**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

**ý****Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934**

 

**for thequarterly period ended September 30, 2004.**

 

**Or**

 

**o****Transition Report Pursuant to Section 13 or 15(d) of the Securities ExchangeAct of 1934**

 

**for thetransition period from                                                      to                                                       **

 

**Commission FileNumber 000-50266**

 

**TRINITY CAPITAL CORPORATION**

(Exact name of registrant as specified in itscharter)

 

| **New Mexico**                                        | **85-0242376**                           |
|-------------------------------------------------------|------------------------------------------|
| (State of incorporation)                              | (I.R.S. Employer  Identification Number) |
|                                                  |                                     |
| **1200 Trinity  Drive, Los Alamos, New Mexico 87544** |
| (Address of principal executive  offices)             |
|                                                  |                                     |
| **(505) 662-5171**                               |
| Telephone number                                      |
|                                                       |                                          |  |

 

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

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the Securities ExchangeAct of 1934).  Yes ý No o

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

Indicate the number of shares outstanding ofeach of the issuer’s classes of common stock, as of the latest practicabledate: 6,732,888 shares of common stock, no par value, outstanding as of October15, 2004.

 

 

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**TRINITY CAPITAL CORPORATION AND SUBSIDIARIES**

 
| ** ** | **PART I. FINANCIAL INFORMATION**                                                           | ** ** |
|------------|---------------------------------------------------------------------------------------------|------------|
| ** ** | ** **                                                                                  | ** ** |
| Item 1.    | Financial Statements                                                                        |       |
|       |                                                                                        |       |
| Item 2.    | Management’s Discussion and Analysis  of Financial Condition and Results of Operations |       |
|       |                                                                                        |       |
| Item 3.    | Quantitative and Qualitative  Disclosures About Market Risk                                 |       |
|       |                                                                                        |       |
| Item 4.    | Controls and Procedures                                                                     |       |
|       |                                                                                        |       |
| ** ** | **PART II. OTHER INFORMATION**                                                              |       |
| ** ** | ** **                                                                                  |       |
| Item 1.    | Legal Proceedings                                                                           |       |
|       |                                                                                        |       |
| Item 2.    | Changes in securities and use of  proceeds and issuer purchases of equity securities        |       |
|       |                                                                                        |       |
| Item 3.    | Defaults upon senior securities                                                             |       |
|       |                                                                                        |       |
| Item 4.    | Submission of matters to a vote of  securities holders                                      |       |
|       |                                                                                        |       |
| Item 5.    | Other information                                                                           |       |
|       |                                                                                        |       |
| Item 6.    | Exhibits                                                                                    |       |
|       |                                                                                        |       |
|       | SIGNATURES                                                                                  |       |
|       |                                                                                        |       |
|       | CERTIFICATIONS                                                                              |       |

 

1

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**PART I – FINANCIAL INFORMATION**

**Item 1. Financial Statements**

**TRINITY CAPITAL CORPORATION &SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

**September 30, 2004 and December 31, 2003**

**(Amounts in thousands, except share data)**

**(Unaudited)**

 
| ** **                                                                                                                                                                                                                                                                                                                         | ** ** | **September  30, 2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                                                                                                                         | ** ** | ** **              | ** ** | ** **             | ** ** |
| Cash and due from banks                                                                                                                                                                                                                                                                                                            |       | $                       | 48,964     |                   | $          | 42,104 |   |
| Interest bearing deposits with banks                                                                                                                                                                                                                                                                                               |       | 43                      |       | 967                    |       |
| Federal funds sold and securities purchased  under resell agreements                                                                                                                                                                                                                                                               |       | 40                      |       | 40                     |       |
| **Cash and cash equivalents**                                                                                                                                                                                                                                                                                                      |       | 49,047                  |       | 43,111                 |       |
| Investment securities available for sale                                                                                                                                                                                                                                                                                           |       | 49,512                  |       | 95,088                 |       |
| Investment securities held to maturity, at  amortized cost (fair value of $68,630 at September 30, 2004 and $75,179 at  December 31, 2003)                                                                                                                                                                                    |       | 68,020                  |       | 73,717                 |       |
| Other investments                                                                                                                                                                                                                                                                                                                  |       | 7,255                   |       | 6,161                  |       |
| Loans (net of allowance for loan losses of  $8,554 at September 30, 2004 and $7,368 at December 31, 2003)                                                                                                                                                                                                                     |       | 839,375                 |       | 733,155                |       |
| Loans held for sale                                                                                                                                                                                                                                                                                                                |       | 10,667                  |       | 9,511                  |       |
| Premises and equipment, net                                                                                                                                                                                                                                                                                                        |       | 25,593                  |       | 18,939                 |       |
| Accrued interest receivable                                                                                                                                                                                                                                                                                                        |       | 6,371                   |       | 6,497                  |       |
| Mortgage servicing rights, net                                                                                                                                                                                                                                                                                                     |       | 8,446                   |       | 7,792                  |       |
| Other real estate owned                                                                                                                                                                                                                                                                                                            |       | 6,728                   |       | 7,383                  |       |
| Other assets                                                                                                                                                                                                                                                                                                                       |       | 3,630                   |       | 5,396                  |       |
| **Total assets**                                                                                                                                                                                                                                                                                                                   |       | $                       | 1,074,644  |                   | $          | 1,006,750 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                                      |       |                    |       |                   |       |
| Liabilities                                                                                                                                                                                                                                                                                                                        |       |                    |       |                   |       |
| Deposits:                                                                                                                                                                                                                                                                                                                          |       |                    |       |                   |       |
| Noninterest bearing                                                                                                                                                                                                                                                                                                                |       | $                       | 62,911     |                   | $          | 60,191 |   |
| Interest bearing                                                                                                                                                                                                                                                                                                                   |       | 805,772                 |       | 776,004                |       |
| **Total deposits**                                                                                                                                                                                                                                                                                                                 |       | 868,683                 |       | 836,195                |       |
| Short-term borrowings                                                                                                                                                                                                                                                                                                              |       | 40,600                  |       | 9,402                  |       |
| Long-term borrowings                                                                                                                                                                                                                                                                                                               |       | 61,883                  |       | 67,398                 |       |
| Junior subordinated debt owed to  unconsolidated trusts                                                                                                                                                                                                                                                                            |       | 22,682                  |       | 16,496                 |       |
| Borrowings made by Employee Stock Ownership  Plan (ESOP) to outside parties                                                                                                                                                                                                                                                        |       | 1,686                   |       | 2,157                  |       |
| Accrued interest payable                                                                                                                                                                                                                                                                                                           |       | 2,494                   |       | 2,797                  |       |
| Other liabilities                                                                                                                                                                                                                                                                                                                  |       | 3,879                   |       | 6,247                  |       |
| **Total liabilities**                                                                                                                                                                                                                                                                                                              |       | 1,001,907               |       | 940,692                |       |
| Stock owned by Employee Stock Ownership  Plan (ESOP) participants; 638,115 and 653,381 shares at September 30,  2004 and December 31, 2003, respectively, at fair value; net of unearned ESOP  shares of 99,748 shares and 126,194 shares at September 30, 2004 and  December 31, 2003, respectively, at historical cost |       | 17,582                  |       | 18,256                 |       |
| Commitments, contingencies and credit risk  (note 7)                                                                                                                                                                                                                                                                               |       |                    |       |                   |       |
| Stockholders’ Equity                                                                                                                                                                                                                                                                                                          |       |                    |       |                   |       |
| Common stock, no par, authorized  20,000,000 shares; issued 6,856,800 shares, outstanding 6,731,318  and 6,701,478 at September 30, 2004 and December 31, 2003, respectively                                                                                                                                             |       | 6,836                   |       | 6,836                  |       |
| Additional paid-in capital                                                                                                                                                                                                                                                                                                         |       | 1,110                   |       | 545                    |       |
| Retained earnings                                                                                                                                                                                                                                                                                                                  |       | 47,844                  |       | 40,845                 |       |
| Accumulated other comprehensive (loss)  income                                                                                                                                                                                                                                                                                     |       | (31                     | )          | 135                    |       |
| Total stockholders’ equity before treasury  stock                                                                                                                                                                                                                                                                             |       | 55,759                  |       | 48,361                 |       |
| Treasury stock, at cost, 25,734 shares and  29,128 shares at September 30, 2004 and December 31, 2003, respectively,  at historical cost                                                                                                                                                                                      |       | (604                    | )          | (559                   | )          |
| **Total stockholders’ equity**                                                                                                                                                                                                                                                                                                |       | 55,155                  |       | 47,802                 |       |
| **Total liabilities and stockholders’ equity**                                                                                                                                                                                                                                                                                |       | $                       | 1,074,644  |                   | $          | 1,006,750 |   |

 

The accompanying notes are an integral part of these unauditedconsolidated financial statements.

 

2

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**TRINITY CAPITAL CORPORATION &SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF INCOME**

**For the Three and Nine Months Ended September30, 2004 and 2003**

**(Amounts in thousands except share and pershare data)**

**(Unaudited)**

 
| ** **                                               | ** ** | **Three Months Ended**  | ** ** | **Nine Months Ended**   | ** ** |
|----------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                               | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** |
| Interest income:                                         |       |                    |       |                    |       |   |   |   |   |
| Loans, including fees                                    |       | $                       | 12,760     |                    | $          | 12,563 |   | $ | 36,654 |   | $ | 37,419 |   |
| Investment securities:                                   |       |                    |       |                    |       |   |   |   |   |
| Taxable                                                  |       | 761                     |       | 831                     |       | 2,443 |   | 2,570 |   |
| Nontaxable                                               |       | 150                     |       | 144                     |       | 471 |   | 370 |   |
| Federal funds sold                                       |       | —                  |       | 1                       |       | — |   | 3 |   |
| Other interest bearing deposits                          |       | 55                      |       | 99                      |       | 124 |   | 232 |   |
| Investment in unconsolidated trusts                      |       | 15                      |       | 17                      |       | 42 |   | 43 |   |
| **Total interest income**                                |       | 13,741                  |       | 13,655                  |       | 39,734 |   | 40,637 |   |
| Interest expense:                                        |       |                    |       |                    |       |   |   |   |   |
| Deposits                                                 |       | 3,178                   |       | 3,686                   |       | 9,108 |   | 12,089 |   |
| Short-term borrowings                                    |       | 51                      |       | —                  |       | 146 |   | 2 |   |
| Long-term borrowings                                     |       | 572                     |       | 614                     |       | 1,770 |   | 1,372 |   |
| Junior subordinated debt owed to  unconsolidated trusts  |       | 503                     |       | 457                     |       | 1,414 |   | 1,334 |   |
| **Total interest expense**                               |       | 4,304                   |       | 4,757                   |       | 12,438 |   | 14,797 |   |
| **Net interest income**                                  |       | 9,437                   |       | 8,898                   |       | 27,296 |   | 25,840 |   |
| Provision for loan losses                                |       | 450                     |       | 600                     |       | 1,650 |   | 1,800 |   |
| **Net interest income after provision for  loan losses** |       | 8,987                   |       | 8,298                   |       | 25,646 |   | 24,040 |   |
| Other income:                                            |       |                    |       |                    |       |   |   |   |   |
| Mortgage loan servicing fees                             |       | 592                     |       | 594                     |       | 1,751 |   | 1,634 |   |
| Loan and other fees                                      |       | 590                     |       | 465                     |       | 1,829 |   | 1,291 |   |
| Service charges on deposits                              |       | 377                     |       | 332                     |       | 1,047 |   | 960 |   |
| Gain on sale of loans                                    |       | 374                     |       | 3,148                   |       | 2,373 |   | 9,871 |   |
| Gain on sale of securities                               |       | —                  |       | —                  |       | 272 |   | — |   |
| Other operating income                                   |       | 164                     |       | 483                     |       | 692 |   | 1,331 |   |
|                                                     |       | 2,097                   |       | 5,022                   |       | 7,964 |   | 15,087 |   |
| Other expenses:                                          |       |                    |       |                    |       |   |   |   |   |
| Salaries and employee benefits                           |       | 3,725                   |       | 3,984                   |       | 11,433 |   | 11,201 |   |
| Occupancy                                                |       | 660                     |       | 407                     |       | 1,728 |   | 1,313 |   |
| Data processing                                          |       | 508                     |       | 426                     |       | 1,442 |   | 1,075 |   |
| Marketing                                                |       | 433                     |       | 318                     |       | 983 |   | 982 |   |
| Amortization and valuation of mortgage  servicing rights |       | 1,230                   |       | (2,486                  | )          | 1,120 |   | 375 |   |
| Supplies                                                 |       | 202                     |       | 252                     |       | 583 |   | 682 |   |
| Other                                                    |       | 1,051                   |       | 1,097                   |       | 3,499 |   | 3,843 |   |
|                                                     |       | 7,809                   |       | 3,998                   |       | 20,788 |   | 19,471 |   |
| **Income before income taxes**                           |       | 3,275                   |       | 9,322                   |       | 12,822 |   | 19,656 |   |
| Income taxes                                             |       | 1,147                   |       | 3,515                   |       | 4,885 |   | 7,495 |   |
| Net income                                               |       | $                       | 2,128      |                    | $          | 5,807 |   | $ | 7,937 |   | $ | 12,161 |   |
| Basic earnings per common share                          |       | $                       | 0.32       |                    | $          | 0.87 |   | $ | 1.18 |   | $ | 1.82 |   |
| Diluted earnings per common share                        |       | $                       | 0.31       |                    | $          | 0.86 |   | $ | 1.16 |   | $ | 1.81 |   |

 

Theaccompanying notes are an integral part of these unaudited consolidatedfinancial statements.

 

3

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**TRINITY CAPITAL CORPORATION &SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**For the Nine Months Ended September 30, 2004and 2003**

**(Amounts in thousands)**

**(Unaudited)**

 
| ** **                                                                                   | ** ** | **Nine Months Ended**  | ** ** |
|----------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                   | ** ** | **September 30, 2004** | ** ** | **September 30, 2003** | ** ** |
| ** **                                                                                   | ** ** | ** **             | ** ** | ** ** | ** ** |
| Cash Flows From Operating Activities                                                         |       |                   |       |   |   |
| Net income                                                                                   |       | $                      | 7,937      |   | $ | 12,162 |   |
| Adjustments to reconcile net income to net  cash provided by (used in) operating activities: |       |                   |       |   |   |
| Depreciation and amortization                                                                |       | 1,627                  |       | 1,428 |   |
| Net amortization of:                                                                         |       |                   |       |   |   |
| Mortgage servicing rights                                                                    |       | 2,016                  |       | 678 |   |
| Premiums and discounts on investment  securities                                             |       | 1,055                  |       | 1,072 |   |
| Junior subordinated debt owed to  unconsolidated trusts issuance costs                       |       | 15                     |       | 14 |   |
| Provision for loan losses                                                                    |       | 1,650                  |       | 1,800 |   |
| Recovery of mortgage servicing rights                                                        |       | (896                   | )          | (303 | ) |
| Gain on sale of available for sale  securities                                               |       | (272                   | )          | — |   |
| Federal Home Loan Bank (FHLB) stock  dividends received                                      |       | (67                    | )          | (63 | ) |
| Gain on sale of loans                                                                        |       | (2,373                 | )          | (9,871 | ) |
| Loss on disposal of other real estate owned                                                  |       | 148                    |       | 41 |   |
| Write-down of value of other real  estate owned                                              |       | 61                     |       | 580 |   |
| Decrease (increase) in other assets                                                          |       | 1,877                  |       | 663 |   |
| (Decrease) increase in other liabilities                                                     |       | (518                   | )          | 1,228 |   |
| Tax benefit recognized for exercise of  stock options                                        |       | 53                     |       | — |   |
| Release of Employee Stock Ownership Plan  (ESOP) shares                                      |       | 950                    |       | 530 |   |
| **Net cash provided by operating activities  before originations and gross sales of loans**  |       | 13,263                 |       | 9,959 |   |
| Gross sales of loans held for sale                                                           |       | 178,432                |       | 520,705 |   |
| Origination of loans held for sale                                                           |       | (178,989               | )          | (464,763 | ) |
| **Net cash provided by operating activities**                                                |       | 12,706                 |       | 65,901 |   |
| Cash Flows From Investing Activities                                                         |       |                   |       |   |   |
| Proceeds from maturities and paydowns of  investment securities available for sale           |       | 44,760                 |       | 13,120 |   |
| Proceeds from maturities and paydowns of  investment securities held to maturity             |       | 5,166                  |       | 7,430 |   |
| Proceeds from sale of investment  securities, available for sale                             |       | 28,388                 |       | — |   |
| Purchase of investment securities available  for sale                                        |       | (28,095                | )          | (35,553 | ) |
| Purchase of investment securities held to  maturity                                          |       | —                 |       | (10,374 | ) |
| Purchase of investment securities other                                                      |       | (1,327                 | )          | (1,797 | ) |
| Proceeds from sale of other real estate  owned                                               |       | 2,604                  |       | 3,206 |   |
| Loans funded, net of repayments                                                              |       | (110,028               | )          | (52,233 | ) |
| Purchases of premises and equipment                                                          |       | (8,281                 | )          | (2,057 | ) |
| **Net cash provided by (used in) investing  activities**                                     |       | (66,513                | )          | (78,258 | ) |
| Cash Flows From Financing Activities                                                         |       |                   |       |   |   |
| Net increase in demand deposits, NOW  accounts and savings accounts                          |       | 40,815                 |       | 87,849 |   |
| Net (decrease) increase in time deposits                                                     |       | (8,327                 | )          | 22,303 |   |
| Proceeds from issuances of short-term  borrowings                                            |       | 481,700                |       | 51,194 |   |
| Proceeds from issuances of long-term  borrowings                                             |       | —                 |       | 40,000 |   |
| Repayment of short-term borrowings                                                           |       | (450,502               | )          | (51,194 | ) |
| Repayment of long-term borrowings                                                            |       | (5,515                 | )          | (5,294 | ) |
| Repayment of ESOP debt                                                                       |       | (471                   | )          | (531 | ) |
| Proceeds from issuance of trust preferred  securities                                        |       | 6,186                  |       | — |   |
| Purchase of treasury stock                                                                   |       | (117                   | )          | — |   |
| Issuance of common stock for stock option  plan                                              |       | 72                     |       | — |   |
| Dividend payments                                                                            |       | (4,098                 | )          | (3,823 | ) |
| **Net cash provided by financing activities**                                                |       | 59,743                 |       | 140,504 |   |
| **Net increase in cash and cash equivalents**                                                |       | 5,936                  |       | 128,147 |   |
| Cash and cash equivalents:                                                                   |       |                   |       |   |   |
| Beginning of year                                                                            |       | 43,111                 |       | 40,979 |   |
| End of period                                                                                |       | $                      | 49,047     |   | $ | 169,126 |   |
| Supplemental Disclosures of Cash Flow  Information                                           |       |                   |       |   |   |
| Cash payments for:                                                                           |       |                   |       |   |   |
| Interest                                                                                     |       | $                      | 12,741     |   | $ | 13,492 |   |
| Income taxes                                                                                 |       | 2,562                  |       | 8,676 |   |
| Non-cash investing and financing  activities:                                                |       |                   |       |   |   |
| Transfers from loans to other real estate  owned                                             |       | 2,158                  |       | 2,872 |   |
| Change in unrealized gain on investment  securities, net of taxes                            |       | (166                   | )          | (275 | ) |

 

The accompanying notes are an integral part of these unauditedconsolidated financial statements.

 

4

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**TRINITY CAPITAL CORPORATION &SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

**Note 1.  Basis of Presentation**

 

Theaccompanying unaudited consolidated financial statements include the consolidatedbalances and results of operations of Trinity Capital Corporation (“Trinity” orthe “Company”) and its wholly owned subsidiaries: Los Alamos National Bank (the“Bank”) and Title Guaranty & Insurance Company (“Title Guaranty”),collectively referred to as the “Company.” Trinity Capital Trust I (“Trust I”), Trinity CapitalTrust II (“Trust II”) and Trinity Capital Trust III (“Trust III”),collectively referred to as the “Trusts”, which are also wholly ownedsubsidiaries of Trinity, are not consolidated in these financialstatements.  The business activities ofthe Company consist solely of the operations of its wholly ownedsubsidiaries.  All significantintercompany balances and transactions have been eliminated inconsolidation.  In the opinion of management,all adjustments (consisting only of normal recurring adjustments) necessary fora fair presentation of the financial position, results of operations and cashflows for the interim periods have been made. The results of operations for the three and nine months ended September 30,2004 are not necessarily indicative of the results to be expected for theentire fiscal year.

 

Theunaudited interim consolidated financial statements have been prepared inconformity with accounting principles generally accepted in the United Statesof America and industry practice. Certain information in footnote disclosure normally included infinancial statements prepared in accordance with accounting principlesgenerally accepted in the United States of America and industry practice hasbeen condensed or omitted pursuant to rules and regulations of the Securitiesand Exchange Commission.  These financialstatements should be read in conjunction with the consolidated financial statementsand notes thereto included in the Company’s December 31, 2003 audited financialstatements filed on Form 10-K.

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions which affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities as of the dateof the financial statements, as well as the reported amounts of income andexpenses during the reported periods. Actual results could differ from those estimates.

 

**Note 2.  Comprehensive Income**

 

Comprehensiveincome includes net income, as well as the change in net unrealized gain oninvestment securities available for sale, net of tax.  Comprehensive income was $2.3 million and $5.5million for the three month periods ended September 30, 2004 and 2003,respectively, and $7.8 million and $11.9 million for the nine month periodsended September 30, 2004 and 2003, respectively.

 

**Note 3.  Earnings Per Share Data**

 

The followingtable sets forth the computation of basic and diluted earnings per share forthe periods indicated:

 
| ** **                                                                         | ** ** | **Three Months Ended September  30,**                          | ** ** | **Nine Months Ended September  30,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                                                       | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                         | ** ** | **(Unaudited; in thousands, except share and per share data)** | ** ** |
| Net income                                                                         |       | $                                                              | 2,128      |                                 | $          | 5,807 |   | $ | 7,937 |   | $ | 12,161 |   |
| Weighted average common shares issued                                              |       | 6,856,800                                                      |       | 6,856,800                            |       | 6,856,800 |   | 6,856,800 |   |
| LESS: Weighted average treasury stock  shares                                      |       | (25,734                                                        | )          | (29,128                              | )          | (27,951 | ) | (29,128 | ) |
| LESS: Weighted average unearned Employee  Stock Ownership Plan (ESOP) stock shares |       | (99,748                                                        | )          | (144,565                             | )          | (101,582 | ) | (148,250 | ) |
| Weighted average common shares outstanding,  net                                   |       | 6,731,318                                                      |       | 6,683,107                            |       | 6,727,267 |   | 6,679,422 |   |
| Basic earnings per common share                                                    |       | $                                                              | 0.32       |                                 | $          | 0.87 |   | $ | 1.18 |   | $ | 1.82 |   |
| Weighted average dilutive shares from stock  option plan                           |       | 108,718                                                        |       | 31,134                               |       | 111,035 |   | 31,134 |   |
| Weighted average common shares outstanding  including dilutive shares              |       | 6,840,036                                                      |       | 6,714,241                            |       | 6,838,302 |   | 6,710,556 |   |
| Diluted earnings per common share                                                  |       | $                                                              | 0.31       |                                 | $          | 0.86 |   | $ | 1.16 |   | $ | 1.81 |   |

 

5

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**Note 4.  Recent Accounting Pronouncements andRegulatory Developments**

 

In December 2003 theFinancial Accounting Standards Board (the “FASB”) revised *Statement ofFinancial Accounting Standards* (“*SFAS”) No. 132, “Employers’Disclosures about Pensions and Other Postretirement Benefits.”*  The provisions of this statement do notchange the measurement and recognition provisions of previous statements, butadds disclosures about retirement plan assets, employer obligations, keyassumptions in these measurements and the measurement date(s) used to determinepensions and other postretirement benefit measurements that make up at leastthe majority of plan assets and benefit obligations.  These provisions are effective for annual andinterim financial statements for periods beginning after December 15,2003.  The adoption of this statement asof January 1, 2004 did not have a material impact onthe Company’s financial statements.

 

In December 2003, the Accounting Standards Executive Committee of theAmerican Institute of Certified Public Accountants (the “AcSEC”) issuedStatement of Position (“SOP”) 03-3, *Accounting for CertainLoans or Debt Securities Acquired in a Transfer*. The SOP iseffective for loans acquired in fiscal years beginning after December 15, 2004,with early adoption encouraged. A certain transition provision applies forcertain aspects of loans currently within the scope of Practice Bulletin 6, Amortizationof Discounts on Certain Acquired Loans. The SOP addresses accounting fordifferences between contractual cash flows and cash flows expected to becollected from an investor’s initial investment in loans or debt securities(loans) acquired in a transfer if those differences are attributable, at leastin part, to credit quality. It includes loans acquired in business combinationsand applies to all nongovernmental entities, including not-for-profitorganizations. The SOP does not apply to loans originated by the entity.  Adoption of this SOP is not expected to havea material impact on the Company’s financial statements.

 

In March, 2004 the Securities and Exchange Commission (the “SEC”)issued *Staff Accounting Bulletin (“SAB”) 105, “Applicationof Accounting Principles to Loan Commitments.”*  This SAB summarizes the views of the SECregarding the application of generally accepted accounting principles to loancommitments accounted for as derivative instruments.  Under this SAB, banks will no longer be ableto record interest rate lock commitments (IRLCs) as assets, but only record anyliabilities resulting from these IRLCs. Through March 31, 2004, the Company followed industry practice inrecording these IRLCs as assets or liabilities, depending on the net positionthe Company had on these IRLCs.  As ofApril 1, 2004, the Company has adopted this SAB.  This did not have a material effect on theCompany’s financial statements.

 

OnMarch 31, 2004, the Financial Accounting Standards Board ratified the consensusof its Emerging Issues Task Force (EITF) Issue 03-01 regarding the recognitionand measurement of other-than-temporary impairments of unrealized losses onavailable for sale debt and equity securities. On September 30, 2004, the FASB staff issued a Staff Position thatdelayed the effective date for the measurement and recognition guidance in EITFIssue 03-01.  The delay did not suspendthe requirement to recognize other-than-temporary impairments as required byexisting authoritative literature.  Adoptionof further provisions when they are effective is not expected to have amaterial impact on the Company’s financial statements.

 

On May 6, 2004, the Board of Governors of the Federal ReserveSystem issued a Notice of Proposed Rulemaking in which it proposed to allow thecontinued inclusion of trust preferred securities in the tier 1 capital ofbank holding companies, subject to stricter standards.  The Federal Reserve is proposing to limit theaggregate amount of a bank holding company’s cumulative perpetual preferredstock, trust preferred securities and other minority interests to 25% ofthe company’s core capital elements, net of goodwill.  Current regulations do not require thededuction of goodwill.  The proposalalso provides that amounts of qualifying trust preferred securities and certainminority interests in excess of the 25% limit may be included in tier 2 capitalbut would be limited, together with subordinated debt and limited-lifepreferred stock, to 50% of tier 1 capital. The proposal provides a three-year transition period for bankholding companies to meet these quantitative limitations.  At this time, this proposed rule, if adopted,will have no material effect on the Company.

 

On June 17, 2004, the SEC issued a Proposed Rule in which it describedthe parameters under which banks may sell securities to their customers withouthaving to register as broker-dealers with the SEC in accordance with Title IIof the Gramm-Leach-Bliley Act of 1999. The proposal, which is designated as Regulation B, clarifies, amongother things: (i) the limitations on the amount that unregistered bankemployees may be compensated for making referrals in connection with athird-party brokerage arrangement; (ii) the manner by which banks may becompensated for effecting securities transactions for its customers in afiduciary capacity; and (iii) the extent to which banks may engage incertain securities transactions as a custodian. At this time, it appears as though this proposed regulation, if adopted,will have no material effect on the Company’s activities or financial results.

 

6

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**Note 5.  Short TermBorrowings**

 

The Company had Federal Home Loan Bank advances withmaturities of less than one year of $40.6 million as of September 30, 2004.  As of December 31, 2003, the Company hadFederal Home Loan Bank advances with maturities of less than one year of $5.0million and federal funds purchased from other financial institutions of $4.4million.  As of September 30, 2004, theadvances had fixed interest rates ranging from 1.96% to 2.16%.

 

**Note 6.  Long TermBorrowings**

 

TheCompany had Federal Home Loan Bank advances with maturity dates greater thanone year of $61.9 million and $67.4 million as of September 30, 2004 andDecember 31, 2003, respectively.  As of September30, 2004, the advances have fixed interest rates ranging from 3.22% to 6.34%.

 

**Note 7.  Junior Subordinated Debt Owed toUnconsolidated Trusts**

 

The following table presents details on thejunior subordinated debt owed to unconsolidated trusts as of September 30,2004:

 
| ** **                                                  | ** ** | **Trust I**                | ** ** | **Trust II**      | ** ** | **Trust III**     | ** ** |
|-------------------------------------------------------------|------------|----------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                  | ** ** | **(Dollars in thousands)** | ** ** |
| Date of issue                                               |       | March 23, 2000             |       | November 28, 2001 |       | May 11, 2004      |       |
| Amount of trust preferred securities issued                 |       | $                          | 10,000     |              | $          | 6,000             |       | $ | 6,000 |   |
| Rate on trust preferred securities                          |       | 10.875                     | %          | 9.95              | %          | 3.88% (variable   | )          |
| Maturity                                                    |       | March 8, 2030              |       | December 8, 2031  |       | September 8, 2034 |       |
| Date of first redemption                                    |       | March 8, 2010              |       | December 8, 2006  |       | September 8, 2009 |       |
| Common equity securities issued                             |       | $                          | 310        |              | $          | 186               |       | $ | 186 |   |
| Junior subordinated deferrable interest  debentures owed    |       | $                          | 10,310     |              | $          | 6,186             |       | $ | 6,186 |   |
| Rate on junior subordinated deferrable  interest debentures |       | 10.875                     | %          | 9.95              | %          | 4.49% (variable   | )          |

 

On the dates of issue indicated above, the Trusts, being Delaware statutory business trusts, issued trust preferred securities (the “trust preferred securities”) in the amount and at the rate indicated above.  These securities represent preferred beneficial interests in the assets of the Trusts.  The trust preferred securities will mature on the dates indicated, and are redeemable in whole or in part at the option of the Company at any time after the date of first redemption indicated above, with the approval of the Federal Reserve Board and in whole at any time upon the occurrence of certain events affecting their tax or regulatory capital treatment.  The Trusts also issued common equity securities to Trinity in the amounts indicated above.  The Trusts used the proceeds of the offering of the trust preferred securities to purchase junior subordinated deferrable interest debentures (the debentures) issued by the Company, which have terms substantially similar to the trust preferred securities.  The Company has the right to defer payments of interest on the debentures at any time or from time to time for a period of up to ten consecutive semi-annual periods with respect to each interest payment deferred.  Under the terms of the debentures, in the event that under certain circumstances there is an event of default under the debentures or the Company has elected to defer interest on the debentures, the Company may not, with certain exceptions, declare or pay any dividends or distributions on its capital stock or purchase or acquire any of its capital stock.  The Company used the majority of the proceeds from the sale of the debentures to add to Tier 1 capital in order to support its growth.

 

Trinity owns all of the outstanding common stock of the Trusts.  The Trusts are considered variable interest entities (VIEs) under *Financial Accounting Standards Board Interpretation (FIN) No. 46, “Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51”*, as revised.  Prior to FIN 46, VIEs were generally consolidated by an enterprise when the enterprise had a controlling financial interest through ownership of a majority of voting interest in the entity.  Under FIN 46, a VIE should be consolidated by its primary beneficiary.  The Company implemented FIN 46 during the fourth quarter of 2003.  Because Trinity is not the primary beneficiary of the Trusts, the financial statements of the Trusts are no longer included in the consolidated financial statements of the Company.  The Company’s prior financial statements have been reclassified to de-consolidate the Company’s investment in the Trusts.

 

7

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The trust preferred securities are currently included in the Tier 1 capital of Trinity for regulatory capital purposes.  However, because the Trusts are no longer a part of the Company’s financial statements, the Federal Reserve Board may in the future disallow inclusion of the trust preferred securities in Tier 1 capital for regulatory capital purposes.  The most recent proposed rule issued by the Board of the Federal Reserve System indicated that it will continue to recognize these trust preferred securities as Tier 1 capital (see discussion in Note 4, “Recent Accounting Pronouncements and Regulatory Developments”.)  However, there can be no assurance that the Federal Reserve Board will continue to permit institutions to include trust preferred securities in Tier I capital for regulatory capital purposes.  As of September 30, 2004, assuming the Company was not permitted to include the $22 million in trust preferred securities issued by the Trusts in its Tier 1 capital, the Company would still exceed the regulatory required minimums for capital adequacy purposes.  If the trust preferred securities were no longer permitted to be included in Tier 1 capital, the Company would also be permitted to redeem the capital securities without penalty.

 

Payments of distributions on the trust preferred securities and payments on redemption of the trust preferred securities are guaranteed by the Company on a limited basis.  The Company also entered into an agreement as to expenses and liabilities with the Trusts pursuant to which it agreed, on a subordinated basis, to pay any costs, expenses or liabilities of the Trusts other than those arising under the trust preferred securities.  The obligations of the Company under the junior subordinated debentures, the related indenture, the trust agreement establishing the Trusts, the guarantee and the agreement as to expenses and liabilities, in the aggregate, constitute a full and unconditional guarantee by the Company of the Trusts’ obligations under the trust preferred securities.

 

Issuancecosts of $615 thousand related to the trust preferred securities were deferredand are being amortized over the period until mandatory redemption of thesecurities in March 2030, December 2031 and September 2034, respectively.  During the three months ended September 30,2004 and 2003, respectively, $5 thousand and $4 thousand of these issuancecosts were amortized.  During the ninemonths ended September 30, 2004 and 2003, respectively, $15 thousand and $14thousand of these issuance costs were amortized.  Unamortized issuance costs were $544 thousandand $481 thousand at September 30, 2004 and December 31, 2003, respectively.

 

Dividendsaccrued and unpaid to securities holders totaled $282 thousand and $270thousand on September 30, 2004 and 2003, respectively.

 

**Note 8.  Commitments, Contingencies and Off-BalanceSheet Activities**

 

*Credit-related financial instruments:*  The Companyis a party to credit-related commitments with off-balance-sheetrisk in the normal course of business to meet the financing needs of itscustomers.  These credit-relatedcommitments include commitments to extend credit, standby letters of credit andcommercial letters of credit.  Such credit-relatedcommitments involve, to varying degrees, elements of credit and interest raterisk in excess of the amount recognized in the consolidated balance sheets.

 

TheCompany’s exposure to credit loss is represented by the contractual amount ofthese credit-related commitments.  TheCompany follows the same credit policies in making credit-related commitmentsas it does for on-balance-sheet instruments.

 

At September30, 2004 and December 31, 2003, the following credit-related commitments wereoutstanding whose contract amounts represent credit risk:

 
| ** **                                 | ** ** | **Contract Amount**     | ** ** |
|--------------------------------------------|------------|-------------------------|------------|
| ** **                                 | ** ** | **September  30, 2004** | ** ** | **December  31, 2003** | ** ** |
| ** **                                 | ** ** | **(In thousands)**      | ** ** |
| Mortgage loans sold with recourse          |       | —                  |       | $ | 17 |   |
| Unfunded commitments under lines of credit |       | $                       | 157,095    |   | 130,868 |   |
| Commercial and standby letters of credit   |       | 23,850                  |       | 27,522 |   |
|                                            |            |                         |            |  |  |  |  |

 

Mortgageloans sold with recourse are loans sold to outside investors, with the Companyretaining servicing and responsibility for collection in the event of adefault.  For 2004 and 2003, no suchdefaults occurred or were expected to occur.

 

Commitmentsto extend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the contract.  Commitments generally have fixed expirationdates or other termination clauses and may require a payment of a fee.  The commitments for equity lines of creditmay expire without being drawn upon. Therefore, the total commitment amounts do not necessarily representfuture cash requirements.  The amount ofcollateral obtained, if it is deemed necessary by the Company, is based onmanagement’s credit evaluation of the customer.  Unfunded commitments under commercial lines ofcredit, revolving credit lines and overdraft protection agreements arecommitments for possible future extensions of credit to existingcustomers.  Overdraft protectionagreements are uncollateralized, but most other unfunded commitments havecollateral.  These unfunded lines ofcredit usually do not contain a specified maturity date and may not necessarilybe drawn upon to the total extent to which the Company is committed.

 

8

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Commercialand standby letters of credit are conditional credit-related commitments issuedby the Company to guarantee the performance of a customer to a thirdparty.  Those letters of credit areprimarily issued to support public and private borrowing arrangements.  Essentially all letters of credit issued haveexpiration dates within one year. The credit risk involved in issuing letters ofcredit is the same as that involved in extending loans to customers.  The Company generally holds collateralsupporting those credit-related commitments, if deemed necessary. In the eventthe customer does not perform in accordance with the terms of the agreementwith the third party, the Company would be required to fund the credit-related commitment.  The maximum potential amount of futurepayments the Company could be required to make is represented by the contractualamount shown in the summary above.  Ifthe credit-related commitment is funded, the Company would be entitled to seekrecovery from the customer.  At September30, 2004 and December 31, 2003, no amounts have been recorded asliabilities for the Company’s potential obligations under these credit-related commitments.  The fair value of these credit-related commitmentsis approximately equal to the fees collected when granting these letters ofcredit.  These fees collected were $28thousand and $30 thousand as of September 30, 2004 and December 31, 2003,respectively, and are included in “other liabilities” on the Company’s balancesheet.

 

*Concentrations of credit risk:*  Themajority of the loans, commitments to extend credit, and standby letters ofcredit have been granted to customers in Los Alamos and surroundingcommunities.  Although the Company has adiversified loan portfolio, a substantial portion of its loans are made tobusinesses and individuals associated with, or employed by, Los Alamos NationalLaboratory (“the Laboratory”).  Theability of such borrowers to honor their contracts is predominately dependentupon the continued operation and funding of the Laboratory.  Investments in securities issued by statesand political subdivisions involve governmental entities within the state ofNew Mexico.  The distribution ofcommitments to extend credit approximates the distribution of loansoutstanding.  Standby letters of creditwere granted primarily to commercial borrowers.

 

*Contingencies:*  In the normal course ofbusiness, the Company is involved in various legal proceedings.  In the opinion of management, afterconsulting with counsel, probable liabilities resulting from such proceedingswould not have a material adverse effect on the Company’s consolidatedfinancial statements.

 

**Note 9.  Pro Forma Impact of Stock-Based CompensationPlans**

 

As allowed under SFAS No. 123, *Accounting for Stock-Based Compensation*,the Company measures stock-based compensation cost in accordance with themethods prescribed in Accounting Principles Board (APB) Opinion No. 25, *Accounting for Stock Issued to Employees*. As stock options are granted at fair value, there are no charges to earningsassociated with stock options granted.  Accordingly, no compensation costhas been recognized for grants made to date.  Had compensation cost beendetermined based on the fair value method prescribed in FASB Statement No. 123,reported net income and earnings per common share would have been reduced tothe pro forma amounts shown below (dollars in thousands, except earnings pershare data):

 
| ** **                                                                                                                                    | ** ** | **Three Months Ended  September 30,**               | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2004**                                            | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                    | ** ** | **(Unaudited; in thousands except per share data)** | ** ** |
| Net income as reported                                                                                                                        |       | $                                                   | 2,128      |                                 | $          | 5,807 |   | $ | 7,937 |   | $ | 12,161 |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | 28                                                  |       | 27                                   |       | 85 |   | 81 |   |
| Pro forma net income                                                                                                                          |       | $                                                   | 2,100      |                                 | $          | 5,780 |   | $ | 7,852 |   | $ | 12,080 |   |
|                                                                                                                                          |       |                                                |       |                                 |       |   |   |   |   |
| Earnings per share:                                                                                                                           |       |                                                |       |                                 |       |   |   |   |   |
| Basic – as reported                                                                                                                      |       | $                                                   | 0.32       |                                 | $          | 0.87 |   | $ | 1.18 |   | $ | 1.82 |   |
| Basic – pro forma                                                                                                                        |       | $                                                   | 0.31       |                                 | $          | 0.86 |   | $ | 1.17 |   | $ | 1.81 |   |
|                                                                                                                                          |       |                                                |       |                                 |       |   |   |   |   |
| Diluted – as reported                                                                                                                    |       | $                                                   | 0.31       |                                 | $          | 0.86 |   | $ | 1.16 |   | $ | 1.81 |   |
| Diluted – pro forma                                                                                                                      |       | $                                                   | 0.31       |                                 | $          | 0.86 |   | $ | 1.15 |   | $ | 1.80 |   |

 

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**Item 2. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

 

*This discussion is intended to focus on certain financial informationregarding the Company and the Bank and is written to provide the reader with amore thorough understanding of its financial statements. The followingdiscussion and analysis of the Company’s financial position and results ofoperations should be read in conjunction with the information set forth inItem 3, Quantitative and Qualitative Disclosures about Market Risk and theannual audited consolidated financial statements filed on Form 10-K.*

 

**Special NoteConcerning Forward-Looking Statements**

 

ThisForm 10-Q contains, and future oral and written statements of the Companymay contain, forward-looking statements, within the meaning of such termin the Private Securities Litigation Reform Act of 1995, with respect to thefinancial condition, results of operations, plans, objectives, futureperformance and business of the Company. Forward-looking statements,which may be based upon beliefs, expectations and assumptions of our managementand on information currently available to management, are generally identifiableby the use of words such as “believe,” “expect,” “anticipate,” “plan,” “intend,”“estimate,” “may,” “will,” “would,” “could,” “should” or other similarexpressions. Additionally, all statements in this document, including forward-lookingstatements, speak only as of the date they are made, and we undertake noobligation to update any statement in light of new information or futureevents.

 

Ourability to predict results or the actual effect of future plans or strategiesis inherently uncertain. Factors which could have a material adverse effect onour operations and future prospects include, but are not limited to, thefollowing:

 

•                                          The strength of the United States economy ingeneral and the strength of the local economies in which we conduct ouroperations which may be less favorable than expected and may result in, amongother things, a deterioration in the credit quality and value of our assets.

 

•                                          The economic impact of any future terroristthreats or attacks, and the response of the United States to any such threatsand attacks.

 

•                                          The effects of, and changes in, federal, state andlocal laws, regulations and policies affecting banking, securities, insuranceand monetary and financial matters.

 

•                                          The effects of changes in interest rates(including the effects of changes in the rate of prepayments of the Company’sassets) and the policies of the Board of Governors of the Federal ReserveSystem.

 

•                                          Our ability to compete with other financialinstitutions as effectively as we currently intend due to increases in competitivepressures in the financial services sector.

 

•                                          Our inability to obtain new customers and toretain existing customers.

 

•                                          The timely development and acceptance of productsand services, including products and services offered through alternative deliverychannels such as the Internet.

 

•                                          Technological changes implemented by us and byother parties, including third party vendors, which may be more difficult ormore expensive than anticipated or which may have unforeseen consequences to usand its customers.

 

•                                          Our ability to develop and maintain secure andreliable electronic systems.

 

•                                          Our ability to retain key executives and employeesand the difficulty that we may experience in replacing key executives andemployees in an effective manner.

 

•                                          Consumer spending and saving habits which maychange in a manner that affects our business adversely.

 

•                                          Business combinations and the integration ofacquired businesses which may be more difficult or expensive than expected.

 

•                                          The costs, effects and outcomes of existing orfuture litigation.

 

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•                                          Changes in accounting policies and practices, asmay be adopted by state and federal regulatory agencies and the FinancialAccounting Standards Board.

 

•                                          Our ability to manage the risks associated withthe foregoing as well as anticipated.

 

Theserisks and uncertainties should be considered in evaluating forward-lookingstatements and undue reliance should not be placed on such statements.Additional information concerning the Company and our business, including otherfactors that could materially affect our financial results, will be included inour filings with the Securities and Exchange Commission.

 

**Critical AccountingPolicies**

 

***Allowance for Loan Losses:***  Managementbelieves the allowance for loan losses accounting policy is critical to theportrayal and understanding of our financial condition and results ofoperations.  As such, selection andapplication of this “critical accounting policy” involves judgments, estimates,and uncertainties that are susceptible to change.  In the event that different assumptions orconditions were to prevail, and depending upon the severity of such changes,the possibility of materially different financial condition or results of operationsis a reasonable likelihood.

 

Theallowance for loan losses is maintained at an amount that management believeswill be adequate to absorb probable losses on existing loans, based on anevaluation of the collectibility of loans and prior loss experience.  This evaluation also takes into considerationsuch factors as changes in the nature and volume of the loan portfolio, thevalue of underlying collateral, overall portfolio quality, review of specificproblem loans and current economic conditions that may affect the borrower’sability to pay.  While management usesthe best information available to make its evaluation, future adjustments tothe allowance may be necessary if there are significant changes in thesefactors.  In addition, as an integral partof their examination process regulatory agencies periodically review ourallowance for loan losses and may require us to make additions to the allowancebased on their evaluation of information available at the time of theirexaminations.

 

Wemaintain our allowance for loan losses at a level that management believes willbe adequate to absorb probable losses on existing loans based on an evaluationof the collectibility of loans and prior loss experience.  Three methods are used to evaluate theadequacy of the allowance for loan losses: (1) historical loss experience,based on loss experience by quality classification in the previous twelvecalendar quarters; (2) specific identification, based upon management’sassessment of loans and the probability that a charge off will occur in theupcoming quarter; and (3) loan concentrations, based on current orexpected economic factors in the geographic and industry sectors wheremanagement believes we may eventually experience some loan losses.

 

***Mortgage Servicing Right (MSR) Assets:***  Servicing residential mortgage loans for third-party investors represents a significant business activity of the Bank.  As of September 30, 2004, mortgage loans serviced for others totaled $910.2 million.  The MSRs on these loans totaled $8.4 million as of September 30, 2004.  The expected and actual rates of mortgage loan prepayments are the most significant factors driving the value of MSRs.  Increases in mortgage loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced.  In determining the initial value of the MSRs, mortgage interest rates, which are used to determine prepayment rates and discount rates, are held constant over the estimated life of the portfolio.  Fair values of the MSRs are provided by an independent third-party broker of MSRs on a monthly basis.  The values given by the broker are based upon current market conditions and assumptions, which incorporate the expected life of the loans, estimated costs to service the loans, servicing fees to be received and other factors.  MSRs are carried at the lower of the initial capitalized amount, net of accumulated amortization, or fair value.

 

The fair value of the MSRs is driven primarily by the effect current mortgage interest rates have on the likelihood borrowers will prepay the underlying mortgages by refinancing at a lower rate.  Accordingly, higher interest rates decrease the likelihood of repayment, extending the life of the MSRs and increasing the value of these assets.  Lower interest rates increase the likelihood of repayment, contracting the life of the MSRs and decreasing the value of these assets.  This can have a significant impact on our income.  In the three months ended September 30, 2004, we recognized an expense of $521 thousand due to the decrease in the values of these MSRs.  In the nine months ended September 30, 2004, we recognized income of $896 thousand due to the increase in the values of these MSRs.  For the year ending December 31, 2003, we recognized an expense of $754 thousand for these assets due to the decrease in the values of these MSRs over the year.  We can have no certainty on the direction and amount of interest rate changes looking forward, and therefore, we can have no certainty on the amount or direction of the change in valuation.

 

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**Overview**

 

The Company’s earnings declined in the third quarter of 2004 over the secondquarter of 2004, largely due to the impairment and amortization of mortgageservicing rights as interest rates decreased. Mortgage loan refinance activity (and its associated income) was muchlower in 2004 compared to 2003 (as expected), and the Company’s net incomedecreased 63.4% from the third quarter of 2003 to the third quarter of 2004, mainlydue to this factor.  The Company’sbalance sheet growth improved, growing 6.7% from December 31, 2003 to September30, 2004.  There was also a shift fromlower-yielding assets (investment securities) to higher-yielding assets (loans),increasing net interest margin on a fully tax-equivalent basis from 3.84% forthe year ended December 31, 2003 to 3.87% for the nine months ended September30, 2004.  The Company also increased itsrisk-based capital by issuing $6 million in trust preferred securities duringthis year, enabling us to continue to grow and remain well-capitalized.  Construction on the second office in Santa Fewas completed during this quarter, and it opened in August 2004.

 

**Income StatementAnalysis**

 

***Net Income-General.***  Net incomefor the three months ended September 30, 2004 was $2.1 million, compared to $5.8million for the same period of 2003. Diluted earnings per share decreased by $0.55 to $0.31 for the threemonths ended September 30, 2004 from $0.86 for the same period of 2003.  This represented a decrease in earnings pershare of 64.0%.  The decrease in netincome was primarily the result of a decrease in gains on loans sold of $2.8million due to the decline in mortgage loan refinancing activity (which managementanticipated) and an increase in the impairment and amortization of mortgageservicing rights of $3.7 million.  Theeffect of these items, net of taxes, was a decline of $4.2 million in netincome for the three months ended September 30, 2004 compared to the sameperiod in 2003.

 

Net incomefor the nine months ended September 30, 2004 was $7.9 million, compared to $12.2million for the same period of 2003. Diluted earnings per share decreased by $0.65 to $1.16 for the ninemonths ended September 30, 2004 from $1.81 for the same period of 2003.  This represented a decrease in diluted earningsper share of 35.9%.  The decrease in netincome was primarily the result of a decrease in gains on loans sold of $7.5million due to the anticipated decline in mortgage loan refinancing activity.  The effect of this item, net of taxes, was adecline in net income of approximately $4.6 for the first nine months of 2004compared to the same period in 2003.

 

Theprofitability of the Company’s operations depends primarily on its net interestincome, which is the difference between total interest earned on interestearning assets and total interest paid on interest bearing liabilities. TheCompany’s net income is affected by its provision for loan losses as well asother income and other expenses. The provision for loan losses reflects theamount thought to be adequate to cover probable credit losses in the loanportfolio. Non-interest income or other income consists of mortgage loanservicing fees, loan and other fees, service charges on deposits, gain on saleof loans, gain on sale of securities and other operating income. Other expensesinclude salaries and employee benefits, occupancy expenses, data processingexpenses, marketing, amortization and valuation of mortgage servicing rights,supplies expense and other expenses.

 

The amountof net interest income is affected by changes in the volume and mix of interestearning assets, the level of interest rates earned on those assets, the volumeand mix of interest bearing liabilities, and the level of interest rates paidon those interest bearing liabilities. The provision for loan losses isdependent on changes in the loan portfolio and management’s assessment of thecollectibility of the loan portfolio, as well as economic and marketconditions. Other income and other expenses are impacted by growth ofoperations and growth in the number of accounts through both acquisitions andcore banking business growth. Growth in operations affects other expenses as aresult of additional employees, branch facilities and promotional marketingexpense. Growth in the number of accounts affects other income includingservice fees as well as other expenses such as computer services, supplies,postage, telecommunications and other miscellaneous expenses.

 

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***Net Interest Income.***  Thefollowing tables present, for the periods indicated, the total dollar amount ofinterest income from average interest earning assets and the resultant yields,as well as the interest expense on average interest bearing liabilities, andthe resultant costs, expressed both in dollars and rates. Borrowings made bythe Company’s Employee Stock Ownership Plan (“ESOP”) to outside parties are notincluded in this analysis, as the interest expense on this borrowing is born bythe ESOP. Funding for the ESOP is recognized as part of compensation expense:

 
| ** **                                                           | ** ** | **Three Months Ended September 30,** | ** ** |
|----------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                           | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| ** **                                                           | ** ** | **Average Balance**                  | ** ** | **Interest** | ** ** | **Yield/Rate** | ** ** | **Average Balance** | ** ** | **Interest** | ** ** | **Yield/Rate** | ** ** |
| ** **                                                           | ** ** | **(Dollars in thousands)**           | ** ** |
| **Interest Earning Assets:**                                         |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Loans(1)(2)                                                          |       | $                                    | 819,202    |   | $ | 12,760 |   | 6.20 | % | $ | 724,764 |   | $ | 12,563 |   | 6.88 | % |
| Taxable investment securities                                        |       | 105,049                              |       | 761 |   | 2.88 |   | 108,993 |   | 831 |   | 3.02 |   |
| Investment securities exempt from federal  income taxes(3)           |       | 19,936                               |       | 227 |   | 4.53 |   | 14,775 |   | 220 |   | 5.91 |   |
| Federal funds sold and securities purchased  under resell agreements |       | 40                                   |       | — |   | 1.11 |   | 560 |   | 1 |   | 0.71 |   |
| Other interest bearing deposits                                      |       | 16,115                               |       | 55 |   | 1.36 |   | 42,702 |   | 99 |   | 0.92 |   |
| Investment in unconsolidated trust  subsidiaries                     |       | 682                                  |       | 15 |   | 8.75 |   | 496 |   | 17 |   | 13.60 |   |
| Total interest earning assets                                        |       | 961,024                              |       | 13,818 |   | 5.72 |   | 892,290 |   | $ | 13,731 |   | 6.11 |   |
| Non-interest earning assets                                          |       | 69,926                               |       |   |   |   |   | 118,609 |   |   |   |   |   |
| Total assets                                                         |       | $                                    | 1,030,950  |   |   |   |   |   | $ | 1,010,899 |   |   |   |   |   |
| ** **                                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| **Interest Bearing Liabilities:**                                    |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                                            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| NOW and money market deposit                                         |       | $                                    | 114,304    |   | $ | 312 |   | 1.09 | % | $ | 201,199 |   | $ | 498 |   | 0.98 | % |
| Savings deposit                                                      |       | 348,514                              |       | 923 |   | 1.05 |   | 223,044 |   | 650 |   | 1.16 |   |
| Time deposits                                                        |       | 324,895                              |       | 1,943 |   | 2.38 |   | 362,000 |   | 2,538 |   | 2.78 |   |
| Short-term borrowings                                                |       | 10,153                               |       | 51 |   | 2.00 |   | 174 |   | — |   | 2.28 |   |
| Long-term borrowings                                                 |       | 62,604                               |       | 572 |   | 3.63 |   | 69,447 |   | 614 |   | 3.51 |   |
| Junior subordinated debt owed to unconsolidated  trusts              |       | 22,682                               |       | 503 |   | 8.82 |   | 16,496 |   | 457 |   | 10.99 |   |
| Total interest bearing liabilities                                   |       | 883,152                              |       | 4,304 |   | 1.94 |   | 872,360 |   | 4,757 |   | 2.16 |   |
| Demand deposits—non-interest bearing                            |       | 51,771                               |       |   |   |   |   | 60,575 |   |   |   |   |   |
| Other non-interest bearing liabilities                               |       | 23,808                               |       |   |   |   |   | 12,917 |   |   |   |   |   |
| Stockholders’ equity, including stock owned  by ESOP            |       | 72,219                               |       |   |   |   |   | 65,047 |   |   |   |   |   |
| Total liabilities and stockholders equity                            |       | $                                    | 1,030,950  |   |   |   |   |   | $ | 1,010,899 |   |   |   |   |   |
|                                                                 |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income/interest rate Spread(4)                          |       |                                 |       | $ | 9,514 |   | 3.78 | % |   |   | $ | 8,974 |   | 3.94 | % |
|                                                                 |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net interest margin on a fully tax  equivalent basis(5)              |       |                                 |       |   |   | 3.94 | % |   |   |   |   | 3.99 | % |
|                                                                 |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net interest margin(5)                                               |       |                                 |       |   |   | 3.91 | % |   |   |   |   | 3.96 | % |

 

----

| (1)    | Includes non-accrual loans of $3.4 million  and $2.2 million for the three months ended September 30, 2004 and 2003,  respectively.                                                                           |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                          |
| (2)    | Interest income includes loan origination  fees of $896 thousand and $927 thousand for the three months ended September  30, 2004 and 2003, respectively.                                                     |
|   |                                                                                                                                                                                                          |
| (3)    | Non-taxable investment income is presented  on a fully tax equivalent basis, adjusting for federal and state exemption of  interest income and certain other permanent income tax differences.                |
|   |                                                                                                                                                                                                          |
| (4)    | Interest rate spread represents the  difference between the average yield on interest earning assets and the  average cost of interest bearing liabilities and is presented on a fully tax  equivalent basis. |
|   |                                                                                                                                                                                                          |
| (5)    | Net interest margin represents net interest  income as a percentage of average interest earning assets.                                                                                                       |

 

 

13

----

 

For the thirdquarter of 2004, net interest income on a fully tax equivalent basis increased$540 thousand (6.0%) to $9.5 million from $9.0 million for the third quarter of2003.  The increase in net interestincome resulted from a decrease in interest expense of $453 thousand (9.5%),while interest income on a fully tax equivalent basis increased $87 thousand (0.6%).  Interest expense decreased mainly due to adecrease in rate on interest bearing liabilities of 22 basis points, whichaccounted for a decrease in interest expense of $400 thousand.  Interest income on a fully tax equivalentbasis increased due to a increase in average earning assets of $68.7 million(7.7%), which accounted for a increase in interest income on a fully taxequivalent basis of $1.5 million.  Thiswas largely offset by an decrease in rate on earning assets of 39 basis points,which accounted for a decrease of $1.4 million in interest income on a fullytax equivalent basis.  The net interestmargin expressed on a fully tax equivalent basis decreased 5 basis points to 3.94%for 2004 from 3.99% for 2003.

 
| ** **                                                 | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                 | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| ** **                                                 | ** ** | **Average  Balance**                | ** ** | **Interest** | ** ** | **Yield/Rate** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Yield/Rate** | ** ** |
| ** **                                                 | ** ** | **(Dollars in thousands)**          | ** ** |
| **Interest Earning Assets:**                               |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Loans(1)(2)                                                |       | $                                   | 790,113    |   | $ | 36,654 |   | 6.20 | % | $ | 748,981 |   | $ | 37,419 |   | 6.68 | % |
| Taxable investment securities                              |       | 114,422                             |       | 2,443 |   | 2.85 |   | 105,580 |   | 2,570 |   | 3.25 |   |
| Investment securities exempt from federal  income taxes(3) |       | 20,586                              |       | 734 |   | 4.76 |   | 13,181 |   | 573 |   | 5.81 |   |
| Federal funds sold                                         |       | 40                                  |       | — |   | 0.89 |   | 546 |   | 3 |   | 0.73 |   |
| Other interest bearing deposits                            |       | 15,217                              |       | 124 |   | 1.09 |   | 30,016 |   | 232 |   | 1.03 |   |
| Investment in unconsolidated trust  subsidiaries           |       | 593                                 |       | 42 |   | 9.46 |   | 496 |   | 43 |   | 11.59 |   |
| Total interest earning assets                              |       | 940,971                             |       | 39,997 |   | 5.68 |   | 898,800 |   | 40,840 |   | 6.08 |   |
| Non-interest earning assets                                |       | 72,601                              |       |   |   |   |   | 63,540 |   |   |   |   |   |
| Total assets                                               |       | $                                   | 1,013,572  |   |   |   |   |   | $ | 962,340 |   |   |   |   |   |
| ** **                                                 |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| **Interest Bearing Liabilities:**                          |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                                  |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| NOW and money market deposit                               |       | $                                   | 140,836    |   | $ | 966 |   | 0.92 | % | $ | 193,014 |   | $ | 1,835 |   | 1.25 | % |
| Savings deposit                                            |       | 307,109                             |       | 2,275 |   | 0.99 |   | 213,098 |   | 2,375 |   | 1.47 |   |
| Time deposits                                              |       | 328,976                             |       | 5,867 |   | 2.38 |   | 351,311 |   | 7,879 |   | 2.97 |   |
| Short-term borrowings                                      |       | 11,108                              |       | 146 |   | 1.76 |   | 290 |   | 2 |   | 1.07 |   |
| Long-term borrowings                                       |       | 64,453                              |       | 1,770 |   | 3.67 |   | 37,519 |   | 1,372 |   | 3.84 |   |
| Junior subordinated debt owed to  unconsolidated trusts    |       | 19,724                              |       | 1,414 |   | 9.58 |   | 16,496 |   | 1,334 |   | 10.81 |   |
| Total interest bearing liabilities                         |       | 872,206                             |       | 12,438 |   | 1.90 |   | 811,728 |   | 14,797 |   | 2.38 |   |
| Demand deposits—non-interest bearing                  |       | 51,970                              |       |   |   |   |   | 59,341 |   |   |   |   |   |
| Other non-interest bearing  liabilities                    |       | 19,755                              |       |   |   |   |   | 4,274 |   |   |   |   |   |
| Stockholders’ equity, including stock owned  by ESOP  |       | 69,641                              |       |   |   |   |   | 62,315 |   |   |   |   |   |
| Total liabilities and stockholders equity                  |       | $                                   | 1,013,572  |   |   |   |   |   | $ | 937,658 |   |   |   |   |   |
|                                                       |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income/interest rate Spread(4)                |       |                                |       | $ | 27,559 |   | 3.77 | % |   |   | $ | 26,043 |   | 3.70 | % |
|                                                       |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Net interest margin on a fully tax  equivalent basis(5)    |       |                                |       |   |   | 3.91 | % |   |   |   |   | 3.87 | % |
|                                                       |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Net interest margin(5)                                     |       |                                |       |   |   | 3.87 | % |   |   |   |   | 3.84 | % |

 

----

| (1)    | Includes non-accrual loans of $3.3 million  and $2.5 million for the nine months ended September 30, 2004 and 2003,  respectively.                                                                            |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                          |
| (2)    | Interest income includes loan origination  fees of $2.3 million and $2.7 million for the nine months ended September 30,  2004 and 2003, respectively.                                                        |
|   |                                                                                                                                                                                                          |
| (3)    | Non-taxable investment income is presented  on a fully tax equivalent basis, adjusting for federal and state exemption of  interest income and certain other permanent income tax differences.                |
|   |                                                                                                                                                                                                          |
| (4)    | Interest rate spread represents the  difference between the average yield on interest earning assets and the  average cost of interest bearing liabilities and is presented on a fully tax  equivalent basis. |
|   |                                                                                                                                                                                                          |
| (5)    | Net interest margin represents net interest  income as a percentage of average interest earning assets.                                                                                                       |

 

14

----

 

For the ninemonths ended September 30, 2004, net interest income on a fully tax equivalentbasis increased $1.6 million (5.8%) to $27.6 million from $26.0 million for thenine months ended September 30, 2003. The increase in net interest income resulted from a decrease in interestexpense of $2.4 million (15.9%), while interest income on a fully taxequivalent basis decreased $843 thousand (2.1%).  Interest expense decreased due to a decreasein rate on interest bearing liabilities of 48 basis points, which accounted fora $3.0 million decrease.  This waspartially offset by an increase in average interest-bearing liabilities of $60.5million (7.5%), which increased interest expense by $671 thousand.  Interest income on a fully tax equivalent basisdecreased due to a decrease in the rate on interest earning assets of 40 basispoints, which accounted for a decrease of $3.2 million.  This was offset by an increase in averageearning assets of $42.2 million (4.7%), which accounted for an increase of $2.4million in interest income on a fully tax equivalent basis.  The net interest margin expressed on a fullytax equivalent basis increased 4 basis points to 3.91% for 2004 from 3.87% for2003.

 

***Volume, Mix and Rate Analysis of Net InterestIncome.***  The following tables present the extent towhich changes in volume, changes in interest rates, and changes in the interestrates times the changes in volume of interest earning assets and interestbearing liabilities have affected our interest income and interest expenseduring the periods indicated. Information is provided on changes in eachcategory due to (i) changes attributable to changes in volume (change involume times the prior period interest rate), (ii) changes attributable tochanges in interest rate (changes in rate times the prior period volume) and(iii) changes attributable to changes in rate/volume (changes in interestrate times changes in volume).  Changesattributable to the combined impact of volume and rate have been allocatedproportionally to the changes due to volume and the changes due to rate:

 
| ** **                                                 | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                 | ** ** | **2004 Compared to 2003**            | ** ** | **2004 Compared to 2003**           | ** ** |
| ** **                                                 | ** ** | **Change Due  to Volume**       | ** ** | **Change Due  to Rate**        | ** ** | **Total  Change** | ** ** | **Change Due  to Volume** | ** ** | **Change Due  to Rate** | ** ** | **Total  Change** | ** ** |
| ** **                                                 | ** ** | **(In thousands)**                   | ** ** |
| **Interest Earning Assets:**                               |       |                                 |       |                                |       |   |   |   |   |   |   |   |   |
| Loans                                                      |       | $                                    | 1,545      |                                | $          | (1,348 | ) | $ | 197 |   | $ | 1,991 |   | $ | (2,756 | ) | $ | (765 | ) |
| Taxable investment securities                              |       | (30                                  | )          | (40                                 | )          | (70 | ) | 204 |   | (331 | ) | (127 | ) |
| Investment securities exempt from federal  income taxes(1) |       | 66                                   |       | (59                                 | )          | 7 |   | 278 |   | (117 | ) | 161 |   |
| Federal funds sold                                         |       | (1                                   | )          | —                              |       | (1 | ) | (3 | ) | — |   | (3 | ) |
| Other interest bearing deposits                            |       | (79                                  | )          | 35                                  |       | (44 | ) | (120 | ) | 12 |   | (108 | ) |
| Investment in unconsolidated trust  subsidiaries           |       | 5                                    |       | (7                                  | )          | (2 | ) | 7 |   | (8 | ) | (1 | ) |
| Total increase (decrease) in interest  income              |       | 1,506                                |       | (1,419                              | )          | 87 |   | 2,357 |   | (3,200 | ) | (843 | ) |
| **Interest Bearing Liabilities:**                          |       |                                 |       |                                |       |   |   |   |   |   |   |   |   |
| NOW and money market deposit accounts                      |       | (233                                 | )          | 47                                  |       | (186 | ) | (444 | ) | (425 | ) | (869 | ) |
| Savings deposits                                           |       | 337                                  |       | (64                                 | )          | 273 |   | 813 |   | (913 | ) | (100 | ) |
| Time deposits                                              |       | (244                                 | )          | (351                                | )          | (595 | ) | (545 | ) | (1,467 | ) | (2,012 | ) |
| Short-term borrowings                                      |       | —                               |       | 51                                  |       | 51 |   | 142 |   | 2 |   | 144 |   |
| Long-term borrowings                                       |       | (62                                  | )          | 20                                  |       | (42 | ) | 463 |   | (65 | ) | 398 |   |
| Junior subordinated debt owed to unconsolidated  trusts    |       | 149                                  |       | (103                                | )          | 46 |   | 242 |   | (162 | ) | 80 |   |
| Total increase (decrease) in interest  expense             |       | (53                                  | )          | (400                                | )          | (453 | ) | 671 |   | (3,030 | ) | (2,359 | ) |
| Increase (decrease) in net interest income                 |       | $                                    | 1,559      |                                | $          | (1,019 | ) | $ | 540 |   | $ | 1,686 |   | (170 | ) | $ | 1,516 |   |
|                                                            |            |                                      |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)                                  Non-taxable investmentincome is presented on a fully tax equivalent basis, adjusting for federal andstate exemption of interest income and certain other permanent income taxdifferences.

 

15

----

 

***OtherIncome.***  Changes in other income between the threemonths ended September 30, 2004 and 2003, and between the nine months ended September30, 2004 and 2003, were as follows:

 
| ** **                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Net  difference** | ** ** | **Nine Months Ended  September 30,** | ** ** | **Net  difference** | ** ** |
|------------------------------|------------|---------------------------------------|------------|---------------------|------------|--------------------------------------|------------|---------------------|------------|
| **2004**                     | ** ** | **2003**                              | ** ** | ** **          | **2004**   | ** **                           | **2003**   |
| ** **                   | ** ** | **(In thousands)**                    | ** ** |
| Other income:                |       |                                  |       |                |       |                                 |       |                |       |   |   |   |   |
| Mortgage loan servicing fees |       | $                                     | 592        |                | $          | 594                                  |       | $                   | (2         | ) | $ | 1,751 |   | $ | 1,634 |   | $ | 117 |   |
| Loan and other fees          |       | 590                                   |       | 465                 |       | 125                                  |       | 1,829               |       | 1,291 |   | 538 |   |
| Service charges on deposits  |       | 377                                   |       | 332                 |       | 45                                   |       | 1,047               |       | 960 |   | 87 |   |
| Gain on sale of loans        |       | 374                                   |       | 3,148               |       | (2,774                               | )          | 2,373               |       | 9,871 |   | (7,498 | ) |
| Gain on sale of securities   |       | —                                |       | —              |       | —                               |       | 272                 |       | — |   | 272 |   |
| Other operating income       |       | 164                                   |       | 483                 |       | (319                                 | )          | 692                 |       | 1,331 |   | (639 | ) |
|                         |       | $                                     | 2,097      |                | $          | 5,022                                |       | $                   | (2,925     | ) | $ | 7,964 |   | $ | 15,087 |   | $ | (7,123 | ) |

 

In the third quarter of 2004,other income decreased by $2.9 million (58.2%) to $2.1 million from $5.0million in the third quarter of 2003. Gain on sale of loans decreased $2.8 million (88.1%) due to a drop inmortgage loan refinancing activity from historically high activity in the thirdquarter of 2003.  This drop inrefinancing was expected and was experienced generally in the financialservices industry.  Mortgage refinancingactivity may continue to diminish during the remainder of 2004 as many mortgageholders have already taken advantage of the low interest rates favorable forrefinancing.  Other operating incomedecreased $319 thousand (66.0%), mainly due to a decrease in title insurancepremium income of $329 thousand (69.9%) also due to the reduced mortgage loanrefinancing volume.

 

In the first nine months of2004, other income decreased by $7.1 million (47.2%) to $8.0 million from $15.1million in the first nine months of 2003. Gain on sale of loans decreased $7.5 million (76.0%) due to a drop inmortgage loan refinancing activity from historically high activity in the firstnine months of 2003.  This drop inrefinancing was expected as was experienced generally in the financial servicesindustry.  Other operating incomedecreased $639 thousand (48.0%), mainly due to a decrease in title insurancepremium income of $704 thousand (54.2%) also due to the reduced mortgage loanrefinancing volume.

 

***OtherExpenses.***  Changes in other expenses between the threemonths ended September 30, 2004 and 2003 and the nine months ended September30, 2004 and 2003 are as follows:

 
| ** **                                               | ** ** | **Three Months Ended  September 30,** | ** ** | **Net  difference** | ** ** | **Nine Months Ended  September 30,** | ** ** | **Net  difference** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------|------------|---------------------|------------|--------------------------------------|------------|---------------------|------------|
| **2004**                                                 | ** ** | **2003**                              | ** ** | ** **          | **2004**   | ** **                           | **2003**   | ** **          |
| ** **                                               | ** ** | **(In thousands)**                    | ** ** |
| Other expenses:                                          |       |                                  |       |                |       |                                 |       |                |       |   |   |   |   |
| Salaries and employee benefits                           |       | $                                     | 3,725      |                | $          | 3,984                                |       | $                   | (259       | ) | $ | 11,433 |   | $ | 11,201 |   | $ | 232 |   |
| Occupancy                                                |       | 660                                   |       | 407                 |       | 253                                  |       | 1,728               |       | 1,313 |   | 415 |   |
| Data processing                                          |       | 508                                   |       | 426                 |       | 82                                   |       | 1,442               |       | 1,075 |   | 367 |   |
| Marketing                                                |       | 433                                   |       | 318                 |       | 115                                  |       | 983                 |       | 982 |   | 1 |   |
| Amortization and valuation of mortgage  servicing rights |       | 1,230                                 |       | (2,486              | )          | 3,716                                |       | 1,120               |       | 375 |   | 745 |   |
| Supplies                                                 |       | 202                                   |       | 252                 |       | (50                                  | )          | 583                 |       | 682 |   | (99 | ) |
| Other                                                    |       | 1,051                                 |       | 1,097               |       | (46                                  | )          | 3,499               |       | 3,843 |   | (344 | ) |
|                                                     |       | $                                     | 7,809      |                | $          | 3,998                                |       | $                   | 3,811      |   | $ | 20,788 |   | $ | 19,471 |   | $ | 1,317 |   |

 

For the third quarter of 2004,other expenses increased $3.8 million (95.3%) to $7.8 million from $4.0 millionin the third quarter of 2003.  This increasewas primarily due to an increase in the mortgage servicing rights impairmentand amortization of $3.7 million (97.5%), due to a decrease in the valuation ofmortgage servicing rights that resulted from a lower interest rate environment.

 

16

----

 

For the nine months ended September 30, 2004, other expenses increased$1.3 million (6.8%) to $20.8 million from $19.5 million in the first ninemonths of 2003.  This increase wasprimarily due to an increase in the mortgage servicing rights impairment and amortizationof $745 thousand (198.7%), due to a lower interest rate environment.  Occupancy expense increased by $415 thousand(31.6%) mainly due to a decrease in rental income of $184 thousand due to theanticipated move of a tenant and an increase in repair and maintenance expensesof $130 thousand due to maintenance of the Los Alamos office.

 

***Income Taxes.***  In the thirdquarter of 2004, income tax expense decreased $2.4 million (67.4%) over the thirdquarter of 2003 to a total of $1.1 million compared to $3.5 million.  The effective tax rate decreased to 35.0% inthe third quarter of 2004, compared to 37.7% in the third quarter of 2003.  This decrease was attributable to theadjustment of deferred taxes made in the third quarter of 2004 due to temporarydifferences in loss recognition in write downs of the value of other realestate owned.

 

In the ninemonths ended September 30, 2004, income tax expense decreased $2.6 million (34.8%)over the nine months ended September 30, 2003 to a total of $4.9 million comparedto $7.5 million.  The effective tax rate wasunchanged at 38.1% in the first nine months of 2004 and 2003.

 

***BalanceSheet—General.***  Total assets at September 30, 2004 were at$1.1 billion, an increase of $67.9 million (6.7%) from December 31, 2003.  Net loans increased $106.2 million (14.5%)during 2004, which was partially offset by a decline in investments of $50.2million (28.7%).  During the same period,total liabilities increased $61.2 million (6.5%) to a total of $1.0 billion on September30, 2004, from $940.7 million on December 31, 2003.  The increase in total liabilities wasprimarily due to an increase in total deposits of $32.5 million (3.9%) and anincrease in borrowings of $25.7 million (33.4%).  Stockholders’ equity (including stock owned bythe Employee Stock Ownership Plan) increased $6.7 million (10.1%) to $72.7million on September 30, 2004 compared to $66.1 million on December 31, 2003.

 

***Investment Securities.***  Theprimary purposes of the investment portfolio are to provide a source ofearnings for liquidity management purposes, to provide collateral to pledgeagainst public deposits and to control interest rate risk. In managing theportfolio, we seek to obtain the objectives of safety of principal, liquidity,diversification and maximized return on funds. For an additional discussionwith respect to these matters, see “Liquidity” and “Capital Resources” underItem 2 and “Asset Liability Management” under Item 3 below.

 

Thefollowing tables set forth the amortized cost and fair value of our securitiesby accounting classification category and by type of security as indicated:

** **
| ** **                                                       | ** ** | **At September 30, 2004** | ** ** | **At December 31, 2003** | ** ** | **At September 30, 2003** | ** ** |
|------------------------------------------------------------------|------------|---------------------------|------------|-------------------------------|------------|---------------------------|------------|
| ** **                                                       | ** ** | **Amortized Cost**        | ** ** | **Fair Value**                | ** ** | **Amortized Cost**        | ** ** | **Fair Value** | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
| ** **                                                       | ** ** | **(In thousands)**        | ** ** |
| Securities Available for Sale:                                   |       |                      |       |                          |       |                      |       |   |   |   |   |   |   |
| U.S. Government agencies                                         |       | $                         | 47,341     |                          | $          | 47,290                    |       | $ | 94,868 |   | $ | 95,081 |   | $ | 53,296 |   | $ | 53,556 |   |
| States and political subdivisions                                |       | 2,221                     |       | 2,216                         |       | —                    |       | — |   | — |   | — |   |
| Equity securities                                                |       | 1                         |       | 6                             |       | 1                         |       | 7 |   | 1 |   | 6 |   |
| Total securities available for sale                              |       | $                         | 49,563     |                          | $          | 49,512                    |       | $ | 94,869 |   | $ | 95,088 |   | $ | 53,297 |   | $ | 53,562 |   |
|                                                             |       |                      |       |                          |       |                      |       |   |   |   |   |   |   |
| Securities Held to Maturity:                                     |       |                      |       |                          |       |                      |       |   |   |   |   |   |   |
| U.S. Government agencies                                         |       | $                         | 52,723     |                          | $          | 53,223                    |       | $ | 53,246 |   | $ | 54,541 |   | $ | 53,420 |   | $ | 54,915 |   |
| States and political subdivisions                                |       | 15,297                    |       | 15,407                        |       | 20,471                    |       | 20,638 |   | 18,917 |   | 19,113 |   |
| Total securities held to maturity                                |       | $                         | 68,020     |                          | $          | 68,630                    |       | $ | 73,717 |   | $ | 75,179 |   | $ | 72,337 |   | $ | 74,028 |   |
|                                                             |       |                      |       |                          |       |                      |       |   |   |   |   |   |   |
| Other securities:                                                |       |                      |       |                          |       |                      |       |   |   |   |   |   |   |
| Non-marketable equity securities (including  FRB and FHLB stock) |       | $                         | 6,573      |                          | $          | 6,573                     |       | $ | 5,665 |   | $ | 5,665 |   | $ | 5,640 |   | $ | 5,640 |   |
| Investment in unconsolidated trusts                              |       | 682                       |       | 682                           |       | 496                       |       | 496 |   | 496 |   | 496 |   |
| Total other securities                                           |       | $                         | 7,255      |                          | $          | 7,255                     |       | $ | 6,161 |   | $ | 6,161 |   | $ | 6,136 |   | $ | 6,136 |   |

 

17

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***Loan Portfolio.***  Thefollowing tables set forth the composition of the loan portfolio:

 
| ** ** | ** ** | **(Dollars in thousands)** | ** ** |
|------------|------------|----------------------------|------------|

 

 
| ** **                | ** ** | **At September 30, 2004**  | ** ** | **At December 31, 2003** | ** ** | **At September 30, 2003** | ** ** |
|---------------------------|------------|----------------------------|------------|--------------------------|------------|---------------------------|------------|
| ** **                | ** ** | **Amount**                 | ** ** | **Percent**              | ** ** | **Amount**                | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                | ** ** | **(Dollars in thousands)** | ** ** |
| Commercial                |       | $                          | 85,439     |                     | 10.05      | %                         | $          | 71,299 |   | 9.61 | % | $ | 68,308 |   | 9.62 | % |
| Commercial real estate    |       | 335,236                    |       | 39.45                    |       | 286,551                   |       | 38.61 |   | 274,266 |   | 38.62 |   |
| Residential real estate   |       | 261,535                    |       | 30.77                    |       | 222,282                   |       | 29.95 |   | 210,050 |   | 29.58 |   |
| Construction real estate  |       | 116,417                    |       | 13.70                    |       | 112,616                   |       | 15.18 |   | 108,353 |   | 15.26 |   |
| Installment and other     |       | 51,260                     |       | 6.03                     |       | 49,349                    |       | 6.65 |   | 49,140 |   | 6.92 |   |
| Total loans               |       | 849,887                    |       | 100.00                   |       | 742,097                   |       | 100.00 |   | 710,117 |   | 100.00 |   |
| Unearned income           |       | 1,958                      |       |                     |       | 1,574                     |       |   |   | 1,343 |   |   |   |
| Gross loans               |       | 847,929                    |       |                     |       | 740,523                   |       |   |   | 708,774 |   |   |   |
| Allowance for loan losses |       | 8,554                      |       |                     |       | 7,368                     |       |   |   | 7,346 |   |   |   |
| Net loans                 |       | $                          | 839,375    |                     |       |                      | $          | 733,155 |   |   |   | $ | 701,428 |   |   |   |

 

Total loansincreased $139.8 million (19.7%) to $849.9 million at September 30, 2004from $710.1 million at September 30, 2003. The increase was due primarilyto growth in the Company’s commercial and residential real estate loan portfoliosas the percentage levels of the categories of loans within the portfolioremained relatively constant.

 

***Asset Quality.***  Thefollowing table sets forth the amounts of non-performing loans andnon-performing assets at the dates indicated:

 
| ** **                                                    | ** ** | **At  September  30, 2004** | ** ** | **At  December  31, 2003** | ** ** | **At  September  30, 2003** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|-----------------------------|------------|
| ** **                                                    | ** ** | **(Dollars in Thousands)**  | ** ** |
| Non-accruing loans                                            |       | $                           | 3,391      |                       | $          | 3,112                       |       | $ | 2,195 |   |
| Loans 90 days or more past due, still  accruing interest |       | 12                          |       | 80                         |       | 455                         |       |
| Total non-performing loans                                    |       | 3,403                       |       | 3,192                      |       | 2,650                       |       |
| Other real estate owned                                       |       | 6,728                       |       | 7,383                      |       | 2,752                       |       |
| Other repossessed assets                                      |       | 68                          |       | 353                        |       | 236                         |       |
| Total non-performing assets                                   |       | $                           | 10,199     |                       | $          | 10,928                      |       | $ | 5,638 |   |
|                                                          |       |                        |       |                       |       |                        |       |
| Total non-performing loans to total  loans                    |       | 0.40                        | %          | 0.43                       | %          | 0.37                        | %          |
| Allowance for loan losses to non-performing  loans            |       | 251.4                       | %          | 230.83                     | %          | 277.21                      | %          |
| Total non-performing assets to total  assets                  |       | 0.95                        | %          | 1.09                       | %          | 0.53                        | %          |

 

At September30, 2004, total non-performing assets increased $4.6 million (80.9%) to $10.2million from $5.6 million at September 30, 2003 due to increases in other realestate owned of $4.0 million (144.5%). The increase in other real estate owned was primarily due to theacquisition of $5.4 million in residential construction property in December2003, which was partially offset by the sale of a $1.3 million commercial realestate property in 2004.

 

At September30, 2004, total non-performing assets decreased $729 thousand (6.7%) to $10.2million from $10.9 million at December 31, 2003 primarily due to decreases in otherreal estate owned of $655 thousand.  Thedecrease in other real estate owned was primarily due to the sale of a $1.3million commercial real estate property in 2004, which was partially offset bythe acquisition of a $899 thousand residential real estate property.

 

*Allowance for Loan Losses.*  Managementbelieves the allowance for loan losses accounting policy is critical to theportrayal and understanding of the Company’s financial condition and results ofoperations. As such, selection and application of this “critical accountingpolicy” involves judgments, estimates, and uncertainties that are susceptibleto change. In the event that different assumptions or conditions were toprevail, and depending upon the severity of such changes, the possibility ofmaterially different financial condition or results of operations is areasonable likelihood.

 

18

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Theallowance for loan losses is maintained at an amount that management believeswill be adequate to absorb probable losses on existing loans, based on anevaluation of the collectibility of loans and prior loss experience. Thisevaluation also takes into consideration such factors as changes in the natureand volume of the loan portfolio, the value of underlying collateral, overallportfolio quality, review of specific problem loans and current economicconditions that may affect the borrower’s ability to pay. While management usesthe best information available to make its evaluation, future adjustments tothe allowance may be necessary if there are significant changes in economicconditions. In addition, as an integral part of their examination processregulatory agencies periodically review the Company’s allowance for loan lossesand may require the Company to make additions to the allowance based on theirevaluation of information available at the time of their examinations.

 

Thefollowing table presents an analysis of the allowance for loan losses for theperiods presented:

 
| ** **                                     | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                     | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                     | ** ** | **(Dollars in thousands)**            | ** ** |
| Balance at beginning of period                 |       | $                                     | 8,289      |                                 | $          | 6,833 |   | $ | 7,368 |   | $ | 6,581 |   |
| Provision for loan losses                      |       | 450                                   |       | 600                                  |       | 1,650 |   | 1,800 |   |
| Total charge-offs                              |       | 308                                   |       | 260                                  |       | 603 |   | 1,277 |   |
| Total recoveries                               |       | 123                                   |       | 173                                  |       | 139 |   | 242 |   |
| Net charge-offs                                |       | 185                                   |       | 87                                   |       | 464 |   | 1,035 |   |
| Balance at end of period                       |       | $                                     | 8,554      |                                 | $          | 7,346 |   | $ | 8,554 |   | $ | 7,346 |   |
|                                           |       |                                  |       |                                 |       |   |   |   |   |
| Gross loans at end of period                   |       | $                                     | 847,929    |                                 | $          | 708,774 |   | $ | 847,929 |   | $ | 708,774 |   |
| Ratio of allowance to total loans              |       | 1.01                                  | %          | 1.03                                 | %          | 1.01 | % | 1.03 | % |
| Ratio of net charge-offs to average  loans (1) |       | 0.09                                  | %          | 0.05                                 | %          | 0.08 | % | 0.18 | % |
|                                                |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |  |

 

----

(1)                                  Net charge-offs are annualized for the purposes ofthis calculation.

 

Netcharge-offs for the three months ended September 30, 2004 totaled $185 thousand,an increase of $98 thousand (112.6%) from $87 thousand from the three monthsended September 30, 2003.  The majorityof the charge-offs were commercial loans. The provision for loan losses declined by $150 thousand (25.0%) for thethree months ended September 30, 2004 and September 30, 2003, due to management’sanalysis of current non-performing loans.

 

Netcharge-offs for the nine months ended September 30, 2004 totaled $464 thousand,a decrease of $571 thousand (55.2%) from $1.0 million from the nine monthsended September 30, 2003.  The majorityof the charge-offs were commercial, personal and residential real estate.  The provision for loan losses declined by$150 thousand (8.3%) for the nine months ended September 30, 2004 and September30, 2003, due to management’s analysis of current non-performing loans.

 

Thefollowing table sets forth the allocation of the allowance for loan losses forthe periods presented and the percentage of loans in each category to totalloans. An allocation for a loan classification is only for internal analysis ofthe adequacy of the allowance and is not an indication of expected oranticipated losses:

 
| ** **                             | ** ** | **At September 30, 2004**  | ** ** | **At December 31, 2003** | ** ** | **At September 30, 2003** | ** ** |
|----------------------------------------|------------|----------------------------|------------|--------------------------|------------|---------------------------|------------|
| ** **                             | ** ** | **Amount**                 | ** ** | **Percent**              | ** ** | **Amount**                | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                             | ** ** | **(Dollars in thousands)** | ** ** |
| Commercial                             |       | $                          | 1,998      |                     | 10.05      | %                         | $          | 2,509 |   | 9.61 | % | $ | 1,594 |   | 9.62 | % |
| Commercial and residential real estate |       | 3,363                      |       | 70.22                    |       | 3,192                     |       | 68.56 |   | 3,480 |   | 68.20 |   |
| Construction real estate               |       | 1,193                      |       | 13.70                    |       | 844                       |       | 15.18 |   | 1,152 |   | 15.26 |   |
| Installment and other                  |       | 1,978                      |       | 6.03                     |       | 799                       |       | 6.65 |   | 1,094 |   | 6.92 |   |
| Unallocated                            |       | 22                         |       | N/A                      |       | 24                        |       | N/A |   | 26 |   | N/A |   |
| Total                                  |       | $                          | 8,554      |                     | 100.00     | %                         | $          | 7,368 |   | 100.00 | % | $ | 7,346 |   | 100.00 | % |

 

----

N/A—not applicable

 

19

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Theportion of the allocation that was based upon historical loss experienceincreased by $534 thousand (23.2%) in 2004, from $2.3 million on December 31, 2003to $2.8 million on September 30, 2004. This was largely due to an increase in the allocation for installmentand other loans which increased by $915 thousand and an increase in theallocation for construction loans which increased by $431 thousand.  This was partially offset by a decrease inthe allocation for commercial loans of $802 thousand.  These changes were due to a change in thelosses we actually experienced during the nine months ended September 30, 2004.  Concentration allocation increased by $1.9million (187.5%) from $963 thousand on September 30, 2003 to $2.8 million onSeptember 30, 2004.  This was primarily dueto an increase in the allocation for consumer and other loans of $1.0 millionand an increase in the allocation for construction real estate loans of $452thousand.  These changes were due togrowth in the loan portfolio in these loan categories, increasing ourconcentrations in the specific sectors identified in our analysis.  From December 31, 2003 to September 30, 2003,the allocation for specifically identified loans increased slightly, from $325thousand to $346 thousand.  From September30, 2004 to September 30, 2003, the allocation for specifically identifiedloans decreased $104 thousand (23.1%).

 

Management anticipatescontinued growth in the loan portfolio due to a strengthened local economy, astabilized Los Alamos National Laboratory budget of over $2 billion and theexpectation of a continued increase in interest rates.  The volume of commercial real estate andconstruction loans is also anticipated to increase as the industry continues tostrengthen and the recovery in capital spending boosts production and profitsinto 2004.  Although record mortgagefinancing peaked in 2003, the housing market for new construction and resalehomes is expected to remain strong, especially in the under $500 thousandmarket, which should remain constant. Residential real estate for property worth greater than $1.5 million isexpected to be as “soft” as during the last several years.

 

Additionsto the allowance for loan losses, which are charged to earnings through theprovision for loan losses, are determined based on a variety of factors, asindicated above.  Although managementbelieves the allowance for loan losses is sufficient to cover probable lossesinherent in the loan portfolio, there can be no assurance that the allowancewill prove sufficient to cover actual future loan losses.

 

*Potential Problem Loans.*  TheCompany utilizes an internal asset classification system as a means ofreporting problem and potential problem assets. At scheduled Board of Directors meetings every quarter, a list of totaladversely classified assets is presented, showing other real estate owned,other repossessed assets, and all loans listed as “Substandard,” “Doubtful” and“Loss.”  All non-accrual loans areclassed either as “Substandard” or “Doubtful” and are thus included in totaladversely classified assets.  A separatewatch list of loans classified as “Special Mention” is also presented.  An asset is classified Substandard if it isinadequately protected by the current net worth and paying capacity of theobligor or of the collateral pledged, if any. Substandard assets include thosecharacterized by the distinct possibility that the Company will sustain someloss if the deficiencies are not corrected. Assets classified as Doubtful have all the weaknesses inherent in thoseclassified Substandard with the added characteristic that the weaknessespresent make collection or liquidation in full, on the basis of currentlyexisting facts, conditions and values, highly questionable and improbable.  Assets classified as Loss are thoseconsidered uncollectible and viewed as non-bankable assets, worthy ofcharge-off.  Assets that do not currentlyexpose the Company to sufficient risk to warrant classification in one of theaforementioned categories, but possess weaknesses that may or may not be withinthe control of the customer are deemed to be Special Mention.

 

TheCompany’s determination as to the classification of its assets and the amountof its valuation allowances is subject to review by the Bank’s primaryregulators, which can order the establishment of additional general or specificloss allowances.  The Comptroller of theCurrency, in conjunction with the other federal banking agencies, has adoptedan interagency policy statement on the allowance for loan losses.  The policy statement provides guidance forfinancial institutions on both the responsibilities of management for theassessment and establishment of adequate allowances and guidance for bankingagency examiners to use in determining the adequacy of general valuationguidelines.  Generally, the policystatement recommends that (i) institutions have effective systems andcontrols to identify, monitor and address asset quality problems;(ii) management has analyzed all significant factors that affect thecollectibility of the portfolio in a reasonable manner; and(iii) management has established acceptable allowance evaluation processesthat meet the objectives set forth in the policy statement.  Management believes it has established anadequate allowance for probable loan losses. The Company analyzes its process regularly, with modifications made ifneeded, and reports those results quarterly at Board of Directors meetings.  However, there can be no assurance that regulators,in reviewing the Company’s loan portfolio, will not request the Company tomaterially increase its allowance for loan losses at a future time.  Although management believes that adequatespecific and general loan loss allowances have been established, actual lossesare dependent upon future events and, as such, further additions to the levelof specific and general loan loss allowances may become necessary.

 

20

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Thefollowing table shows the amounts of adversely classified assets and specialmention loans as of the periods indicated:

 
| ** **                        | ** ** | **At  September  30, 2004** | ** ** | **At  December  31, 2003** | ** ** | **At  September  30, 2003** | ** ** |
|-----------------------------------|------------|-----------------------------|------------|----------------------------|------------|-----------------------------|------------|
| ** **                        | ** ** | **(Dollars in thousands)**  | ** ** |
| Loans classified as:              |       |                        |       |                       |       |                        |       |
| Substandard                       |       | $                           | 12,734     |                       | $          | 9,815                       |       | $ | 4,837 |   |
| Doubtful                          |       | 218                         |       | 180                        |       | 3                           |       |
| Total adversely classified loans  |       | 12,952                      |       | 9,995                      |       | 4,840                       |       |
| Other real estate owned           |       | 6,728                       |       | 7,383                      |       | 2,752                       |       |
| Other repossessed assets          |       | 68                          |       | 353                        |       | 236                         |       |
| Total adversely classified assets |       | $                           | 19,748     |                       | $          | 17,731                      |       | $ | 7,828 |   |
|                              |       |                        |       |                       |       |                        |       |
| Special mention loans             |       | $                           | 17,673     |                       | $          | 17,507                      |       | $ | 21,179 |   |

 

Total adversely classified assets increased $11.9million (152.3%) from September 30, 2003 to September 30, 2004.  The main reason for the increase was anincrease of $7.9 million in loans classified as substandard and an increase of$4.0 million in other real estate owned. The increase in loans classified as substandard was due to thedowngrading of two commercial borrowers, one in the retail businessconcentration and one in the Office Building / Business Property loanconcentration.  Special mention loans decreased$3.5 million (16.6%) from September 30, 2003 to September 30, 2004.

 

**Sources of Funds**

 

***Liquidity and Sources of Capital***

 

TheCompany’s cash flows are comprised of three classifications: cash flows fromoperating activities, cash flows from investing activities and cash flows fromfinancing activities. Net cash provided by operating activities was $12.7million and $65.9 million for the nine months ended September 30, 2004 and 2003,respectively.  Net cash provided byoperating activities decreased $53.2 million in the first nine months of 2004compared to the first nine months of 2003 largely due to a decline in the grosssales of loans held for sale by $342.3 million over the first nine months of2003, which was partially offset by the origination of loans held for sale thatdecreased $285.8 million in the same period. Net cash used in investing activities was $66.5 million and $78.3million for the nine months ended September 30, 2004 and 2003,respectively.  The $11.8 million decreasein cash used by investing activities was largely due to the sale of $28.1million in investment securities, and the increase of cash provided bymaturities and paydowns of securities of $29.4 million.  Cash used for the purchasing of investmentsecurities declined $18.3 million as well. This was largely offset by an increase in cash used in funding new loansof $57.8 million.  Net cash provided byfinancing activities was $59.7 million and $140.5 million for the nine monthsended September 30, 2004 and 2003, respectively.  The $80.8 million decrease in cash providedby financing activities was mainly due to a decrease in new deposit growth of $77.7million from the first nine months of 2003 compared to the first nine months of2004.

 

TheCompany expects to have available cash to meet its liquidity needs. Liquidity management is monitored by the Asset/Liability committee of the Bank,which takes into account the marketability of assets, the sources and stabilityof funding and the level of unfunded commitments.  In the event that additional short-termliquidity is needed, the Company has established relationships with severallarge regional banks to provide short-term borrowings in the form of federal fundspurchases.  The Company has borrowed, andmanagement believes that the Company could again borrow, up to$84.0 million for a short time from these banks on a collective basis.  Additionally, the Bank is a member of theFederal Home Loan Bank (“FHLB”) and has the ability to borrow from theFHLB.  As a contingency plan forsignificant funding needs, the Asset/Liability committee may also consider thesale of investment securities, selling securities under agreement torepurchase, sale of certain loans and/or the temporary curtailment of lendingactivities.

 

At September 30, 2004, the Company’s total risk-basedcapital ratio was 12.12%, the Tier 1 capital to risk-weighted assets ratio was 11.12%,and the Tier 1 capital to average assets ratio was 9.16%.  The Bank was categorized as “well-capitalized”under Federal Deposit Insurance Corporation regulations at September 30, 2004and December 31, 2003.  At December 31,2003, the Company’s total risk-based capital ratio was 11.61%, the Tier 1capital to risk-weighted assets ratio was 10.64%, and the Tier 1 capital toaverage assets ratio was 8.05%.

 

At September 30, 2004 and December 31, 2003, the Company’sbook value per common share was $10.89 and $9.86, respectively.

 

21

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**Item 3.  Quantitative and Qualitative DisclosuresAbout Market Risk**

 

**Asset LiabilityManagement**

 

TheCompany’s net interest income is subject to “interest rate risk” to the extentthat it can vary based on changes in the general level of interest rates. It isthe Company’s policy to maintain an acceptable level of interest rate risk overa range of possible changes in interest rates while remaining responsive tomarket demand for loan and deposit products. The strategy employed by the Company to manage its interest rate risk isto measure its risk using an asset/liability simulation model and adjust thematurity of securities in its investment portfolio to manage that risk.

 

Interestrate risk can also be measured by analyzing the extent to which the repricingof assets and liabilities are mismatched to create an interest sensitivity “gap”.  An asset or liability is said to be interestrate sensitive within a specific time period if it will mature or repricewithin that time period.  The interestrate sensitivity gap is defined as the difference between the amount ofinterest earning assets maturing or repricing within a specific time period andthe amount of interest bearing liabilities maturing or repricing within thatsame time period.  A gap is consideredpositive when the amount of interest rate sensitive assets exceeds the amountof interest rate sensitive liabilities. A gap is considered negative when the amount of interest rate sensitiveliabilities exceeds the amount of interest rate sensitive assets.  During a period of rising interest rates,therefore, a negative gap would tend to adversely affect net interestincome.  Conversely, during a period offalling interest rates, a negative gap position would tend to result in anincrease in net interest income.

 

Thefollowing table sets forth the amounts of interest earning assets and interestbearing liabilities outstanding at September 30, 2004, which are anticipated bythe Company, based upon certain assumptions, to reprice or mature in each ofthe future time periods shown. Except as stated below, the amount of assets andliabilities shown which reprice or mature during a particular period weredetermined based on the earlier of the term to repricing or the term torepayment of the asset or liability.  Thetable is intended to provide an approximation of the projected repricing ofassets and liabilities at September 30, 2004 on the basis of contractualmaturities and scheduled rate adjustments within a three-month period andsubsequent selected time intervals.  Theloan amounts in the table reflect principal balances expected to be reinvestedand/or repriced as a result of contractual amortization and rate adjustments onadjustable-rate loans. Loan and investment securities contractual maturitiesand amortization reflect modest prepayment assumptions.  While NOW, money market and savings depositaccounts have adjustable rates, it is assumed that the interest rates on theseaccounts will not adjust immediately to changes in other interest rates.  Therefore, the table is calculated assumingthat these accounts will reprice based upon an historical analysis of ratechanges of these particular accounts, with repricing assigned to these accountsfrom one to thirteen months.

 

Borrowingsmade by the Employee Stock Ownership Plan (ESOP) are not included below, as theCompany does not recognize interest expense on these borrowings.  The Company makes discretionary contributionsto the ESOP to service this debt, and these contributions are recognized as compensationexpense.

 

22

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| ** **                                              | ** ** | **Time to Maturity or Repricing** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------|------------|
| **As of  September 30, 2004:**                          | ** ** | **0-90 Days**                     | ** ** | **91-365 Days** | ** ** | **1-5 Years** | ** ** | **Over 5 Years** | ** ** | **Total** | ** ** |
| ** **                                              | ** ** | **(In thousands)**                | ** ** |
| **Interest Earning Assets:**                            |       |                              |       |   |   |   |   |   |   |   |   |
| Loans                                                   |       | $                                 | 405,374    |   | $ | 388,912 |   | $ | 47,258 |   | $ | 6,385 |   | $ | 847,929 |   |
| Loans held for sale                                     |       | 10,667                            |       | — |   | — |   | — |   | 10,667 |   |
| Investment securities                                   |       | 17,899                            |       | 37,815 |   | 61,398 |   | 7,675 |   | 124,787 |   |
| Securities purchased under agreements to  resell        |       | 40                                |       | — |   | — |   | — |   | 40 |   |
| Interest bearing deposits with banks                    |       | 43                                |       | — |   | — |   | — |   | 43 |   |
| Total interest earning assets                           |       | $                                 | 434,023    |   | $ | 426,727 |   | $ | 108,656 |   | $ | 14,060 |   | $ | 983,466 |   |
|                                                    |       |                              |       |   |   |   |   |   |   |   |   |
| **Interest Bearing Liabilities:**                       |       |                              |       |   |   |   |   |   |   |   |   |
| NOW and money market deposit accounts                   |       | $                                 | 77,802     |   | $ | 48,870 |   | — |   | — |   | $ | 126,672 |   |
| Savings deposits                                        |       | 139,468                           |       | 205,342 |   | 5,231 |   | — |   | 350,041 |   |
| Time deposits                                           |       | 75,855                            |       | 168,085 |   | 79,189 |   | 5,930 |   | 329,059 |   |
| Short- and long-term borrowings                         |       | 42,476                            |       | 5,746 |   | 10,728 |   | 43,533 |   | 102,483 |   |
| Junior subordinated debt owed to  unconsolidated trusts |       | 6,186                             |       | — |   | — |   | 16,496 |   | 22,682 |   |
| Total interest bearing liabilities                      |       | $                                 | 341,787    |   | $ | 428,043 |   | $ | 95,148 |   | $ | 65,959 |   | $ | 930,937 |   |
|                                                    |       |                              |       |   |   |   |   |   |   |   |   |
| Rate sensitive assets (RSA)                             |       | $                                 | 434,023    |   | $ | 860,750 |   | $ | 969,406 |   | $ | 983,466 |   | $ | 983,466 |   |
| Rate sensitive liabilities (RSL)                        |       | 341,787                           |       | 769,830 |   | 864,978 |   | 930,937 |   | 930,937 |   |
| Cumulative GAP (GAP=RSA-RSL)                            |       | 92,236                            |       | 90,920 |   | 104,428 |   | 52,529 |   | 52,529 |   |
| RSA/Total assets                                        |       | 40.39                             | %          | 80.10 | % | 90.21 | % | 91.52 | % | 91.52 | % |
| RSL/Total assets                                        |       | 31.80                             | %          | 71.64 | % | 80.49 | % | 86.63 | % | 86.63 | % |
| GAP/Total assets                                        |       | 8.59                              | %          | 8.46 | % | 9.72 | % | 4.89 | % | 4.89 | % |
| GAP/RSA                                                 |       | 21.25                             | %          | 10.56 | % | 10.77 | % | 5.34 | % | 5.34 | % |

 

Certainshortcomings are inherent in the method of analysis presented in the foregoingtable. For example, although certain assets and liabilities may have similarmaturities or periods to repricing, they may react in different degrees tochanges in market interest rates. Also, the interest rates on certain types ofassets and liabilities may fluctuate in advance of changes in market interestrates, while interest rates on other types of assets may lag behind changes inmarket rates.  Additionally, in the eventof a change in interest rates, prepayment and early withdrawal levels wouldlikely deviate significantly from those assumed in calculating the table.  Therefore, the Company does not rely solelyon a gap analysis to manage its interest rate risk, but rather it uses what itbelieves to be the more reliable simulation model relating to changes in netinterest income as set forth below.

 

Changes innet interest income between the periods below reflect changes in thecomposition of interest earning assets and interest bearing liabilities,related interest rates, repricing frequencies, and the fixed or variablecharacteristics of the interest earning assets and interest bearingliabilities.  Projections of income givenby the model are not actual predictions, but rather show our relative interestrate risk.  Actual interest income mayvary from model projections.  Based onsimulation modeling at September 30, 2004 and December 31, 2003, the Company’snet interest income would change over a one-year time period due to changes ininterest rates as follows:

 

**Change in Net Interest Income Over One YearHorizon**

 
| **Changes  in Levels of  Interest Rates** | ** ** | **At September 30, 2004**  | ** ** | **At December 31, 2003** | ** ** |
|-------------------------------------------|------------|----------------------------|------------|--------------------------|------------|
| **Dollar Change**                         | ** ** | **Percentage Change**      | ** ** | **Dollar Change**        | ** ** | **Percentage Change** |
| ** **                                | ** ** | **(Dollars in thousands)** | ** ** |
| + 2.00                                    | %          | $                          | (2,273     | )                        | (5.90      | )% | $ | (4,461 | ) | (12.17 | )% |
| + 1.00                                    |       | (720                       | )          | (1.87                    | )          | (2,207 | ) | (6.02 | ) |
| (1.00                                     | )          | (1,198                     | )          | (3.11                    | )          | (1,671 | ) | (4.56 | ) |
| (2.00                                     | )          | (1,499                     | )          | (3.89                    | )          | (3,566 | ) | (9.73 | ) |
|                                           |            |                            |            |                          |            |  |  |  |  |  |  |

 

Simulationsused by the Company assume the following:

 

1.                                       Changes in interest rates are immediate.

 

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2.                                       It is the Company’s policy that interest rateexposure due to a 2.00% interest rate rise or fall be limited to 15.0% of theCompany’s annual net interest income, as forecasted by the simulation model. Asdemonstrated by the table above, the Company’s interest rate risk exposure waswithin this policy at September 30, 2004.

 

**Item 4. Controls and Procedures.**

 

An evaluation was performed under thesupervision and with the participation of the Company’s management, includingthe Chief Executive Officer and Chief Financial Officer, of the effectivenessof the design and operation of the Company’s disclosure controls and procedures(as defined in Rule 13a-15(e) promulgated under the Securities andExchange Act of 1934, as amended) as of September 30, 2004. Based on thatevaluation, the Company’s management, including the Chief Executive Officer andChief Financial Officer, concluded that the Company’s disclosure controls andprocedures were effective. There have been no significant changes in theCompany’s internal controls or in other factors that could significantly affectinternal controls.

 

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**PART II – OTHER INFORMATION**

 

**Item 1.   LegalProceedings**

 

The majority of lawsuits theCompany are involved in are foreclosure and collection proceedings due to loandefault which arise in the normal course of business. However, because the Bankacts as a depository of funds, from time to time it is named as a defendant inlawsuits (such as garnishment proceedings) involving claims to the ownership offunds in particular accounts and in other actions arising in the normal courseof business. Management does not believe that the Company’s probable liabilityresulting from pending or threatened proceedings would have a material effecton its business, financial condition or results of operations.

 

**Item 2.  Changes in Securities****, Use of Proceeds and IssuerPurchases of Equity Securities**

 

None

 

**Item 3.  Defaults UponSenior Securities**

 

None

 

**Item 4.  Submission ofMatters to a Vote of Security Holders**

 

No matterswere submitted to a vote of security holders during the quarter endingSeptember 30, 2004.

 

**Item 5.  OtherInformation**

 

None

 

**Item6.  Exhibits**

 

(a)           Exhibits

 
| 31.1 | Certification of Chief  Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a)                                                                       |
|------|------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 | Certification of Chief  Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a)                                                                       |
| 32.1 | Certification of Chief  Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.2 | Certification of Chief  Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this registration statement to be signed on its behalf by theundersigned thereunto duly authorized.

 
| ** **             | **TRINITY CAPITAL CORPORATION** |
|------------------------|---------------------------------|
| ** **             | ** **                      |
| ** **             | ** **                      |
| Date: November 5, 2004 | By:                             | /s/ WILLIAM C. ENLOE |
|                   |                            | William C. Enloe |
|                   |                            | President and Chief Executive Officer |
|                   |                            |   |
|                   |                            |   |
| Date: November 5, 2004 | By:                             | /s/ DANIEL R. BARTHOLOMEW |
|                   |                            | Daniel R. Bartholomew |
|                   |                            | Chief  Financial Officer |

 

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