Rates (1)

(Dollars in thousands and tax equivalent)
   
2008
   
2007
   
2006
 
   
Average
         
Yield/
   
Average
         
Yield/
   
Average
         
Yield/
 
   
Balance
   
Interest
   
Rate
   
Balance
   
Interest
   
Rate
   
Balance
   
Interest
   
Rate
 
Assets
                                                     
Loans and leases (2)
                                                     
Residential real estate(3)
  $ 660,779     $ 40,132       6.07 %   $ 586,141     $ 37,441       6.39 %   $ 588,426     $ 36,723       6.24 %
Consumer
    387,983       20,503       5.28       365,334       25,367       6.94       344,316       23,172       6.73  
Commercial loans and leases
    1,371,278       88,565       6.46       1,162,001       90,730       7.81       855,960       66,657       7.79  
Total loans and  leases
    2,420,040       149,200       6.17       2,113,476       153,538       7.26       1,788,702       126,552       7.08  
                                                                         
Securities:
                                                                       
Taxable
    242,422       10,684       4.41       279,881       14,603       5.22       310,740       14,710       4.73  
Nontaxable
    186,057       12,838       6.90       216,047       15,060       6.97       248,610       17,220       6.93  
Total securities
    428,479       23,522       5.49       495,928       29,663       5.98       559,350       31,930       5.71  
Interest-bearing deposits with banks
    11,305       112       .99       21,600       1,123       5.20       2,501       123       4.92  
Federal funds sold
    22,619       555       2.45       42,305       2,157       5.10       21,145       1,081       5.12  
Total earning assets
  $ 2,882,443       173,389       6.02 %   $ 2,673,309       186,481       6.98 %   $ 2,371,698       159,686       6.73 %
Less: allowances for loan and lease losses
    (32,629 )                     (22,771 )                     (18,584 )                
Cash and due from banks
    49,981                       54,294                       46,741                  
Premises and equipment, net
    53,207                       52,604                       45,980                  
Other assets
    199,584                       178,015                       117,838                  
Total assets
  $ 3,152,586                     $ 2,935,451                     $ 2,563,673                  
                                                                         
Liabilities and Stockholders’ Equity:
                                                                       
Interest-bearing demand deposits
  $ 242,848     $ 671       0.28 %   $ 236,940     $ 808       0.34 %   $ 226,699     $ 657       0.29 %
Regular savings deposits
    153,123       455       0.30       165,134       535       0.32       182,610       687       0.38  
Money market  savings deposits
    669,239       12,247       1.83       643,047       23,809       3.70       409,578       12,655       3.09  
Time deposits
    777,979       29,443       3.78       768,005       34,764       4.53       631,712       25,335       4.01  
Total interest-bearing deposits
    1,843,189       42,816       2.32       1,813,126       59,916       3.30       1,450,599       39,334       2.71  
Short-term borrowings
    409,933       13,212       3.22       319,418       13,673       4.28       414,274       17,049       4.12  
Long-term borrowings
    103,304       4,358       4.22       42,466       2,560       6.03       36,977       2,304       6.23  
Total interest-bearing liabilities
    2,356,426       60,386       2.56       2,175,010       76,149       3.50       1,901,850       58,687       3.08  
Net interest income and spread
          $ 113,003       3.46 %           $ 110,332       3.48 %           $ 100,999       3.65 %
Noninterest-bearing demand deposits
    441,459                       440,853                       415,747                  
Other liabilities
    29,706                       29,364                       16,716                  
Stockholders’ equity
    324,995                       290,224                       229,360                  
Total liabilities and stockholders’ equity
  $ 3,152,586                     $ 2,935,451                     $ 2,563,673                  
                                                                         
Interest income/ earning assets
                    6.02 %                     6.98 %                     6.73 %
Interest expense/ earning assets
                    2.10                       2.85                       2.47  
Net interest margin
                    3.92 %                     4.13 %                     4.26 %

 (1)
Interest income includes the effects of taxable-equivalent adjustments (reduced by the nondeductible portion of interest expense) using the appropriate marginal federal income tax rate of 35.00% and, where applicable, the marginal state income tax rate of 7.51% (or a combined marginal federal and state rate of 39.88%) for 2008, a marginal state income tax rate of 6.55% (or a combined federal and state rate of 39.26%) for 2007 and a marginal state income tax rate of 7.00% (or a combined federal and state rate of 39.55%) for 2006, to increase tax-exempt interest income to a taxable-equivalent basis.  The taxable-equivalent adjustment amounts utilized in the above table to compute yields totaled to $4.5 million in 2008, $5.5 million in 2007, and $6.2 million in 2006.
(2)
Non-accrual loans are included in the average balances.
(3)
Includes residential mortgage loans held for sale. Home equity loans and lines are classified as consumer loans.

 
10

 
Net Interest Income
The largest source of the Company’s operating revenue is net interest income, which is the difference between the interest earned on interest-earning assets and the interest paid on interest-bearing liabilities.

Net interest income for 2008 was $108.5 million, representing an increase of $3.6 million or 3% from 2007. Comparing 2007 to 2006, net interest income increased 11% to $104.8 million.

For purposes of this discussion and analysis, the interest earned on tax-exempt investment securities has been adjusted to an amount comparable to interest subject to normal income taxes. The result is referred to as tax-equivalent interest income and tax-equivalent net interest income.

The tabular analysis of net interest income performance (entitled "Table 1 – Consolidated Average Balances, Yields and Rates") shows a decrease in net interest margin for 2008 of 21 basis points, or 5% when compared to 2007.  Comparing the years 2008 and 2007 shown in Table 1, average earning assets increased by 8%.  Table 2 shows the extent to which interest income, interest expense and net interest income were affected by rate changes and volume changes.  The decrease in tax-equivalent net interest margin in 2008 resulted from increases in non-accrual loans coupled with a decrease in interest income due to rapidly declining rates on earning assets which were not offset entirely by declining interest rates on deposits due to intense competition. While average noninterest bearing deposits remained essentially level in 2008, the percentage of noninterest bearing deposits to total deposits decreased to 19% in 2008 compared to 20% in 2007 and 22% in 2006. The decrease in the tax-equivalent net interest margin in 2007 resulted mainly from a higher yield on interest bearing deposits due to the existing flat yield curve. Tax-equivalent net interest income increased by 2% in 2008 (to $113.0 million in 2008 from $110.3 million in 2007) and increased 9% in 2007 (from $101.0 million in 2006).  Pressure on the net interest margin in recent years has been an industry-wide trend and a significant challenge for management.  It has led to greater sophistication in margin management, heightened emphasis on noninterest revenues and improved control over noninterest expenses.  During 2008, margin compression continued as a result of a flat yield curve environment and intense competition for deposits among banks and other providers of financial services and the effect of interest rate cuts by the Federal Reserve throughout 2008. The Company is continuing its emphasis on producing consistent earnings results from its core loan, deposit and noninterest income businesses while exercising greater control over noninterest expenses.

Table 2 – Effect of Volume and Rate Changes on Net Interest Income
 
         
2008 vs. 2007
         
2007 vs. 2006
 
   
Increase
   
Due to Change
   
Increase
   
Due to Change
 
   
Or
   
In Average:*
   
Or
   
In Average:*
 
(In thousands and tax equivalent)
 
(Decrease)
   
Volume
   
Rate
   
(Decrease)
   
Volume
   
Rate
 
Interest income from earning assets:
                                   
Loans and leases
  $ (4,338 )   $ 20,508     $ (24,846 )   $ 26,986     $ 23,515     $ 3,471  
Securities
    (6,141 )     (3,832 )     (2,309 )     (2,267 )     (3,742 )     1,475  
Other investments
    (2,613 )     (1,129 )     (1,484 )     2,076       2,067       9  
Total interest income
    (13,092 )     15,547       (28,639 )     26,795       21,840       4,955  
Interest expense on funding of earning assets:
                                               
Interest-bearing demand deposits
    (137 )     18       (155 )     151       30       121  
Regular savings deposits
    (80 )     (43 )     (37 )     (152 )     (62 )     (90 )
Money market savings deposits
    (11,562 )     931       (12,493 )     11,154       8,276       2,878  
Time deposits
    (5,321 )     451       (5,772 )     9,429       5,906       3,523  
Total borrowings
    1,337       5,785       (4,448 )     (3,120 )     (3,976 )     856  
Total interest expense
    (15,763 )     7,142       (22,905 )     17,462       10,174       7,288  
Net interest income
  $ 2,671     $ 8,405     $ (5,734 )   $ 9,333     $ 11,666     $ (2,333 )

* Where volume and rate have a combined effect that cannot be separately identified with either, the variance is allocated to volume and rate based on the relative size of the variance that can be separately identified with each.

Interest Income
The Company's interest income decreased by $12.1 million or 7% in 2008, compared to 2007, preceded by an increase of $27.5 million or 18% over 2006. On a tax-equivalent basis, the respective changes were a decrease of 7% in 2008, and an increase of 17% in 2007. Table 2 shows that, in 2008, the decrease in interest income resulted primarily from a decline in earning asset yields which was partially offset by growth in average earning assets.

 
11

 

During 2008, average loans and leases, yielding 6.17% versus 7.26% a year earlier, grew 15% to $2.4 billion, due mainly to an 18% increase in average commercial loans and leases. Average residential real estate loans increased 13% and average consumer loans increased 6% due to growth in home equity lines, while the increase in average commercial loans and leases reflected growth in all categories of such loans. In 2008, average loans and leases comprised 84% of average earning assets, compared to ratios of 79% in 2007 and 75% in 2006. Average total securities, yielding 5.49% in 2008 versus 5.98% last year, declined 14% to $428.5 million. Average non-taxable securities declined in 2008 by 14% compared to 2007. Average total securities comprised 15% of average earning assets in 2008, compared to 19% in 2007 and 24% in 2006. This decline of investment securities in 2008 was due mainly to the need to fund loans as a result of the lack of deposit growth during much of the year, whereas the declines for the prior years were consistent with the Company’s strategic plan to migrate an increasing share of its assets from investment securities to its commercial loan portfolio.

Interest Expense
Interest expense decreased by 21% or $15.8 million in 2008, compared to 2007, primarily as a result of a 94 basis point decrease in the average rate paid on deposits and borrowings (decreasing to 2.56% from 3.50%).

Deposit and borrowing activity during 2008 was driven primarily by extremely volatile market conditions due to the overall state of the national and regional economy. This brought about an intensely competitive market for deposits as liquidity became a major concern for most financial institutions. This lack of overall liquidity in the banking system together with the intensely competitive market for deposits caused the Company to pay somewhat higher rates on interest bearing deposits than it otherwise might normally pay in such a declining rate environment in order to maintain adequate liquidity levels.

In 2007, interest expense increased due to a 42 basis point increase in the average rate paid on deposits and borrowings and an increase of 25% or $362.5 million in average interest bearing deposits. These increases were due in large part, to the flat yield curve environment and a very competitive market for deposits.

Interest Rate Performance
The net interest margin decreased by 21 basis points in 2008, as compared to a decrease in net interest spread of 2 basis points. The difference between these two indicators of interest rate performance is attributable primarily to a decrease in the benefit of funding average earning assets from interest-free sources, which is reflected in the net interest margin. During 2008, the Company experienced virtually the same decrease in the funding rate compared to the yield on earning assets, resulting in a greater decrease in the net interest margin compared to the net interest spread.

In 2007 versus 2006, a greater relative increase in the funding rate compared to the yield on earning assets resulted in a decrease in the net interest margin and spread.

Noninterest Income
Total noninterest income was $46.2 million in 2008, a $2.0 million or 4% increase from 2007. The primary reasons for the increase in noninterest income for 2008, as compared to 2007 were a $1.6 million increase in service charges on deposit accounts, due primarily to higher overdraft fees and the growth in deposits due to the acquisition of Potomac Bank of Virginia (“Potomac”) and County National Bank (“County”) in 2007 and a $0.5 million increase in fees on sales of investment products due to higher annuity sales. These increases were partially offset by decreases in gains on sales of mortgage loans of $0.5 million due to market conditions and insurance agency commissions of $0.7 million. Comparing 2007 to 2006, noninterest income increased $5.4 million or 14%. This increase was mainly due to increases in service charges on deposit accounts from higher overdraft fees and trust and investment management fees due to growth in assets under management. These increases were partially offset by a decrease of $0.2 million in gains on sales of mortgage loans.

The Company recognized securities gains of $0.7 million in 2008 compared to virtually no securities gains in 2007 or 2006. The increase in 2008 was due primarily to a $0.4 million gain on the sale of stock in Visa, Inc.

Service charges on deposits totaled $12.8 million in 2008, an increase of $1.6 million or 15% due primarily to higher overdraft fees.

Fees on sales of investment products increased to $3.5 million from $3.0 million, an increase of $0.5 million or 17% over 2007 due largely to increased sales of annuities as customers sought out a perceived higher level of safety for their investments. Fees on sales of investment products remained virtually level in 2007 compared to 2006. The lack of growth in 2007 was due primarily to uncertain economic conditions and eroding consumer confidence at the time.

Gains on mortgage sales decreased by $0.5 million or 16% in 2008 compared to 2007, after a decrease of 8% in 2007 compared to 2006. The Company achieved gains of $2.3 million on sales of $186.7 million in 2008 compared to $2.7 million on sales of $286.4 million in 2007 and gains of $3.0 million on sales of $296.9 million in 2006. Insurance agency commissions decreased by $0.7 million or 11% in 2008 compared to 2007 after an increase of $0.1 million or 2% in 2007 compared to 2006. The decrease in 2008 was due to declines in commissions on commercial lines and contingency fees.

 
12

 

Trust and investment management fee income amounted to $9.5 million in 2008, a decrease of $0.1 million or 1% compared to 2007, reflecting a decrease in assets under management. During 2008, investment management fees in West Financial Services decreased slightly to $4.6 million due to a decrease in assets under management largely due to market conditions. Trust services fees also showed a small decline to $4.9 million compared to the prior year due mainly to an 18% decrease in assets under management. Trust and investment management fees of $9.6 million for 2007 represented an increase of $0.8 million or 9% over 2006. This increase was due primarily to growth in assets under management at both West Financial Services and in the Company’s trust department. Total assets under management for West Financial Services, trust and investment services decreased $300.3 million or 16% to $1.5 billion at December 31, 2008.

Income from bank owned life insurance reflected an increase of $0.1 million or 3% in 2008 compared to 2007 and an increase of $0.5 million or 20% from 2007 to 2006. The increase in 2007 was due primarily to higher rates and insurance policies added from the two acquisitions. The Company invests in bank owned life insurance products in order to better manage the cost of employee benefit plans. Investments totaled $72.8 million at December 31, 2008 and were well diversified by carrier in accordance with defined policies and practices. The average tax-equivalent yield on these insurance contract assets was 6.78% for 2008.

Noninterest Expenses
Noninterest expenses increased $2.3 million or 2% in 2008, compared to 2007. The increase in expenses in 2008 included goodwill impairment charges of $4.2 million and an increase of $1.3 million in FDIC insurance premiums together with a pension prior service credit of $1.5 million and a decrease of $1.5 million in merger expenses incurred in 2007. Excluding these transactions, noninterest expenses were virtually even with the prior year. Outside data services increased $0.4 million or 10% and intangibles amortization increased $0.4 million or 9%. These increases were offset by decreases of $0.7 million or 1% in salaries and benefits expenses, excluding the pension credit mentioned above, and $0.1 million or 3% in marketing expenses. Comparing 2007 to 2006, noninterest expenses increased $14.7 million or 17% due primarily to a 9% increase in salaries and employees benefits expenses and a 47% increase in other noninterest expenses due largely to merger expenses mentioned above.

Salaries and employee benefits, the largest component of noninterest expenses, decreased $2.2 million or 4% in 2008. This decrease was due in part to the credit recognized in the third quarter of $1.5 million for prior service credits relating to the Company’s defined benefit pension plan. Excluding this credit, salaries and benefits expenses decreased $0.7 million or 1% compared to 2007. This decrease was largely due to a freeze of the defined benefit pension plan effective January 1, 2008, termination of the Supplemental Executive Retirement Agreements and to other elements of Project LIFT. Established at the end of 2007, Project LIFT was adopted by the Company primarily to implement stronger control over operating expenses. Also contributing to the decline in this category of expenses, commission compensation decreased 20% compared to 2007 due to a lower volume of mortgage loan originations resulting from market conditions. Average full-time equivalent employees decreased to 697 in 2008, representing a decrease of 2% from 709 in 2007, which was 13% above the 626 full-time equivalent employees in 2006.

In 2008, occupancy expense increased $0.4 million or 4%. This increase was due in part to new branches acquired in the County National Bank acquisition which occurred in May, 2007. The rate of increase was $1.9 million or 22% in 2007 over 2006 due to rent increases on existing properties and the addition of acquired branches. Equipment expenses decreased $0.4 million or 6% in 2008 compared to 2007. This decrease was due mainly to lower negotiated software expenses and one time expenses incurred in connection with the acquisition of Potomac Bank and County National Bank in 2007. Marketing expense decreased by $0.1 million or 3% in 2008 following a decrease of $0.3 million or 13% in 2007. The decrease in 2007 was due mainly to the Company’s efforts to better control its noninterest expenses and was continued in 2008 under project LIFT.

Expenses for outside data services increased $0.4 million or 10% in 2008 compared to 2007 due to the overall growth of the loan and deposit portfolios and the effect of a full year of expense relating to the ten branches added from the acquisitions of County and Potomac in 2007. Outside data services increased $0.8 million or 24% in 2007 compared to 2006 due to growth in the loan and deposit portfolio resulting from the two acquisitions.

As a result of its annual assessment in September 2008, the Company determined that a triggering event had occurred in The Equipment Leasing Company and, accordingly, the Company began a two phase impairment analysis of goodwill. The Phase I analysis utilized both the Income approach (discounted future cash flow analysis) and the Market approach (using price to earnings multiples of comparable companies). The results obtained from the Phase I analysis indicated a potential impairment might exist and that a Phase II analysis was required to determine the amount of the impairment. Based on its Phase I analysis the Company recorded an estimated impairment charge of $2.3 million. Upon completion of its Phase II analysis in the fourth quarter of 2008, the Company determined that an additional impairment charge of $1.9 million was warranted. This additional charge, which constituted the remaining goodwill in The Equipment Leasing Company was recorded in the fourth quarter of 2008. The total impairment charges of $4.2 million were recorded in the income statement under the caption “Goodwill impairment loss”.

 
13

 

Other noninterest expenses decreased $0.4 million or 2% compared to 2007. This decrease was due primarily to merger expenses of $1.5 million recognized in 2007 which were largely offset by an increase of $1.3 million in FDIC insurance premiums in 2008 and the control of discretionary expenses under Project LIFT. Other noninterest expenses increased $5.5 million or 46% in 2007 compared to 2006 due mainly to merger expenses, higher consulting and professional fees and an expense accrual for possible Visa, Inc. litigation costs.

Amortization of intangible assets increased $0.4 million or 9% over 2007 due to the effect of a full year of amortization relating to the two acquisitions in 2007. The Company’s intangible assets are being amortized over relatively short amortization periods averaging approximately five years at December 31, 2008. Intangible assets arising from branch acquisitions were not classified as goodwill and continue to be amortized since the acquisitions did not meet the definition for business combinations.

In October 2007, Sandy Spring Bank, as a member of Visa U.S.A. Inc. (“Visa U.S.A.”), received shares of restricted stock in Visa, Inc. (“Visa”) as a result of its participation in the global restructuring of Visa U.S.A., Visa Canada Association, and Visa International Service Association in preparation for an initial public offering. In November 2007, Visa announced that it had reached a settlement with American Express related to an antitrust lawsuit. Sandy Spring Bank and other Visa U.S.A. member banks were obligated to share in potential losses resulting from this and certain other litigation. In consideration of the announced American Express settlement, Sandy Spring Bank’s proportionate membership share of Visa U.S.A., and accounting guidance provided by the SEC, the Company recorded a liability and corresponding expense in the fourth quarter of $0.2 million with respect to the American Express and certain other litigation with Visa U.S.A. The Company has not reflected in its financial statements any value for its membership interest in Visa as a result of the Visa reorganization. The anticipated IPO was completed during the first quarter of 2008, and as a result, a portion of the Company’s shares in Visa were redeemed for a total of $0.4 million reported as a gain on securities sold. In addition, in the first quarter of 2008, the Company reversed the liability of $0.2 million mentioned above due to the fact that Visa had funded an escrow account with an amount deemed sufficient to fund any potential losses resulting from the litigation at that time.

In October 2008, Visa announced that it had agreed to settle litigation with Discover Financial Services which involved a payment from the escrow account mentioned above for approximately $1.7 billion, which exceeds the amount that Visa had originally funded in the escrow account for this purpose. It is currently intended that the Class B shareholders, such as the Company, will bear this cost via a reduction in their number of shares received as a result of the public offering. The Company recorded no additional expense as a result of this settlement due to its immateriality. The Company currently has 15,890 class B shares remaining that are subject to conversion by Visa prior to the above adjustment in shares.

Operating Expense Performance
Management views the efficiency ratio as an important measure of expense performance and cost management. The ratio expresses the level of noninterest expenses as a percentage of total revenue (net interest income plus total noninterest income). This is a GAAP financial measure. Lower ratios indicate improved productivity.

Non-GAAP Financial Measure
The Company has for many years used a traditional efficiency ratio that is a non-GAAP financial measure of operating expense control and efficiency of operations. Management believes that its traditional ratio better focuses attention on the operating performance of the Company over time than does a GAAP ratio, and is highly useful in comparing period-to-period operating performance of the Company’s core business operations. It is used by management as part of its assessment of its performance in managing noninterest expenses. However, this measure is supplemental, and is not a substitute for an analysis of performance based on GAAP measures. The reader is cautioned that the non-GAAP efficiency ratio used by the Company may not be comparable to GAAP or non-GAAP efficiency ratios reported by other financial institutions.

In general, the efficiency ratio is noninterest expenses as a percentage of net interest income plus noninterest income. Noninterest expenses used in the calculation of the non-GAAP efficiency ratio exclude the goodwill impairment loss in 2008, the amortization of intangibles, and non-recurring expenses. Income for the non-GAAP ratio includes the favorable effect of tax-exempt income (see Table 1), and excludes securities gains and losses, which vary widely from period to period without appreciably affecting operating expenses, and non-recurring gains. The measure is different from the GAAP efficiency ratio, which also is presented in this report. The GAAP measure is calculated using noninterest expense and income amounts as shown on the face of the Consolidated Statements of Income. The GAAP and non-GAAP efficiency ratios are reconciled in Table 3. As shown in Table 3, both efficiency ratios decreased in 2008. This decrease was mainly the result of the decline in noninterest expenses in 2008 compared to 2007 coupled with the increase in net interest income in 2008.

 
14

 

Table 3 – GAAP and non-GAAP efficiency ratios

(In thousands)
 
2008
   
2007
   
2006
   
2005
   
2004
 
GAAP Efficiency ratio:
                             
Noninterest expenses
  $ 102,089     $ 99,788     $ 85,096     $ 77,194     $ 92,474  
Net interest income plus noninterest income
    154,702       149,115       133,651       125,087       105,162  
                                         
Efficiency ratio – GAAP
    65.99 %     66.92 %     63.67 %     61.71 %     87.93 %
                                         
Noninterest expenses
  $ 102,089     $ 99,788     $ 85,096     $ 77,194     $ 92,474  
Plus non-GAAP adjustment:
                                       
Pension prior service credit
    1,473       0       0       0       0  
Less non-GAAP adjustments:
                                       
Amortization of intangible assets
    4,447       4,080       2,967       2,198       1,950  
Goodwill impairment loss
    4,159       0       0       0       1,265  
FHLB prepayment penalties
    0       0       0       0       18,363  
Noninterest expenses – as adjusted
  $ 94,956     $ 95,708     $ 82,129     $ 74,996     $ 70,896  
                                         
Net interest income plus noninterest income
                                       
Plus non-GAAP adjustment:
                                       
Tax-equivalency
    4,545       5,506       6,243       7,128       8,156  
Less non-GAAP adjustments:
                                       
Securities gains
    663       43       1       3,262       540  
Net interest income plus noninterest
                                       
Income – as adjusted
  $ 158,584     $ 154,578     $ 139,893     $ 128,953     $ 112,778  
                                         
Efficiency ratio – Non-GAAP
    59.88 %     61.92 %     58.71 %     58.16 %     62.86 %

Provision for Income Taxes
The Company had an income tax expense of $3.6 million in 2008, compared with an income tax expense of $13.0 million in 2007 and $12.9 million in 2006. The resulting effective tax rates were 19% for 2008, 29% for 2007, and 28% for 2006. The decline in the effective tax rate for 2008 compared to 2007 was due to a change in the amount of tax advantaged income as a percent of taxable income.

Balance Sheet Analysis
The Company's total assets increased $269.7 million to $3.3 billion at December 31, 2008. Earning assets increased $303.2 million to $3.1 billion at December 31, 2008. These increases were mainly due to growth in the loan portfolio.

Loans and Leases
Residential real estate loans, comprised of residential construction and permanent residential mortgage loans, increased $23.5 million or 4%, during 2008 to $646.8 million at December 31, 2008. Residential construction loans increased to $189.2 million in 2008, an increase of $22.2 million or 13%. Permanent residential mortgages, most of which are 1-4 family, remained virtually even with the prior year at $457.6 million.

Over the years, the Company’s commercial loan clients have come to represent a diverse cross-section of small to mid-size local businesses, whose owners and employees are often established Bank customers. The Company’s long-standing community roots and extensive experience in this market segment make it a natural growth area, while building and expanding such banking relationships are natural results of the Company’s increased emphasis on client relationship management.

Consistent with this strategy, the Company has targeted growth in the commercial loan portfolio as a central tenet of its long-term strategic plan. This involves a planned migration of assets from the investment portfolio to the commercial loan portfolio and emphasis on growth in related deposit accounts and other services such as investment management and insurance services.

Commercial loans and leases increased by $160.1 million or 13%, to $1.4 billion at December 31, 2008. Included in this category are commercial real estate loans, commercial construction loans, equipment leases and other commercial loans.

In general, the Company's commercial real estate loans consist of owner occupied properties where an established banking relationship exists or, to a lesser extent, involve investment properties for warehouse, retail, and office space with a history of occupancy and cash flow. Commercial mortgages rose $184.6 million or 28% during 2008, to $847.5 million at year-end. Commercial construction loans decreased $39.7 million or 15% during the year, to $223.2 million at December 31, 2008. While the Company follows generally very conservative underwriting guidelines, it has not been immune to the continued rapid deterioration in the national and regional economy, and particularly its effect on the real estate market. The state of the economy and its effect on builders and developers is the primary reason for the decrease in this loan sector. Other commercial loans increased $17.7 million or 6% during 2008 to $333.8 million at year-end.

 
15

 

The Company's equipment leasing business provides leases for essential commercial equipment used by small to medium sized businesses. Equipment leasing is conducted through vendor relations and direct solicitation to end-users located primarily in states along the east coast from New Jersey to Florida. The typical lease is “small ticket” by industry standards, averaging less than $100 thousand, with individual leases generally not exceeding $500 thousand. The leasing portfolio decreased $2.5 million or 7% in 2008, to $33.2 million at year-end due in large part to market conditions and their effect on small and medium-sized businesses.

Consumer lending continues to be important to the Company’s full-service, community banking business. This category of loans includes primarily home equity loans and lines of credit. The consumer loan portfolio increased 8% or $29.9 million, to $406.2 million at December 31, 2008. This growth was driven largely by an increase of $43.4 million or 14% in home equity lines and loans during 2008 to $352.0 million at year-end. This increase was a result of growth in the volume of such lines and a higher utilization rate.

Table 4 – Analysis of Loans and Leases
This table presents the trends in the composition of the loan and lease portfolio over the previous five years.

   
December 31,
 
(In thousands)
 
2008
   
2007
   
2006
   
2005
   
2004
 
Residential real estate:
                             
Residential mortgages
  $ 457,571     $ 456,305     $ 390,852     $ 413,324     $ 371,924  
Residential construction
    189,249       166,981       151,399       155,379       137,800  
Commercial loans and leases:
                                       
Commercial real estate
    847,452       662,837       509,726       415,983       386,911  
Commercial construction
    223,169       262,840       192,547       178,764       88,974  
Leases
    33,220       35,722       34,079       23,644       15,618  
Other commercial
    333,758       316,051       182,159       162,036       135,116  
Consumer
    406,227       376,295       344,817       335,249       309,102  
Total loans and leases
  $ 2,490,646     $ 2,277,031     $ 1,805,579     $ 1,684,379     $ 1,445,525  

Table 5 – Loan Maturities and Interest Rate Sensitivity
 
   
At December 31, 2008
 
   
Remaining Maturities of Selected Credits in Years
 
(In thousands)
 
1 or less
   
Over 1-5
   
Over 5
   
Total
 
Residential construction loans
  $ 189,093     $ 142     $ 14     $ 189,249  
Commercial construction loans
    202,361       5,328       15,480       223,169  
Commercial loans not secured by real estate
    234,806       78,569       20,383       333,758  
Total
  $ 626,260     $ 84,039     $ 35,877     $ 746,176  
                                 
Rate Terms: