**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC  20549**

 

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**FORM 10-Q**

 

| **(Mark One)** |
|----------------|
| **ý**     | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934** |
|           |   |
|           | **For the  quarterly period ended September 30, 2003** |
|           |   |
| **OR**         |
|           |   |
| **o**          | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|           |   |
|           | **For the  transition period from                               to                            ** |
|           |   |
|           | **Commission  file number: 000-50426** |

 

**KNBT Bancorp, Inc.**

(Exact Name of Registrant as Specified in Its Charter)

 

| **Pennsylvania**                                               |   | **38-3681905**                       |
|----------------------------------------------------------------|--------|--------------------------------------|
| (State or Other Jurisdiction of Incorporation or Organization) |   | (I.R.S. Employer Identification No.) |
|                                                           |   |                                 |
| **90 Highland Avenue  Bethlehem, Pennsylvania**                |   | **18017**                            |
| (Address of Principal Executive Offices)                       |   | (Zip Code)                           |
|                                                           |   |                                 |
| **(610) 861-5000**                                             |
| (Registrant’s Telephone Number, Including Area Code)      |

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section  13 or 15(d) of the Securities ExchangeAct of 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90days.     Yes o       No ý

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act).   Yes o   No ý

 

**APPLICABLE ONLY TO CORPORATE ISSUERS:**

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date: As of November 11, 2003, 30,363,138 shares of the Registrant’scommon stock were issued and outstanding.

 

 

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**PART I - FINANCIAL INFORMATION**

 

Interim financial informationrequired by Rule 10-01 of Regulation S-X and Item 303 of Regulation S-K isincluded in this Form 10-Q as referenced below.

 
|                            |                                                                                        | **Page** |
|---------------------------------|---------------------------------------------------------------------------------------------|----------|
| Item 1 -                        | Financial Statements                                                                        | 3        |
|                            |                                                                                        |     |
| Item 2  -                       | Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 12       |
|                            |                                                                                        |     |
| Item 3  -                       | Quantitative and Qualitative Disclosures  About Market Risk                                 | 20       |
|                            |                                                                                        |     |
| Item 4  -                       | Controls and Procedures                                                                     | 20       |
|                            |                                                                                        |     |
| **PART II - OTHER INFORMATION** |
|                            |                                                                                        |     |
| Item 1  -                       | Legal  Proceedings                                                                          | 20       |
|                            |                                                                                        |     |
| Item 2  -                       | Changes in Securities and Use of Proceeds                                                   | 20       |
|                            |                                                                                        |     |
| Item 3  -                       | Defaults Upon Senior Securities                                                             | 21       |
|                            |                                                                                        |     |
| Item 4  -                       | Submission of Matters to a Vote of Security  Holders                                        | 21       |
|                            |                                                                                        |     |
| Item 5  -                       | Other  Information                                                                          | 21       |
|                            |                                                                                        |     |
| Item 6  -                       | Exhibits and Reports on Form 8-K                                                            | 21       |
|                            |                                                                                        |     |
| Signatures                      | 22                                                                                          |

 

2

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**Keystone Savings Bank****andSubsidiaryConsolidated Balance Sheet**September 30, 2003 (Unaudited) and December 31, 2002(in thousands)

 
|                                                   |   | **September 30,  2003** |      | **December 31,  2002** |   |
|--------------------------------------------------------|--------|------------------------------|-----------|-----------------------------|--------|
|                                                   |   | **(unaudited)**              |      |                        |   |
| ASSETS                                                 |   |                         |      |                        |   |
|                                                   |   |                         |      |                        |   |
| Cash and due from banks                                |   | $                            | 13,326    |                        | $      | 33,535 |   |
| Interest-bearing deposits with banks                   |   | 364,619                      |      | 52,758                      |   |
| Total cash and cash equivalents                        |   | 377,945                      |      | 86,293                      |   |
|                                                   |   |                         |      |                        |   |
| Investment securities available for sale               |   | 337,980                      |      | 294,150                     |   |
| Federal Home Loan Bank of Pittsburgh stock             |   | 8,889                        |      | 8,011                       |   |
| Loans receivable, net                                  |   | 572,847                      |      | 555,526                     |   |
|                                                   |   |                         |      |                        |   |
| Mortgage loans held for sale                           |   | 10,617                       |      | 23,796                      |   |
|                                                   |   |                         |      |                        |   |
| Bank owned life insurance                              |   | 27,374                       |      | 26,334                      |   |
| Premises and equipment, net                            |   | 17,700                       |      | 12,178                      |   |
| Accrued interest receivable                            |   | 4,826                        |      | 4,964                       |   |
| Other assets                                           |   | 9,867                        |      | 4,654                       |   |
|                                                   |   |                         |      |                        |   |
| Total assets                                           |   | $                            | 1,368,045 |                        | $      | 1,015,906 |   |
|                                                   |   |                         |      |                        |   |
| LIABILITIES AND RETAINED EARNINGS                      |   |                         |      |                        |   |
|                                                   |   |                         |      |                        |   |
| Liabilities                                            |   |                         |      |                        |   |
| Deposits                                               |   | $                            | 819,347   |                        | $      | 771,825 |   |
| Securities sold under agreements to  repurchase        |   | 11,034                       |      | 8,904                       |   |
| Advances from the Federal Home Loan Bank               |   | 106,000                      |      | 113,500                     |   |
| Advance payments by borrowers for taxes and  insurance |   | 993                          |      | 2,283                       |   |
| Accrued interest payable                               |   | 781                          |      | 711                         |   |
| Stock subscription escrow                              |   | 304,477                      |      | —                      |   |
| Other liabilities                                      |   | 7,360                        |      | 7,634                       |   |
|                                                   |   |                         |      |                        |   |
| Total liabilities                                      |   | 1,249,992                    |      | 904,857                     |   |
|                                                   |   |                         |      |                        |   |
| Retained earnings - substantially  restricted          |   | 113,657                      |      | 106,326                     |   |
| Accumulated other comprehensive income                 |   | 4,396                        |      | 4,723                       |   |
|                                                   |   |                         |      |                        |   |
| Total retained earnings                                |   | 118,053                      |      | 111,049                     |   |
| Total liabilities and retained earnings                |   | $                            | 1,368,045 |                        | $      | 1,015,906 |   |

 

See accompanying notes to consolidated financialstatements.

 

3

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**Keystone Savings Bank and Subsidiary**

**Consolidated Statements of Income**

**Three and Nine Months EndedSeptember 30, 2003 and 2002**

(in thousands)

 
|                                                          |   | **Three  Months Ended********September 30,** |   | **Nine  Months Ended********September 30,** |   |
|---------------------------------------------------------------|--------|---------------------------------------------------|--------|--------------------------------------------------|--------|
|                                                          |   | **2003**                                          |   | **2002**                                         |   | **2003** |   | **2002** |   |
|                                                          |   | **(unaudited)**                                   |   |
| Interest income                                               |   |                                              |   |                                             |   |   |   |   |   |
| Loans receivable, including amortization of  origination fees |   | $                                                 | 9,745  |                                             | $      | 10,716 |   | $ | 29,404 |   | $ | 33,361 |   |
| Investment securities                                         |   | 3,403                                             |   | 4,398                                            |   | 11,346 |   | 11,283 |   |
| Other interest                                                |   | 45                                                |   | 50                                               |   | 160 |   | 168 |   |
| Total interest income                                         |   | 13,193                                            |   | 15,164                                           |   | 40,910 |   | 44,812 |   |
|                                                          |   |                                              |   |                                             |   |   |   |   |   |
| Interest expense                                              |   |                                              |   |                                             |   |   |   |   |   |
| Deposits                                                      |   | 3,452                                             |   | 5,540                                            |   | 11,424 |   | 18,329 |   |
| Advances from the Federal Home Loan Bank                      |   | 1,177                                             |   | 937                                              |   | 3,439 |   | 2,154 |   |
| Other expense                                                 |   | 28                                                |   | 44                                               |   | 88 |   | 112 |   |
| Total interest expense                                        |   | 4,657                                             |   | 6,521                                            |   | 14,951 |   | 20,595 |   |
|                                                          |   |                                              |   |                                             |   |   |   |   |   |
| Net interest income                                           |   | 8,536                                             |   | 8,643                                            |   | 25,959 |   | 24,217 |   |
|                                                          |   |                                              |   |                                             |   |   |   |   |   |
| Provision for loan losses                                     |   | 468                                               |   | 301                                              |   | 856 |   | 53 |   |
| Net interest income after provision for  loan losses          |   | 8,068                                             |   | 8,342                                            |   | 25,103 |   | 24,164 |   |
|                                                          |   |                                              |   |                                             |   |   |   |   |   |
| Noninterest income                                            |   |                                              |   |                                             |   |   |   |   |   |
| Deposit charges and service fees                              |   | 1,789                                             |   | 1,437                                            |   | 5,068 |   | 3,618 |   |
| Net gains on sales of investment securities                   |   | —                                            |   | —                                           |   | 2 |   | 1,202 |   |
| Bank owned life insurance                                     |   | 344                                               |   | 364                                              |   | 1,041 |   | 1,069 |   |
| Net gains (losses) on sales of residential  mortgages         |   | (127                                              | )      | 205                                              |   | 513 |   | 392 |   |
| Net gains (losses) on sales of other real  estate owned       |   | 12                                                |   | (42                                              | )      | (23 | ) | (10 | ) |
| Total noninterest income                                      |   | 2,018                                             |   | 1,964                                            |   | 6,601 |   | 6,271 |   |
|                                                          |   |                                              |   |                                             |   |   |   |   |   |
| Noninterest expense                                           |   |                                              |   |                                             |   |   |   |   |   |
| Compensation and employee benefits                            |   | 4,333                                             |   | 3,187                                            |   | 11,791 |   | 9,521 |   |
| Occupancy expenses                                            |   | 487                                               |   | 330                                              |   | 1,385 |   | 955 |   |
| FDIC insurance premiums                                       |   | 32                                                |   | 33                                               |   | 95 |   | 101 |   |
| Advertising                                                   |   | 77                                                |   | 156                                              |   | 593 |   | 542 |   |
| Data processing                                               |   | 514                                               |   | 437                                              |   | 1,434 |   | 1,342 |   |
| Depreciation and amortization                                 |   | 435                                               |   | 338                                              |   | 1,230 |   | 960 |   |
| Other                                                         |   | 1,974                                             |   | 1,598                                            |   | 5,378 |   | 3,559 |   |
| Total noninterest expense                                     |   | 7,852                                             |   | 6,079                                            |   | 21,906 |   | 16,980 |   |
|                                                          |   |                                              |   |                                             |   |   |   |   |   |
| Income before income taxes                                    |   | 2,234                                             |   | 4,227                                            |   | 9,798 |   | 13,455 |   |
|                                                          |   |                                              |   |                                             |   |   |   |   |   |
| Income taxes                                                  |   | 478                                               |   | 1,210                                            |   | 2,467 |   | 3,941 |   |
| Net income                                                    |   | $                                                 | 1,756  |                                             | $      | 3,017 |   | $ | 7,331 |   | $ | 9,514 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

4

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**KeystoneSavings Bank and Subsidiary**

**ConsolidatedStatement of Retained Earnings**

Nine Months Ended September 30, 2003(Unaudited)

(in thousands)

** **
|                                                                       |   | **Retained  earnings** |    | **Accumulated  other  comprehensive  income (loss)** |   | **Comprehensive  income** |   | **Total** |   |
|----------------------------------------------------------------------------|--------|------------------------|---------|------------------------------------------------------|--------|---------------------------|--------|-----------|--------|
|                                                                       |   |                   |    |                                                 |   |                      |   |      |   |
| Balance at December 31, 2002                                          |   | $                      | 106,326 |                                                 | $      | 4,723                     |   |      |   | $ | 111,049 |   |
|                                                                       |   |                   |    |                                                 |   |                      |   |      |   |
| Net income                                                                 |   | 7,331                  |    | —                                               |   | $                         | 7,331  |      | 7,331  |   |
|                                                                       |   |                   |    |                                                 |   |                      |   |      |   |
| Other comprehensive (loss), net of reclassification adjustments and  taxes |   | —                 |    | (327                                                 | )      | (327                      | )      | (327      | )      |
|                                                                       |   |                   |    |                                                 |   |                      |   |      |   |
| Total comprehensive income                                                 |   |                   |    |                                                 |   | $                         | 7,004  |      |   |   |
|                                                                       |   |                   |    |                                                 |   |                      |   |      |   |
| Balance at September 30, 2003                                         |   | $                      | 113,657 |                                                 | $      | 4,396                     |   |      |   | $ | 118,053 |   |

 

See accompanying notes to consolidated financial statements.

 

5

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**KeystoneSavings Bank and Subsidiary**

**ConsolidatedStatements of Cash Flows**

Nine Months Ended September 30, 2003 and 2002

(in thousands)

 
|                                                                                                |   | **Nine Months Ended********September 30,** |       |
|-----------------------------------------------------------------------------------------------------|--------|-------------------------------------------------|------------|
|                                                                                                |   | **2003**                                        |       | **2002** |   |
|                                                                                                |   | **(unaudited)**                                 | ** ** |
| Operating activities                                                                                |   |                                            |       |   |   |
| Net income                                                                                          |   |                                            |       |   |   |
| Adjustments to reconcile net income to net cash providedby (used in) operating activities           |   | $                                               | 7,331      |   | $ | 9,514 |   |
| Depreciation and amortization                                                                       |   | 1,230                                           |       | 960 |   |
| Amortization of discounts on investment securities, net                                             |   | (2,477                                          | )          | (196 | ) |
| Provision for loan losses                                                                           |   | 856                                             |       | 53 |   |
| Mortgage loans originated for sale                                                                  |   | 45,514                                          |       | 22,855 |   |
| Mortgage loan sales                                                                                 |   | (46,027                                         | )          | (23,247 | ) |
| Changes in mortgages held for sale                                                                  |   | 13,179                                          |       | (18,723 | ) |
| Net loss (gain) on sale of real estate owned                                                        |   | 23                                              |       | 10 |   |
| Net loss (gain) on sale investment securities                                                       |   | (2                                              | )          | (1,202 | ) |
| Increase/decrease in accrued interest receivable                                                    |   | (902                                            | )          | (1,928 | ) |
| Increase/decrease in other assets                                                                   |   | (5,381                                          | )          | (3,139 | ) |
| Increase/decrease in advance payments by borrowers for taxesand insurance                           |   | (1,290                                          | )          | (1,232 | ) |
| Increase/decrease in other liabilities and accrued interest payable                                 |   | (204                                            | )          | 4,163 |   |
| Net cash provided by (used in) operating activities                                                 |   | 11,850                                          |       | (12,112 | ) |
|                                                                                                |   |                                            |       |   |   |
| Investing activities                                                                                |   |                                            |       |   |   |
| Proceeds from sales of real estate owned                                                            |   | 740                                             |       | 705 |   |
| Proceeds from sales of investment securities available for sale                                     |   | 3,051                                           |       | 63,844 |   |
| Proceeds from maturities, calls and principal repayments of investmentsecurities available for sale |   | 217,427                                         |       | 53,235 |   |
| Purchases of investment securities available for sale                                               |   | (214,987                                        | )          | (158,470 | ) |
| Purchases of premises and equipment                                                                 |   | (6,752                                          | )          | (1,697 | ) |
| Purchases of Federal Home Loan Bank of Pittsburgh stock                                             |   | (1,111                                          | )          | (84 | ) |
| Redemption of Federal Home Loan Bank of Pittsburgh stock                                            |   | 233                                             |       | — |   |
| Net increase in loans                                                                               |   | (65,428                                         | )          | (20,951 | ) |
| Purchase of bank-owned life insurance                                                               |   | —                                          |       | (4,000 | ) |
| Net cash (used in) investing activities                                                             |   | (66,827                                         | )          | (67,418 | ) |
|                                                                                                |   |                                            |       |   |   |
| Financing activities                                                                                |   |                                            |       |   |   |
| Net increase (decrease) in deposits                                                                 |   | 47,522                                          |       | (3,219 | ) |
| Net increase in repurchase agreements                                                               |   | 2,130                                           |       | 2,477 |   |
| Net advances from (repayment to) the Federal Home Loan Bank                                         |   | (7,500                                          | )          | 53,500 |   |
| Increase in Stock Escrow Funds                                                                      |   | 304,477                                         |       | — |   |
| Net cash provided by financing activities                                                           |   | 346,629                                         |       | 52,758 |   |
| Net increase (decrease) in cash and cash equivalents                                                |   | 291,652                                         |       | (26,772 | ) |
| Cash and cash equivalents at beginning of year                                                      |   | 86,293                                          |       | 51,844 |   |
| Cash and cash equivalents at end of year                                                            |   | $                                               | 377,945    |   | $ | 25,072 |   |
|                                                                                                |   |                                            |       |   |   |
| Supplemental disclosure of cash flow information:                                                   |   |                                            |       |   |   |
| Income Taxes                                                                                        |   | $                                               | 3,195      |   | $ | 3,075 |   |
| Interest on deposits, advances and borrowed money                                                   |   | $                                               | 14,882     |   | $ | 20,399 |   |
| Supplemental disclosure of noncash activities                                                       |   |                                            |       |   |   |
| Mortgage loan securitizations                                                                       |   | $                                               | 47,251     |   | $ | 115,336 |   |
| Reclassifications of loans receivable to other real estate owned                                    |   | $                                               | 1,367      |   | $ | 813 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

6

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**Keystone Savings Bank and SubsidiaryNotes to Consolidated Financial Statements**(unaudited)

 

**1.****                                      Basisof Presentation.**

 

On May 22, 2003, Keystone Savings Bank(the “Bank” or “Keystone”) incorporated KNBT Bancorp, Inc., a Pennsylvaniacorporation (the “Company” or “registrant”) to facilitate the conversion of theBank from a Pennsylvania chartered mutual savings bank to a Pennsylvaniachartered stock savings bank (the “Conversion”).  The Conversion was consummated on October 31, 2003, at whichtime the Company became the holding company for the Bank and issued shares ofits common stock to the general public. The Company owns all the outstanding common stock of the Bank which wasissued upon completion of the Conversion. Immediately after the completion of the Conversion, the Companycompleted its merger with First Colonial Group, Inc. (“First Colonial”), theholding company for Nazareth National Bank and Trust Company (“NazarethNational”), which was then merged with the Bank.  Prior to October 31, 2003, the registrant was inorganization and had not yet engaged in any operations; accordingly, nofinancial statements of the Company have been included herein.

 

References in this document to “we,” “our” or“us” refer to the Company together with the Bank, unless the context requiresotherwise.

 

**2.****                                      Basisof Consolidation**

 

The consolidated financial statements includethe accounts of the Bank and its wholly owned subsidiary, KLVI, Inc.(“KLVI”).  KLVI was formed in 1997 tohold and manage certain securities investments.

 

The accompanying unaudited consolidatedfinancial statements as of September 30, 2003, and for the three and ninemonth periods ended September 30, 2003 and 2002 have been prepared inaccordance with the instructions to Form 10-Q and therefore do not include allinformation and notes necessary for complete financial statements in conformitywith accounting principles generally accepted in the United States of America.  All significant intercompany accounts andtransactions have been eliminated in consolidation.  In the opinion of management, the accompanying unauditedconsolidated financial statements contain all adjustments (consisting of normalrecurring accruals) considered necessary for a fair presentation.  The results of operations for interimperiods are not necessarily indicative of the results to be expected for theentire year.  These interim financialstatements should be read in conjunction with the Company’s consolidatedaudited financial statements and the notes thereto contained in the Company’sprospectus dated August 12, 2003 and filed with the Securities andExchange Commission (“SEC”) as a part of its registration statement on Form S-1(File No. 333-105899).

 

7

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**3.****                                      InvestmentSecurities**

 

Investment securities at September 30, 2003 and December 31,2002 are summarized below:

 
|                                              |   | **September 30,  2003 (unaudited)** |    |
|---------------------------------------------------|--------|------------------------------------------|---------|
|                                              |   | **Amortized********Cost**                |    | **Gross  unrealized  gains** |   | **Gross  unrealized  losses** |   | **Fair********Value** |   |
|                                              |   | **(in  thousands)**                      |    |
| Available for sale                                |   |                                     |    |   |   |   |   |   |   |
| U.S. Government and agencies                      |   | $                                        | 19,633  |   | $ | 114 |   | $ | (21 | ) | $ | 19,726 |   |
| Obligations of states and political  subdivisions |   | 56,631                                   |    | 3,149 |   | (175 | ) | 59,605 |   |
|                                              |   |                                     |    |   |   |   |   |   |   |
| Asset-managed funds                               |   |                                     |    |   |   |   |   |   |   |
| Adjusted rate mortgage portfolio                  |   | 4,939                                    |    | — |   | (59 | ) | 4,880 |   |
| Mortgaged-backed securities:                      |   |                                     |    |   |   |   |   |   |   |
| GNMA                                              |   | 2,331                                    |    | 17 |   | — |   | 2,348 |   |
| FHLMC                                             |   | 17,188                                   |    | 209 |   | (85 | ) | 17,312 |   |
| FNMA                                              |   | 76,112                                   |    | 2,364 |   | (37 | ) | 78,439 |   |
| Other CMO’s                                  |   | 132,923                                  |    | 1,047 |   | (733 | ) | 133,237 |   |
|                                              |   | 228,554                                  |    | 3,637 |   | (855 | ) | 231,336 |   |
| Corporate and other debt securities               |   | 21,563                                   |    | 870 |   | — |   | 22,433 |   |
|                                              |   | $                                        | 331,320 |   | $ | 7,770 |   | $ | (1,110 | ) | $ | 337,980 |   |

 
|                                              |   | **December 31,  2002** |    |
|---------------------------------------------------|--------|-----------------------------|---------|
|                                              |   | **Amortized********Cost**   |    | **Gross  unrealized  gains** |   | **Gross  unrealized  losses** |   | **Fair********Value** |   |
|                                              |   | **(in  thousands)**         |    |
| Available for sale                                |   |                        |    |   |   |   |   |   |   |
| U.S. Government and agencies                      |   | $                           | 30,677  |   | $ | 398 |   | $ | — |   | $ | 31,075 |   |
| Obligations of states and political  subdivisions |   | 38,935                      |    | 2,148 |   | (44 | ) | 41,039 |   |
|                                              |   |                        |    |   |   |   |   |   |   |
| Asset-managed funds                               |   |                        |    |   |   |   |   |   |   |
| Adjusted rate mortgage portfolio                  |   | 4,939                       |    | — |   | (25 | ) | 4,914 |   |
| Mortgaged-backed securities                       |   |                        |    |   |   |   |   |   |   |
| GNMA                                              |   | 3,234                       |    | 93 |   | — |   | 3,327 |   |
| FHLMC                                             |   | 17,963                      |    | 390 |   | (5 | ) | 18,348 |   |
| FNMA                                              |   | 73,743                      |    | 2,382 |   | (24 | ) | 76,101 |   |
| Other CMO’s                                  |   | 83,449                      |    | 862 |   | (137 | ) | 84,174 |   |
|                                              |   | 178,389                     |    | 3,727 |   | (166 | ) | 181,950 |   |
| Corporate and other debt securities               |   | 34,053                      |    | 1,132 |   | (13 | ) | 35,172 |   |
|                                              |   | $                           | 286,993 |   | $ | 7,405 |   | $ | (248 | ) | $ | 294,150 |   |

 

8

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**4.****                                      LoanPortfolio Composition**

 

Loansreceivable at September 30, 2003 and December 31, 2002 are summarizedbelow.

 
|                         |   | **September 30,  2003** |    | **December 31,  2002** |   |
|------------------------------|--------|------------------------------|---------|-----------------------------|--------|
|                         |   | **(in  thousands)**          |    |
| Real estate                  |   |                         |    |                        |   |
| Mortgage                     |   | $                            | 329,945 |                        | $      | 396,604 |   |
| Construction                 |   | 98,668                       |    | 59,363                      |   |
| Total real estate loans      |   | 428,613                      |    | 455,967                     |   |
|                         |   |                         |    |                        |   |
| Commercial business loans    |   | 17,124                       |    | 10,050                      |   |
| Consumer loans               |   | 168,441                      |    | 143,731                     |   |
| Total loans                  |   | 614,178                      |    | 609,748                     |   |
|                         |   |                         |    |                        |   |
| Less:                        |   |                         |    |                        |   |
| Mortgage Loans held for sale |   | (10,617                      | )       | (23,796                     | )      |
|                         |   |                         |    |                        |   |
| Loans in process             |   | (25,894                      | )       | (24,263                     | )      |
| Deferred fees                |   | (1,879                       | )       | (3,236                      | )      |
| Allowance for loan losses    |   | (2,941                       | )       | (2,927                      | )      |
| Net loans                    |   | $                            | 572,847 |                        | $      | 555,526 |   |

 

The followingtable sets forth the activity in the Bank’s allowance for loan losses duringthe periods indicated.

 
|                                       |   | **Nine Months  Ended********September 30,** |   |
|--------------------------------------------|--------|--------------------------------------------------|--------|
|                                       |   | **2003**                                         |   | **2002** |   |
|                                       |   | **(in  thousands)**                              |   |
|                                       |   |                                             |   |   |   |   |   |
| Balance, beginning                         |   | $                                                | 2,927  |   | $ | 3,386 |   |
| Provisions charged to operations           |   | 856                                              |   | 53 |   |
| Loans charged off                          |   | (886                                             | )      | (456 | ) |
| Recoveries of loans previously charged off |   | 44                                               |   | 13 |   |
|                                       |   |                                             |   |   |   |
| Balance, end                               |   | $                                                | 2,941  |   | $ | 2,996 |   |

 

9

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The following table shows the amounts of non-performing assets, definedas non-accruing loans, accruing loans 90 days or more past due and real estateowned, at the dates indicated.  Keystonedid not have troubled debt restructurings at any of the dates indicated.

 
|                                                        |   | **September 30,  2003** |   | **December 31,  2002** |   |
|-------------------------------------------------------------|--------|------------------------------|--------|-----------------------------|--------|
|                                                        |   | **(Dollars  in Thousands)**  |   |
| Non-accruing loans:                                         |   |                         |   |                        |   |
| One- to four-family residential                             |   | $                            | 1,474  |                        | $      | 2,023 |   |
| Multi-family residential                                    |   | —                       |   | —                      |   |
| Commercial real estate and land                             |   | —                       |   | —                      |   |
| Construction and land development                           |   | —                       |   | —                      |   |
| Commercial business                                         |   | —                       |   | —                      |   |
| Consumer                                                    |   | 183                          |   | 174                         |   |
| Total non-accruing loans                                    |   | 1,657                        |   | 2,197                       |   |
|                                                        |   |                         |   |                        |   |
| Accruing loans 90 days or more past due:                    |   |                         |   |                        |   |
| One- to four-family residential                             |   | 50                           |   | 283                         |   |
| Multi-family residential                                    |   | —                       |   | —                      |   |
| Commercial real estate                                      |   | —                       |   | —                      |   |
| Construction and land development                           |   | —                       |   | —                      |   |
| Commercial business                                         |   | 14                           |   | 15                          |   |
| Consumer                                                    |   | —                       |   | —                      |   |
| Total accruing loans 90 days or more   past due        |   | 64                           |   | 298                         |   |
| Total non-performing loans(1)                               |   | 1,721                        |   | 2,495                       |   |
|                                                        |   |                         |   |                        |   |
| Real estate owned, net(2)                                   |   | 56                           |   | 115                         |   |
| Total non-performing assets                                 |   | $                            | 1,777  |                        | $      | 2,610 |   |
|                                                        |   |                         |   |                        |   |
| Total non-performing loans as a percentage of loans, net    |   | 0.30                         | %      | 0.45                        | %      |
| Total non-performing loans as a percentage of total assets  |   | 0.13                         | %      | 0.25                        | %      |
| Total non-performing assets as a percentage of total assets |   | 0.13                         | %      | 0.26                        | %      |

 

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(1)                                  Non-performingloans consist of non-accruing loans plus accruing loans 90 days or more pastdue.

 

(2)                                  Realestate owned balances are shown net of related loss allowances and include bothreal property and other repossessed collateral consisting primarily ofautomobiles.

 

10

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**5.****                                      RecentAccounting Pronouncements**

 

The Companyadopted Statement of Financial Accounting Standards No. 149 (SFAS No. 149), *Amendment ofStatement 133 on Derivative Instruments and Hedging Activities*, onJuly 1, 2003.  SFAS No. 149clarifies and amends SFAS No. 133 for implementation issues raised byconstituents and includes the conclusions reached by the Financial AccountingStandards Board (“FASB”) on certain FASB Staff Implementation Issues.  Statement 149 also amends SFAS No. 133 torequire a lender to account for loan commitments related to mortgage loans thatwill be held for sale as derivatives. SFAS No. 149 is effective for contracts entered into or modified afterJune 30, 2003.  The Companyperiodically enters into commitments with its customers, which it intends tosell in the future.  Management does notanticipate the adoption of SFAS No. 149 to have a material impact on theCompany’s financial position or results of operations.

 

The FASBissued SFAS No. 150, *Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity*, on May 15,2003.  SFAS No. 150 changes theclassification in the statement of financial position of certain commonfinancial instruments from either equity or mezzanine presentation toliabilities and requires an issuer of those financial statements to recognizechanges in fair value or redemption amount, as applicable, in earnings.  SFAS No. 150 is effective for publiccompanies for financial instruments entered into or modified after May 13,2003 and is effective at the beginning of the first interim period beginningafter June 15, 2003.  Managementhas not entered into any financial instruments that would qualify under SFASNo. 150.

 

InJanuary 2003, the FASB issued Interpretation No. 46, Consolidation ofVariable Interest Entities (“FIN 46”). On October 31, 2003, the FASB issued an Exposure Draft related tothe consolidation of Variable Interest Entities, and the interpretation of FIN46 (“FIN 46 Interpretation”).  Theconsolidation requirements, as amended by FASB Staff Position (FSP) 46-6,“Effective Date of FIN 46,” apply to existing entities in the first fiscal yearor interim period beginning after December 15, 2003.  Management does not anticipate that FIN 46or FIN 46, Interpretation will have material impact on the Company’s financialposition or results of operations.

 

11

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**Item 2 - Management’s Discussion and Analysisof Financial Condition and Results of Operations.**

 

**Forward-Looking Statements**

 

This QuarterlyReport on Form 10-Q contains certain forward-looking statements and informationrelating to the Company and the Bank that are based on the beliefs ofmanagement as well as assumptions made by and information currently availableto management.  In addition, in portionsof this document the words “anticipate,” “believe,” “estimate,” “expect,”“intend,” “should” and similar expressions, or the negative thereof, as theyrelate to the Company or the Bank or their management, are intended to identifyforward-looking statements.  Suchstatements reflect the current views of the Company and/or the Bank withrespect to forward-looking events and are subject to certain risks,uncertainties and assumptions.  Shouldone or more of these risks or uncertainties materialize or should underlyingassumptions prove incorrect, actual results may vary materially from thosedescribed herein as anticipated, believed, estimated, expected orintended.  The Company does not intendto update these forward-looking statements.

 

**General**

 

The Company was formed by the Bank in connection with the Bank’sconversion and has not yet commenced operations. The Company’s results ofoperations initially will be primarily dependent on the results of the Bank,which will be a wholly owned subsidiary upon completion of the conversion.  The Bank’s results of operations depend, toa large extent, on net interest income, which is the difference between theincome earned on its loan and investment portfolios and the cost of funds, consistingof the interest paid on deposits and borrowings.  Results of operations are also affected by provisions for loanlosses, loan sale activities and loan servicing.  Non-interest expense principally consists of compensation andemployee benefits, office occupancy and equipment expense, data processing,advertising and business promotion and other expense.  Our results of operations are also significantly affected bygeneral economic and competitive conditions, particularly changes in interestrates, government policies and actions of regulatory authorities.  Future changes in applicable law,regulations or government policies may materially impact our financialconditions and results of operations.

 

**Critical AccountingPolicies**

 

Keystone has identified the calculation of the allowance for loanlosses as a critical accounting policy, due to the higher degree of judgmentand complexity than its other significant accounting policies.  Provisions for loan losses will continue tobe based upon management’s periodic valuation and assessment of the overallloan portfolio and the underlying collateral, trends in non-performing loans,current economic conditions and other relevant factors in order to maintain theallowance for loan losses at a level believed by management to be sufficient toabsorb estimated, probable losses. Although management uses the best information available, the level ofthe allowance for loan losses remains an estimate which is subject tosignificant judgment and short-term change.

 

12

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**Comparisonof Financial Condition at September 30, 2003 and December 31, 2002**

 

Keystone’stotal assets increased by $352.1 million, or 34.7%, to $1.4 billion atSeptember 30, 2003 compared to $1.0 billion at December 31,2002.  The increase in total assets wasdue primarily to a $291.7 million increase in cash and cash equivalentsprimarily as a result of funds received for subscription orders in Keystone’srecently completed subscription offering conducted in connection withKeystone’s mutual-to-stock conversion (the “Conversion”).  Keystone also reported increases ininvestment securities, net loans receivable, premises and equipment and otherassets at September 30, 2003 compared to December 31, 2002.  During the nine-months endedSeptember 30, 2003, Keystone’s investment securities increased by $43.8million, or 14.9%, to $338.0 million at September 30, 2003 compared to$294.2 million at December 31, 2002. At September 30, 2003, Keystone’s net loans receivable amounted to$572.8 million compared to $555.5 million at December 31, 2003, anincrease of $17.3 million or 3.1%. During the nine months endedSeptember 30, 2003, Keystone’s construction loans increased by $39.3million, or 66.2%, its commercial business loans increased $7.1 million, or70.4%, and its consumer loans increased $24.7 million, or 17.2%.  The increases in construction loans,commercial business loans and consumer loans more than offset a $66.7 million,or 16.8%, decrease in Keystone’s real estate mortgage loans during the nine monthsended September 30, 2003.  Thedecrease in Keystone’s residential mortgage loans during the first nine monthsof 2003 reflects the continuing high prepayment levels of mortgage loans, ascustomers continue to take advantage of the low market rates of interest torefinance mortgage loans, as well as Keystone’s securitization of $47.3 millionin residential mortgage loans in the first quarter of 2003.  Keystone’s loan portfolio growth during thenine months ended September 30, 2003, shows, in part, its efforts toincrease originations of relatively higher yielding construction, commercialbusiness and consumer loans.  Keystone’sgrowth in consumer loans during 2003 has been due primarily to increases inhome equity loans and lines of credit and automobile loans. AtSeptember 30, 2003, Keystone’s home equity loans and lines of creditamounted to $107.5 million compared to $102.3 million at December 31,2002.  Keystone’s automobile loansamounted to $52.8 million at September 30, 2003 compared to $32.0 millionat December 31, 2002.  In additionto its portfolio of net loans receivable, Keystone held $10.6 million ofmortgage loans for sale at September 30, 2003 compared to $23.8 million atDecember 31, 2002. During 2003, Keystone’s general policy has been to sellinto the secondary market [**all**] of its newly originated, agencyeligible long-term, fixed rate single-family residential mortgage loans.  Keystone’s net premises and equipmentincreased by $5.5 million to $17.7 million at September 30, 2003 comparedto $12.2 million at December 31, 2002 primarily as a result of a $5.0million purchase of a building to house Keystone’s operations departments.

 

Keystone’stotal liabilities amounted to $1.2 billion at September 30, 2003, anincrease of $345.1 million, or 38.1%, compared to total liabilities atDecember 31, 2002.  The primaryreason for the increase in liabilities was $304.5 million of stock subscriptionfunds held in escrow by Keystone at September 30, 2003.  Keystone’s deposits increased by $47.5million, or 6.2%, to $819.3 million at September 30, 2003 compared toDecember 31, 2002.  Federal HomeLoan Bank (“FHLB”) advances and other borrowings decreased by an aggregate of$5.4 million, or 4.4%, to $117.0 million at September 30, 2003 compared to$122.4 million at December 31, 2002. Keystone’s total retained earnings increased by $7.0 million, or 6.3%,to $118.1 million at

 

13

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September 30, 2003compared to $111.0 million at December 31, 2002.  Such increase in retained earnings was due primarily to $7.3million in net income for the nine-months ended September 30, 2003.

 

Keystone’s netloans receivable amounted to 41.9% of its total assets at September 30,2003.  At such date, its investmentsecurities, all of which are classified as available for sale, constituted24.7% of total assets.  Keystone’s ratioof retained earnings to total assets at September 30, 2003 amounted to8.6%, and its ratio of total non-performing assets to total assets was 0.13%.

 

**Comparison of Operating Results for the Threeand Nine Months Ended September 30, 2003 and 2002**

 

**General.**  Keystone’s net income for the three monthsended September 30, 2003 was $1.8 million, a $1.3 million, or 41.8%,decrease compared to $3.0 million of net income for the three months endedSeptember 30, 2002.  For the ninemonths ended September 30, 2003, Keystone’s net income was $7.3 million, a$2.2 million, or 23.0%, decrease from net income of $9.5 million for the ninemonths ended September 30, 2002.  Theprimary reason for the decrease in the three-month and nine-month periods in2003 was an increase in Keystone’s non-interest expenses which more than offsetan increase in its net interest income. Keystone’s average interest rate spread decreased by 47 basis points to2.97% for the three months ended September 30, 2003 compared to 3.44% forthe three months ended September 30, 2002.  For the nine-months ended September 30, 2003 and 2002,Keystone’s average interest rate spread was 3.30% and 3.26%, respectively.  The decreases in Keystone’s average interestrate spread were due primarily to decreases of 148 basis points and 104 basispoints, respectively, in the average yield earned by Keystone on itsinterest-earning assets in the respective three-month and nine-month periodsover the prior year comparable periods. Keystone’s net interest margin was 3.29% and 3.74% for the three monthsended September 30, 2003 and 2002, respectively, and 3.55% and 3.58% for thenine months ended September 30, 2003 and 2002, respectively.  Keystone’s ratio of average interest-earningassets to average interest-bearing liabilities increased in both thethree-month and nine-month period ended September 30, 2003 over the prioryear comparable periods.

 

**Interest Income.**  Keystone’s total interest income was $13.2million for the three months ended September 30, 2003 compared to $15.2million for the three months ended September 30, 2002, a $2.0 million or13.0% decline.  For the nine monthsended September 30, 2003, total interest income was $40.9 million comparedto $44.8 million for the nine months ended September 30, 2002, a $3.9million or 8.7% decrease.  The primaryreason for the decrease in total interest income in the 2003 periods was thecontinuing effects of the low market rates of interest.  The average yield on Keystone’sinterest-earning assets was 5.08% and 5.59% for the three months and ninemonths, respectively, ended September 30, 2003 compared to 6.56% and 6.63%for the respective comparable period in 2002. Such decreases in the average yields earned on Keystone’sinterest-earning assets more than offset increases of 12.4% and 8.2%,respectively, in the average balance of Keystone’s interest-earning assetsduring the respective three-months and nine months ended September 30,2003 compared to the similar periods in 2002.

 

14

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**Interest Expense.**  Keystone’s total interest expense was $4.7million for the three months ended September 30, 2003 compared to $6.5million for the three months ended September 30, 2002, a decrease of $1.9million or 28.6%.  Total interestexpense at Keystone was $15.0 million for the nine months endedSeptember 30, 2003 compared to $20.6 million for the nine months endedSeptember 30, 2002, a $5.6 million or 27.4% decline.  Such reductions reflect the lower averagerates of interest paid by Keystone on both its deposits and its borrowings inthe 2003 periods.  Keystone’s averagerate paid on interest-bearing liabilities was 2.11% for the three months endedSeptember 30, 2003 compared to 3.12% for the three months endedSeptember 30, 2002.  For the ninemonths ended September 30, 2003, Keystone’s average rate paid oninterest-bearing liabilities was 2.29% compared to 3.37% for the nine months endedSeptember 30, 2002.

 

15

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**Average Balances, Net Interest Income, andYields Earned and Rates Paid.** The following tableshows for the periods indicated the total dollar amount of interest fromaverage interest-earning assets and the resulting yields, as well as theinterest expense on average interest-bearing liabilities, expressed both indollars and rates, and the net interest margin.  Tax-exempt income and yields have not been adjusted to atax-equivalent basis. All average balances are based on monthly balances.Management does not believe that the monthly averages differ significantly fromwhat the daily averages would be.

 

 
|                                                                     |   | **Three  Months********Ended  September 30,** |      |
|--------------------------------------------------------------------------|--------|----------------------------------------------------|-----------|
|                                                                     |   | **2003**                                           |      | **2002** |   |
|                                                                     |   | **Average  Balance**                               |      | **Interest** |   | **Average  Yield/Rate** |   | **Average  Balance** |   | **Interest** |   | **Average  Yield/Rate** |   |
|                                                                     |   | **(Dollars in  Thousands)**                        |      |
| Interest-earning assets:                                                 |   |                                               |      |   |   |   |   |   |   |   |   |   |   |
| Deposits at other institutions                                           |   | $                                                  | 89,131    |   | $ | 176 |   | 0.79 | % | $ | 15,194 |   | $ | 43 |   | 1.13 | % |
| Investment securities (1)                                                |   | 370,758                                            |      | 3,272 |   | 3.53 |   | 319,941 |   | 4,405 |   | 5.51 |   |
| Loans receivable (2)                                                     |   | 578,414                                            |      | 9,745 |   | 6.74 |   | 589,068 |   | 10,716 |   | 7.28 |   |
| Total interest-earning assets                                            |   | 1,038,303                                          |      | 13,193 |   | 5.08 |   | 924,203 |   | 15,164 |   | 6.56 |   |
| Non-interest-earning assets                                              |   | 64,594                                             |      |   |   |   |   | 56,712 |   |   |   |   |   |
| Total assets                                                             |   | 1,102,897                                          |      |   |   |   |   | 980,915 |   |   |   |   |   |
| Interest-bearing liabilities:                                            |   |                                               |      |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                                                |   |                                               |      |   |   |   |   |   |   |   |   |   |   |
| Savings accounts                                                         |   | 130,135                                            |      | 201 |   | 0.62 | % | 114,067 |   | 433 |   | 1.52 | % |
| Checking accounts (3)                                                    |   | 93,482                                             |      | 56 |   | 0.24 |   | 82,256 |   | 120 |   | 0.58 |   |
| Money market accounts                                                    |   | 168,822                                            |      | 480 |   | 1.14 |   | 136,343 |   | 696 |   | 2.04 |   |
| Certificate accounts                                                     |   | 374,247                                            |      | 2,715 |   | 2.90 |   | 411,225 |   | 4,291 |   | 4.17 |   |
| Total deposits                                                           |   | 766,686                                            |      | 3,452 |   | 1.80 |   | 743,891 |   | 5,540 |   | 2.98 |   |
| FHLB advances and other borrowings                                       |   | 116,928                                            |      | 1,205 |   | 4.13 |   | 92,332 |   | 981 |   | 4.25 |   |
| Total interest-bearing liabilities                                       |   | 883,614                                            |      | 4,657 |   | 2.11 |   | 836,223 |   | 6,521 |   | 3.12 |   |
| Non-interest-bearing liabilities:                                        |   |                                               |      |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                                 |   | 45,920                                             |      |   |   |   |   | 29,526 |   |   |   |   |   |
| Other                                                                    |   | 57,560                                             |      |   |   |   |   | 7,253 |   |   |   |   |   |
| Total liabilities                                                        |   | 987,094                                            |      |   |   |   |   | 873,002 |   |   |   |   |   |
| Retained earnings                                                        |   | 115,803                                            |      |   |   |   |   | 107,913 |   |   |   |   |   |
| Total liabilities and retained earnings                                  |   | $                                                  | 1,102,897 |   |   |   |   |   | $ | 980,915 |   |   |   |   |   |
| Net interest-earning assets                                              |   | $                                                  | 154,689   |   |   |   |   |   | $ | 87,980 |   |   |   |   |   |
| Net interest income; average interest rate spread                        |   |                                               |      | $ | 8,537 |   | 2.97 | % |   |   | $ | 8,643 |   | 3.44 | % |
| Net interest margin (4)                                                  |   |                                               |      |   |   | 3.29 | % |   |   |   |   | 3.74 | % |
| Average interest-earning assets to average interest-bearing  liabilities |   |                                               |      |   |   | 117.51 | % |   |   |   |   | 110.52 | % |

 

*(Footnotes on next page)*

 

16

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|                                                                   |   | **Nine Months Ended September 30,** |      |
|------------------------------------------------------------------------|--------|------------------------------------------|-----------|
|                                                                   |   | **2003**                                 |      | **2002** |   |
|                                                                   |   | **Average  Balance**                     |      | **Interest** |   | **Average********Yield/********Rate(1)** |   | **Average********Balance** |   | **Interest** |   | **Average********Yield/********Rate** |   |
|                                                                   |   | **(Dollars in Thousands)**               |      |
| Interest-earning assets:                                               |   |                                     |      |   |   |   |   |   |   |   |   |   |   |
| Deposits at other institutions                                         |   | $                                        | 63,085    |   | $ | 417 |   | 0.88 | % | $ | 30,094 |   | $ | 327 |   | 1.45 | % |
| Investment securities (1)                                              |   | 347,126                                  |      | 11,089 |   | 4.26 |   | 263,251 |   | 11,124 |   | 5.63 |   |
| Loans receivable (2)                                                   |   | 564,867                                  |      | 29,404 |   | 6.94 |   | 607,550 |   | 33,361 |   | 7.32 |   |
| Total interest-earning assets                                          |   | 975,078                                  |      | 40,910 |   | 5.59 |   | 900,895 |   | 44,812 |   | 6.63 |   |
| Non-interest-earning assets                                            |   | 76,309                                   |      |   |   |   |   | 52,490 |   |   |   |   |   |
| Total assets                                                           |   | 1,051,387                                |      |   |   |   |   | 953,385 |   |   |   |   |   |
| Interest-bearing liabilities:                                          |   |                                     |      |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                                              |   |                                     |      |   |   |   |   |   |   |   |   |   |   |
| Savings accounts                                                       |   | 124,902                                  |      | 798 |   | 0.85 | % | 110,673 |   | 1,245 |   | 1.50 | % |
| Checking accounts (3)                                                  |   | 90,311                                   |      | 236 |   | 0.35 |   | 81,165 |   | 349 |   | 0.57 |   |
| Money market accounts                                                  |   | 160,757                                  |      | 1,634 |   | 1.36 |   | 131,348 |   | 2,077 |   | 2.11 |   |
| Certificate accounts                                                   |   | 381,536                                  |      | 8,756 |   | 3.06 |   | 425,361 |   | 14,658 |   | 4.59 |   |
| Total deposits                                                         |   | 757,506                                  |      | 11,424 |   | 2.01 |   | 748,547 |   | 18,329 |   | 3.26 |   |
| FHLB advances and other borrowings                                     |   | 114,291                                  |      | 3,527 |   | 4.12 |   | 66,675 |   | 2,266 |   | 4.53 |   |
| Total interest-bearing liabilities                                     |   | 871,797                                  |      | 14,951 |   | 2.29 |   | 815,222 |   | 20,595 |   | 3.37 |   |
| Non-interest-bearing liabilities:                                      |   |                                     |      |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                               |   | 40,291                                   |      |   |   |   |   | 27,817 |   |   |   |   |   |
| Other                                                                  |   | 24,087                                   |      |   |   |   |   | 7,323 |   |   |   |   |   |
| Total liabilities                                                      |   | 936,175                                  |      |   |   |   |   | 850,362 |   |   |   |   |   |
| Retained earnings                                                      |   | 115,212                                  |      |   |   |   |   | 103,023 |   |   |   |   |   |
| Total liabilities and retainedEarnings                                 |   | $                                        | 1,051,387 |   |   |   |   |   | $ | 953,385 |   |   |   |   |   |
| Net interest-earning assets                                            |   | $                                        | 103,281   |   |   |   |   |   | $ | 85,673 |   |   |   |   |   |
| Net interest income; average interestrate spread                       |   |                                     |      | $ | 25,959 |   | 3.30 | % |   |   | $ | 24,217 |   | 3.26 | % |
| Net interest margin (4)                                                |   |                                     |      |   |   | 3.55 | % |   |   |   |   | 3.58 | % |
| Average interest-earning assets toaverage interest-bearing liabilities |   |                                     |      |   |   | 111.85 | % |   |   |   |   | 110.51 | % |

 

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(1)                                  Includes securities available-for-sale andheld-to-maturity.  Investment securitiesalso include Federal Home Loan Bank stock.

 

(2)                                  Includes nonaccrual loans during therespective periods.  Calculated net ofdeferred fees and discounts, loans in process and allowance for loan losses.

 

(3)                                  Includes non-interest-bearing checking accounts.

 

(4)                                  Equals net interest income divided by averageinterest-earning assets.

 

17

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**Rate/Volume Analysis.**  The following table shows the extent towhich changes in interest rates and changes in volume of interest-earningassets and interest-bearing liabilities affected Keystone’s interest income andexpense during the periods indicated. For each category of interest-earning assets and interest-bearingliabilities, information is provided on changes attributable to (1) changes inrate, which is the change in rate multiplied by prior year volume, and (2)changes in volume, which is the change in volume multiplied by prior yearrate.  The combined effect of changes inboth rate and volume has been allocated proportionately to the change due torate and the change due to volume.

 
|                                       |   | **Three  Months Ended September 30, 2003 vs.  Three Months Ended September 30, 2002** |                     | **Nine  Months Ended September 30, 2003 vs.  Nine Months Ended September 30, 2002** |       |
|--------------------------------------------|--------|-------------------------------------------------------------------------------------------------|--------------------------|-----------------------------------------------------------------------------------------------|------------|
|                                       |   | **Increase (Decrease)  Due to**                                                                 |                     | **Total  Increase (Decrease)**                                                                |       | **Increase (Decrease)********Due to** |   | **Total  Increase  (Decrease)** |   |
| **Rate**                                   |   | **Volume**                                                                                      | **Increase  (Decrease)** |                                                                                          | **Volume** |
|                                       |   | **(In Thousands)**                                                                              |                     |
| Interest income:                           |   |                                                                                            |                     |                                                                                          |       |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                  |   | $                                                                                               | (9                       | )                                                                                             | $          | 142 |   | $ | 133 |   | $ | (50 | ) | $ | 140 |   | $ | 90 |   |
| Investment securities                      |   | (1,833                                                                                          | )                        | 700                                                                                           |       | (1,133 | ) | (3,579 | ) | 3,544 |   | (35 | ) |
| Loans receivable, net                      |   | (779                                                                                            | )                        | (191                                                                                          | )          | (970 | ) | (1,683 | ) | (2,274 | ) | (3,957 | ) |
| Total interest-earning assets              |   | (2,621                                                                                          | )                        | 651                                                                                           |       | (1,970 | ) | (5,312 | ) | 1,410 |   | (3,902 | ) |
| Interest expense:                          |   |                                                                                            |                     |                                                                                          |       |   |   |   |   |   |   |   |   |
| Savings accounts                           |   | (304                                                                                            | )                        | 72                                                                                            |       | (232 | ) | (636 | ) | 189 |   | (447 | ) |
| Checking accounts                          |   | (83                                                                                             | )                        | 19                                                                                            |       | (64 | ) | (159 | ) | 46 |   | (113 | ) |
| Money market accounts                      |   | (467                                                                                            | )                        | 251                                                                                           |       | (216 | ) | (1,187 | ) | 744 |   | (443 | ) |
| Certificate accounts                       |   | (1,219                                                                                          | )                        | (359                                                                                          | )          | (1,578 | ) | (4,511 | ) | (1,394 | ) | (5,905 | ) |
| Total deposits                             |   | (2,073                                                                                          | )                        | (17                                                                                           | )          | (2,090 | ) | (6,493 | ) | (415 | ) | (6,908 | ) |
| FHLB advances and other borrowings         |   | (26                                                                                             | )                        | 253                                                                                           |       | 227 |   | (184 | ) | 1,448 |   | 1,264 |   |
| Total interest-bearing liabilities         |   | (2,099                                                                                          | )                        | 236                                                                                           |       | (1,863 | ) | (6,677 | ) | 1,033 |   | (5,644 | ) |
| Increase (decrease) in net interest income |   | $                                                                                               | 522                      |                                                                                          | $          | 415 |   | $ | (107 | ) | $ | 1,365 |   | $ | 377 |   | $ | 1,742 |   |

 

**Provision for LoanLosses.** Keystone made provisions for loan losses of $468,000 for the threemonths ended September 30, 2003 compared to $301,000 for the three monthsended September 30, 2002.  For thenine months ended September 30, 2003, Keystone’s provision for loan losseswas $856,000 compared to $53,000 for the nine months ended September 30,2002.  During the first quarter of 2002,Keystone made a recovery of $445,000 on its loan loss allowance, primarilyreflecting its securitizations of $115.3 million of mortgage loans during thequarter.  At September 30, 2003,Keystone’s total non-performing loans amounted to $1.7 million compared to $1.9million in non-performing loans at September 30, 2002.  Keystone’s allowance for loan losses was$2.9 million, or 170.9% of total non-performing loans, at September 30,2003 compared to $3.0 million, or 158.8% of total non-performing loans, atSeptember 30, 2002.  Keystone’s netloan charge-offs amounted to $341,000 and $886,000 for the three months andnine months ended September 30, 2003, respectively, compared to $227,000and $456,000 for the three months and nine months ended September 30,2002, respectively.

 

**Other Income.**  Keystone’s total non-interest incomeamounted to $2.0 million for both of the three month periods endedSeptember 30, 2003 and 2002.  Forthe nine months ended September 30, 2003, Keystone’s total non-interestincome was $6.6 million compared to $6.3 million for the nine months ended, a$330,000 or 5.3% increase.  Keystone’snon-interest income during 2003 reflects increased fee income from transactionaccounts.  Deposit charges increased

 

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by $352,000 and $1.5 million,respectively, in the three-months and nine month periods endedSeptember 30, 2003 compared to the same periods in 2002.  Such increases were partially offset by theabsence of $1.2 million in net gains on the sale of investment securitiesrecognized in the first quarter of 2002. In addition, Keystone recognized a $127,000 loss on the sale ofresidential mortgage loans in the quarter ended September 30, 2003compared to a $205,000 gain in the quarter ended September 30, 2002.  The primary reasons for Keystone’s increasesin non-interest income in the 2003 periods were increased fee income fromtransaction accounts as well as increased income from bank owned life insurance(“BOLI”).

 

**Other Expense.**  Keystone’s non-interest expense was $7.9million for the three months ended September 30, 2003 compared to $6.1million for the three months ended September 30, 2002, a $1.8 million or29.2% increase.  For the nine monthsended September 30, 2003, Keystone’s non-interest expense was $21.9 millioncompared to $17.0 million for the nine months ended September 30, 2002, anincrease of $4.9 million or 29.0%.  Theprimary reasons for the increase in Keystone’s non-interest expenses in the2003 periods were increases in employee compensation and benefits costs.  Compensation and employee benefits costsincreased by $1.1 million and $2.3 million, respectively, in the three-monthsand nine-months ended September 30, 2003 compared to the prior comparableperiods in 2002.  The increases incompensation and employee benefits costs were due primarily to an increase inthe number of employees, certain additional compensation costs incurred as aresult of the proposed merger with First Colonial as well as increased healthcare costs.  Other non-interest expensesincreased by $376,000 and $1.8 million in the three months and nine monthsended September 30, 2003 compared to the prior year comparable period dueprimarily to certain planning costs related to Keystone’s proposed merger withFirst Colonial as well as increased loan origination costs incurred as a resultof higher loan origination volumes in the 2003 periods.

 

**Income Tax Expense.**  Keystone’s income tax expense was $478,000for the three months ended September 30, 2003 compared to $1.2 million forthe three months ended September 30, 2002.  For the nine months ended September 30, 2003, Keystone’sincome tax expense was $2.5 million compared to $3.9 million for the ninemonths ended September 30, 2002. The decreases were due primarily to the decreases in net income as wellas the effects of Keystone’s investments in municipal securities.

 

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**Item3 - Quantitative and QualitativeDisclosures About Market Risk.**

 

For a discussion of the Bank’s asset and liability management policiesas well as the methods used to manage its exposure to the risk of loss fromadverse changes in market prices and rates market, see “Management’s Discussionand Analysis of Financial Condition and Results of Operations of Keystone – HowKeystone Manages Market Risk” and – “Quantitative and Qualitative DisclosuresAbout Market Risk” in the Company’s prospectus dated August 12, 2003.  There has been no material change in theBank’s asset and liability position or the market value of the Bank’s equitysince June 30, 2003.

 

**Item 4 - Controls and Procedures.**

 

Our managementevaluated, with the participation of our Chief Executive Officer and ChiefFinancial Officer, the effectiveness of our disclosure controls and procedures(as defined in Rules 13a-15(e) or 15d-15(e) under the Securities Exchange Actof 1934) as of the end of the period covered by this report.  Based on such evaluation, our ChiefExecutive Officer and Chief Financial Officer have concluded that ourdisclosure controls and procedures are designed to ensure that informationrequired to be disclosed by us in the reports that we file or submit under theSecurities Exchange Act of 1934 is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and regulations and areoperating in an effective manner.

 

No change in our internal control overfinancial reporting (as defined in Rules 13a-15(f) or 15(d)-15(f) under theSecurities Exchange Act of 1934) occurred during the most recent fiscal quarterthat has materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

 

**PARTII - OTHER INFORMATION**

 

**Item1 - Legal Proceedings.**

 

There are no matters required to be reportedunder this item.

 

**Item2 - Changes in Securities and Useof Proceeds.**

 

(a), (b) and (c) Not applicable.

 

(d)                                 The Company’s Form S-1(File No. 333-105899) was declared effective by the SEC on August 12,2003.  The offering commenced onAugust 22, 2003, and the offering subscription period endedSeptember 15, 2003.  SandlerO’Neill & Partners, L.P. was the underwriter.  A total of 20,201,188 shares of common stock were sold at $10.00per share in the subscription offering, which was consummated onOctober 31, 2003.  The gross offeringproceeds were $202,011,880 and net proceeds are estimated to be approximately$198,083,371.  In addition, 8,527,264shares were issued to former shareholders of First Colonial

 

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in exchange for their shares of common stockof First Colonial (based upon an exchange ration of 3.7:1) and 1,616,095 sharesof the Company’s common stock were contributed to the Keystone NazarethCharitable Foundation.

 

**Item3 - Defaults Upon Senior Securities.**

 

There are no mattersrequired to be reported under this item.

 

**Item4 - Submission of Matters to a Voteof Security Holders.**

 

There are no matters required to be reportedunder this item.

 

**Item5 - Other Information.**

 

There are no matters required to be reportedunder this item.

 

**Item6 - Exhibits and Reports on Form 8-K.**

 

(a)                                  List of exhibits: (filedherewith unless otherwise noted)

 

2.1                                 Plan of Conversion*

2.2                                 Agreement and Plan ofMerger between Keystone Savings Bank and First Colonial Group, Inc. (withoutexhibits)*

3.1                                 Articles ofIncorporation of KNBT Bancorp, Inc.*

3.2                                 Bylaws of KNBTBancorp, Inc.*

4.0                                 Form of StockCertificate of KNBT Bancorp, Inc.*

10.1                           Employment Agreement betweenKeystone Savings Bank, KNBT Bancorp and Scott V. Fainor*

10.2                           Employment Agreement betweenKeystone Savings Bank, KNBT Bancorp and Eugene T. Sobol*

10.3                           Letter Agreement betweenKeystone Savings Bank and Eugene T. Sobol*

10.4                           Retirement Agreement  between Keystone Savings Bank and FrederickE. Kutteroff*

10.5                           Supplemental Executive RetirementPlan*

10.6                           Performance Unit Plan*

10.7                           Senior Management VariableCompensation Program*

10.8                           Severance Agreement betweenKeystone Savings Bank and Richard L. Meares*

31.1                           Section 302Certification of the Chief Executive Officer

31.2                           Section 302 Certificationof the Chief Operating Officer

31.3                           Section 302Certification of the Chief Financial Officer

32.1                           Certification Pursuant to 18U.S.C. Section 1350 as Adopted Pursuant to Section 906 of theSarbanes-Oxley Act of 2002

 

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*                                         Incorporated by reference from the Company’sRegistration Statement on Form S-1, filed on June 6, 2003, as amended, anddeclared effective on August 12, 2003 (File No. 333-105899).

 

(b)                                 Reports on Form 8-K:

 

No reports on Form 8-K were filed by theRegistrant during the quarter ended September 30, 2003.

 

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**SIGNATURES**

 

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 

 
|   |                    |   | **KNBT BANCORP, INC.**                                       |
|--------|-------------------------|--------|--------------------------------------------------------------|
|   |                    |   |                                                         |
|   |                    |   |                                                         |
| Date:  | November 12,  2003 | By:    | /s/ Scott V.  Fainor                                         |   |
|   |                    |   | Scott V.  Fainor                                             |
|   |                    |   | President  and Chief Executive Officer                       |
|   |                    |   |                                                         |
|   |                    |   |                                                         |
| Date:  | November 12,  2003 | By:    | /s/ Eugene  T. Sobol                                         |   |
|   |                    |   | Eugene T.  Sobol                                             |
|   |                    |   | Senior Executive Vice President and  Chief Operating Officer |
|   |                    |   |                                                         |
|   |                    |   |                                                         |
| Date:  | November 12,  2003 | By:    | /s/ Reid L.  Heeren                                          |   |
|   |                    |   | Reid L.  Heeren                                              |
|   |                    |   | Executive Vice President and  Chief Financial Officer        |

 

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