FRAF

Business Context and Reporting Period

Company: Franklin Financial Services Corp (and subsidiaries, primarily Farmers and Merchants Trust Company of Chambersburg).
Filing Type: Form 10-Q (Unaudited Quarterly Report).
Period Ended: September 30, 2009.
Operations: Commercial banking operations in Franklin, Cumberland, Fulton, and Huntingdon Counties, Pennsylvania. The company is an accelerated filer.

Key Financial Metrics

Key Ratios (Annualized, 9 Months 2009):
- Return on Average Equity (ROE): 8.34% (vs. 12.62% in 2008)
- Return on Average Assets (ROA): 0.66% (vs. 1.18% in 2008)
- Net Interest Margin: 3.44% (vs. 4.04% in 2008)
- Efficiency Ratio: 65.50% (vs. 58.06% in 2008)

Material Changes vs. Prior Period

• Profitability Decline: Net income decreased 37% year-over-year to $4.8 million. This was driven by a 37% drop in pre-tax income, primarily due to a higher provision for loan losses and a special FDIC assessment.
• Provision for Loan Losses: Increased significantly to $2.7 million (from $0.8 million in 2008) due to loan growth and specific reserves for nonperforming loans.
• Net Interest Margin Compression: Margin fell 60 basis points to 3.44%. Asset yields dropped 96 basis points (mainly variable rate commercial loans), while liability costs only decreased 49 basis points.
• Asset Quality Deterioration: Nonperforming assets rose to 1.21% of total assets (from 0.44% at year-end 2008). Nonperforming loans increased to $11.2 million, driven by construction, land development, and farm real estate sectors.
• Deposit Growth: Total deposits grew 13.2% to $709.9 million, fueled by a 167% increase in brokered time deposits and growth in money market accounts.
• Expense Increases: Noninterest expense rose 12% to $19.6 million. Notable increases included FDIC insurance ($1.0 million increase due to special assessment) and pension expense ($0.4 million increase due to low interest rates).

Outlook, Risks, and Contingencies

• CIT Group Exposure: The Bank holds a $1 million debt security issued by CIT Group, Inc. CIT filed for bankruptcy in November 2009. Management expects a loss to be recorded prior to December 31, 2009, with estimated recovery ranging from 65% to 85% of pre-bankruptcy value.
• FDIC Prepayment: A proposed FDIC rule may require the prepayment of assessments for 2010-2012. The Corporation estimates this liability at approximately $4.0 million.
• Investment Portfolio: The portfolio contains $5.9 million in unrealized losses. Management deems impairments on debt securities temporary but notes that equity write-downs of $0.4 million were taken in 2009, with potential for additional write-downs.
• Dividend Policy: Management decided not to increase the dividend for the third and fourth quarters of 2009 to preserve capital. The payout ratio for the first nine months was 64%.
• Interest Rate Risk: An extended period of low market interest rates is expected to continue reducing the net interest margin as liability rates cannot be reduced significantly further.

Investor Verification Checklist

• CIT Group Loss Impact: Verify the final loss amount recognized on the CIT Group debt security in the Q4 2009 filing.
• FDIC Assessment: Confirm the final impact of the proposed FDIC prepayment rule on 2009 and 2010 liquidity and earnings.
• Nonperforming Loan Trends: Monitor the coverage ratio (currently 78.55%) and the specific performance of construction and farm real estate loans.
• Investment Impairments: Review Q4 2009 for any additional "other-than-temporary" impairment charges on equity securities.
• Capital Ratios: Verify that regulatory capital ratios remain "well capitalized" following the CIT loss and potential FDIC prepayment.